Layne Christensen (LAYN) is a leading company in the global water management, construction and drilling space. Layne provides services, most notably to government agencies, and to a lesser extent mining firms, industrials, and engineering contractors. The company recently came to the forefront of the investment community when Kian Ghazi of Hawkshaw Capital pitched the company at the most recent Value Investor Conference. Ghazi provided numerous strong and underanalyzed reasons that could make the company attractive.
However, certain negative features of the company, such as poor industry economics, and inability to generate FCF, among others, threaten the company's profitability over any horizon. Layne is a poor short because of some of the key ideas presented by Ghazi, and a lack of a short term catalyst. Consequently, individuals are likely best off not investing in Layne Christensen.
Before continuing with the analysis, examination of Ghazi's presentation linked above is recommended. It provides a concise and accurate picture of the current state of the company. Furthermore some of the upcoming analysis responds to his points, and a quick perusal will provide helpful background.
The company generates about ¾ of its revenue in its water infrastructure segment and about ¼ in its mineral exploration segment. The percentages are reversed when one looks at segment profits. Reasons why water related profits are so low include margin pressure and poor management of projects particularly in the heavy civil division. Ghazi sees an improvement in water performance as a major driver of upside, reasonable given Layne's recent poor performance, while the mineral exploration segment and the company's hard assets provide stability.
Source: Hawkshaw Capital
Additionally, Ghazi sees improved profitability and greater revenue generation as the company enters more profitable spaces such as industrial and energy, from which the company derives relatively low levels of revenue and profits in comparison to other segments and similar companies. Unfortunately, it is unlikely that the company's current segments will revert quickly, if at all, to historical margins, and barriers to entry in the energy and industrial area are also present.
The main causes of these difficulties are the extremely poor characteristics of the industry in which it operates. The customer and geographic breakdown of revenue, seen below, illustrate one of these reasons.
The dominance of government business is most concerning. While Ghazi is correct that funds for company projects are not threatened by reduced government spending because these monies come from taxes on water bills, this concept does not necessarily lead to profitability. Most government civil contracts are by law required to go to the lowest bidder, especially when the job is relatively straightforward, there are numerous companies bidding and similar projects have been previously completed. Layne states it has an edge in equipment and expertise and creates innovative technology at multiple points in its 10-K, but this advantage is largely nullified by the bidding process which is based upon lowest cost and not greatest value.
Given the downturn, there has been an overall decrease in spending in contracting on the whole. In fact the company states that, and speaks about the bidding process in its most recent 10-K:
Many of our customers, especially federal, state and local governmental agencies (which make up the majority of our customers in our Water Infrastructure Group) competitively bid for their contracts. Since the recessionary economic environment that began in 2008, governmental agencies have reduced the number of new projects that they have started and the bidding for those projects has become increasingly competitive. In addition, prices for negotiated contracts have also been negatively impacted. Our customers may also demand lower pricing as a condition of continuing our services. We expect to see an increase in the number of competitors as other companies that do not normally operate in our markets enter seeking contracts to keep their resources employed.
While the company has "made operational and overhead changes to curtail the losses, including terminating certain project managers, reducing administrative staff and changing our bidding practices" in the heavy civil area which should bring its margins up, the rise in competitors will only push margins lower. The number of competitors in the industry is likely to remain elevated for some time, because the significant amount of capital prevents these companies from being nimble. Even if the overall contracting market improves, allowing competitors to switch industries, future lean periods will attract inordinate competition due to lack of barriers to entry. Layne states that "there are no proprietary technologies or other significant factors, which prevent other firms from entering these local or regional markets or from consolidating into larger companies more comparable in size to us," about its water resources division, and makes similar statements about all its other lines of business in describing competition. Competition, lack of barriers to entry and public bidding will prevent the company from achieving oversize profits in water infrastructure over the long run.
In addition to the public nature of Layne's contracts, the structure of Layne's contracts also results in poor industry economics, as "the majority of such contracts are awarded on a fixed price basis." Fixed contracts are used for projects that have been completed before and costs are relatively predictable. Fixed contracts are favored by owners because it places overrun risk on contractors and brings down their cost when there are numerous bidders. From the contractor side, this fixed price generally caps their margin, which is determined by number of competitors, only allows them to make unforeseen profits when the owner makes an error in estimation that result in expensive modifications, and exposes them to loses if they manage the project poorly. This bidding process compares starkly and unfavorably to that of a company such as Lockheed Martin (LMT) which procures many of its contracts on a fixed price plus incentive, cost reimbursable or time and materials. These contracts prevent downside from overrun and even achieve outsized profits through strong performance. The fixed contract structure creates an asymmetrical situation in that the already lower margin is much more likely to decrease than increase. This is actually the continuation of the trend as seen by the progression of Layne's quarterly gross margin over the past 10 years:
This indicates that the recent decline in margins is not simply the result of a few bad contracts in the heavy civil area or the temporary forces of a more competitive recessionary environment. Rather this is a long term trend that squeezes profits from businesses until they are operating at cost.
Even if the company were lucky enough to return margins to higher past levels, the company's inability to generate free cash flow, largely resulting from large capital expenditures, prevents long term profitability from the company. The following chart of the company's quarterly FCF since January 31st 2003 is very telling:
Examination of earnings over a long period of time is important because of the volatility of the company's earnings. There can be earnings shocks due a slow spell of building, a major contract, timing of payments and seasonal issues. Examination over a longer horizon smooths these results and provides a more accurate picture, which in this case is quite negative. The sum of these quarterly amounts is -$39MM, and if one grows the FCF at 10% per year, the sum grows to -$50MM. Although past results do not predict future results, the company must make a major change, beyond just firing managers in the heavy civil division, in its operations to reverse this trend. The continuation of large capital expenditures will likely prevent this trend from reversing.
The company's yearly capital expenditures over the past 12 years, and net income over the past 10 years can be seen below.
Sources: ycharts.com; LAYN 10-K
Backing out a growth rate for net income is difficult at best because of the negative and negligible values in the beginning and ending periods. From 2006 to 2011 the company grew net income at 15.4%. Depending upon the starting between 2001 and 2006, CAPEX for the company has grown at a 6.3% to 20.2% CAGR. Furthermore, CAPEX is greater than net income at all periods and has consistently grown unlike net income. Large CAPEX could be acceptable if the company were either young, or part of a rapidly growing industry requiring, both of which require up front CAPEX. Neither of these situations applies. Worse, the primary focus of the company's capital expenditures is on maintenance, and not projects with strong rates of return, illustrated by the company's description of recent CAPEX.
The Company's capital expenditures of $70,826,000 for fiscal 2012 were split between $66,952,000 to maintain and upgrade its equipment and facilities and $3,874,000 toward the Company's unconventional natural gas exploration and production... The equipment and facilities spending in fiscal 2012 included $9,667,000 to purchase and prepare our new facility in California, completion of second rig for the Florida injection well market and purchase of rigs to support geoconstruction projects.
80% of the company's CAPEX went capital already in existence, a terrible figure given the company's relatively large CAPEX levels. Large CAPEX will likely continue due to the nature of the company's services. The company's capital operates in hazardous environments, involves intricate parts, and often generates significant forces that damage machinery. This explains why the company's Depreciation charge is currently $53MM, which represents almost 20% of its property and equipment ($277MM) on its balance sheet. This reflects an average equipment life of slightly over 5 years, which indicates the constant need for new equipment. The company has little goodwill to generate excess returns, indicating that the technological advantage the company claims is only due to large CAPEX which is expensive. As long as the company remains in this industry, capital expenditures will remain an insurmountable headwind to profitability.
Even if the company were to return to historical margins the company is not particularly attractive at its current price. Data on key company metrics can be seen below:
Source: LAYN 10-K
The statistics above remove the loss of earnings from impairments, and pretax earnings are actually higher than they were in 2011, at approximately $51MM. an EV/EBIT ratio of 8.79 is not expensive but not cheap either. The EV/EBITDA ratio looks intriguing but it is the result of large D&A addbacks and exclusion of CAPEX which is greater than the income before taxes. Additionally, a company like this deserves cheap valuations given the inconsistent revenue and poor industry dynamics.
Additionally, Ghazi's less aggressive bull case relies on a premium valuation for the company:
Source: Hawkshaw Capital
Also the above estimate, which assumes that heavy civil returns to historical 4% margins from -8%, rest of water margins remains flat, and new energy/industrial water generates 10% margins, values the company on normalized earnings and not on FCF. This is a mistake given the company's significant capital expenditures. One can also extract from the data above that Ghazi is applying a P/FCF multiple of >30 to the stock, with assumptions such as reversion to historical water margins that are unlikely.
Ghazi's slide also illustrates optimism towards energy and industrial margins, which may be too great. 10% is on the lower side of what Ghazi's research found. However, the company would be a new entrant into this industry. In order to typically get contracts in the private industry, you must either have relationships or significant technical expertise accompanied by a track record for these projects. Many owners will simply not even speak with a company which has not performed similar work. Layne has neither of these qualifications. The only way to enter the industry would be through significantly undercutting competitors to establish a presence, and 10% margins may be aggressive.
Ghazi does make a very strong point about the company trading at or above its tangible book value summarized by the following slide.
Source: Hawkshaw Capital
This is a very sound argument as otherwise the company could simply liquidate its hard assets and profit if it trades below tangible book. However, there may be the implicit argument that the company can not drop much lower than its price because of this floor. Over time, however this is untrue. If the company generates negative free cash flow, then by construction the company's tangible book value must decline. Given the upcoming headwinds described here and in the company's 10K, this floor could fall in the future, negating the downside protection.
Nonetheless, Layne does not present a particularly attractive short now as pointed out by Ghazi. While tangible book could fall in the coming quarters, it is unlikely to fall significantly and consistently over the long run, because the company can simply stop contracting providing a long cap on losses. Even though the water segment may remain weaker than Ghazi predicts, the company's mineral exploration has performed extremely well and is well positioned for future growth because it operates in the early stages, exploratory and definitional, of mining. This segment helps other mining companies determine the potential of sites, implying that Layne earns revenue even if the site is a dud. Additionally, the company's energy revenue has been significantly held back by the divergence of natural gas prices from historical relative values from WTI which is likely to converge over the long run. The company has also changed its bidding process, particularly in the heavy civil which should at least prevent the losses seen recently. Finally, the weaknesses of the company are generally gradual and there are not readily apparent catalysts to drive the price down, which is needed given the cost of borrowing shares.
The strength of Layne Christensen appears to be overstated most notably because of poor industry characteristics and the company's perpetual inability to generate cash for investors. The structure of the projects Layne bids inherently cause margin deterioration; recent weaknesses from the recession, which is likely to continue due to the lack of barriers to entry, compounds this problem. These poor industry characteristics manifest themselves in the company's large capital expenditures and the company's inability to generate bottom line growth. Yet in spite of these shortcomings, the company is not trading at a deep discount to operating earnings even after adding back losses from impairments. At this point, Layne Christensen constitutes a poor investment.
Additional disclosure: Author is an engineer working in a federal agency. Author works in areas different than those covered by LAYN and has had and will have no interaction with LAYN.