In 2014, we've seen a fair amount of volatility across US equity markets. The degree of uncertainty reflected by the behavior of market participants has been substantially higher than recently, and while this does generate a fair amount of negativity for stock prices, it subsequently creates excellent buying opportunities. Among other US equities, Pike Electric Corporation (PIKE) has not experienced a high level of volatility in 2014, and in fact, its beta of only 1.04 indicates that its security price is extremely stable. Operating as a smaller company within the industrial sector, PIKE is a general contractor for engineering, construction, and maintenance services corresponding to distribution and transmission power lines as well as substations. PIKE's fundamentals are strong and the keen position it holds within the industry will give it the ability to further augment its value as a company. Furthermore, current valuation metrics are highly attractive, which is a strong signal to investors that its current per share market price is significantly lower than the true valuation its operations deserve. PIKE's shares offer a solid return in the short-run, yet only give investors minimal exposure to risk. Before traders exploit this simple arbitrage opportunity, it's time for investors to take a further look at what PIKE's shares have to offer.
In 1945, PIKE was founded as a private company. Starting out, the focus of PIKE's business was quite similar to what it is today, but it's hard to say the same for its size. Prior to its IPO in 2005, the geographical footprint of its business was very small. Its operations were solely concentrated in the southeastern region of the US, which was in a desperate need for change. The first major transitions in its business did not occur until PIKE engaged in a series of acquisitions following the IPO of 2005. The transformation of its business follows the typical "acquisition-growth" story we see when new firms enter or expand across saturated markets. From 2008-2012, PIKE completed a total of five acquisitions. These acquisitions allowed PIKE to veer off from having a sole dependence on serving one region and branch out to the rest of the United States. Overall, these acquisitions served as an effective way for PIKE to utilize the capital it received at the time.
For understanding PIKE's business, it's important to recognize that even though PIKE's market cap makes it a small company by definition, the extent of its operations is not small scale. Today, PIKE's customer base consists of more than 300 investor-owned, municipal and cooperative utilities throughout the United States. Being a contractor, PIKE has the luxury of being able to profit off outsourcing services to satisfy its customer's needs, but also is capable of tailoring these services upon a customer's request. The relationships between PIKE and its customers tend to be long in duration, and in most cases, current relationships span well over two decades. As you will see, PIKE's customer base includes a handful of well-known public corporations, such as Southern Company (SO), First Solar (FSLR), Progress Energy (PGN), Duke Energy (DUK), Dominion Resources (D), AT&T (T), and the list goes on.
For simplicity in understanding the services PIKE provides to these customers, we can break it operations into two reporting segments, which include (1) construction, and (2) engineering. Historically, the majority of its revenue (roughly 80%) has been from the construction segment, so this will be the primary area of focus. In this segment, PIKE routinely provides a wide range of services, including installation, maintenance and repair of power delivery systems. The wide variety of services is a key component to PIKE's growth strategy, and with the breadth of its customer base, it's able to leverage the strong customer relationships it has to cross-sell services to new as well as existing markets. In a lot of cases, PIKE is providing more than one service, and by bundling multiple services together, it provides customers with a cost cutting tool that will help achieve the operational efficiencies they are striving for. In the end, cross-selling services strengthens PIKE's current customer relations, and does an excellent job generating business from new customers.
Once we take a look at PIKE's recent earnings, this will be much easier to understand, but PIKE's construction segment is responsible for a large portion of the variability in its revenue from quarter to quarter. On top of the regular services its construction segment provides, PIKE also provides storm restoration services. The chunk of revenue is directly correlated with the annual weather patterns across the US. Unfortunately, PIKE has no control over this revenue stream, but it has gained national recognition for its ability to cater to this niche demand. Since 2006, you'll see that PIKE has engaged in a hefty amount of restoration projects across a variety of different states. Catering to these types of services enhances the cyclical nature of its business, and in this next discussion on its earnings, you'll have a clearer understanding.
(Source: PIKE's Investor Presentation for the Fiscal 2Q14 Earnings Conference Call)
Key Take Aways From The 2Q 2014 Earnings Report
Following the closing bell Tuesday, February 4th, PIKE released its quarterly earnings report. Reporting on a nonstandard fiscal calendar, PIKE finished its second quarter of fiscal 2014 with revenue of $210.9mm and net income of $5.7mm, which translates to quarterly EPS of $0.18 on a diluted basis. On a YoY basis, both revenue and net income came out slightly lower than the top quarterly performance figures we have seen in past years. Moreover, it was not just one segment of its business that contributed to the lower revenue and net income figures. PIKE's construction and engineering segment both saw a lower level of business all around.
As you're starting to understand, PIKE's Q2 earnings report was not flattering from an investment standpoint, but on the bright side, there are several key reasons why its Q2 revenue and net income figures are lower YoY. Internally, PIKE's cost structure has not remained flat, and actually, it has fluctuated quite a bit over the last couple of quarters. Even though PIKE is not suffering with a high degree of operating leverage from an adjusting cost structure, its costs have impacted its operating profits, which can be seen through its lower EBIT margin at 5.3%. Furthermore, the changes on the expense side can also be explained by the unforeseen events that PIKE had no control over. During the winter months, there were several isolated winter storms that resulted in additional work. While operating costs were higher than expected, these storms did push operating income higher than consensus analyst has approaching the quarters end. In the recent earnings call, management explicitly made note of the impact these storms had:
"During the quarter, several small isolated winter storm events from the Gulf Coast to the upper Northeast related in a sustained level of storm response that lasted from before Thanksgiving through the calendar year-end, and as a result quite a few of a crew members were not home to celebrate the holidays with their families this year. On behalf of the entire leadership team here at Pike I would like to thank each of them for their hard work and sacrifice during the quarter. Compared to this quarter's consensus estimates both revenue and earnings exceeded the consensus average, as well as most of the range of revenue and earnings estimates. However, I would caution that these results were significantly impacted by the several Northeastern storm responses. These events resulted in higher than average storm profit due to both the location and the timing over the holidays."
Despite the changes this produced within its cost structure, PIKE's business within the construction segment would have taken an even larger hit if it was not for the $22mm in revenue it generated from unexpected storm restoration. On a YoY basis, $22mm is still 3.5x less revenue than PIKE generated from storm restoration the previous year. This goes to show that there are external factors that can heavily influence performance for any given quarter. Internally, PIKE can establish a better grasp on managing its cost structure, however, it cannot control winter storms. To back this up, historical revenue trends serve as an excellent example.
(Source: PIKE's Investor Presentation for the Fiscal 2Q14 Earnings Conference Call)
PIKE's storm restoration services are clearly the most volatile stream of revenue. The level of revenue derived form services pertaining to distribution, transmission, and substation are fairly steady, and investors should continue to see a low level of volatility in these revenue streams. Also, the engineering segment has proven to be fairly stable, and while the fluctuations in this segment's revenue levels are the highest, the changes are directly associated with the rapid expansion and growth this segment has seen. The cyclical nature of its business can be advantageous if investors play it right, but at a minimum, investors now at least have a better idea of what to expect from here on out.
PE Valuation Indicates Shares Are Cheap
PIKE's historical P/E ratio has fluctuated quite a bit, but the recent stability it has gained makes this an appropriate method for valuating its shares. As of now, PIKE trades at 15x its forward earnings. Its two year average for this ratio is 19x, which is substantially higher than both its forward and current P/E ratio. It's safe to say PIKE's common shares are undervalued on a stand alone basis. However, we need to understand where PIKE trades relative to its peer group before drawing any conclusions.
It's safe to say PIKE's common shares are undervalued on a stand alone basis. However, we need tounderstand where PIKE trades relative to its peer group beforedrawing any conclusions. Industry wide, there's quite a few firms providing services that are relatively similar in nature to PIKE's. However, the peer group chosen for this analysis has been narrowed down to firms that are similar in size, yet also aim to provide the same group of niche services. These firms include The AES Corporation (AES), Ameresco (AMRC), EMCOR Group (EME), and Quanta Services (PWR).
Modeling The True Discount
In order to provide investors with a fair value estimate of what PIKE's shares are truly worth, I have modeled a scenario that uses basic DCF techniques to approximate the true intrinsic value of PIKE's common stock. To start, the model uses FCF projections along with its capital structure to estimate the value of operations, and then accounts for the appropriate balance sheet items that stand between the value of operations and the implied value of its equity. As far as data goes, there are two key assumptions in addition to PIKE's FCF that allow us to project its intrinsic value of operations, and these include, the WACC and a perpetual growth. While these inputs are essential to the accuracy of this model, they are also subject to a large amount of variability. Therefore, I have modeled its equity value in two scenarios that factor in different levels of FCF. The first model assumes PIKE's year end FCF figure will be no higher than its current TTM FCF figure.
The final output of the model above produced a year end share price estimate of $17.80, which implies an upside of nearly 80% from its market value today. While this may seem unrealistic at first, it's important to note that the high level of debt on its balance sheet has been subtracted from the value of operations, and the correct cost component has been included in its WACC to account for its high cost of debt. The assumptions in the second scenario below are fairly similar, but more optimistic. The estimated FCF figure in this model is 5% higher and is designed to account for slightly higher OCF in the latter part of the year. However, you will see the final output does not deviate far from the previous model.
The intrinsic share value estimate in this model is just shy of being 100% higher than today's market price. Conclusively, both scenarios suggest the fair value of PIKE's common shares is between 80-100% higher than its current market valuation.
Pike's P/FCF<15 and PEG<1 Reinforce The Discount Exists
To supplement the PE valuation and DCF models shown above, here are two additional valuation metrics that provide strong evidence reinforcing the fact its shares are undervalued. The P/FCF and PEG ratio are two fairly common valuation metrics, but when analyzed together, these ratios can be a useful tool for investors. For instance, a P/FCF and PEG ratio above 15 and 1, respectively, is a sound indication that a stock is overvalued. However, this can be looked at two ways. So if you reverse the constraints, you can determine if a stock in undervalued. Let's take a look at PIKE's P/FCF and PEG ratios:
Institutions Have Caught On, But Pike Continues To Trade Under The Radar
Initially, it may seem that a portion of this discount is due to the fact PIKE receives little attention in the market place from investors; however, this is not the case. Nearly 87% of PIKE's common shares outstanding are owned by institutional investors, which does not come as a surprise given the amount of sell-side analyst coverage it receives. In total, there are seven analysts providing revolving coverage on this stock at handful of institutions and specialized research firms, including Avondale Partners, BB&T Capital Markets, FBR Capital Markets, Janney Montgomery Scott, Jefferies, KeyBlanc Capital Markets, as well as Stifel Nicolaus. Based off the estimates set fourth by the firms above, the median price target lies right around $13.25, which equates to an implied upside of 33%.
Clearly, there are not a whole of individual investors who own this security. Holdings among institutions, hedge funds, and asset management firms account for the vast majority of its shares, but that does not obliterate the fact this company continues to trade under the radar. The discount gap between market and fair value, make PIKE a feasible investment, and with decline its stock price has seen over the last four months, the likelihood of an institutional sell off is extremely low.
Dealing With Balance Sheet Risk
PIKE's Q2 earnings may have came as a surprise to many analysts, but let's face it, PIKE has a lot to accomplish before we see revenue and EBIT bounce back to its all time highs. Moreover, its valuation continues to be attractive when pricing in current performance and the outlook for 2014 is currently better than predicted. Therefore, the risks in this discussion are not to be a deterrent to current or prospective investors, but simply items that investors need to bear in mind moving forward.
First, we have the risk investors receive via PIKE's balance sheet. As we saw earlier, PIKE's financial strength is strong, and although it's likely to remain this way for the rest of 2014, it's critical that investors take note of its capital structure. Particularly, PIKE's level of debt with respect to the other mediums it uses to finance its operations. In just the last two years, we've seen a strong increase in PIKE's D/E ratio.
Prior to 2012, the level of long-term debt outstanding remained pretty consistent, but as capital adequacy became an issue, you can clearly see where PIKE's operations expressed the need for additional funding. PIKE ended this recent quarter with $220.5mm in long-term debt, which is just about 2.8x less its total assets. Generally speaking, all the prospective investments in my book are typically firms with a very small amount of debt relative to their size as well as what the average peer in the industry likes to hold. However, there are a couple of circumstances in which I will allow room for leeway. For instance, if a firm's valuation is extremely attractive and/or its operating profits are consistently greater than the interest expense obligations at hand, it has earned a second look. Since we already know PIKE is heavily undervalued, it's a matter of understanding whether or not it will have any issue covering upcoming interest expenses. The interest coverage ratio is the best way to quantify this, and can be computed by simply dividing EBIT by the interest expense for the same period of interest. At the end of Q2 2014, PIKE's interest coverage ratio was approximately 3.6x, which in other words is telling us that it's capable of paying the interest expense more than 3x. Obviously, the threshold for this ratio is 1, but if it ever declines below 1.5, investors will need to routinely monitor it. Also, the fact this ratio is not overly high suggests PIKE is utilizing a sufficient amount of leverage, and is not neglecting any potential opportunities it may have to magnify its earnings. Conclusively, PIKE engages in a high level of debt financing, but with an operating margin high enough to cover its obligations, the risk from this angle is minimal.
The Bottom Line
The risk to reward opportunity at stake is quite attractive. PIKE's shares are extremely undervalued and its stock still has yet to receive the market attention it deserves. Its recent earnings came out better than expected, but current investors still have not been rewarded. The outlook for the construction services segment of its business is looking good for 2014, which will enhance the intrinsic value of its equity and certainly help narrow this gap between market and fair value in a direction that's favorable for shareholders. Conclusively, now is an excellent time to initiate a position while PIKE continues to trade at such a low valuation.