Will 2016 Turn Fortunes For Quanta Services?

| About: Quanta Services (PWR)

Summary

Quanta Services expects an appreciable recovery in both electric power and oil and gas segments because of strong backlog of orders that will be executed in 2016.

Additionally, the company has relatively strong capability to pass on the impact of volatile operating costs to its consumers, as corroborated by the low volatility in its operating profit margins.

Based on this thesis, the stock is currently trading at 43% discount and deserves a Buy recommendation.

Quanta Services Inc (NYSE:PWR) is a provider of specialty contracting services, offering infrastructure solutions primarily to the electric power, and natural gas and oil pipeline industries. The company's services include the design, installation, upgrade, repair and maintenance of infrastructure within each of the industries the company serves, such as electric power transmission and distribution networks, etc. It operates in two segments: electric power infrastructure services, and oil and gas infrastructure services.

Quanta reported 3Q15 revenues of $1.94b (down 9.8% Y/Y) and net income from continuing operations attributable to common stock of $43.2m or $0.23 per diluted share, down 42.5% Y/Y compared to $0.40 per diluted share in 3Q14. Adjusted diluted earnings per share from continuing operations as presented in today's press release was $0.30 for the third quarter of 2015 as compared to $0.58 for the third quarter of 2014. Consolidated gross margin was 12.1% in 3Q15 as compared to 15.7% in the third quarter of 2014, primarily as a result of the negative impact of lower revenues from large electric transmission projects and main line transmission revenues, both of which typically carry higher margin. Selling, general, and administrative expenses as a percentage of revenues were 7.5% in the third quarter of 2015 as compared to 6.7% in the same period last year. This increase was primarily attributable to the decline in revenues and its negative impact on the absorption of consolidated overhead costs.

For the third quarter of 2015, operating cash flow from continuing operations provided approximately $109 million. Net capital expenditures were approximately $39 million, resulting in approximately $69 million of free cash flow as compared to negative free cash flow of approximately $14 million for the third quarter of 2014. Prior year's free cash flow was negatively impacted by the timing of projects as certain electric power transmission projects were ramping up during the three months ended September 30, 2014, which resulted in an increase in working capital requirements during the period.

For the full year 2015, Quanta's management guidance is that revenues are likely to be $7.45-7.55b and diluted EPS from continuing operations are expected to be $0.79-0.85. For 4Q15, management is expecting revenues to clock in at $1.75-1.85b and diluted EPS from continuing operations to be $0.20-0.26. These estimates include the benefit of an expected $2.2 million release of income tax contingency reserves as well as share repurchase activities through October 30, 2015

Quanta had a weak year in 2015, because of some job issues and some weather-related issues. However, management guidance regarding the outlook for 2016 is positive, where it expects that it would see an appreciable recovery in both the electric power and on the oil and gas segments, because it has a strong backlog of orders and projects in the pipeline that will be executed, particularly big transmission projects will break through and will get back to some level of normalcy seen over the last few years.

Financial Valuation:

Here is an excerpt of the company's past performance. Every metric is presented in millions of dollars, except for percentages and ratios.

PWR (USD Mil.)

CY10

CY11

CY12

CY13

CY14

Sales

3,629

4,194

5,920

6,523

7,851

Sales Growth

9%

16%

41%

10%

20%

Operating Profit

237

195

465

527

476

Operating Profit Growth

-2%

-18%

139%

13%

-10%

Operating Margin

6.53%

4.65%

7.86%

8.08%

6.06%

Net Margin

4.22%

3.16%

5.18%

6.16%

3.78%

PAT Growth

-6%

-13%

131%

31%

-26%

ROE

4.4%

3.5%

8.1%

10.0%

6.8%

Total Assets/Total Equity

1.29

1.39

1.36

1.37

1.40

CFO/Net Income

1.57

1.65

0.35

1.11

1.05

Click to enlarge

Source: Reuters

As shown in the table above, sales growth has very robust, averaging 20% per annum over CY10-14. Excluding the effect of CY12, where the company benefited immensely from record levels of emergency restoration work as it returned power to millions of end users after major hurricanes impacted the Gulf Coast and Eastern Seaboard of the United States, average annual sales growth clocks in at 14% per annum. Additionally, the company has relatively strong capability to pass on the impact of volatile operating costs to its consumers, as corroborated by the low volatility in its operating profit margins which have averaged 6.6% per annum, with a range of 4.65%-7.86% as shown in the table above.

The stability in operating profit margins has historically trickled down to the net margins as well, possibly due to the fact that the company maintains a steady capital restructure, as indicated by the stable asset/equity (leverage) ratio which has hovered closely around the 1.38x mark for the past 4 years. The low level of leverage and lack of dividend payouts has resulted had a negative effect on the company's ROE, which has not managed to move beyond 10%, as shown in the table above. Cash flow from operations has been on a downtrend, indicating greater working capital requirements - CFO/Net Income ratio has fallen from 1.57x in CY10 to 1.05x in CY14.

The table below summarizes the projections until 2020.

PWR (USD Mil.)

CY15

CY16

CY17

CY18

CY19

CY20

Sales

7,500

8,250

9,240

10,349

11,591

12,982

Sales Growth

-4%

10%

12%

12%

12%

12%

Operating Profit

309

392

398

686

768

861

Operating Profit Growth

-35%

27%

2%

72%

12%

12%

Operating Margin

4.12%

4.75%

5.00%

6.63%

6.63%

6.63%

Net Margin

5.10%

3.09%

3.25%

4.31%

4.31%

4.31%

PAT Growth

29%

-33%

18%

49%

12%

12%

ROE

8.1%

5.1%

5.7%

7.9%

8.1%

8.4%

CFO/Net Income

1.21

1.34

1.34

1.34

1.34

1.34

Click to enlarge

Going forward, we have incorporated a gradual recovery in the company's revenues, in line with its historical average and management guidance. While 2015 has been a weak year for the company, we expect its earnings to improve in CY16 and over the longer term, with net margins reverting to 4.3% by CY18 from 3.0% expected in CY16. Note that CY15 earnings include the one-off impact of earnings from discontinued operations.

We have valued this stock based on Free Cash Flow to Equity (FCFE) basis, with valuation parameters presented below:

Beta

0.68

MRP

4.40%

Risk Free Rate

2.24%

Terminal Growth

2.00%

Cost of equity

5.23%

Click to enlarge

By assuming terminal FCFE growth of 2.00% and applying discounted cash flow (DCF) valuation method, the equity value comes out to be $5.89 billion, resulting in a target price of $26.81 per share, offering an impressive upside of 43.4% from the last closing price of $18.70 per share. The stock is currently trading at 16.9x CY16 earnings whereas we expect its P/E to rise to 23.1x in view of its solid recovery that is on the cards.

Conclusion:

Quanta has underperformed the market over the past 12 months, falling by 29.4% (as of 29th January closing) and underperforming the S&P 500 Index which fell by just 2.7% over the same period. The weak set of results expected for CY15 should provide an attractive opportunity for investors with a long-term view to take exposure to this stock. While the company does not pay any dividends, it may continue to generate value for its investors via its share repurchase program.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.