CECO Environmental: Busting Dust

| About: CECO Environmental (CECE)

One company’s pain is another’s pleasure. And so far — until the dustup last week — it’s been one delightful year for investors in CECO Environmental Corp. (Nasdaq: CECE).

As U.S. Environmental Protection Agency standards have expanded this year, so has the value of CECO, which provides equipment and expertise to help meet the new clean-air regulations. In the past 52 weeks, CECO shares have rallied from a low last August at $7.25 to a high of $18.14 this March. Share prices then leveled off before falling last week like a slip joint with a faulty band iron clamp. CECO settled Friday at $11.39, bouncing from an intraday low of $10.59.

General market credit and funding concerns — and CECO’s own vulnerability to debt —were behind last week’s rout. But before that, the share gains in CECO were powered by surging revenues and income as cleaner air demands by EPA and the U.S. Occupational Safety and Health Administration brought in a flood of business.

Based in Cincinnati, Ohio, the $131-million-dollar company’s main job is to provide air pollution control products and services. The group engineers and installs systems to take care of air contamination from any offending industry, including aerospace, metalworking, paper plants, food makers, chemical sites, and automotive manufacturers.

CECO’s strategy: instead of enforcing the CECO brand, the vertically integrated company acquires complementary businesses and leaves them to their own names, brands and specialties. It has gathered a growing family of diverse yet related companies, all committed to freshening the air.

There’s a lot to keep them busy. In CECO’s hometown just last week, the Ohio EPA was scheduled to hold a public meeting on how to get the Cincinnati area fully into compliance with federal ozone standards. The Ohio EPA’s draft plan includes a call for cleaner paints and architectural coatings, and lower emissions from coal-burning power plants. The state also has replaced a vehicle emissions testing program with a cleaner gasoline and controls on auto body paint shops and solvents used at companies with degreasing operations.

There was a similar hearing set for the Cleveland-Akron area. The Clean Air Act gives states three years to submit a plan outlining how certain areas afoul of federal standards will be cleaned up. Cleveland-Akron must meet the standard by mid-June 2010.

Ohio is certainly not hogging all the bad air. The EPA pegs the cost of meeting its revised air quality standards for particle pollution at $5.4 billion by 2020, including the costs of purchasing and installing controls for reducing pollution. (Health benefits are estimated at $9 billion to $76 billion.)

CECO Environmental, with its eight subsidiaries, takes on these standards as a full-service air quality controller. How about a thermal oxidation control system? Industrial air quality ventilation? Fiber bed filtration? High-temperature baghouse filter fabrics? On-site air quality monitoring? CECO designs ‘em, makes ‘em, installs ‘em and rakes in profits.

Operating income in the first quarter ended March 31 increased 258% to $2.5 million, from $696,000 in the year-ago period. Earnings soared, too, ending at $0.08 per share, compared to a loss of $0.07. Orders booked increased 84% to $66.2 million.

Sales for quarter were $43.5 million, up 78.3% from the same quarter in 2006, in part because equipment sales increased as the ethanol industry expanded. Revenue also notably came from H.M. White, a subsidiary integrated into CECO in 2006, and from Effox, Inc, which makes dampers and expansion joints for use in the power industry. Effox, purchased by CECO in late February, increases CECO’s exposure in the power and utilities industries, where product margins are likely higher than in other segments.

But even clean living can’t get out all the flaws. In CECO‘s case expenses tied to business expansion and a highly leveraged debt position raise doubts about upside potential.

William Gregozeski, an analyst at Capstone Investments, presciently lowered his rating on CECO to a hold from a strong buy in a research note May 11. Citing higher SG&A expenses and a higher tax rate in 2007, among other things, Gregozeski put a price target on shares of $11.50. That price is 21 times his forward twelve month earnings estimate of $0.53 per diluted share. CECO’s P/E at the time of his note was near 32.

CECO admits to growing pains. In its annual report, the company said it has “experienced rapid growth, which may be difficult to sustain and which has placed significant demands on our accounting systems and other operational, administrative and financial resources.”

The company is planning to upgrade its accounting and operating software systems within the next year and a half, and may need to improve other internal systems and hire additional staff. These efforts may mean significant capital expenditures or large expenses, and could divert attention from core business operations, adversely affecting financial performance, CECO said.

CECO’s long-term debt is 104% of equity, and its loans are secured by substantially all of its assets, Gregozeski said. This may make it difficult to obtain additional debt financing on acceptable terms. It also leaves CECO exposed to wider credit concerns.

The company has guided analysts to expect 2007 sales between $200 million to $210 million and EBITDA between $10.5 million and $11.5 million. These numbers are a sharp increase from 2006 sales of $135.4 million and EBITDA of $7.2 million. Still, this guidance “seems to be extraordinarily low and should be viewed as a worst case scenario,” said Gregozeski.

Despite his hold rating, he did note that “CECO has a robust pipeline of contracts which could drive sales and earnings higher than our estimates.” Other positives: No industry has accounted for 20% of CECO’s sales, although automotive likely will this year. CECO’s competition also mainly comes from small, regional companies with a narrower service focus; CECO is the only vertically integrated provider.

Depending on the pace of expansion in the ethanol industry and the enforcement of new air regulations, CECO’s happy days are likely to return. But for now, managing expenses, debt concerns and general market indigestion are forcing the company to take a breather of its own.