Ecology and Environment (NASDAQ:EEI) is a global company with over 20 years experience in international work (international revenues account for 15% of sales). The Company has partners in over 30 countries and has completed over 25,000 major environmental assignments in over 67 countries worldwide. The Company also has extensive experience working with environmental development contracts funded by international lending institutions. International revenues have accounted for approximately 15% of EEI’s annual revenues.
The environmental consulting industry is a highly fragmented $9.9 billion industry with the top four companies estimated to command just 25% of total industry revenue according to IBIS. Chart I illustrates the historical and projected growth for the industry.
Focus on global health, environmental, and energy issues are becoming increasingly important topics for governments and corporations. Leading companies such as General Electric have taken a stand on the need to establish controls to reverse the deterioration in the environment and reign in climate change while others such as Wal-Mart and Applied Micro Devices have renovated certain facilities to utilize alternative energy sources. Some companies recognize the need for environmental changes while others have been compelled into action due to new laws. For example, the EPA issued new rules for air quality under the Clean Air Act's New Source Review which was rolled out across states in February 2003. These regulations mandates that any operator that expands or makes major changes to existing plants must install modern pollution controls if changes are expected to increase emission levels.
Valuation: EEI’s valuation on both an absolute and relative value basis is extremely attractive given the secular growth trends in the overall industry. EEI generates roughly $7.0-$7.5MM in EBITDA and maintenance capex has generally been about $1.0-2.0MM per year resulting in annual free cash flow of $5.0-$6.0MM. Working capital needs are not an issue so with a market cap of just $45MM or so, EEI trades at just 9.0x cash flow if not less. On an EV/EBITDA basis, EEI is valued at just under 5.0x further demonstrating how cheap the Company is.
On a P/E basis, EEI is valued at 17.7x 2006 EPS. This figure understates EPS, however, due to the minority interest resulting from the excellent performance of its Walsh Environmental subsidiary as well other noise from one-time items. Looking towards the current fiscal year, EEI could generate $0.71 in diluted EPS resulting in a forward P/E multiple of just 15.8x EPS if not lower. Further, EEI maintains $3.31 in net cash per diluted share. Stripping that cash out of its current value results in a share price of approximately $7.94, which would value EEI at just 11.1x a reasonable 2007 EPS estimate.
While there are no direct public comparables, there are a handful of companies that operate in the environmental consulting/engineering arena. Table IV presents these companies and their valuation multiples, illustrating that EEI is undervalued on a relative valuation basis as well. Using the mean and median figures for the entire peer set, Company shares could reasonably be valued at $15.00 to $26.00 per share. This valuation range is further supported by DCF analysis using both perpetual growth rates as well as EBITDA exit multiples for terminal values. There have also been some recent acquisitions in this industry, most notably URS’ acquisition of Washington Group (“WNG”) for $2.6B which translates into 15.0x EV/EBITDA and 0.7x EV/Revenue. WNG specializes in the energy market, specifically nuclear. In comparison, EEI boasts a strong alternative energy practice with specialty in LNG, clean coal, nuclear, and wind energy. Given EEI’s absolute and relative valuation, along with its high return metrics (ROIC in excess of 15% with potential to exceed 20% in the coming years), EEI appears to be an incredible bargain.
Insider Ownership: Insiders own 29.6% o the Company’s outstanding shares with founder, CEO, and President Gerhard Neumaier owning 8.8%, founder and Vice President Frank Silvestro owning 6.7%, founder and Vice President Gerald Strobel owning 5.1%, and founder Ronald Frank owning 4.9%.
Trend to Higher Margin Work: Recent historical performance has been choppy due to the performance of the Company’s Analytical Lab Services division. This segment produced $5.8MM in revenues in 2004 and about $2.0MM in revenues in 2005 before being discontinued by EEI due to performance issues. Eliminating this segment reduced revenues but enhanced profitability. Further, the Company is quite different from some of the comparables listed in Table IV because it has moved away from government work such as EPA contracts and moved more towards traditional consulting engagements which have offer higher margin projects. Government projects have required subcontracting assignments which kept EEI’s gross margins in the mid 30% range. Since 2004, EEI secured more private sector work resulting in gross profit margins above 40%. Going forward, a good portion of EEI’s future work will be focused on consulting for alternative energy projects such as wind farms, LNG terminals, clean-coal electricity, and nuclear power plants which should continue EEI’s trend towards higher margin projects. In fact, the first half of 2007 generated 45% gross profit margins in comparison to 40% gross profit margins in the same period in 2006 (42% gross profit margins for full year 2006).
Dividend: EEI has paid a $0.36 dividend to shareholders annually resulting in an approximately 3% dividend yield. In addition, management recently decided to issue a 5% stock dividend to shareholders on top of the $0.18 semi-annual dividend to add liquidity to its stock.
Liability and Insurance Risk: EEI’s subsidiary Walsh Environmental is the subject of a class action lawsuit stemming from a forest fire in Boulder, Colorado. The Plaintiffs may be seeking damages in excess of $17.0MM and while the Company maintains liability insurance which would cover the damages, a successful lawsuit could diminish the brand value of Walsh Environmental, a highly successful arm of EEI.
Dual Share Class: The Company’s management team owns over 70% of Class B shares which carry ten times the voting power of Class A shares. As a result, a variety of material corporate governance issues can be significantly influenced by management’s voting power to the potential detriment of Class A shareholders. While the imbalance in voting power can warrant a reduced valuation, dual class shares are not uncommon in businesses where founders serve as management. In addition, the significant equity interest held by EEI’s management aligns them with common shareholders and management has demonstrated a willingness to have both class of shareholders participate in various stock events (stock dividend for example).
Obscured Prior Year Comparisons: Hurricanes Katrina and Rita devastated the U.S. Gulf Coast in 2005 which resulted in significant revenues for EEI due to major increases in environmental clean up projects. As a result, the Company achieved unusually high revenue performance in 2006. While FY 2007 has done well in matching FY 2006 revenues, outperforming 2006 from a revenue basis may be difficult for the remainder of the year due to the lack of any catastrophic events or natural disasters. However, demand for EEI’s services is strong and payer and contract type is much more important than the absolute revenue dollars generated because certain contract types and payers offer projects that produce better margins. The current year has indicated that EEI is securing higher margin work and revenues are essentially the same as in 2006.
Another obstacle that could face EEI shareholders is misinterpretation of headline earnings news. EEI’s subsidiaries such as Walsh Environmental and E&E do Brasil are experiencing tremendous growth, collectively contributing about $8MM in H1 2007 revenues. Consequently, minority interest expense has been much higher resulting reduced EPS on a comparative basis. As a result, a headline report saying “EEI revenue and profits slip” could be completely misread by the market given the microcap nature of the Company.
Potential investors should also be aware that expenses in the administrative and marketing items for EEI are front loaded and these expenses have risen because of the Company’s growth plans. Participating in a higher number of bids and expanding operations incur costs before any potential contract wins are awarded which could further portray an inaccurate view of the Company’s business performance and prospects.
Illiquid Microcap: While EEI may be an interesting company at an attractive price, the stock is highly illiquid and the Company is a microcap. This can result in drastic swings in reaction to perceived (and real) adverse and positive results. That volatility could make this stock unattractive to some potential investors.
Disclosure: author manages a hedge fund that is long EEI
EEI 1-yr chart: