(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)
Energy Services of America (OTCQB:ESOA) is a beaten down company competing for market share as a service and equipment provider in the natural gas industry. ESOA's market share within the industry is significantly small and its operations command a much higher valuation. At $1 per share, ESOA presents a speculative buying opportunity. The potential for abnormal returns is high, while downside risk remains minimal. This article provides an overview to ESOA's business model, highlights its recent performance in the market, and the performance of its peers within the industry. In addition, this article will outline some of the factors that contributed to ESOA's decline in market value including backlogged work, its capital structure, and financing agreements. Next, I will briefly touch on valuation and then conclude with several concerns investors should be aware of.
ESA provides contracting services for energy related companies. Its services include installation, replacement and repairs of pipelines for the oil and natural gas industries, general electrical services for both power companies and various other industrial applications, installation of water and sewer lines for various governmental agencies, and various other ancillary services. In addition, ESOA also provides services for liquid pipeline construction, pump station construction, production facility construction, and other services related to pipeline construction. ESOA currently has 602 employees serving customers that are primarily located in the Mid-Atlantic region in states such as West Virginia, Virginia, Ohio, Pennsylvania, Kentucky, and North Carolina. Note these are the most common areas in which ESOA operates and that it does operate nationwide. Here is a specific list outlining a few of ESOA's customers:
- Spectra Energy (NYSE:SE)
- Dominion Resources (NYSE:D)
- Columbia Gas Transmission
- Columbia Gas of Ohio and Pennsylvania
- Nisource (NYSE:NI)
- Marathon Ashland Petroleum LLC
- American Electric Power (NYSE:AEP)
- Toyota (NYSE:TM)
- Kentucky American Water
- Equitable Resources
- Markwest Energy (NYSE:MWE)
- Range Resource
It is important to note that due to the seasonal impacts on ESOA's operations activities such as laying pipeline often does not occur during winter months, therefore not all of the customers listed above can be classified as year-around customers. In order to provide services to its customers, ESOA operates through its wholly owned subsidiaries including:
For additional information pertaining to ESOA and its subsidiaries please visit ESOA's company website or click on the link above corresponding to the individuals subsidiary of interest.
Shortly after the credit crisis of 2008, ESOA's share price experienced a sharp decline. Several attempts to recover have been made along the way, but a full recovery has yet to take place. Looking at the graph below, its clear there has been a tremendous amount of variability in ESOA's share price. For the past six months, volume has been relatively stagnant. However, within the past month ESOA's share price has experienced a small recovery. ESOA is currently trading at the bottom of its five year valuation. With roughly 14.46 mm shares outstanding, its market capitalization is nearly $14.46 mm.
Peer & Industry Analysis
The graph below illustrates the relative performance of ESOA's peers over the past five years. The companies shown below include Matrix Service Company (NASDAQ:MTRX), Cal Dive International (NYSE:DVR), MasTec (NYSE:MTZ), Primori Services Corporation (NASDAQ:PRIM), and CDI Corporation (NYSE:CDI). As you will see below, not ever company is capable of maintaining its market share in the industry. Over the past five years, several firms such as DVR, CDI, and MTRX have shown a tremendous drop in market value. A large portion of this can be attributed to poor financing decisions that ultimately suppressed the valuation of these firms.
As you are beginning to understand, ESOA operates in an industry that is highly competitive in nature. The high level of competition displayed across the industry derives from the need for implementing an optimal financing strategy. Successfully strategies implemented within the industry entail long-term funding agreements with creditors to finance the high fixed costs associated with operations. Additionally, it is common to see firms use this funding to cover unexpected variable costs, which are subject to large variation due to a number of externalities. These externalities include poor weather conditions only cause projects to be delayed and force contracts to be extended. Therefore, its clear ESOA and its peers suffer from issues regarding leverage. The high level of fixed costs these firms take on is directly reflected through the high degree of operating leverage. In addition, this can be easily seen through the financial leverage of these firms, which you will see below.
High levels of leverage and additional risk go hand in hand. Firm's that exhibit high amounts of leverage reveal larger variation earnings and often suffer heavily from margin compression during economic downturns. Industry wide, the contracts for major pipeline projects are typically awarded through a competitive bid process. The process can be lengthy and create additional uncertainty. Therefore, investors should note that firms operating in this industry are going provide additional exposure to risk due to the competitive environment itself and capital outlay that is required to fund operations.
ESOA's Backlogged Work Still Exists, But Improvements Are Underway
As previously mentioned, externalities such as poor weather conditions have had a major impact on ESOA's ability to execute projects and should be viewed as a competitor of its own. The poor weather conditions throughout the regions where ESOA operates has created major delays. A fair number of projects have yet to be completed and the amount of backlogged work has only been compounding. ESOA's earning variability over the past two years can be directly linked to the substantial amount of backlogged work and its clear the market has factored this into its share price. According to ESOA's 10-K, as of September of FY 2012 there was roughly $57.4 mm in outstanding work on current contracts. While this number remains high, its comparably less the $128.5 mm in backlogged work that was outstanding at the end of FY 2011. Note that ESOA's backlogged work represents contracts for services that have been entered, but have yet to be commenced. One reason for this is mentioned by ESOA's management:
"Due to the timing of ESOA's construction contracts and the long-term nature of some of our projects, portions of our backlog may not be completed in the current fiscal year."
The majority of ESOA's projects can be completed in a relatively short period of time. The typical lifespan of ESOA's projects range from two to five months. Its larger projects can take up to as much as 18 months to be finished.
As I touched on earlier, the industry in which ESOA operates demands a high level of capital adequacy. The fixed costs needed to operate are high and variables costs are subject to a wide range of variation. And in order to generate stable margins and maintain market share in this industry, it requires a strategic working capital policy that accounts for uncertainty. However, unfortunately ESOA's capital structure is an area of concern. In particular, its ability to complete projects has been hindered due to the lack of working capital available to fund projects.
ESOA's primary source of debt derives from its $18 million line of credit with a regional bank. Under a Forbearance Agreement with the bank, ESOA has agreed to pay a 6.5% interest rate on the principal outstanding during this period. The Forbearance Agreement between ESOA and its lenders was established and made effective on November 28, 2012. The primary disadvantage of this agreement is it prevents ESOA from making additional draws on its revolving line of credit. In addition, as stated in ESOA's 10-K the major covenants governing this line of credit are:
- Its current ratio cannot fall below 1.5.
- Debt to tangible net worth must not exceed 3.5.
- Capital expenditures must not exceed $7.5 million per year.
- Dividends shall not exceed 50% of taxable income without prior bank approval.
This Forbearance Agreement may be terminated upon certain evens and in any case on May 31, 2013. The termination of a contract as such would have a dramatic effect of ESOA's ability to complete projects. Primarily, it would restrict its working capital available to allot to unfinished projects. ESOA has the potential to receive a separate forbearance line of credit, if it were to apply and be accepted, however taking into account ESOA's current level of profitability and capital structure this not highly plausible.
An additional concern I have underlying the Forbearance Agreement is in regards to its subsidiary S.T. Pipeline and is clearly written in its 10-K:
"The Forbearance Agreement, among other things, requires that we close our S T Pipeline subsidiary and dispose of its assets."
For an easy reference, here is ESOA's long-term debt outstanding listed in order of maturity.
ESOA's high degree of leverage and solvency issues regarding capital adequacy are the primary reasons its security price experienced a strong decline. Insufficient capital to complete projects resulted in negative earnings and market participants were quick to price this into the market. ESOA's current market value is $14.46 mm, which clearly more than its current book value of equity. As of March 31, 2013, ESOA's balance sheet reported $4.5 mm in total equity. Currently, its difficult to place a fair value on ESOA's common stock. Normal discounted cash flow models would not be applicable given its current operating cash flows and weighted average cost of capital. However if a fair amount of backlogged work is complete and new financing options are undertaken, ESOA's share price could easily bounce back to the $2 to $3 range.
In addition, investors should note ESOA's valuation was also impacted by a management's disclosure in regards to the goodwill on ESOA's balance sheet. The financial statements shown below are fairly dated, however serve as a good source for understanding a factor that compressed ESOA's valuation. Looking at the highlighted values below, you will see total assets were $59,755,749 and total liabilities were $53,314,384. The difference between the two equates to only $6,441,365. In contrast to previous years you will see the difference between its assets and liabilities was significantly greater. This can be attribute to the $36,914,021 in goodwill that deemed to no longer have value. According to ESOA's 10-K, "Based on our continued operating losses and management's forecasts of future cash flows our goodwill impairment test indicated that the goodwill of the Company had no value."
Firm Specific Market Risk
Despite ESOA's significant decline in its market value per share, historical patterns of volatility are relatively low. ESOA reveals a firm-specific beta value on only 1.27, which is slightly above the market beta level of 1.0. To analyze ESOA's firm-specific risk, I used its holding period returns with distributions for approximately the past six years (2007-Present) in order to compute the sample estimates above in both normal and logarithmic form. For accuracy and effort towards eliminating error in computing the sample estimates, I used the same methods in all calculation and retrieved equivalent data with an identical number of observations.
Notice the variation between ESOA's sample estimates for the HPR (normal) and HPR (logarithmetic). The deviation between the artihmetic average for both computations is quite significant. ESOA's normal arithmetic average return for this period was 10.98% where as the logarithmic return was 3.60%. Note the "Arithmetic Average" was computes using weekly data and therefore has been adjusted to represent the annualized return for both HPR normal and logarithmic. The standard deviation revealed through its holding period returns is high at 6.73%. Compared to an average market index fund, this is high. An average market index for this period would typically reveal a standard deviation of around 1.5%. However, this is not a concern for the industry ESOA operates in. Overall, the quantitative market risk within ESOA's holding period returns is not a concern.
Investor Concerns: Off-Balance Sheet Items
In terms of the risk exposure from off-balance sheet items, investors need to be aware that ESOA engages in lease financing and understand there is a fair concentration of credit risk that derives from short-term customer transactions. In practice, it common for firms to exclude short-term financing for items such as leases from the balance sheet, however ESOA excludes several long-term items as well.
ESOA has various leases that are not capitalized and therefore are not reported on its balance sheet. These leases are specifically to help ESOA obtain equipment, vehicles, and facilities that are depreciable in nature and serve little benefit if purchased for long-term use. ESOA first lease obligation consists of two pieces of real-estate under-long term agreements extending through August 15, 2014, which require monthly rental payments of $5,000. ESOA's second lease agreement is for its headquarters office and requires monthly payments of $7,500 with an option to renew expiring October 2013. ESOA's last lease agreement is for its office and shop space requiring monthly payments amount to $11,800. ESOA's level of internal credit risk revolves around and in entirely dependent upon the credit extended to customers. These lines of credit are extended to customers under normal payment terms, however it is typically unsecured credit meaning its extended without any form of collateral to back it up.
If the appropriate changes are made to ESOA's capital structure and new financing options are implemented, it has the ability to make a strong turn around in the industry. Capital adequacy for funding projects and complications surrounding debt financing are the key underlying issues that initiated a sell off by market participants with high uncertainty. In conclusion, ESOA is a speculative investment that needs critical attention. It holds the potential to provide investors with abnormal returns, however the continuation of stagnant volume and a further decline in market value are both probable if ESOA's issue of solvency is not improved.
Sources: TD Ameritrade, YCharts, Google Finance, Yahoo Finance, and The US Securities and Exchange Commission Website.
Disclosure: I 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.