Short Dycom: Perennially NPV Negative, 60% Downside To Fair Value

| About: Dycom Industries (DY)
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Summary

Dycom is priced like a fantastic business. Yet, the space enjoys few barriers to entry. Its scale is not a competitive advantage due to the presence of a similarly-sized rival.

Dycom's unusual growth has been at the expense of competitor MasTec. Going forward, MasTec will likely be highly irrational, making Dycom's EBITDA margin targets potentially unattainable.

Even if we give the Company full credit for growth and margins, there is little evidence that this would result in value creation; Dycom has been perennially NPV negative.

Fair value of $26-$28, implying ~60% downside. As the growth story seems largely priced in, upside risk is unlikely to be significant.

Dycom Industries (NYSE:DY) ("Dycom", "DY," or "the Company") has supposedly been revitalized. For much of 2005-2011, growth was anemic and profits were thus representative of a steady-state business. Suffice to say, shares of Dycom went nowhere during said period.

However, near the start of the current decade, shares have been given a new lease of life, largely thanks to the ramp-up of capital spending budgets at major telecoms. This resurgence in capital investment by telecoms has led to unbridled investor euphoria with respect to Dycom, evident by shares tripling in recent years to ~2.6x EV/IC.

Bulls are apparently convinced that the capital spending binge by telecoms would bestow upon Dycom newfound riches in the form of larger, sustainable, economic profits. The valuation requires that.

That is a big ask, in my view.

The Dark Side Of The Telecom Value Chain

The problem with DY (and its peers) is that they control the wrong slice of the telecom value chain. Of the many components that make up the value chain, some are enormously and sustainably profitable thanks to long-lasting, structural advantages. Alas, Dycom is not in a position to make a similar claim.

Companies such as Charter Communications (NASDAQ:CHTR), which owns the distribution infrastructure, are prodigious cash generators because their massive scale, government-granted protection, and sheer upfront and ongoing capital expenditure requirements deter potential entrants and protect profitability.

Content mammoths such as Discovery Communications (NASDAQ:DISCA) (NASDAQ:DISCB) (NASDAQ:DISCK) are extremely profitable as they own the intellectual property rights to highly sought-after content, and their massive scale lowers per-unit costs to levels that new entrants cannot hope to achieve.

While players like Charter and Discovery are blessed with barriers to entry that stand tall and protect their respective economic castles, the same cannot be said for Dycom.

Dycom is in the business of digging trenches, laying cable, and doing other related activities that help telecoms get their networks up and running. Anyone with the capital, manpower, and equipment can replicate this.

The fact that small firms such as Hewitt Power & Communications, Moll's Utility Services, and Venture Communications can do well enough to be acquired (for $8m, $6.5m, and $15.6m respectively) by DY suggests there are few barriers to entry to the space, something that is admitted by Dycom and its peers in their regulatory filings.

But such an assessment is fairly elementary; a first-year economics student could have surmised as much. Thus, there must be something that management is touting to investors (and given the valuation, investors are apparently believing) as its fantastic competitive advantage which enables Dycom to earn economic profits to justify the Company's valuation.

The main argument bulls seem to believe, is scale. Management gently implies this in its shareholder communications. The idea that executives seem to want to convey is that DY's massive scale and national presence allows the firm to, a) obtain equipment, vehicles, and raw materials at prices which are materially lower than its competitors and, b) enable customers to subcontract the upgrading of their networks to fewer firms, simplifying the administrative process. These are things that smaller firms cannot hope to replicate.

The above explanation makes sense and is something that I do not deny. However, what is omitted from management's statements is that similar attributes are enjoyed by DY's key competitor, MasTec (NYSE:MTZ).

Both are of similar scale (~$2b in 2015 telecom-related revenues), attack similar markets (U.S. and Canada), and ride similar growth trends in telecom capital spending (driven by smartphone penetration, growing demand for voice, video, and data, Connect America Fund II, etc).

The point I am getting at is, relatively speaking, Dycom does not have a competitive advantage. Put simply, if two players have similar competitive positions, neither would have a meaningful advantage over the other. The implications of such an assessment is important for the reader to note, as I explain below.

In MasTec's 10-K, the firm concurs that price is "often the principal factor in determining which service provider is selected." Hence, as Dycom and MasTec's communications segment are fairly similar in terms of scale and presence, they primarily compete on price, making it difficult to envision either player being able to obtain a sustainable profit margin lead over the other.

Putting this in context, MasTec's communications segment revenue has been flat in recent years while its segment EBITDA margins have declined from ~12% to ~10%. On the other hand, DY's top line has grown at 15%-30% rates while its EBITDA margins have expanded from ~10% to ~12% over the same period.

MasTec attributes flat revenues and declining EBITDA margins to lower-than-anticipated levels of wireless/wireline services, which I interpret as the firm not being able to secure additional contracts to grow its revenue base.

The reason for this is because MasTec's "starting" EBITDA margins were higher than Dycom's, and since the two compete primarily on price, it is clear that the Company was able to achieve the unusually high growth rates and EBITDA margin expansion that it did at the expense of MasTec.

In this space, contract pricing is fixed in nature. Overall pricing will rise over time to keep up with costs (or else the entire space would go bankrupt in the long run) - this is illustrated by MasTec's communications segment margins falling on flat revenue. Essentially, MasTec got ahead of itself as it was pricing its business higher and Dycom's lower "starting" EBITDA margins suggests it was increasing price to match MasTec.

Given the expansion in valuation multiples, bulls are clearly betting on the future looking like the recent past. With the positions between the two competitors now reversed, assuming Dycom can continue on a similar 15%-30% top line growth pattern, keeping in mind that price is often the deciding factor in this space, strikes me as an overly optimistic expectation.

EBITDA Margin Targets Are Potentially Unattainable Due To The Presence Of An Irrational Competitor

Moreover, it seems highly likely MasTec would be extremely aggressive and irrational in competing with Dycom going forward.

Apart from its communications segment, MasTec also operates two other businesses of note, one of which offers engineering, construction, and maintenance services to the oil & gas industry, while the other caters to energy & utilities industry. The O&G segment accounts for ~36% of MasTec's sales, while the communications segment's contribution is ~47%.

The carnage in the oil & gas and energy industries is fairly well-documented and has unsurprisingly affected MasTec. O&G segment revenues declined ~20% organically in 2015, a trend that would likely continue in 2016.

Although the electrical transmission segment is only ~8% of 2015 sales, it has turned hugely unprofitable, with 2015 segment EBITDA clocking in at a negative ~$71m, pulling the overall firm EBITDA down to a mere ~$150m.

With ~$150m in annual EBITDA and around a billion in net debt, net debt/EBITDA for MasTec currently sits at a gut-wrenching ~6.7x. Needless to say, the firm is likely scrambling to reduce debt and grow EBITDA by any means possible.

Against such a backdrop, it does not seem like a stretch to assert that MasTec would likely be extremely aggressive in undercutting on price in its communications segment. After all, with the overall energy space in the doldrums, the communications segment seems to be the only avenue MasTec's management can count on.

Management commentary on the 1Q '16 call certainly supports this assertion and suggests that the firm has reinvigorated its growth profile in its communications segment:

Now, I'd like to cover some industry specifics. Our Communications revenue for the quarter was $512 million versus $470 million last year. The increase in revenue was driven by strong increases in our wireline and installation businesses and as expected a decrease in our wireless business on a year-over-year basis. In our install-to-the-home market, revenues were up 25% year-over-year.

Demand for our installation services is strong. We have seen increased demand related to the DIRECTV-AT&T merger and have continued to grow and diversify our business. We're beginning to see the fruits of how we've leveraged, what we believe to be the largest third-party independent fulfillment company in the United States with broad geographic coverage.

We're now working with four additional customers on pilot programs that could build into solid long-term opportunities. There is strong demand for a customer-touching workforce to help differentiate product offerings and we believe we're well-positioned to fill this demand in the marketplace."

Source: MasTec 1Q '16 Earnings Call Transcript

Couple this with my prior assertion that positions have been reversed between Dycom and MasTec, and you would be hard-pressed to believe that DY can maintain its current growth trajectory and achieve its stated mid-teens EBITDA margin targets going forward.

Perennially NPV Negative, Value Creation Through Growth Appears Elusive

Even if we are very kind and assume that Dycom can sustain the growth rates it has achieved in the recent past, the overall situation does not appear materially better.

Sure, bulls will cite the following: the Company's top line has grown - sales have more than doubled since the start of the current decade. Net income has followed a similar trajectory, rising from ~$16m to the trailing twelve-month figure of ~$100m. Due to the ~5% reduction in shares outstanding to ~34m, EPS numbers are even better. Backlog numbers are similarly robust, growing to ~$5b as of 2Q '16.

Given the above performance, investors are likely valuing Dycom using valuation multiples that are rooted in EBITDA/EPS numbers. Management subtly encourages this, evident by its press releases detailing quarterly results only focusing on profitability metrics such as EBITDA and EPS.

However, valuing Dycom off EBITDA/EPS-based metrics is the incorrect approach, in my view. EBITDA/EPS figures do not account for capital expenditures, among other items (non-cash charges, changes in working cap, etc). Ideally, one should only utilize EBITDA/EPS numbers as a valuation multiple if the delta between EBITDA/EPS and unlevered/levered free cash flow respectively is insignificant. In the context of Dycom, this is not the case.

Despite the aforementioned growth in sales and EPS, FCF (defined as OpCF - CapEx) has not followed a similar trend. The 2015 FCF number is ~$40m. Now, obviously Dycom's business is lumpy in nature, so it would be unfair of me to look solely at single-period numbers. Yet, FCF numbers averaged over different multi-year periods (3-, 5-, 7-, and 10-year) paint a much bleaker picture, as seen below.

Dycom (in $mm)

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Free Cash Flow

45

31

32

96

-1

-18

-12

42

-5

39

3-year average

25.3

5-year average

9.2

7-year average

20.1

10-year average

24.9

Source: Company filings, author's calculations

From the above table, it is clear that FCF has gone nowhere for years. Thus, despite strong top and bottom line growth, value creation appears elusive, as the growth of these two metrics have not translated into larger free cash flows. Hence, it appears that bulls are focused on EPS growth, ignoring the fact that CapEx is a very real expense.

The main culprit preventing FCF from growing is capital expenditures. While net income has grown from ~$18m in 2006 to the trailing twelve-month figure of ~$100m, CapEx has grown from ~$57m to ~$155m over the same period, fully offsetting the growth in net income, and more. There is reason to believe that this trend will continue going forward.

CapEx, in the context of Dycom, comprise primarily of vehicles, machinery and equipment. While the Company does not disclose its suppliers, firms such as Alcatel-Lucent who sell telecom equipment are likely suppliers for machinery and equipment, while auto OEMs likely supply their vehicles.

Alcatel-Lucent acknowledges in its 20-F that its products often have short life cycles (due to telecom industry demanding frequent upgrades) which implies that new products are coming onto the market at a rapid pace - its expanding gross margin supports this assertion. As for vehicles, due to Dycom's growth, utilization is likely very high, making frequent vehicle replacements necessary.

Given such a narrative, it is hard to argue for a reversal in DY's CapEx trend. As a result, it seems highly unlikely that growth would result in significant value creation - indeed, there is little evidence to support this. 3-, 7-, and 10-year average FCF numbers are fairly close (I exclude the 5-year number to be generous).

Moreover, it is widely known that a significant portion of the capital spending by telecom giants is 'growth CapEx' in nature, suggesting that steady-state revenues for Dycom could be meaningfully lower than current numbers.

To make matters worse, Dycom has not been able to earn more than a 10% ROIC in any single year throughout the past decade - the 10-year average through 2015 is a measly ~4.6%, according to Morningstar:

Dycom 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Return on Invested Capital % 5.13 8.70 4.92 -6.95 2.85 4.95 8.85 4.82 4.39 8.54
10-year average 4.62

Source: Morningstar

Such low ROIC numbers suggest that it is very unlikely that Dycom is earning greater than its cost of capital over the long run. If you agree with my assessment that the Company possesses no meaningful, sustainable competitive advantages, these numbers should not be surprising.

Consider this: if a firm is unable to turn an economic profit for more than a decade, despite huge top and bottom line growth, when will it actually happen?

Furthermore, the ROIC numbers are calculated based on after-tax operating income - as discussed, FCF is the far more important metric to focus on. Suffice to say, if we used FCF as the numerator in the ROIC calculation, the numbers would be much, much worse.

Valuation: Fair Value Of $26-$28

Dycom trades at ~2.6x EV/IC (~$2.3b market cap, ~$630m net debt, ~$1.1b invested capital, defined as fixed assets, goodwill/intangibles included, + non-cash working cap). Generally, an EV/IC premium requires sustainable ROIC in excess of the cost of capital, which Dycom clearly does not possess. Assuming multiple contraction to 1x EV/IC suggests ~60% downside from current levels to ~$26 per share on 33.5m shares outstanding.

Alternatively, we can value Dycom off its free cash flows. To be extremely generous, let's value the Company using its peak FCF of ~$96m, which it achieved in 2009. To illustrate the extent of my conservatism and generosity, note that Dycom had a ~$53m net loss in that year.

How then did it get to ~$96m in FCF? Largely through the add-back of a ~$94m goodwill impairment charge, a severe tightening of working capital (accounts receivable was a massive ~$29m source of cash compared to ~$500k in the prior year), and a ~60% decline in CapEx. Clearly, peak FCF is unlikely to recur and is indicative of a best-case scenario, but let's run with it.

Since there is little evidence that top and bottom line growth results in improved FCF, we shall assume that ~$96m is representative of steady-state FCF and assign a 10x multiple (implying zero growth, assuming a 10% discount rate), which gets us to ~$28 per share on 33.5m shares outstanding, even in a "perfect" scenario.

Fair value of $26-$28 is also not an unreasonable expectation considering that during its anemic growth period (2005-2011) where investors likely valued Dycom as a business that is close to steady-state, shares traded somewhere between the $15-$25 range.

Asymmetry, Catalysts, Risks

Perhaps the most important reason why I believe this short is asymmetric in nature is because:

  • if a business has been unable to generate ROICs in excess of its cost of capital for more than a decade even despite undergoing a period where sales doubled and net income exploded,
  • and there are no radically positive changes to its reinvestment requirements (see CapEx discussion), among other things (profitability, competitive landscape, barriers to entry, etc.),
  • it seems quite improbable that Dycom would ever sustainably earn more than its cost of capital in the future.

Businesses that do not earn more than their cost of capital in the long run are unlikely to command premium multiples forever.

Since the Company's growth story seems to be largely priced in, if during the short, all goes well for Dycom, shares are unlikely to appreciate by a significant amount - 2Q '16 was perhaps one of the best quarterly results in the Company's entire history, with backlog growing ~$2b y/y and ~$1b sequentially. Yet, shares fell ~15% that day due to EPS guidance coming in below consensus.

However, if due to intensifying competitive pressures, growth stalls, resulting in a contraction of EBITDA margins or a delay in expansion, and/or FCF continues to be uninspiring, the market would likely begin to grasp the reality of the economic situation at Dycom - realizing that little has changed since 2005-2011, shares should see a massive sell-off. As MasTec appears to have reinvigorated growth in its communications segment, and is likely rushing to grow EBITDA and/or reduce debt, these catalysts could materialize over the next few quarters.

The risks here are fairly obvious. The Company has upped its share buyback program to $100m - while this may provide some share price support, it is unlikely to be significant given the amount is quite small relative to the current market cap.

While there has been consolidation in the space, firms like Dycom and MasTec, due to their size, are the acquirers not the acquirees, so it is hard to see any meaningful buyout risk. Consolidation is also unlikely to result in a concentrated industry structure (which would theoretically allow sustainable economic profits) in the long run, as the few barriers to entry would allow small firms to continue entering the space.

If the growth trajectory is sustained, shares will probably rise higher. But again, the growth story seems priced in and is unlikely to result in value creation, so upside risk shouldn't be much.

3Q '16 results should be announced in the next two weeks or so if history is any guide, and since the Company provides non-GAAP EPS guidance one quarter ahead, one can compare the full-year expected EPS number with the Company's guided raise in capital expenditures for the fiscal year to ~$175m, up from $125m expected for 2016 at the end of fiscal 2015.

My expectation is that the incremental CapEx would offset a significant amount of EPS growth, which reinforces my thesis that growth at Dycom would hardly result in value creation, and consequently, the Company should trade at no more than 1x EV/IC.

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.

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