DYCOM - Time To Connect

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About: Dycom Industries, Inc. (DY), Includes: MTZ, PWR
by: John B. Rogers
Summary

Telecom Network Contractor Positioned to Ride Multi-Year Investment Wave in Gigabit Service, 5G Wireless and Secular Growth in Connectivity.

Recent Earnings Disappointment Provides Potential Opportunity. Shares at Low End of Historical Price and Valuation Ranges.

Further Near-term Risk but Exceptional Long-term Prospects.

Are the shares of Dycom (DY) worth considering? The shares fell sharply in response to the recent report for the quarter and fiscal year ended in January, down over 30%. The most recent decline extends a difficult period for company investors as the stock has reversed most of the gains from the last four years. Yet the business has continued to grow and industry prospects appear to be improving.

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Successful Communication Infrastructure Contractor

Dycom is the leading provider of specialty contracting services for telecommunications net work operators in the United States. These services include program management, engineering, construction and maintenance services for hardline and wireless network infrastructure used for voice, video and data communications. You have probably seen Dycom's crews working along roadways stringing cable or burying underground fiber, coaxial or other elements of our expanding communication infrastructure. In addition the company also provides underground locating services (think of the painted lines on roadways indicating utility locations prior to construction/repair) and selected construction and maintenance services for electric and gas utilities.

Over the past decade the company has delivered notable long-term growth, including 10% top line growth and double digit per share gains. Although the operating results have varied with cyclical network investment trends, the company has remained consistently profitable and generated median returns on capital of 14%. Dycom's financial success is attributable to growth in investment in communications networks as well as reinvestment in the business (acquisitions and share repurchases).

Dycom's current revenue and national reach in communication infrastructure substantially exceeds all other contractors, although MasTec (MTZ) and Quanta (PWR) do compete in some markets. Additionally there are multiple private contractors in all regions of the country.

Major customers include the largest telecommunications network owners, including AT&T (T), Verizon (VZ) Comcast (CMCSA) and CenturyLink (NYSE:CTL). Additionally the company has in the past worked for almost all other sizable network operators which were consolidated or have previously invested in infrastructure including Windstream (WIN), Charter (NASDAQ:CHTR), Frontier (FTR), Crown Castle (REIT)">CCI) Google (GOOG), regional providers, utilities and private operators.

Market Prospects - Notable Secular Growth Anticipated

We look for the market opportunities for Dycom to further improve over the next several years. Consumers and businesses are increasingly expecting/demanding high speed connectivity for communications, including gig-speed internet (gigabit-per-second download speeds). As more of our devices are connected and new formats, including 5G wireless standards emerge, more fiber needs to be deployed for direct connections and backhaul for wireless towers.

Recent Financial Results - Weak Margins Raise Concerns

Dycom's recent financial results reflect growth in work and prospects, but also some unanticipated margin pressure which significantly reduced earnings. For the fiscal year ended January 2019, the company reported 5% revenue growth but a 60% decline in GAAP EPS ($1.97 vs $4.74). However these results included some unusual items in both years, non-cash charges for amortization of debt discounts on previously issued Notes and the write down in FY19 of an account receivable from Windstream following their bankruptcy filing and a one-time tax credit in the prior year and other tax adjustments. On an adjusted basis Dycom would have reported EPS of $2.78 compared to $3.88, nevertheless down almost 30%.

The lower core operating earnings were primarily due to margin compression. The weaker earnings trends were particularly pronounced in the fourth quarter, revenue grew by 14%, nearly all organic, yet earnings continued to slip, $0.10 per share compared to $0.12 last year on an adjusted basis. These results fell well short of reported consensus expectations of $0.16 per share.

Management cited the impact of higher than expected costs for work with a single unnamed customer. Management called out under absorption of labor, which appeared to stems from a lack of coordination and execution on both sides under the work agreement. Although the customer was unnamed, we suspect the margin pressure resulted from an aggressive roll out of new fiber work, for which the customer was not adequately prepared.

Notably most of Dycom's work is negotiated and performed under Master Service Agreements, which provide for basis contract terms. Specific projects are then subject to discrete task orders. If Dycom is unable to respond to these tasks orders efficiently, the costs for both Dycom and the customer are likely to increase. Although the problem work is still profitable, it will likely continue to generate lower margins over the next year.

Dycom management suspended their recently introduced practice or providing full-year financial guidance and returned to only providing guidance for the next quarter with additional limited comments on trends for the next six months. Based on their comments, margins are likely to remain under pressure for the current fiscal year ending January 2020. Consensus expectations call for normalized EPS of $2.50.

As shown below, Dycom's margins have cycled over time as the company's revenue mix evolves and the operations gain experience or renegotiates terms with customers. Margin trends tend to track revenue growth on a slightly delayed basis as the company is able to capitalize on operating efficiency and gain experience under new MSAs.

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Potential for Earnings Recovery

As the largest national provider of telecom contracting services, highly develop back office support and advance labor training experience, Dycom has distinct competitive advantages. Accordingly we see the company as the preferred supplier for most network operators. Additionally the company has pushed to increase it's service offerings which typically offer more stable revenue and margins.

With a long-term tailwind of demand growth, advantages of scale and improved execution and/or renegotiation of low margin agreements, Dycom appears well positioned to revive margins. Accordingly, the current year seems likely to represent a cyclical low point for EPS.

Step in Now or Wait for Margin Clarity?

At current price levels, the shares of Dycom are trading a historically low valuation relative to historical earnings. Based on average annual earnings for the last five years, Dycom trades at less than 16X earnings the lowest point since 2009.

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With even a modest recovery in margins, we estimate earnings could rebound substantially. Assuming modest revenue growth and applying historical average margins to the current capital structure and tax rates would support EPS in excess of $4.00 per share. Based on historical valuation metrics for EV/EBITDA and P/E, these earnings could support valuation levels of $80 to $100.

Of course if margins and earnings continue to decline, being early will be a lot like being wrong. However based on the company's position in a growing market and management's proven past execution, financial returns appear poised to rebound and support higher stock levels in the years ahead.

Dycom does not appear to be a stock to buy and put away, but rather one to watch closely and begin to wade in. With the first signs of margin recovery the market is likely to push the shares much higher and inattentive investors could be left on the sidelines looking for another way to participate in a long-term powerful secular growth trend.

Disclosure: I am/we are long DY. 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.