Limbach - You Pay For The Construction Business And Get The Service Business At A Considerable Bargain

Summary

• By consolidating regional markets, LMB can secure higher margins by reducing competitive bids.
• Insiders are buying and the CEO has skin in the game.
• The outlook for the E&C industry is strong supported by the Infrastructure Investment and Jobs Act.
• Based on the economics of each segment, I valued the construction segment at $6 per share and the service segment at $15 per share.
• By buying the stock at this levels, you are paying 6x for the construction business and getting the service business for 10% its value. That is a material margin of safety.

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Many interesting articles have been written about Limbach Holdings (NASDAQ:LMB) on Seeking Alpha. Their main investment thesis is that LMB is in the process of changing its product mix from the lower-margin GCR to the higher-margin ODR which will cause a re-rating of the stock. Currently, 70% of revenues are generated from GCR, the goal is to reduce GCR's contribution to 50% of revenues by 2025. I agree with the thesis as I have been invested since September 2021 when the stock price sank below $7. But in this article, I want to provide another four reasons why LMB is a good investment that you should consider.

Overview of Limbach Holdings

Rather than paraphrasing, here is an extract from Seeking Alpha's Overview page:

LMB operates as an integrated building systems solutions company in the United States. It operates in two segments, Construction and Service. The company engages in the design, prefabrication, installation, management, and maintenance of mechanical, electrical, plumbing, and control systems, as well as heating, ventilation, air-conditioning (HVAC) system; and maintenance, and equipment upgradation, emergency service work, automatic temperature control, specialty contracting, and energy monitoring services.

The construction segment (GCR) is the less attractive segment. The projects tend to be larger, ~50M USD, they require significant working capital, capex and have a 10% gross margin if all goes as planned. Any hiccups and those projects could become losing propositions for LMB. In 2018, GCR generated 438M USD of revenues, since then the company has been purposefully not participating in the larger projects and rather bidding on smaller projects that have higher margins. As a result, GCR revenues declined 24% by 3Q21 but the margin increased from 8.4% in 2018 to 11.8% as of 3Q21. Management's plan is to reduce the size of GCR but not eliminate it at all. GCR projects are a good pipeline to lock in ODR services.

On the other hand, the service segment (ODR) is very attractive. Those services tend to be recurring and predictable revenues. They require minimal capex and have gross margins from 25% to 29%. There are two main types of services, preventive maintenance and emergency services. This segment is growing at a nice pace. In 2017, ODR revenues were 94M USD, by 2020 it grew to 127M USD and I expect ODR revenues to close at 141M USD in 2021.

Reason #1: LMB can consolidate the market at attractive valuations

This market is very regional and fragmented. That is a reason why bids are so competitive and margins so low. As most operators are small and unsophisticated, once they decide to exit the business and retire, selling to LMB is a sound option. The going rate for such businesses is 4 to 5 times EBITDA and the acquirer may include an earn-out option to ensure the proper transition.

By consolidating the market, LMB could lower regional bidding wars and lock in a higher margin. Also, by consolidating players in the same region there are cost synergies.

Pre-COVID, the latest acquisition of LMB was Dunbar Mechanical. Then it had more pressing matters to deal with such as the debt level - so acquisition halted. But by 1Q21, LMB raised 24.9M USD via issuance of stocks. Those proceeds went to reduce debt by 10.2M USD and as of September LMB had 33.3M USD of cash and just 26.2M USD in debt (excluding capital leases).

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Now with less debt, the company could resume its acquisition strategy. By the end of 2021, LMB acquired a mechanical contractor for 20M USD. This acquisition was closed at 4.4x EBITDA excluding any synergies. I expect more acquisitions in the coming years.

Reason #2: CEO has skin in the game and insiders are buying shares

The CEO, Charles Bacon owns 4.3% of the shares. He has been buying the stock opportunistically. But also we witnessed directors investing around 545k USD in the stock in the past year. Keep in mind I am ignoring the uninformative buys as they don't indicate conviction buys.

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Reason #3: Attractive outlook for the Engineering and Construction (E&C) industry

According to a Deloitte report, E&C revenue for 2021 is likely to grow 6.9% and they expect an acceleration in 2022. The acceleration of non-residential E&C will be supported by The Infrastructure Investment and Jobs Act. This bill will benefit both residential and non-residential projects. In addition to infrastructure work, LMB will likely benefit from the investments focused on health care in this bill.

Also during the earnings call, Charles provided some data points and third party outlooks for the industry that support the findings above:

The September AIA billing index continues to indicate expansion at 56.6. The Dodge Momentum Index hit a 14-year high, a 47% increase over the same period last year. The FMI fourth-quarter forecast presents a forward view of continued growth, with non-residential building sectors growing through 2025, with health care, our largest sector, indicating very strong growth over the period. The FMI report also reinforces the growth in the Southeast U.S., where we are looking at expansion opportunities.

Reason #4: Very attractive valuation, buy the GCR segment and pay 10% for the ODR segment

The two main drivers of the valuation were the revenues and margins for each segment. For revenues, I assumed a continuation of the current trend, which is growing ODR and shrinking GCR. By 2025, ODR would represent 53% of revenues, a bit higher than the 50% guided by management.

As per gross margin, I expect GCR long-term margin to converge to 10%. FY 2021 margin will likely close around 11.8%, however, I think the higher margin is a one-timer due to the COVID situation. The 10% also is a bit lower than the 10.5%-11.5% guidance, while I believe that management is picking the profitable projects, I think the competitive nature of the business will compress margins. Having said that, if management succeeds in consolidating the market in key regions, it will lower competition and may increase margins. As per the gross margin for the ODR segment, LMB is pacing to close at 29% in 2021. I expect margins to gradually decrease to 25%.

Based on an unlevered beta of 1.09 for the sector and a debt-to-capital ratio of 60%, I estimate the WACC at 7.7%. If these assumptions come true, the fair value for the stock is $21 per share.

10k filings & Author estimates

However, I found it more interesting to value each segment by itself as they have different economics. In steady-state, EBITDA margin for GCR should hoover 3%, capex should be 0.4% of GCR revenues and it is a shrinking business for LMB - all these would justify an EV/EBITDA multiple of 6x. Next year, I expect EBITDA for this segment at 10M USD leading to a value per share of $5.80 per share or 76% of LMB current share price.

As per the ODR segment, I expect EBITDA margin to be ~8% and capex to be 0.1% of revenues thanks to the asset-light business model. Also, as this is a growing segment, a multiple of 14x EBITDA seems reasonable. Applying the expected EBITDA for this segment, 11.3M USD, the value of this segment is $15.30 per share.

I triangulated the EV/EBITDA multiples with comparable companies in the sector with similar profitability and growth profiles. In the chart below, the companies within the red box are similar to the GCR segment while those within the blue box assimilate the economics of the ODR segment.

Ycharts

If you like the details, below are the companies used in the chart above with their respective EV/EBITDA multiple and (EBITDA-CAPEX) margin.

Ycharts

This valuation suggests that by buying LMB shares, you are paying for the GCR business and only paying $2 for a business worth $15 offering a nice margin of safety.

Author estimates

Risks

There are reasons that the share price trades where it is right now. Currently, LMB is less profitable, is shrinking (while the industry is growing) and is more levered.

LMB is less profitable

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LMB is shrinking revenues and EPS while the industry is growing

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LMB is more levered

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However, if the ODR segment grows as expected, all these problems will be solved. By 2023, revenue would be positive and LMB would have a net cash position (including capital leases). And by 2026 gross margin would be at the industry average.

Another risk I see is regarding M&A. Other companies are replicating LMB's strategy and consolidating their market. So there is a risk of LMB overpaying for the acquisitions.

Conclusion

In this article, I offered 4 reasons why I believe LMB shares are an attractive investment. LMB has the opportunity to play the consolidator card in a growing industry. Also, the valuation seems very attractive as you are getting the ODR segment for a bargain price.

Disclosure: I/we have a beneficial long position in the shares of LMB either through stock ownership, options, or other derivatives. 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.