Schuff International – Long
Sententia Capital Management
June 2014
ticker: SHFK mkt cap: $121m price: $29 intrinsic value: $40
Recommendation:
Schuff International is a buy at $29 with an intrinsic value above $40, representing a 30% margin of safety.
Key Points:
Why Undervalued?
- Non-residential construction downturn
- Illiquid market- OTC
- Underfollowed- No SEC filings
- 1.1x BV; likely closer to 0.8x BV
Company Trends
- Historic backlog trends equate to 40% revenue increase in 2014
- Low-end realization of current backlogs will lead to a double in EPS
Industry Trends
- Non-residential construction appears to have bottomed out
- Consensus non-residential is expected to grow 5-7% over the next 3 to 5 years
Catalyst
- HC2 Holdings purchased 60% of the company
- HC2 files with the SEC and will shed light onto Schuff’s quarterly financials
Executive Summary
Overview
Schuff International (SHFK, Financial) Âis a well-positioned company in the steel fabrication and erector industry. The company is primed to benefit from near record backlogs and a potential uptrend in the non-residential construction cycle. The stock is trading near book value and offers a great entry point at $29.
Summary
Schuff is tied to the non-residential construction cycle. The industry has remained pressured since the Great Recession but appears to have bottomed in 2012. As the cycle turns upward, Schuff is positioned to benefit as they have great operational leverage and recapitalized at the bottom of the cycle. For the industry, AIA has a consensus estimate of 5-8% non-residential construction growth over the next 2 years, which will continue to enhance Schuff’s returns.
The strength of the business shows through Schuff’s backlogs. The backlogs surged to company highs at the end of 2013. Should these backlogs equate to average forward revenue recognition, the company would double EPS. This represents a very attractive opportunity, as the free cash flow yield would be north of 20%. The combination of these dynamics in an upturning non-residential construction cycle represents an attractive investment.
The Schuff family has proved savvy as they purchased nearly 60% of stock from majority shareholders in 2012. This transaction has been a boom for the company’s earnings, as the purchase appears to have occurred at the bottom of the business cycle.
As a time of transition, the Schuff family recently sold its controlling portion. The family sold their 60% stake, controlled by Scott Schuff, to HC2 Holdings. Phil Falcone owns 40% of HC2 Holdings, recently changing the name from PTGi to HC2. This presents a catalyst that will shed light onto Schuff’s operations as the SEC filing company, HC2, reports quarterly earnings.
We believe HC2 purchased the company for access to their cash flows, as the newly formed HC2 repositions itself in the market. This shareholder of opportunity can also be a point of concern, as Mr. Falcone has had a troubled past with the SEC. We believe his incentives are aligned. However, in addition to value creation activities such as uplisting or enacting a dividend, HC2 control can also hinder the company through a bad transition or self-guided actions, so this should be closely tracked.
Potential Catalyst
To date, Schuff has not filed with the SEC and trades on the OTC market. The company does file annual reports on its website, which gives yearly insight into the company’s progress. The recent purchase of Schuff by HC2 will provide the investment community insight into Schuff’s quarterly progression, increasing transparency and confidence for the investment community.
Variant Perception
Behavioral
We are an emerging fund that can take advantage of more illiquid opportunities. Schuff presents such an opportunity. Additionally, the company does not file with the SEC, representing an obstacle to funds that are focused on tracking investments through each quarter. Focused on long-term investments, we are positioned to take advantage of this opportunity.
Why is Schuff Undervalued?
OTC Market and Industry Pressure
Limited SEC Filings
Since 2011, Schuff has only reported annual statements on their website. The company has historically traded in the typically less followed and more illiquid OTC market. Additionally, the company reports less rigorous and timely financial statements, as it does not file with the SEC, limiting investor awareness and willingness to own the stock.
Pressured non-residential construction industry
Non-residential construction has struggled to stabilize and grow since the Great Recession, which has impacted earnings potential across the industry. This represents an opportunity, as there appears to be a shifting of the tides as we look at industry trends and company backlogs.
Valuations
EV/EBIT
Schuff’s share price of $29 implies a 9x trailing P/E and 5x EV/EBIT. On a forward basis, Shuff trades at 4.5x P/E and 3x EV/EBIT. The stated book value is $25, which we feel is understated as a majority of their land purchases occurred before 2000 and are carried at cost.
Taking a conservative view on the backlogs to revenue recognition shows EPS doubling for 2014. Estimating a below consensus growth after 2014 of 7% will lead to a double digit EPS by 2016. The operational leverage of the company will lead to a 20%+ Free Cash Flow yield for 2014.
Our base case scenario, with 4x EV/EBIT and a conservative range of backlogs to revenue, implies a $39 price target, or 34% upside.
A low case scenario of 3x EV/EBIT with the low range of backlogs to revenue leads to a share price of $25, or 21% lower than today’s price. Our high case scenario, with 5x EV/EBIT and the high range of backlogs to revenue, leads to a share price of $55, or 90% upside.
Keys to getting the stock right
Business as usual, Exposure
The main components for the investment to materialize are both management and exposure.
Business as Usual
In light of the recent ownership change, Schuff must continue to operate as it has before. There is always potential for a rough transition in majority holders and when a family takes a lesser role in the company, so this will be tracked. We spoke with management about this transition and they appeared to be less concerned as they stated “the regional managers do the majority of the work when it comes to customers so we don’t expect an impact.” Scott Schuff, the CEO and previous majority owner, is expected to continue in an advisory role for the company and there is no indication that additional senior leadership will step down.
Schuff also announced Rustin Roach as the next CEO and President. Mr. Roach has been with Schuff for 15 years and brings stability to this transition. He will be taking a step up from his regional position to the nationally focused company and will rely heavily on his regional managers. This will be a big step for Mr. Roach but he will bring new breath into the company as they position for the coming years.
Exposure
The second key component to the stock is having additional exposure to this company. The company currently has minimal exposure as it trades on the OTC market and does not file with the SEC. The recent majority holder, HC2, files with the SEC quarterly and will bring exposure to Schuff’s operations through these filings.
Schuff Business
Backlogs, Financials, Industry, Management
Backlogs
Schuff shows strong backlogs for 2014. If we forward project backlogs to next year’s revenue, the range from 2002 to 2013 has been a low of 86.5% and a high of 40.8%, averaging 53.2%. Removing the extremes shows an average of 55% backlog/revenue.
This represents a favorable scenario as Schuff’s backlogs are near their historic highs of 2008. The story from that time shows a peak of cycles as we entered into the Great Recession, limiting revenue recognition in the subsequent years.
Today’s scenario is different as the non-residential construction cycle seemingly bottomed in 2012. We anticipate this will be a boost for Schuff and the industry in the coming years. A further point to the health of the business is that current backlogs don’t reflect a ‘Vegas Effect’ that company management is anticipating. The management foresees Vegas returning to growth and they anticipate this will be further benefit revenue and backlogs.
Financial Highlights
Schuff has displayed great operational leverage and as the company’s revenue increases, we see the same historical returns increasing. This will have a direct impact on the cash flows and operational flexibility of Schuff.
Our current financial estimates are conservative and project 7.5% EBITDA margin, 20% ROE margin and 20% FCF yield. We anticipate Schuff will surpass these numbers but will remain conservative in our projections.
Free Cash Flow yield
SHFK currently yields a 10% FCF yield. Looking at a sensitivity analysis for backlog realized as a percentage of revenue and the current backlog increase of 129% from 2012, the FCF yield would approach 20%+. Going into a potential non-residential up cycle, Schuff could build up cash and buy the entire company in less than five years.
EPS
2013 EPS was $3. Applying the same sensitivity analysis shows a potential double for EPS in 2014. P/E is currently 9x, which equates to a 4.5x Forward P/E. Projecting two years ahead, with 7% growth, the EPS would eclipse $11.
Looking back at an adjusted EPS (for shares repurchased) from 2005 to 2007 shows an increase from $4 to $14. We’re conservative to these numbers but should be cognizant of the potential.
Industry
“The U.S. economy has recovered its momentum since the first quarter, suggesting that nonresidential construction’s steady recovery will remain in place,” said Basu (Associated Builders and Contractors Chief Economist Anirban Basu).
The non-residential construction industry appears to have stabilized as of 2012 and shows an upward trajectory over the coming years.
As seen from the AIA chart on the right, the consensus estimate for non-residential construction is forecast to grow 5.8% in 2014 and 8% in 2015. Honing in on Schuff’s specific subset, you can see that the industrial portion is expected to grow quicker than the sum. This bodes well for Schuff as they surge to a solid foundation this year.
Management
Schuff has had a great track record for increasing shareholder value. The highlight is their leveraged purchase of 60% of their shares outstanding from D.E. Shaw and Plainfield Direct in 2012 for $13.25/share. The company used debt, which is mostly paid down now, and the purchase has had a material impact on EPS as the purchase appears to have been at the bottom of the macro and business cycle. The latest sale of the stock to HC2 Holdings was near $31/share.
The main question is- why would they sell their stake if the company were at the beginning of substantial growth? A simple explanation could be that the Schuff founder, David Schuff, is nearing the end of a generation at 82. His son, Scott, has been the CEO since 1991 and there appears to be a desire to transition from the industry.
Also, why sell at $31 when the stock is at $29? Cash. HC2 had the cash available and was willing and able to purchase the family portion to have access to Schuff’s operations and cash flow.
Competition
Fragmented, Merging
Schuff is the largest publicly traded fabricator company but is likely second or third in the industry as compared to its private competitors. Overall, the steel fabrication industry is fragmented with more than 3000 active and competes on price. However, when big projects are brokered, many companies look to size and reputation of the company and seek out bigger firms. In this regard, Schuff is well positioned.
From speaking with Schuff management and industry representatives, fabrication capacity is less restrictive as these companies ‘swing-out’ contracts to smaller fabricators. Although these ‘swing-outs’ would appear to pressure margins, industry representatives hold that they don’t have an effect and may even increase margins as the larger companies retain the scale and business leverage over the smaller companies.
Industry representatives indicate that the industry is going through a consolidation phase as smaller companies continue to feel the pressure of the past years.
The Bear Case
Management/Family Transition
Revenue and future business will be hurt, as the Schuff family is no longer in control. –Schuff has been exceptional at building the business and forming relationships. However, the main work loads and relationship development has been with the regional managers vice Scott Schuff directly. After speaking with industry representatives, who did not have the best view of Scott Schuff, this leadership transition may actually benefit the company.
Key Risks
HC2 Holdings, Transition
Phil Falcone is the major holder for HC2 Holdings. He comes with a troubled record including SEC charges and a 5-year ban from the securities industry. He recently purchased a 40% stake in the former PTGi, creating HC2 Holdings, which is now the majority holder of Schuff. A key risk is key man risk, as Mr. Falcone will have a strong influence in strategic and potentially operational decisions. Folks may view him as a wild card due to his past business practices. Due to his recent SEC charges, we anticipate that Phil will more strictly adhere to common practices, as HC2 Holdings can easily be seen as Harbinger Capital 2, or a fresh start for Mr. Falcone. As Schuff owners, we will be interested in his steps.
The second key risk is the leadership transition with Scott Schuff stepping down as CEO/President. We view this as a small risk as Rustin Roach has been selected as the new CEO and has been with Schuff for 15 years. Additionally, the regional managers manage most of the customer relationships and will remain in place along with other Schuff senior managers such as Mike Hill.
Premortem
Majority Holders, Transition
Majority holder
Although we identified HC2 as a key risk, we didn’t appreciate the impact of the key man.
Transition
The Schuff family control had more weight than we appreciated. This hurt the realization of backlogs and future earnings potential of the company.
