ESOA- Buying More After Strong 1Q Results

  • ESOA posted solid year over year revenue growth, margin expansion, and EBITDA.
  • Management reached out to allay a few concerns some investors have noted about the stock.
  • At under 3x EV/EBITDA, 3x EV/OI, and > 10% EV/FCF yield run-rate, the company is undervalued.
  • The stock is worth at least $3, a 70-100% return from the current trading range.

Shares in ESOA have rallied 10% since my initial investment in January. The CEO was also kind enough to reach out to help rectify a few errors in my initial analysis. We recently circled back to discuss 1Q results and I have incorporated some of his comments with my own thoughts. Overall results were strong, and the stock is still very attractive relative to the market and to peers.

Operating Fundamentals Solid Across the Board

ESOA posted a very strong 1Q, in part due to contract timing, but also reflecting solid improvements in operating metrics.

Revenue of $37.5m vs $34.3m in the prior year.

Gross, EBITDA, and Net Margins all expanded by 100-300 basis points.

EBITDA grew 54% YoY to $3.2m with margins expanding from 6% to 8.4%.

Cash from Operations more than doubled, again partly due to the time of contracts, but definitely a strong start compared to prior years. The backlog of $81.2m was a bit lower than prior year’s backlog of $91.1m. Management believes that this is because there is less a sense of urgency than early 2016. Prospects look good for 2017 and beyond.

Infrastructure Thesis Intact

From my research it looks like at least 2 of the projects circulated by the current administration, and listed here could benefit ESOA. While I am worried about the protectionist bent of wording, such as insisting on American-made steel pipes, I think less regulation in general around pipeline and electrical infrastructure should be bullish for Energy Services of America. Management has also confirmed that some of these projects will run through areas which ESOA services. ESOA’s peers have traded up.

Four Details I Missed

  1. MRO =/= MPC. I mistakenly researched Marathon Oil, rather than Marathon Petroleum as a customer in my initial analysis. The linguist in me took those two words to be interchangeable. MPC is an oil pipeline focused company and in less danger than MRO of paying its bills. MPC recently announced plans to expand production in the Marcellus shale, which could be a good thing for ESOA’s backlog.
  2. A captive insurance company keeps insurance costs low, but also includes some tail risk which is hard to quantify here. To-date the captive insurer has consistently returned a small dividend (a few hundred thousand dollars) to ESOA.
  3. ESOA does not have a fiduciary responsibility for any of the several multicompany pensions to which it contributes, which lowers the risk from any sort of pension fund blowup significantly. I do not believe that ESOA would be on the hook for a significant sum of money.
  4. ESOA has a large dilution overhang which partly explains the lackadaisical share performance. A helpful Seeking Alpha user, Fijas, posted the following:

I think it should be mentioned that there are (dilutive) Series A Preferred units out. Per the December 2016 10-K, there are 206 preferred units out, which in total convert to 3,433,333 shares (16,666 shares per Series A unit). Page 9 states that they issued 56 of these units for debt forgiveness of $1.4mm, which implies a conversion price of $1.4mm / (16,666 * 56) = $1.50.For share prices above $1.50, the Series A pref should be considered dilutive. Given there are 14.8mm ESOA shares outstanding as of December 2016, you’re looking at 3.43 / 14.8 = 23% dilution above $1.50. Seems we can’t treat the preferred as debt, because most were issued to company insiders (they own 63% – see 2016 10-K page 35) and there doesn’t seem to be a liquid market for the preferred (therefore no obvious way for the company to buy them back). Also, the company is paying $309K per annum on the preferred (page F-3), which by my calculations is something like a 6% yield ($309K / (3.4mm underlying shares x $1.50 per share)).All told, this isn’t bad – the company had to make some deals to get out of forbearance, and 6% “convertible debt” in the form of Series A Preferred sold to insiders at least keeps management aligned with shareholders. Just thought it should be mentioned since the stock is hovering around $1.50 and 23% dilution is pretty material.

I think the biggest concern is #4. After speaking with the CEO, I believe that management is aware of investor concerns and will either redeem the Preferred Series A shares for cash or institute a share repurchase plan in the event of pending dilution.The calculation below should capture the full dilution. An important takeaway from our conversation was that the preferred shares are in fact, redeemable.


Even with full 24% dilution and no share buybacks my new valuation numbers are close to the old numbers. When something is this ridiculously cheap it takes a LOT of share dilution to make it significantly more expensive, and at 1.3x tangible book value, it starts looking pretty reasonable for the board of a company like ESOA to either redeem the preferred shares or repurchase common stock.

Why So Cheap?

Setting aside the dilution highlighted above, virtually no ESOA shares (<2%) are held by institutions currently, which may partly explain the low valuation. The company is “uninvestable” for many institutional investors simply because of its low market capitalization, OTC listing, and low share price. Management could lever up, buy-back shares, and/or make a few acquisitions to boost the company past the $50m market cap threshold, which would then begin to make it “investable” to smaller institutional small cap investors. Willbros Group (Ticker:WG) is an example of a slightly larger small cap stock at a $190m market cap which is >60% owned by institutional investors currently, and which incidentally has worse operating performance than ESOA. WG trades on the NYSE. ESOA trades over the counter currently. Over-the-counter stocks tend to trade at discounts due to illiquidity and an often unfounded investor bias that OTC companies are lower quality. So the game plan for management would seem to be either to buyback shares, do some M&A, and/or keep organically growing past the $50m mark, then re-list on a more “prestigious” stock exchange, which should engender more institutional investor interest. I am not saying one of these things will happen, but the potential exist for any combination, any of which should be good for the share price.

Another risk could be M&A. Acquisitions can be messy and often lead to the destruction of shareholder capital, so I don’t want to downplay the risk of M&A, however I feel pretty comfortable knowing that the Chairman in particular has a long and successful track record of wheeling and dealing businesses.

Factoring in Dilution, Stock is Worth 2x the Present Value

I am still learning the energy services industry, but I am a big believer that when a stock is so glaringly “stupid cheap” from a valuation perspective, good things will come. Many options exist for shareholder returns, and management interests seem to be aligned with common shareholders. The issues holding the stock back appear to be simply dumb market forces which haven’t caught up to the changing industry outlook, under-levered balance sheet, and strong company fundamentals due to the small size of the company.

Even after including the 24% share overhang this is a very attractive stock. Looking at comps like MasTec and Quanta, which trade at 10-13x EV/EBITDA currently, ESOA shares should be worth more than $3 after dilution.

Let’s disregard the stellar current quarter results, and assume a more conservative $10m EBITDA run-rate (only slightly better than 2016’s $9.4m. This is still well below the growth rate for the past 4 years since Doug Reynolds first took the reins. Using a $10m EBITDA estimate for 2017, the firm is currently trading at a post-dilution multiple of 3x EV/EBITDA. This is just blatantly undervalued to comps like PWR, MTZ, PRIM, and WG which are all trading between 11-13x. I should also mention that the run-rate EV/FCF yield is >10%, and that the TTM dividend yield was 3%. I also expect that management will continue some form of capital return to shareholders this year similar to the prior year.

I always hate getting the price down to a decimal point (false precision), so consider this more illustrative of my thinking than an actual estimate of the fair price.

Over the past 6 months peers have rallied 40%  vs ~8% for ESOA. Even discounting Energy Services of America a bit for being small, the stock should be trading at roughly twice the current price of $1.66, which would put it around a more reasonable 6x EV/EBITDA ratio, a 5% EV/FCF yield, and a dividend yield closer to peers at 1.5%.

Management does not sound interested in selling the company anytime within the next several years. I could be wrong here, but that is my perspective. I generally prefer companies that are willing to be sold rather than acquisitive companies, but I haven’t found much else that is this cheap in the present market. Given the strong growth prospects and rock-bottom valuation, I believe ESOA is a good buy and hold prospect with several options that should eventually yield strong shareholder returns in the years ahead.

I bought more shares over the past week, and made this a medium size position.



Closing out EarthLink in favor of CSAL. Exiting PayPal.

Every month or so I take a hard-look at my portfolio. In addition to exiting RAD, last week I closed out of EarthLink(Ticker: ELNK) and PayPal (Ticker: PYPL).

ELNK-WIN is Less Attractive than CSAL At Current Spread

EarthLink had appreciated a bit since my initial purchase, and while I still believe it is cheap, I prefer to play Windstream via Communications Sales & Leasing. With the deal spread between ELNK-WIN having narrowed significantly to <2%, I saw no reason to keep holding. I took my gains and exited. I prefer CSAL because it weirdly still pays a higher dividend than WIN, yet sits higher in the capital structure than Windstream stock.

These are the kinds of spin-out situations which Joel Greenblatt loves. Not only did WIN spin-out an entirely different investment industry classification (telecom -> REIT), but in doing so it went from being a mid-cap stock to a small-cap. This resulted in both stocks being undervalued significantly post-spin as investors hit the Nope button, likely due to size/sector fund investment limitations.

CSAL pays a 9% dividend currently vs triple-net REIT peers at 5-7%. WIN pays a 7.8% dividend currently.. despite sitting lower in the cap structure. This. Makes. No. Sense. I don’t know of any other REIT-Customer dividend spread quite like it. CSAL is also significantly exposed to WIN revenue, but if WIN were to go bankrupt, CSAL would still own the copper/fiber assets and should still be collecting lease payments throughout any bankruptcy process. Bond investors in Windstream do not appear to believe that bankruptcy is on the horizon currently.

A lot has happened in the REIT space with the REITS now designated as a separate sector within Financials. As REIT-focused funds get more comfortable with CSAL we should eventually see solid share price appreciation, offset by some potential interest rate hike headwinds. I consider CSAL to be relatively macro safe. If the economy turns South, people will still need internet and telephone service. They are much more likely to stop buying new clothes and computers than to stop what is effectively a utility these days.

With interest rate rises lurking in the horizon, and CSAL being a very unique REIT I think it could be another 1-2 years before the stock achieves a fair value. To the extend that CSAL can minimize WIN exposure through further deals, that should be good for the stock, but management has been cagey there. I’m willing to sit back and collect the 9% dividend in the meantime. It is currently one of my largest positions.

PayPal Operating Momentum is Slowing, Deals with Credit Card Holders is Meh

PYPL operating momentum appears to have slowed a bit year-over-year, and having gained 23%, I am happy to exit. I think the deals last year with Visa and MasterCard were only so-so, and while recent AMZN news could be good, I suspect Amazon will drive a hard-bargain.

I appreciate the potential of Venmo (how many times have you heard the term “I’ll just Venmo you.”?)  I don’t know how or when PYPL monetizes it without losing customers. So I’ve chosen to move to the sidelines for now. From a valuation perspective the stock is not cheap at 1.4x PEG and >18x EV/EBITDA. I like PayPal/Venmo as brands but I’m just not excited about the fundamentals or the general business direction currently.

Maybe I’m missing something here?

New Buys

OK I’ll bite on the community banks thesis which others have described. I’m looking hard at a few now and will write more about that later. I also bought some INSW – an undervalued spin-out from OSG. More to follow.