Tuesday, July 23, 2013

7 Reasons To Buy Terex

Terex Corporation (TEX) is mid-sized company with a market capitalization of around $3.22 billion operating in the industrial goods sector. Right now, Terex is trading at about $29 per share. Although its debt to equity ratio remains a high, the recent growth it has seen in its earnings per share along with basic valuation metrics suggest Terex's stock is undervalued. Both its technicals and fundamentals suggest a favorable upside is highly probable in the near term. It's now time for investors to take that into consideration. This article provides a brief overview of Terex's operations as well as its recent performance in the market. Additionally, investors will be provided with seven reasons why Terex is a strong buy at its current valuation. To conclude, I will highlight several areas for concern that investors should bear in mind.
Company Background
Terex is an equipment manufacturer of specialized machinery products that was incorporated in Delaware in October of 1986. Since 1986, Terex has changed significantly. The large amount of acquisitions Terex has made over the last ten years has greatly enhanced the position in the market for industrial goods. Today, Terex's operations are widespread across the globe and are highly diversified in nature. The primary focus of Terex's business is centered around providing its customers with timely solutions that incorporate degree of specialization across a wide breadth of applications such as construction, infrastructure, quarrying, mining, manufacturing, shipping, transportation, refining, energy, and utilities industries. For simplicity, Terex's operations can be easily divided into five business segments:
  1. Aerial Work Platforms
  2. Construction
  3. Cranes
  4. Material Handling and Port Solutions
  5. Materials Processing
As mentioned earlier, Terex is trading right around $29 per share. With 110.8 million shares outstanding, its market capitalization is roughly $3.22 billion. In terms of ownership, Terex's stock appears to be a prime target for institutional investors who currently hold nearly 95% its common shares outstanding. Insiders only own about 3.8%, which leaves very little for individual investors. Recently, there has not been any significant transactions by either institutional investors or insiders. In the last three months, institutional and insider holdings increased by roughly 0.46% and 10.44%, respectively.
TEX Chart
TEX data by YCharts
7 Reasons To Buy Terex At $29 Per Share:
#1 Terex's basic valuation metrics alone suggest its stock is undervalued in the market. Currently, its price-to-free cash flow ratio is only 9.35, which is favorable given a P/FCF ratio of less than 15 is a strong indication a stock is undervalued. In other terms, this also tells us that in excess of capital expenditures Terex has about $3.12 in free cash flow (FCF) available per share, which equates to total FCF of roughly $344 million. For a mid-sized company, Terex's level of FCF TTM is adequate, but do not expect it to stay the same. Over the past two years, Terex's FCF has experienced significant growth, and going forward, it appears as if this growth will continue. Let's take a look:
TEX Free Cash Flow TTM Chart
TEX Free Cash Flow TTM data by YCharts
#2 Improvements in earnings will cater to a higher valuation and upside potential for investors. First, its important to note that on a five year time frame its earnings growth is not favorable. Terex's EPS growth over the last five years is actually negative displaying a decline by about 29%, however a more narrow time frame presents an entirely different story. First, let's take a look at its changes in revenue over the past couple of years.
TEX Revenue TTM Chart
TEX Revenue TTM data by YCharts
Evidently, Terex's revenue has experienced excellent growth over the last two and a half years. For the fiscal year ending 2012, Terex's total revenue came out to $7.25 billion. As you are beginning to understand, Terex has made significant changes that have not only allowed its business to expand, but also allow it to sustain higher margins. And this is reflected through its EPS growth. Let's take a look:
TEX EPS Diluted TTM Chart
TEX EPS Diluted TTM data by YCharts
So far this year, its EPS has already increase by nearly 160%, and that's only two quarters of operating results. Going forward, analysts estimates continue to be favorable. Analysts are anticipating its EPS will increase by about 50% in the next year.
#3 Terex is in position to benefit from changes made to its cost structure. Along with margin improvement comes cost reduction, which is exactly what Terex has done. Terex has dramatically improved its EPS and increased its overall profit margin by reducing the aggregate amount of capital it allocated to variable as well as fixed costs such as capital expenditures. Let's take a look:
TEX Capital Expenditures Quarterly Chart
As you can see above, Terex has significantly decreased the amount of cash it allocates to investing activities. The decrease in capital expenditures is attractive from an investment standpoint because it allows for a higher level of FCF, which indirectly impacts its valuation. Holding all other factors constant, a higher level of FCF will increase the intrinsic value of its common stock.
#4 Terex competes in an industry that is extremely competitive, however the diversified nature of its product/service venue will allow Terex to maintain the market share necessary to compete in the industry. A few of Terex's competitors include Caterpillar (CAT), Manitowoc (MTW), Manitex International (MNTX), and Deere (DE). Although the magnitude of Terex's revenue is much smaller than some of the bigger competitors such as CAT and DE, the increase in Terex's revenue shows that it's still capable of gaining new business.
TEX Revenue TTM Chart
TEX Revenue TTM data by YCharts
#5 From a technical standpoint, Terex is quite attractive. Its 30-day relative strength index (RSI) indication is relatively low at only 42.4, which does not suggest the stock has been over bought. However, an RSI indication falling between 20 and 30 would be ideal for initiation a position. And within the next month, it appears as if its RSI will reach the low 30s. In addition to the tedious metrics used by market technicals to determine the likelihood of a stock price moving one way or another, technical analysis, under rare circumstances, can also be used to generate price targets. And as rare as it may be, Terex's YTD price graph offers an excellent example as for how a price target can be determined using the underlying patterns and trends within its price.
(click to enlarge)
Looking at the graph above, you will see that I have highlighted three circles, which represents what is often called a inverse head and shoulders. The four key components have been illustrated by the shapes in the graph above and include the neckline (LINE), shoulders (circles), and the head (oval). The price target formula for an inverse head an shoulders pattern is: [Price Target = Neckline + (Neckline - Head)]. Therefore, this graph reveals a short-term price target ranging from about $28 to $30.
#6 Based on intrinsic value, the fair value of Terex's common stock is $34 per share. To compute this value, I used a variation of the corporate valuation model taking into account its FCF TTM, its current weighted average cost of capital, and a perpetual growth rate of 2.5%, which is fairly conservative. Note this is not by any means a price estimate. It's the true value of what Terex's common stock is worth right now. Overall, this suggests Terex is trading 17% below is fair value per share.
#7 Analysts seem to be on board as well. Of the seven analysts that cover the stock, the mean and median six month price targets are $35 and $36.50, respectively. In other terms, the mean and median price targets suggest an upside of 20.7% and 25.9%, respectively.
Bottom Line
While an excellent investment opportunity exists, there are several risk investors need to be aware of. As you saw, Terex's EPS made a dramatic turnaround this year. The vast majority of this can be attributed to major changes made to its cost structure. Therefore, going forward, it will be crucial Terex's management maintains an adequate level of control over its variable as well as fixed costs to prevent margin compression. In addition, its important for investors to know that Terex is affected by the cyclical nature of the different markets it serves. And given Terex's customer base is highly diversified among different industries, this risk is subject to vary greatly.
Overall, Terex is a profitable company with sound fundamentals. Its common stock is on sale trading at a hefty discount to its fair value. With that being said, now is an excellent time for active investors to initiate a position before this simple market inefficiency is exploited.
Sources: YCharts, Google Finance, Yahoo Finance, TD Ameritrade, FinViz, and Bloomberg Market Data.

TGC Industries: Undervalued By 30% And Positioned To Grow From A Sustainable Clientele

TGC Industries (TGE) is a small capitalization company in the basic materials sectors. TGE's operates as a service provider of seismic data acquisition services catering to the needs of firms within the oil and gas exploration and production industry. TGE is a profitable company that derives its margins from several keen advantages, including its widespread operations, a highly specialized service menu, and a customer base that's sustainable.
Over the last few years, the oil and gas exploration and production industry has seen rapid growth as a result of increased activity on the exploration side. Majority of the firms within this industry are operating in a mature stage, and therefore, tend to have the capital needed to exert a consistent demand for TGE's services. Given the recent demand for TGE's services has been relatively stable, we can assume this holds true. TGE's position in the market is unique, because the demand for its services will reflect an increase much similar to the growth rate of its customer's business, which later we will see is quite favorable.
Overall, TGE's strong financial position will provide it with the solvency necessary to sustain its operations in the long run and provide it with enough capital on hand to adjust its service menu to ensure it addresses the needs produced by outward shifts in the demand curve for its services. The sustainability of TGE's customer base is by far the most lucrative resource at its disposal, however its current valuation is what I find most enticing. Not only do TGE's basic valuation metrics provide a sound indication that its common stock is undervalued, but computing its intrinsic value reveals a substantial difference between what investors have priced into the market versus what TGE is truly worth. As of now, investors have yet to exploit this market inefficiency, and a feasible investment stands to exist. This article will provide an overview of the company as well as its operations, highlight its recent performance, and discuss the characteristics of the industry that TGE's customers operate in. Additionally, this article will include a detailed segment covering its valuation and provide investors with a sense of what to expect in terms of its stock price for the end of 2013. To conclude, I will outline several potential risks that investors should be mindful of.
Company Background
The start of TGE's business dates back to as early as 1980 where it was it began operating under Supreme Industries, Inc. as a wholly owned subsidiary called Tidelands Geophysical Co., Inc. Several years later, in June of 1986, the Board of Directors of Supreme Industries and Tidelands Geophysical approved a spin-off of substantially all of the shares of Tidelands owned by Supreme Industries. Ultimately, the spin-off resulted in the distribution of its shares in the form of a stock dividend that was paid to Supreme Industries' shareholders. This marked the original formation of Tidelands Geophysical Co. Inc., which today is known as TGC Industries, Inc.
Today, TGE is incorporated in Texas and maintains control over its wholly-owned subsidiary, Eagle Canada, which is a Delaware corporation. TGE is one of the leading providers of seismic data acquisition services and through its operations is actively engaged in the geophysical service business of conducting three-dimensional surveys for its clients in the oil and gas exploration and production industry. As of December 31, 2012, TGE operated a total of 14 seismic crews. Nine of the crews are located in the United States, while the other five remain stationed in Canada. The primary goal of these crews is to provide seismic data to companies that are actively exploring and working towards developing oil and natural gas on land as well as in land-to-water transition areas.
As you are starting to understand, TGE's services cover a vast landscape and provide critical need-to-know information for the dominant players in the oil and gas exploration and production industry. To maintain a competitive edge, TGE acquires its geophysical data using the latest three-dimensional survey techniques. TGE's 10-K goes into further detail, on the process:
"We introduce acoustic energy into the ground by using vibration equipment or dynamite detonation, depending on the surface terrain and subsurface requirements. The reflected energy, or echoes, is received through geophones, converted into a digital signal at a multi-channel recording unit, and then transmitted to a central recording vehicle. Subsurface requirements dictate the number of channels necessary to perform our services."
Basically, TGE takes on the full costs associated with obtaining the-state-of-the-art equipment to obtain the data as well as the costs associated with processing and interpreting the data. Then the results of the data are then used to generate the final deliverable to customers, which is simply a three-dimensional model that helps reduce discover costs and improve recover rates from existing wells. For further details on its operations, visit TGE's company website.
In the market, TGE is trading at about 20x its 2012 earnings per share. With a total of 22.81 mm shares outstanding, its market capitalization is small barely tipping $200 mm. In terms of technicals, I cannot say TGE offers a perfect entry point at the moment, but its 30-day relative strength index (RSI) indication does not reveal anything investors should be concerned about. Currently, its 30-day RSI indication is 43.5, which lies right about in the middle. and should be viewed as neutral.
TGE Chart
(Click to enlarge)
TGE data by YCharts
The One Time "Being Needy" Doesn't Get Old
Broadly speaking, there is a widespread need for TGE's services. And going forward, the need will only magnify as positive growth is experienced by its customer base. While the probability of this growth trend continuing is highly favorable, the underlying probability of zero growth or even a decline always exists. Therefore, in order to accurately make an informed prediction regarding TGE's growth potential, we must start by shifting our focus directly on its customer base.
As mentioned earlier, TGE's customer base is comprised of the companies operating in the oil and gas exploration and production industry. This general structure of this industry entails several large firms operating in a mature stage that dominate in terms of revenue market share. Just for reference, some of these firms are Apache (APA), ConocoPhillips (COP), Exxon Mobil (XOM), BP plc (BP), National Iranian Oil Company, and Petroleo Brasileiro Petrobras SA (PBR). In the last several years, TGE along with several of its peers in the Oil and Gas equipment services industry have had the luxury of being able join the ride and prosper off the massive growth experienced by companies operating in the oil and gas exploration and production industry. Increased exploration activities among these companies in the United States and Canada has had a major impact on the demand for TGE's services.
So far, we have established the idea that growth in this industry does not seem to be an issue, but let's quantify growth in terms of revenue to make this easier to understand. According to IBIS World, in 2008, the total revenue generated by oil and gas exploration and production companies globally was around $4.2 trillion. In the following year, revenue declined by 40% as a result of the 2009 credit crisis, however the significant revenue increases over the next two years made up for more than their fair share. After 2009, the YoY revenue increases in 2010 and 2011 alone were almost enough to entirely offset the damage done in 2009. As you can tell, this setback was purely temporary, and the industry is only beginning to excel beyond its performance we saw in 2008. Going forward, the industry's total revenue for 2013 is projected to increase by 3% YoY to approximately $4.5 trillion by the end of the year. From 2008, this is an increase of roughly 7.14%, which annualized equates to 1.42%. While this may seem to be a bit of a slowdown in terms of its revenue increases on a YoY basis, it's important to understand that the oil and gas exploration and production industry has finally recovered from the nasty turn it took in 2008. With that being said, YoY revenue growth in the 2% to 3% range should not be perceived as slow or inadequate growth -- it's rather favorable.
Operating Performance
Over the last five years, TGE has grown tremendously. For starters, let's take a look at its revenue:
In just a five-year period, TGE's revenue has increased by nearly 125%. More importantly, it's crucial to note what did not happen in 2009. While the dominant players in its customer base had a rough time following the credit crisis, the impact on TGE's performance was much smaller. In fact, the impact was so insignificant that you cannot even tell by looking at its revenue. It's TGE's net income that reveals the change. Let's take a look:
Since 2010, TGE's net income has remained positive and is continuing to increase. Additionally, when analyzing earnings it becomes even more crucial to look at the cash flow generated by operations. Operating cash flow will allow us to determine whether or not a firm is capable of generating real earnings and it will expose any accounting gimmicks that may have potentially been used to distort net income. Overall, TGE has a history of producing steady cash flows. With the exception of 2010, for the last five years TGE has generated cash flow from operations in excess of capital expenditures each year leaving a positive amount of free cash flow available to shareholders.
Going forward, I expect the difference between operating and free cash flow to shrink as its cost structure stabilizes. In 2012, capital expenditures alone were roughly $32 mm, and based on past performance, this is not shocking. If we take a look at the change in total assets over time, the large amount of cash outflows for investing activities makes sense.
TGE's current free cash flow trailing to maturity is about $15 mm, and by the end of 2013, I expect the final free cash flow figure to be closer to $17 mm. Regardless, as cash outlays for investing activities are reduced, investors should see a substantial increase in free cash flow by the end of 2013.
Capital Structure
As noted earlier, TGE's debt is hardly a concern. Right now, its current debt-to-equity ratio is about 31%. With only $13.94 million in long-term debt on its balance sheet, its long-term debt-to-equity ratio is even more appealing at only 17%. Now that we have eliminated solvency as a potential set back, let's take a look at TGE's short-term financing needs. Below, you will see a figure I retrieved directly from TGE's most recent 10-K displaying all of its current contractual obligations.
As shown in the figure above, TGE's total debt outstanding is $25.028 mm. Of this total, roughly $11.088 mm is debt tied to short-term financing needs, which means repayments on this debt will be due in less than a year. Up to this point, TGE has not revealed any signs of major liquidity issues, but with a current ratio of only 1.6 we cannot eliminate the possibility of short-term financing creating an issue down the road. Additionally, the fact there is more short- than long-term debt suggests the use of high fixed costs is relatively low. Furthermore, this indicates TGE exhibits a lower degree of financial leverage, which means that are not faced with the risk of performance being determined by whether or not it's capable of incurring high fixed costs.
Valuation
TGE is extremely undervalued and there is no question about it. For starters, let's begin with taking a look at several of its price multiples as they are an excellent way to begin illustrating this story. In the figure below, you will notice its current price-to-cash flow (P/FCF) and price-to-earnings growth (PEG) ratios are 12.72 and 0.31, respectively.
TGE Price to Cash Flow TTM Chart
(Click to enlarge)
TGE Price to Cash Flow TTM data by YCharts
Now on a standalone basis, these valuation metrics are not extremely useful. However, the combination of the two falling within specific constraints for a given period of time is a different story. The combination of a P/FCF ratio of less than 15 and a PEG ratio of less than 1 is a strong indication that the stock is undervalued.
Like other companies operating in the Oil and Gas equipment services industry, TGE has never really traded at a consistent price-to-earnings ratio. This can be attributed to the large amount of earnings variability created by the negative earnings in 2010. As you will see below, TGE has been trading at about 20.5x its 2012 earnings per share.
TGE PE Ratio TTM Chart
(Click to enlarge)
TGE PE Ratio TTM data by YCharts
In 2012, its earnings per share came out to $0.72, which is based on the diluted weighted average number of shares of 23.3 mm. For the period ending March 31, 2013, TGE reported earnings per share of $0.27, which was just the first quarter of 2013. TGE will report its earnings for Q2 on July 29th. Following this announcement, we will have a much better idea of what to expect by the end of 2013. But as of now, I anticipate its earnings per share will easily exceed its diluted total for 2012. Its Q1 earnings alone is about 40% of its total earnings in 2012, and after Q2, it will exceed well over 60%.
In addition to these favorable metrics, TGE is trading at a deep discount to its intrinsic value. TGE's true value is best reflected through the intrinsic value of its operations and the model I am about to show you will compute this for you. In the model below, I used a conservative free cash flow estimate for the end of 2013, TGE's weighted average cost of capital as the risk-adjusted discount rate, and last, a perpetual growth rate of 3%. To derive the intrinsic value of operations, the model simply divides the free cash flow estimate projected one year forward by the difference between the weighted average cost of capital and the perpetual growth rate. In order to provide a more conservative estimate, I used TGE's current trailing to maturity cash flow figure in place of the $17 mm I projected earlier.
After computing the value of its operations, I subtracted net debt to arrive at the intrinsic value of equity. Then divided that figure by the number of shares outstanding to arrive at the true value per share. As a result, the model indicated its implied share price should be right around $11.76, which suggests TGE is undervalued by roughly 30% given its current price in the market. It's clear without a doubt, there is a strong case for value. TGE is on sale for only a fraction of what it's actually worth, and with that being said, it's now time for active investors to take advantage of this intriguing upside potential.
Investor Concerns
While I feel being a solid growth candidate with attractive valuation makes TGE a strong buy, there are several risks investors need to be aware of. First, it's obvious that poor performance in the oil and gas exploration and production will have an impact on TGE's performance, but investors should be mindful of the "lagged" effect. Poor performance through the profit margins of its customers will also impact TGE's margins, but it may not be noticeable for a couple of quarters down the road. Therefore, it's important for investors to stay up to date on the operating performance of TGE's customers. Second, it's important to recognize that TGE competes in an industry that is highly competitive in nature. The services its operations provide are lucrative, but expensive in terms of short-term financing costs. In fact these services play an essential role in an exploration company's ability to maintain a competitive edge, big players in the industry do not have an issue paying a premium for these services. As long as TGE maintains an adequate level of solvency like it historical has, it will not have an issue meeting the costs necessary to sustain its operations. However, if TGE does not maintain an adequate level of capital, then there is an open opportunity for firms with financial resources to enter the market and take away from TGE's business.
Bottom Line
It's clear that the performance of the oil and gas equipment services industry is fairly correlated with the performance of the oil and gas exploration and production industry. The major exploration and production companies such as XOM and BP typically generate higher margins than companies such as TGE, however during economic downturns companies such as TGE tend to not suffer quite as bad. TGE is a profitable company with a strong financial position that is well positioned to grow over the next couple of years. Its lucrative customer base comprised of some of the largest publicly traded companies adds to the sustainability of its business. The oil and gas exploration and production industry is continuing grow and it's expected that we will see about 3% YoY growth industry wide by the end of 2013. Additionally, TGE's customer base exhibits a consistent demand. Its customers are needy, and in this case, it's not an issue. As long as TGE effectively maintains an appropriate capital budget, it will be able to cater to any shifts in the demand for its services. As you saw, TGE's valuation is attractive as it continues to trade at a severe discount to its intrinsic value. Its 2013 Q1 earnings were solid and its intrinsic valuation will only continue to augment as its future earnings translate into free cash flow. A feasible investment exists and investors are positioned to benefit from a short-term upside of as much as 30%.
Sources: Google Finance, TD Ameritrade, YCharts, Bloomberg Market Data, sec.gov, and FinViz.

ENGlobal: A Deeply Undervalued High Reward Growth Play

ENGlobal (ENG) is a small capitalization company operating as a provider of engineering and various specialty services for companies within the energy sector. Despite the inherent volatility that's commonly associated with small capitalization companies, ENGlobal presents a different story. In terms of operations, its business risk is minimal and its growth potential is tremendous. Right now, its common shares offer pretty solid value as they continue to trade at a severe discount to intrinsic value. The suppressed valuation also provides investors with an adequate level of downside risk protection. Clearly, a feasible investment exists, but it's important to realize that it is only a matter of time before active market participants begin to exploit this simple market inefficiency. Within the next six to twelve months, I believe ENGlobal could see a substantial upside. An upside in excess of 100% is not out of the question. Actually, it's highly probable - and shortly, you will see why. This article will give an overview to ENGlobal's operations focusing specifically on its historical and recent performance. In addition, it will place an emphasis on its valuation and highlight the key differences between its market and intrinsic value investors need to be aware of. For a good primer, here's an overview of ENGlobal's business.
Background
EnGlobal was incorporated in the State of Nevada in June of 1994. Since, it has operated as a major service provider to its wide range of customers primarily concentrated in the energy sector. In terms of geographical placement, its operations are quite diverse and cover a vast landscape. As of the most recent reporting period, ENGlobal has roughly 1,700 employees in 15 offices located in six different states including Texas, Louisiana, Oklahoma, Colorado, Alabama and Illinois. For simplicity, ENGlobal's operations can easily be divided into two segments including:
  1. Engineering and Construction
  2. Automation
The Engineering and Construction Segment incorporates all the services related to the development, management and execution of projects requiring professional engineering to the midstream and downstream sectors throughout the United States. According toENGlobal's 10-K, the services provided within this segment include the following:
  • Conceptual studies
  • Project definition
  • Cost estimating
  • Engineering design
  • Environmental design
  • Environmental compliance
  • Material procurement
  • Project and construction management
  • Facility inspection
For this segment, the services listed above are provided to customers through one of its two wholly owned subsidiaries including:
  1. ENGlobal U.S., Inc.
  2. ENGlobal Government Services, Inc.
The ENGlobal U.S., Inc. subsidiary focuses on providing its services primarily to midstream and downstream segments of the oil and gas industry, chemical and petrochemical manufacturers, utilities and alternative energy developers. In addition, this subsidiary works on a wide range of energy infrastructure projects in the U.S. These projects entail services related to construction management, process plant turnaround management as well as plant asset management. TheENGlobal Government Services, Inc. subsidiary provides automated fuel handling systems and maintenance services to branches of the U.S. military and public sector entities. The customer base of this subsidiary includes government agencies, refineries, petrochemical and process industry customers around the world.
Overall, this entire segment is far more labor than capital intensive. With that being said, ENGlobal's operating performance is heavily dependent on its ability to generate revenue and maintain cash flows in excess of cost required to sustain its operations, pay employees and cover any additional SG&A expenses. In terms of revenue, the Engineering and Construction segment is by far ENGlobal's largest segment. The revenue generated from this segment derives from contracts. This segment has an existing blanket service contract which it provides clients with either services on a time-and-material basis or with services corresponding to a fixed-price that is agreed upon in advance. Typically, about three-fourths of annual revenue is generated from this segment. In 2012, 74.1% of its revenue was derived from this segment, which is the equivalent of $168.93 mm. Although the Engineering and Construction segment is ENGlobal's large source of revenue, its Automation segment was the only portion of its business to produce a positive operating profit in 2012. The combination of high operating costs and work pushed forward have not only increased the amount of backlogged work, but had a major impact on its 2012 operating performance.
(click to enlarge)
The Automation Segment provides services pertaining to the design, fabrication as well as implementation of process distributed control systems, analyzer systems, advanced automation, information technology, electrical and heat tracing projects primarily to the upstream and downstream sectors throughout the United States. In addition, this segment of caters to specific projects for customer needs in the Middle East and Central Asia. The automation segment only constitutes about a quarter of ENGlobal's total revenue. Therefore, the performance of this segment has a significantly smaller impact on ENGlobal's business as a whole. In addition, the growth in this segment is seemingly smaller than its engineering and construction segment, which is reflected by the decline in the proportion of its revenue from this segment from 2011 to 2012. In 2012, the revenue generated from this segment was roughly 25.9%. Below, you will see the decline in its revenue from 2011 to 2012.
(click to enlarge)
For both segments, we saw a decline in total operating assets on a year-over-year basis. The total assets for its Construction and Engineering segment decreased by nearly 33%, while total assets for its Automation segment only saw about a 2% decrease. Despite the large decline in total assets for its larger segment, the magnitude of this impact is still not significant enough to heavily influence ENGlobal's fair value. Going forward, I expect ENGlobal's Engineering and Construction business segment to experience the most growth in terms of revenue generated and return on capital invested in this segment of its business. Also, I anticipate the revenue generated from its Automation segment to remain relatively the same.
Switching gears for a minute, let's take a look at ENGlobal's performance in the market. As you will see below, its clear that the fair value of ENGlobal's operations is not by any means accurately reflected by its current price in the market.
ENG Chart
ENG data by YCharts
In early 2011, ENGlobal's stock price took a nasty turn. At the time, its share price was right above $5, and now, ENGlobal trades at barely above $1 per share. In just a two-year period, its stock price managed to decline by 80%. But, the question is - why?
Earlier this year, management announced the discontinuation of one of its business segments - Field Solutions. The revenue generated from this segment was comparable to the revenue generated by the Automation segment. However, the Field Solutions segment was not growing. It was simply producing a negative operating profit and has been doing increasingly worse over the course of the last few years. While the discontinuation of this business segment had relatively little impact in the short-run, the capital that would have been used to sustain this business segment can now be utilized appropriately - to fund expansion.
Yes, ENGlobal's operations have expanded overtime. However, issues concerning capital adequacy and low levels of solvency have ultimately served as a deterrent preventing ENGlobal from developing any form of sustainability in regards to its operations. Low levels of capital available to fund projects has forced work to pile up, which overall has increased ENGlobal's aggregate amount of backlogged work. The discontinuation of its Field Solutions segment will fulfill ENGlobal's liquidity needs for reducing its backlogged work and improve its solvency position in the long-run.
Operating Performance Has Been Mediocre, But Is Already Showing Signs of Improvement
In addition to net income, it's crucial to look at the amount of cash generated from operations. By looking at operating cash flow we can determine whether a company is generating real earnings and eliminate the potential usage of accounting gimmicks that distort net income. But as you will see below, ENGlobal's performance in the last couple of years is nothing to get excited about. In fact, looking at its operating cash flow may seem almost useless given the unfavorable loss in net income for both years, 2011 and 2012. But shortly, you will see how this has already begin to change in 2013.
First, let's take a look at a portion of its cash flow statement for the past two fiscal years:
(click to enlarge)
Clearly, ENGlobal's earnings did not improve from 2011 to 2012. Its level of operating cash flow went from positive to negative after reporting a loss on net income of nearly 5x more than the loss in the previous year. Furthermore, its operating cash flow for 2011 was barely positive. If you look closely at the cash inflow items for 2011, you will see the income taxes received for this year ($6.738 mm) made all the difference. The sole reason ENGlobal had positive operating cash flow of $5.579 mm in 2011 was because of the income tax receivables. Unfortunately, its historical earnings do not reveal the stability investors like to see, but it does provide some support for why ENGlobal was heavily sold off the way it was. Going forward, investors should expect to see major changes.
So far in 2013, we have seen the structural changes management made by eliminating one of its business segments. However we have yet to see the full economic value this decision has the potential to add. Besides the depletion of an entire business segment, the changes related to the costs associated with sustaining that segment are going to have the greatest influence. And ENGlobal's Q1 2013 financials are just beginning to show this. For Q1 2013, ENGlobal reported operating revenue of $49.763 mm. Its net income came out to $1.937 mm, which is the equivalent of $0.07 earnings per share based on the weighted average number of shares outstanding. Its important to note that the final net income figure reflects the loss from continuing operations and income from discontinuing operations, which as previously mentioned, the Field Solutions business segment. At the share level, the income from discontinued operations was $0.11 and the loss from continuing operations was $0.04, which combined equates to net earnings per share of $0.07. This is a significant improvement from the previous quarter as well as this same quarter the previous year. In addition, the improvement is revealed through its operating cash flow.
For Q1 2013, its operating cash flow came in at $5.89 mm. As you will see in the graph below, this is a dramatic change from the previous quarter where its operating cash flow was negative at $4.874 mm. The significant variation between these two figures can be attributed to the discontinuation of one of its business segments as mentioned earlier. Going forward, I expect ENGlobal to gain stability in its operating cash flow and sustain a positive level.
ENG Cash from Operations Annual Chart
Other notable changes made in this quarter concern capital expenditures and changes in working capital. Capital expenditures saw a major decrease from roughly $670,000 to $20,000. On the other hand, working capital increased quite a bit to $6.34 mm from $2.63 mm.
Shareholder Base
ENGlobal's 27.4 mm common shares are primarily split between insiders and institutional investors. Nearly 44% are held by insiders while institutional investors account for about 28%. The remaining portion of its common shares are disbursed among private investors with a majority of them residing in the United States.
The Stock Is Dirt Cheap...
Valuing a company in either its early growth stages or rather small in terms of the magnitude of its earnings can be rather difficult. Additionally, it's important for investors to understand the absence of stable free cash flows can cause the inputs in present value models to produce variation within the results. Therefore, I am going to stay on the conservative side in regards to the inputs I use.
Below, you will see that I used the corporation valuation model to arrive at an intrinsic share price estimate for the end of 2013. Although this model does not incorporate free cash flow estimates extending beyond one year, I feel it provides greater accuracy given ENGlobal lacks a strong history of generating free cash flows. Let's take a look:
As a result, this model concluded with an intrinsic share value of $2.56, which suggests an upside of nearly 115% from its current price in the market. Note this model takes into account ENGlobal's current capital structure, which is reflected through its weighted average cost of capital (WACC) of 10.5%. In addition, I assumed its operations will grow at 6.5% over the next year.
Investor Concerns
As previously mentioned, for a small capitalization ENG presents relatively low business risk. In addition, the quantitative risk within its holding period returns is relatively low as well. Using its historical monthly holding period returns, I computed a firm-specific beta of only 1.83. But like any investment, we have to assume the worst and account for the probability of extreme outcomes. To ensure investors are ready to protect themselves in a timely manner from unforeseen events, there are several things investors need to bear in mind.
First, it's important investors understand that there is a moderate level of uncertainty surrounding future revenue and earnings. The extent to which this uncertainly will actually translate into a material impact on ENGlobal's operating performance heavily depends on the state of its backlogged work. As of December 29, 2012, ENGlobal's backlogged work was approximately $205.3 mm. Since December, the total amount of backlogged work has been reduced, however it's not certain that the remaining portion of revenue projected in backlogged work will be realized or not. In addition, ENGlobal's dependence on a few select customers has the potential to negatively impact its performance down the road. Last year, ENGlobal heavily relied on three customers including Caspan Pipe Consortium, the US Government and BASF Corporation. These three customers comprised 9%, 7% and 5% of its revenue, respectively. The loss of business from any of these customers could have an adverse impact on total revenue in the future.
Bottom Line
As you can see, ENGlobal is in a recovering state. Its operating margins reflect low levels of profitability and its cash flows are just starting to gain stability. The discontinuation of its Field Solutions segment enhanced its performance in Q1 of 2013 in terms of its net earnings, but its operating income on a standalone basis tells us ENGlobal has not recovered. The increases in its operating income will depend on management's ability to complete backlogged work and effectively maintain the level of outstanding work to a minimum. Liquidity has been a major issue in the past, but recent enhancements in this area eliminate this concern. As a result of the discontinuation of ENGlobal's Field Solutions segment, its level of solvency improved dramatically. The increased level of solvency will not only help reduce backlogged work, but more importantly, allow ENGlobal to sustain its operations in the long-run.
ENGlobal's performance will also rely on management's ability to effectively implement a new cost structure. While ENGlobal is not highly leveraged in terms of the fixed costs used to sustain its operations, maintaining an effective capital budget that monitors cash outflows to investing activities will be crucial. And since a portion of its contracts use a fixed pricing structure, being able to minimize capital expenditures will certainly help strengthen margins and tighten down on operating expenses.
Overall, ENGlobal presents an intriguing investment opportunity. The aggregate risk involved is moderate at best, and yet, the reward potential is substantial. ENGlobal should be viewed as a speculative buy with an abnormal amount of downside risk protection from its suppressed valuation. The probability of achieving an abnormal return on an initial investment is high. Therefore, I recommend buying ENGlobal at its current valuation.
Sources: TD Ameritrade, Google Finance, Yahoo Finance, Morningstar, FinViz, YCharts, sec.gov, and ENGlobal's Company Website.