LMB - Limbach Holdings: Volatile Cash Flow Here To Stay

2023-09-01 13:21:26 ET

Summary

• Limbach's execution to differentiate strategies by segment provided strong gross profits growth in the past few quarters.
• The company's historically volatile cash flow has roots in its business operation.
• Limbach is likely to look for future acquisitions in a way that helps with scaling and market share expansion that complements its current portfolio and capacity.
• Strong growth moment expected to continue, so does its cash flow volatility.

Investment Thesis

Company Overview

Limbach Holdings, Inc. ( LMB ), a Delaware corporation headquartered in Warrendale, Pennsylvania formed on July 20, 2016, provides building systems solutions in the design, prefabrication, installation, management, and maintenance of heating, ventilation, air-conditioning (“HVAC”), mechanical, electrical, plumbing and controls systems. The Company operates primarily in the Northeast, Mid-Atlantic, Southeast, and Midwest regions of the United States with two reportable operating segments, General Contractor Relationships (“GCR”) and Owner Direct Relationships (“ODR”).

Strength

Limbach provides comprehensive facility services consisting of mechanical construction, full HVAC service and maintenance, energy audits and retrofits, engineering and design-build services, constructability evaluation, equipment and materials selection, off site/prefabrication construction, in addition to a complete range of sustainable building solutions. The company's gross profit margin took off in 2020. Since then, it has risen from about 13% to almost 22% while its revenue has remained within a range.

In particular, its gross profits grew about 200 bps in '20, 400 bps in '21, and 200 bps in '22, respectively, even with declining or stagnant revenue growth. To understand what happens, we need to look at its two segments separately.

In the GCR segment, the company explained that it was pursuing opportunities that are smaller in size, and shorter. It tends to be able to leverage its captive designs and engineering services to improve project execution and profitability, but this results in lower revenue. While in its ODR segment, it executes an opposite strategy - focusing on growth that leads to expanding revenue with a lower margin. The results are a direct reflection of these growth strategies. Its GCR revenue decreased by 19.9% while in-segment gross profits decreased by 14.9%. At the same time, its ODR revenue increased by 54.2% while in-segment gross profits increased by 36.1%. Totally, its revenue as a whole only grew 1.3%, but its gross profits grew 9.1% in 2022. We summarize them in the table below:

Moreover, the two segments' revenue are also balanced. The smaller segment ODR was only less than half of GCR's revenue before it pursued this strategy. By the end of 2022, ODR generated $216 million, while GCR generated $280 million. This rebalanced growth strategy ended up with a better revenue/margin mix and a better growth rate as a whole.

In its ODR segment, the company partners with a wide range of institutional customers with mission-critical infrastructures, such as data centers and healthcare, industrial and light manufacturing, cultural and entertainment, higher education, and life science facilities.

As its CEO Michael McCann explained :

While, our GCR segment continues to make solid progress in improving its margin profile, ODR continues to be our main focus through the improvement in margin profile, the more favorable risk profile and the opportunity to strengthen relationships with long term customers.

This highlights how effectively and flexibly the company pursues its value-added growth strategy from building customer relationships. By becoming the trusted partner for all of the customers' facility needs and providing proactive recommendations to drive future benefits for their physical assets, it aligned itself with the long-term growth of its customers.

Limbach is actively utilizing its managerial and sales resources to be closer to its customers than ever before. It has started to shift its internal staff to direct account management and to position them at their station on a daily basis on-site with the key customers. This allows it to quickly adapt to the ever-evolving needs of the business, and in turn, effectively drive the sales. So far, the results have shown in its sales momentum. Its current days of sales outstanding is at the lowest in almost six years.

Efforts to continue making repayments have been in place since 2018 for the company to control or reduce the debt burden. The management has keenly expressed its goal of paying it down. It has cut its debt-to-equity ratio down to only one-third from its peak at 38%, while its debt-to-EBITDA is only in the teens.

As a result of declining debt and steady assets, its total equity has more than doubled since 2020, providing support to its rising stock prices as of late.

Weakness/Risks

Limbach's cash flow is so volatile that its interquartile range covers seven standard deviations. The company's net cash flow is dominated by its operating cash flow. So the growth of operating cash flow basically underlies both free cash flow and net cash flow for the company. Why is its operating cash flow so volatile, one may ask?

The largest components of its operating cash flow are indeed its account receivables and account payables. The difference between them is largely making up for the fluctuation in its operating cash flow.

This indicates that volatility is inherent in its business. Limbach has quoted the risks that could impact its cost side of the equation: supply chain, production, logical issues, and commodity prices. For example, the company is closing out of its Southern California business unit and fully exiting it in 2023 based on profitability and geographic focus to reduce losses. On the other hand, Limbach has a front seat in experiencing how climate change and related policies impact society first-hand, as it needs to adapt to those policies and implement them into its customers' daily lives. Severe weather can slow its productivity on construction projects, while mild weather can decrease the demand for maintenance. These changes will shift its costs and revenue earlier or later. On the other hand, climate changes drive energy efficiency demand to upgrade old buildings to reduce their consumption and footprints. Another way to see this is, although the long-term growth momentum of its business is strong, the short-term volatility due to its project-based business model will continue. Its CEO also addressed this fluctuation regarding its earnings:

we continue to remind investors that margins can vary quarter to quarter, based on project mix, timing and execution.

Also, the planned usage of its future cash flow plays a large part in what to expect. Limbach has plans to continue paying down the debt and fund more acquisition programs, which was mentioned several times during its last earnings call. The company completed an acquisition of Chattanooga, TN-based specialty industrial contractor, ACME Industrial Piping, LLC (“ACME”) on July 3, 2023. It cost $5 million cash to close and up to another $2.5 million earn out to be paid over the next two years. ACME, as a leading mechanical solutions provider for hydroelectric producers, complements and strengthens Limbach's capacity and also provides more market access in the south. ACME expects to contribute on average $10 million in revenue and in excess of $1 million in EBITDA annually. It is possible that Limbach can recoup its cash spending within five years' time.

Limbach had about $46 million cash at hand at the end of last quarter. The last time it was at this level was before it acquired ACME.

Limbach is likely to look for future acquisitions in a similar way that helps with scaling and market share expansion that complements its current portfolio and capacity.

As the CFO Jayme Brooks put it in the earnings call:

With our current cash balances and our expected free cash flow, we believe we have ample capital to pursue our acquisition program without needing any equity financing.

The target new geographies for the next acquisition could be in the South or Mid-West, as Limbach is traditionally strong in the Northeast region. If the company were to pursue the acquisition with its own cash, it is likely to be within the same category of $5 to 10 million to close the transaction.

Coming back to the point about its cash flow volatility, Limbach did provide guidance on its target free cash flow conversion to be 70% annually. The last quarter came in better than the target, but historically, this conversion rate was equally volatile. It is likely it can reach this target for this year, and for the reasons alluded to earlier, we are cautiously optimistic for the future.

Financial Overview

For further details see: