MEG - Montrose Environmental: Short-Term Pain But Long-Term Story Intact

2023-04-06 00:53:01 ET

Summary

• Montrose Environmental's financial performance for 4Q22 was disappointing, and its guidance for 2023 is bleak due to a decline in CTEH.
• MEG's success in cross-selling its services is evident in the growth of revenues from customers who purchase multiple service lines.
• While MEG's guidance is not great, its long-term story stays intact.

Summary

I initially recommended to buy Montrose Environmental ( MEG ) based on a few key factors. Firstly, the environmental industry is challenging to enter due to its complex regulations and fragmented market. As a result, customers are seeking environmental solutions providers that can handle issues throughout their entire life cycle and across different jurisdictions. MEG aims to target oversaturated markets with many competitors, many of which specialize in a particular niche or regulation. MEG has the advantage of being able to attract and retain clients and grow relationships due to its global reach and diverse range of offerings. When competing for large accounts that need a national scale provider, MEG stands out with its ability to offer unified, geographically dispersed services and a single point of contact for all of a client's needs. I still hold a buy rating on MEG stock; however, I now acknowledge that the path to the attractive long-term returns is not going to be as smooth as I thought. As such, I would cautious investors against sizing up any existing position in FY23. In my opinion, MEG has the potential to achieve significant organic growth, particularly when we exclude the more unstable CTEH. Additionally, acquisitions will contribute to the company's revenue growth.

Updates

MEG's financial performance for 4Q22 was disappointing, and its guidance for 2023 is also bleak. The emergency response business, CTEH, which is a part of the Assessment, Permitting, and Response segment and provides emergency response services, continues to be a source of volatility from quarter to quarter. A decline in CTEH's contribution in 4Q22 led to a failure to meet EBITDA expectations, and the reduction of COVID-related work is still having a negative impact on the company's overall revenue outlook for 2023. Despite uncertainty about the development of the CTEH market, I believe that MEG can succeed by offering a wide range of services to attract and retain customers. The increase from 18% in 2021 to 35% in 2022 in revenues from customers who purchase multiple service lines is evidence of MEG's success in cross-selling its services. Growth in the company's organic revenue, excluding CTEH, increased to 26% annually in 2022 from 17% in 2021. Additionally, I appreciate that MEG's services related to greenhouse gas measurement, PFAS water treatment, and renewable energy/biogas have all demonstrated strong growth over the past few years.

While the aforementioned positives are great, I feel compelled to "wet blanket" them by noting that in 2022, the adj. EBITDA margin was weighed down by a number of factors, including ongoing investments in PFAS water treatment and biogas services. MEG also saw increased corporate costs as a result of recent acquisitions, which further eroded the company's profit margins. Unfortunately, I believe that these factors will all remain a drag on profits in 2023. I expect the increased pace of acquisitions in 2023 compared to 2022 will continue to dilute margins, which is the main contributor to a weak FY23. However, I do see a reason why now is a good time to pick up the pace of acquisition as rates are high, which means assets value are lower. If MEG is able to pick up a few good assets during this tough period, it will emerge as a stronger business once the good times come.

Guidance not great

MEG has projected revenue of $550 million to $600 million and adjusted EBITDA of $68 million to $74 million for the year 2023. The revenue forecast assumes double-digit organic growth excluding CTEH. When factoring in CTEH, which is projected to see a decrease of COVID-related revenues in 2023, the midpoint of the guidance range indicates a mid-single-digit growth in organic revenue. Importantly, operating leverage will be muted in FY23 and FY24, as I mentioned above. According to the revised adj EBITDA forecast, margins will likely remain stable year over year. The percentage of revenues spent on overhead is projected to remain high at 6% in 2023 before beginning a gradual decline. Additionally, MEG plans to maintain its investment in its Remediation and Reuse division, which is currently performing below target levels for run-rate margin. All in all, the guidance can be summed up into short-term pain, but long-term story stays intact

Valuation update

Given the revision in outlook, I have updated my model as shown below. Before we go into the updated model, I like to point out that my previous model had a target price of $61 which MEG did inch towards to until $55 – which I believe my thesis was playing out well (at least on a narrative basis) until the earnings came in. As for the new model, there are 2 key changes. FY23 EBITDA is now expected to be flat and we now have an upside potential from the re-rating of multiples (current 18x forward EBITDA to 22x). I would say that the risk/reward today is much better than January given that the stock price has already been decimated even since the results release. I believe all negative sentiments are already baked in.

Catalyst

MEG would expand faster if regulations were put in place concerning PFAS contamination. In just a few short years, MEG's PFAS water treatment services have grown substantially, contributing nearly 20% of the company's total revenue. To establish a legally binding standard for the maximum contaminant level of PFAS in drinking water, the Environmental Protection Agency in the United States is working on a proposed National Drinking Water Regulation for the two most potent PFAS chemicals, PFOA and PFOS. If the EPA rules are finalized, I believe MEG stands to gain even more traction in the PFAS market.

Conclusion

MEG has faced challenges in the short term due to a decline in the contribution of CTEH and ongoing investments in PFAS water treatment and biogas services that have weighed down its profit margins. However, MEG's ability to cross-sell its diverse range of environmental solutions and achieve significant organic growth excluding CTEH, particularly in its services related to greenhouse gas measurement, PFAS water treatment, and renewable energy/biogas, are positive factors. Although the guidance for 2023 is not great, I believe that the long-term story of MEG stays intact, and the current risk/reward is much better than it was in January, given the stock price's recent decline. The potential for a re-rating of multiples and MEG's ability to expand faster if regulations concerning PFAS contamination are established are catalysts for the stock. Therefore, I maintain my buy rating on MEG but would caution investors against sizing up any existing position in FY23.

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