TH - Target Hospitality: Great Fundamentals Post-Pandemic But Intrinsic Value Implies Little Upside

Summary

• Target Hospitality's year-on-year revenue growth is in double digits with median revenue growth of around 20%.
• There is a clear uptrend in EBITDA and operating margins with year-over-year growth of around 25%.
• The firm has high financial leverage with a debt-to-equity ratio of around 2.3.
• My intrinsic valuation - based on the average of DCF, comparable firms' P/Es, and EV/EBITDA valuations - is around $15.
• I rate the stock a hold, based primarily on shares trading near my estimated intrinsic value.

Investment Thesis

Target Hospitality (TH) has been performing very well post-pandemic. The company signed multiple projects with a considerable number of public firms and a wide range of capital-intensive, workforce-driven private sectors. The numbers are showing in revenues and the return the stock has generated over the past year. However, there is a catch. Past performance does not guarantee future returns, and TH might be a good example of it. Target Hospitality has a few weaknesses that, if not addressed now, might affect its performance in the coming years.

What Target Hospitality Does

Target Hospitality is a Woodland, Texas-based company with a market cap of $1.5 billion that was established in 1978. The firm recently changed its name to Target Hospitality from Target Logistics. It provides temporary accommodation and lodging services for other companies' workforces. The services provided cater to a wide range of industries for both public and private sectors, concentrating on oil and gas, construction, and disaster relief teams. The business model of the firm is easy to understand: TH's clients outsource the accommodation and lodging services for projects in remote areas (where there is no housing and where it will not be required once the project is complete) to Target Hospitality.

Recent Corporate Performance

Excluding 2020, the year-on-year revenue growth of the firm is in double digits, with the lowest around 20%. However, the net income generated by the firm, which has been negative in the recent two years, has increased by about 35% on a TTM (trailing 12 months) basis. Earnings margins, compared to revenue, have also touched double digits after five years.

Looking at the balance sheet, the cash ratio (cash and equivalents to current liabilities), which is a liquidity ratio, is around 1. That says the firm has enough cash to pay its short-term liabilities if such a situation were to occur. It looks good, considering the short-term liquidity, whereas the firm has a high leverage ratio (long-term debt to equity) of 2.3x compared to just 1x in 2018.

The cash from operations has seen a significant bump from around $40 million in 2016 to $260 million in the recent year. It's a sign that the company is able to generate more cash from its daily operations.

Strengths

Target Hospitality has built itself a brand due to its vertical integration. From building temporary facilities to providing culinary services to the workforce being housed, the firm manages it all. A vertically integrated firm generally saves a lot of operational costs and effort. This is reflected in the firm's EBITDA trend. Its EBITDA is increasing year on year by over 25%, excluding 2020 - the year the pandemic started. It is reflected in the firm's operational efficiency.

Except for the leverage the firm has, the financials look strong. The uptrend in top-line revenue, solid operating profit margins, decent cash on the balance sheet, and significant cash generated from operating activities are the reasons I consider it to be a healthy business.

Weaknesses

Although the firm has developed its brand, the industry is highly competitive. Also, the moat (a competitive edge) a firm develops depends highly on the long-term deals the firm has with officials in the public sector. However, the firm has been doing well as more than half of its revenue is concentrated in its clients in the public sector. There is almost always an inherent threat of natural disasters in remote access areas, and how the firm manages that will develop the brand it has created.

A major threat I see in such an industry is that its performance depends mainly on the spending of its clients. For Target Hospitality, the major clients are oil and gas companies, as well as construction businesses in the private sector and various parts of the public sector. Thus, TH has a business-to-business model; the revenues depend significantly on the relationships the firm maintains with its clients.

The company faced legal threats and moratoriums on its housing services in counties in North Dakota. I see a proverbial "canary in a coal mine" type of threat because such incidents tarnish the brand name of the firm. That can then indirectly directly impact future revenue, and even the business as a whole.

Looking Forward

According to the data from TH's recent company filings and Seeking Alpha's valuation page, the intrinsic valuations based on DCF (discounted cash flows), EV/EBITDA (enterprise value to EBITDA), and P/E (price to equity) multiples resulted in an average stock price of around $15 vs. the current stock price of $14.60. My assumptions for valuation methods are as follows:

EV/EBITDA - the average multiple (based on the peer group) of 10.5x compared to around 9x. The company has a slightly lower EV/EBITDA of 9x compared to the average multiple (based on the peer group) of 10.5x. This implies that TH can generate slightly higher EBITDA compared to its peers, given the enterprise value.

The P/E value of the firm is 30x, twice that of the average multiple (based on the company's peer group) of 15.5x. This signifies that in an industry where the average firm generates an average amount of earnings, the price of Target Hospitality is $30 compared to the average price of a firm of around $15.

DCF - The details are as follows:

• Cost of equity: 8%

• Cost of debt: 9%

• Tax rate: 22%

• WACC (weighted average cost of capital): 9%

Note that the values presented above are rounded off to their nearest integers.

My valuation indicates that TH stock could plateau near the current price until there is a catalyst event, such as an earnings surprise or revised multiples. The technical chart pattern confirms this, as TH has failed to break above its very wide trading range ($10-$18) since the stock vaulted up into that range last July.

Conclusion

Despite the controversies mentioned in the weaknesses section, TH has strong fundamentals. It is able to generate revenue, and a huge portion of it is from the public sector.

With a high P/E, low EV/EBITDA multiples, and an intrinsic price valuation of around $15, I rate the stock a hold currently. My intrinsic value analysis and the technical (chart) view on this stock both indicate to me that this stock's upside might have ground to a halt for now. I'll consider revisiting TH when it next announces earnings during the first half of March.

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