2023-12-02 02:02:28 ET
Summary
- Dycom Industries, Inc. has seen a post-earnings increase in market value, implying a period of better business ahead.
- The company has attractive investment factors, including recycling capital at high rates of return and heavy investment in growth initiatives.
- The investment outlook for DY in the next 3 years looks robust, with projected sales and earnings growth, compelling starting valuations, and high returns on net capital employed.
Investment update
Dycom Industries, Inc. ( DY ) posted Q3 earnings last week, booking solid upsides versus Wall Street estimates at the top and bottom lines. The post-earnings drift in market value since then suggests the market projects a period of better business for the company ahead. Based on thorough analysis of the investment facts, I cannot disagree.
Since my September DY publication , the stock has now thrust off 2023 lows to reclaim its July highs (Figure 1). In that analysis, I rated DY a buy for the following reasons:
- Recycling capital at attractive rates of return-pulling in $0.30 in gross per $1 in assets
- Heavy capital investment towards growth initiatives-$195mm growth CapEx in the 12 months to Q2 '23
- Expanding rate of profits earned on capital invested to run the business
- Potentially undervalued at 1.92x EV/invested capital and 15x forward earnings.
DY survived choppy markets in 2022-'23, as seen in Figure 1. It found buying support at the 200DMA throughout October and November, and rallied leading into Q3 earnings. Two potent catalysts are behind the reversal- (i) The Fed's decision to pause its hiking cycle shifted the market's character and lifted the bid on equities in November, and (ii) DY's fundamentals, propped by Q3 earnings. The company's robust economic characteristics also positioned it well to attract investment amid the broad market rally.
Revisiting DY requires an appraisal of the following economic factors:
- Sales and earnings growth (inc. recent history + projections),
- Starting valuations,
- Earnings produced on net capital employed into the business,
- FCF per share (growth and/or total).
After extensive review of the investment facts, my judgment is DY has the economics to continue adding shareholder wealth over the long-term. There are several reasons why. Recent growth trends are supported by the combination of productive assets and strengthening end markets. Starting valuations are within a cheap performance band. DY also earns high returns on net capital and therefore throws off reasonable FCF per share for investors. Collectively, these points have me constructive on the company. Net-net, rate buy.
Investment Thesis Points | Summary |
---|---|
Recent Growth Trends | - Supported by productive assets + business returns |
- Strengthening end markets | |
Starting Valuations | - Within a cheap performance band (13x earnings) |
DY's Returns on Net Capital | - Earns high returns on net capital (15-20%) |
Free Cash Flow ("FCF") | - Throws off reasonable FCF per share for investors |
Figure 1.
Analysis of the critical investment facts
(1). Sales + earnings growth
The investment outlook over the coming 1-3 years is highly sensitive to the company's sales + earnings growth over this time. Founded in 1969, DY's maturity means it does not enjoy the growth characteristics of a younger offering.
The next 3-years could be an exception. Why? Three reasons.
One, Wall Street has the company to push 6-10% sales growth from FY'24-'26 and 27%-58% earnings growth over the same period. Earnings have already grown at the compounding rate of 100% over the 3-years to Q3 2023, off 3-year asset growth of CAGR 9%. The revenue ramp is seen in Figure 2.
Two, as of Q3 FY'24, the company's backlog was $6.6Bn, up $406mm from $6.2Bn in Q2 '24. It put up $1.14Bn in quarterly sales, 5% growth on adj. EBITDA of $167mm. Management said fibre network opportunities are growing increasingly in rural America, as capital is drawn more regionally. Customer demand is ratcheting higher as customers begin to digest a pause in the cost of capital surging. Management noted this on the call:
"For several customers, the pace of deployments is increasing into next year, including for those customers whose capital expenditures were more heavily weighted towards the first half of calendar year 2023," it said.
Three, management's constructive use of capital is comforting- $37mm OCF outflow in Q3 "to support organic growth", $57mm in CapEx, $123mm in the acquisition of Bigham cable . A total of $217mm of quarterly investment (~$860mm annualized) to growing the business for a $2.9Bn market value company (investment 29% of market cap on annualized figures) can't be overlooked.
Based on these facts, my judgement is the investment outlook for DY in the next 3-years looks robust.
Figure 2.
(2). Starting valuations
Investment returns for the next 12 months will be highly dependent on multiples paid today, less so than over 10 years, say.
The stock sells at 13x forward earnings , 12x forward EBIT and 2.8x book value. In my opinion these represent compelling value, for the following reasons:
- Put into context, the forward PEG ratio is just 0.8x when adjusting for growth forecasts. As a reminder, a PEG < 1x is desirable. Growth projections were obtained from linear regression on analyst estimates,
- Growth looks accretive to value, as earnings produced on net capital could tally 17-20% alongside this,
- One obtains a 12.5% cash flow yield buying DY today,
- Paying 2.8x net capital (2.8 x $35.97/share = ~$100) on 20% ROE reduces the investor ROE to just 7.15% (7.54 / ~100 = 7.15%), still reasonable in my opinion, considering the growth.
On the function of FY'24-'26 growth estimates, the rate of profits earned on capital, and starting multiples, DY could compound its intrinsic value to $129-$130 by 2026 in my estimation, 28% value gap.
Figure 3.
(3). Earnings produced on net capital employed
The rate of earnings compared to investor capital employed into DY's business has swung higher since 2021 (Figure 4). The company earned 21% on equity capital last period, up from 13.8% 1 year ago, considerable change (TTM values).
Leverage cannot be ignored. As seen in Figure 4, unlevered ROE tallies 8.3%, with no change in trend vs. fully-levered equity returns of 21%. Here, returns are adjusted for the equity multiplier (assets/equity), that breaks down ROE and ROIC into their subcomponents.
My judgment is these trends can continue moving forward. Holding a 20-21% ROE will compound shareholder wealth immensely. The question is, can it maintain this threshold.
Additional findings to support the case:
- This is also a low-margin, high capital turnover business, where the ratio of sales to capital is high, but profits to sales low. Three-year capital turns are 2x on avg. with <5% post-tax margins.
- This squares off with the economics of the business. Being service-based, the majority of cost is absorbed at the top in COGS, in labour to the individual service providers. Profits are therefore tight, and it requires ongoing contracts to support revenues + growth, getting 'jobs' done quickly and at scale.
- Cash flows + profits are likely to be less sensitive to changes in profit margins (great in inflationary + rates environment),
- Capital is therefore mostly tied up in receivables-53% of total assets. As sales grow, capital invested to receivables invariably expands too. Without high turnover of assets, it would get messy for DY. Receivables would just build, and cash would begin to evaporate.
Hence, asset turnover drives returns + FCF in this business. It therefore drives investor returns. Excellent news for the company's owners, who have watched profits earned on equity advance from 5.4% in Q3 CY 2021 to 21% last period, as seen below, compounding $1 of equity value into $3.12 over the 2 years.
Figure 4.
(4). Cash flow durability + FCF per share
Cash flows to the business have been lumpy since 2020 given the net working capital requirements. Critically, since Q2 2022, growth CapEx has outmatched maintenance investment, the latter approximated at the level of depreciation + amortization. In the last 12 months, for instance, DY put up $226mm of CapEx investment vs. $154mm of maintenance investment, around $72mm positive spread.
The new investments expanded DY's value in my eyes, by- (i) increasing the profits earned on equity, and (ii) producing respectable FCF per share. Since mid-2021, the company has thrown off $35.30/share in cash to shareholders, whilst simultaneously growing profits and investing for growth.
FCF has been lumpy at times (Figure 5)-but expected, given the firm's cash commitments to growth. In Q3, TTM FCF was just $0.66/share. But it had also reinvested 92% of its post-tax earnings, and ROE was its 3-year highs. The recipe appears relatively simple for the company:
- Investors put up capital (debt, equity)
- This is put to work in the business to run, as means of production, etc.
- Profits earned on the new assets expand company cash flows
- Meaning the company can pursue growth without jeopardising what it can produce for shareholders
- Retained earnings (investor equity) are then reinvested at similar, high rates of return.
The market is an efficient discounting mechanism over the long-run, rewarding companies with superior fundamentals. Since DY traded at its low points of $66/share in Q2 CY 2021, the company had thrown off $35/share in FCF, as mentioned earlier. The company's stock price now also trades at ~$100/share, roughly $35.00 gain from the lows. In mature companies like DY, it is wise to check growth, earnings relative to equity, and FCF per share. In this instance, it is clear evidence of value.
Figure 5.
Discussion summary
Analysis of the available investment facts in DY's investment debate supports a buy rating on the company's shares. DY is performing well in four key competencies, namely- (1) sales + earnings growth, (2) starting valuations on earnings + asset factors, (3) profits earned on shareholder equity, and (4) FCF generated per share.
The four competencies paint a bright picture of investment performance for the company over the 3 investment horizons (short to long-term). In my opinion, the company presents with durable long-term economics that can compound shareholder wealth over the long-term. Based on the latest appraisal, I reiterate DY as a buy, looking to $129-$130 as the next objective, with eyes on $163/share long-term.
For further details see:
Dycom Industries: Well Priced, Positioned, To Compound Shareholder Wealth Over Long Term