By Trevor Muchedzi
- NV5 Global is a fast growing provider of professional engineering and consulting services to public and private sector institutions;
- The company is vertically structured around five core service offerings: Construction quality assurance, infrastructure, energy, program management and environmental services;
- Since its debut on NASDAQ in 2014, the company’s annual revenue has grown over 4x from ~US$100 million to >$425 million expected in FY 2018. Management’s stated goal is to reach a revenue run rate of US$600 million by FY 2020;
- However, approximately 46% of this revenue growth has been from acquisitions. Over the last five years, NV5 has made 32 bolt-on acquisitions to either augment its existing solution offering or enter into new verticals;
- The key question for investors is therefore, how sustainable is this acquisition-fuelled growth?
Down the memory lane…
Nothing hurts investors more than being late to a party. When I first came across Canadian software company, Constellation Software towards the end of 2015, the company’s share price had gone up ~3200% since its IPO back in 2006 (a GAGR of ~41% p.a.). Aside from missing the ride of one of the best stock in the past decade, I was intrigued by Constellation’s acquisition led business model which until then, I steadfastly believed isn’t the best way to grow a business whilst creating shareholder value.
Constellation Software’s business model is premised on acquiring small to mid-sized vertical software companies, that is, companies that create software for a particular industry, as opposed to those that create software usable in a wide variety of industries. Most of its acquisitions are relatively small, on average less than $5 million and the sellers are usually entrepreneurs either looking to exit or to be part of a bigger group in order to stay competitive and get access to bigger clients. In 2017 alone, the company made 42 acquisitions for a total purchase price of $185 million.
Do acquisition led growth create value shareholders?
Investors are well aware that not all revenue growth is created equal. Just because a company is growing its revenue and earnings, it does not necessarily mean it is creating value for shareholders. In fact, if a company’s ROIC (Return on Invested Capital) is less than its WACC (Weighted Average Cost of Capital), then growing the business actually destroys shareholder value.
Empirically, organic revenue growth is one of the two most important drivers of shareholder value creation; the other is improving return on invested capital. Tim Koller, Marc Goedhart and David Wessels in their book, Measuring and Managing the Value of Companies, made a compelling case to show that, on average, acquisition-led growth create the least value for shareholders, about $0-$0.20 increase in shareholder value for every $1 incremental of revenue. It’s very rare to find acquisitive companies that generate high rates of return on invested capital mainly because most of the additional value created from the investee company through cost reduction and accelerated revenue growth is usually captured by the sellers of the business in the form of high premiums normally paid for acquisitions.
Whilst this argument is generally true, a few companies like Constellation Software have been able to create value from an acquisition-led business model. There are a number of reason to explain the company’s impressive history but some of the key factors are:
- Constellation was the pioneer consolidator of vertical software businesses;
- They targeted small to medium sized companies where competition for acquisitions were low and therefore the premium paid for the purchases were relatively low;
- Mark Leonard, Constellation’s CEO, is a classic contrarian investor; greedy when everyone else is fearful and fearful when everybody else is greedy. The bulk of the company’s foundational acquisitions were made between 2007 and 2009 when equity valuations were very low;
- The company also pioneered a vertical organizational structure in which investee companies are embedded into their respective platforms which allow them to benefit from cross-selling opportunities within the group
But as the company grows bigger and the number of cheap low hanging fruits run out, questions around reversion to the mean are gaining momentum. Competition for acquisitions of vertical software businesses has heated and the average takeover valuations have skyrocketed. In his recent letter to shareholders, Mark acknowledges this issue and admitted that going forward, he believes growth in the company’s intrinsic value per share will decrease for the 10 year average of 30% p.a. to less 15% per annum.
Which leads us to NV5 Global
NV5 Global seems to be replaying Constellation’s business model but this time through acquiring small vertical engineering consulting companies, all of which are run under one of its five verticals: construction quality assurance, infrastructure, energy, program management and environmental services. Within the U.S. alone, there are more than 144,000 engineering consulting firms, providing a robust pool for attractive acquisitions. Like Constellation Software, management is also targeting entrepreneurs who are either looking to partially or fully exit or looking to be part of a bigger group so they can tap into a bigger client pool and benefit from cross selling opportunities. Over the last five years, NV5 acquired 32 companies, some of which were made to enable the company to enter new verticals like LNG gas and clean energy space where it didn’t have presence before.
An analysis of NV5’s organic growth
The tricky part for management is to balance between organic and acquisition-led growth. Investors are always looking for evidence that management is not over paying for the acquisitions and that they are delivering on promises to realize both revenue and cost synergies within the portfolio companies. To date NV5 has delivered on that: the company’s organic growth over the past five years has averaged 8.2% p.a. which is almost double the industry average of 4.4% p.a. They have achieved this largely through cross selling consulting opportunities within the group and thereby negating the need to sub-contract to more expensive external 3rd parties. The company has also been deliberate in this approach and has even created a Chief Synergy Officer position within the group whose main responsibility is to drive revenue and cost synergies across the different platforms.
NV5’s marginal profitability
The best companies to invest in are those that can scale “nicely,” meaning all things being equal, higher revenues should lead to higher profit margins. Cloud based Software-as-a-Service (SaaS) companies scale in this manner because they are able to distribute their software to a growing customer base with extremely low incremental costs. Such companies generate higher ROIC and free cash flows due to the compounding effect of revenue growth and increased profitability.
To measure how NV5 is scaling, I looked at the company’s marginal incremental profitability. It looks at changes in revenue against changes in costs, and then calculates the incremental operating margin of the two results. If this marginal profitability is higher than historical profitability, then the company is scaling nicely. If it’s lower, then it raises red flags as new growth initiatives and acquisitions are yielding lower cash flow per dollar than previous investments.
Marginal profitability for NV5 Global
|FY 2016||FY 2017||9 months|
|Difference: Full |
|Total operating costs||205.5||306.5||220.7||277.1||101.0||56.4|
The table above shows that NV5’s marginal incremental profitability for the ten months ending September 2018 relative to same period in 2017 was 11.3%. This compares favourably to historical marginal profitability for FY 2017 relative to FY 2016 of 7.4% and to the historical annual operating profit margins of between 7.7% and 8.4%. This means that the combination of recent acquisitions and organic growth initiatives within NV5 are yielding higher cash flow per dollar invested compared to historical averages.
Free cashflow (FCF) per share metric
However some of NV5’s acquisitions are partly financed with issuing equity in the company to the prospective sellers. As such, investors require a metric that takes into account the dilutive effective of such acquisitions on existing shareholders. Increase in FCF per share is a good metric to measure two things: management’s discipline to not over pay for acquisitions and their ability to create incremental shareholder value from those acquisitions. The table below shows NV5’s FCF per share over the past four years
NV5’s FCF per share
|Period||Free cash flows from operations||Basic common shares outstanding||Free cash flows per share||YoY change|
|FY 2015||$5.371 m||6.773 m||$0.79/share|
|FY 2016||$14.228 m||9.125 m||$1.56/share||97.4%|
|FY 2017||$15.386 m||10.179 m||$1.51/share||(0.31%)|
|FY 2018***||$19.404||11.656 m||$1.66/share||10.2%|
***Estimates based on management’s guidance during the Q3 – 2018 earnings call. The actual numbers can materially differ than those forecasted by management
The key takeaway from this table that, management have so far been successful at making value accretive acquisitions. This is expected given how fragmented the engineering consulting industry is which give NV5 the luxury to be picky on its acquisitions and negotiate good prices. The target companies have also benefitted from being part of a bigger and individually growth their free cash flows.
Investment thesis for NV5
The US infrastructure market is enormous, about $3.6 trillion. The deteriorating state of infrastructure assets means both the Federal and State Government spending is expected to remain robust if not increase going forward. Between 60% and 65% of NV5’s revenue comes from public sector projects which are generally defensive in nature even during economic downturns as governments usually increase spending on infrastructure to stimulate economic growth. People have to go over bridges that don’t fail whether the economy is good or not; they have to drink clean water and to treat waste whether there’s a good economy or bad weather. So it’s a market segment that I believe has lower earnings volatility.
The company also has many opportunities outside the U.S., specifically in Asia and Middle East where infrastructure spending is at all-time record (both newly built and also maintenance spend). During the last Q3 earnings call, management spoke about the significant opportunities in those regions, particularly within transport, logistics, travel and hospitality. As the global population grows and urbanization rises, countries around the world will definitely increase their spending on both economic and social infrastructure assets. In addition, the sector is also being opened up to private sector capital and this provides secular tailwinds to specialised engineering firms like NV5.
As demonstrated by Constellation Software, vertical acquisitions tend to create value given their specialised nature. The energy vertical is one of NV5’s fastest growing verticals largely driven by massive investments in Gas and LNG infrastructure. Towards the end of 2018, the company acquired CHI Engineering, a specialised consulting firm that provides engineering, procurement, construction management services to the liquefied natural gas, petroleum gas and natural gas industries. CHI’s client base includes more than 80% of the 140 LNG facilities in the U.S. This acquisition will complement NV5’s rapidly growing power group in the West and drive the expansion of energy services nationwide. Other opportunities exist within the clean energy space and bulk pipelines for hazardous materials.
There are many similarities in the business models being pursued by NV5 and Constellation Software. However despite the compelling case, investors shouldn’t lose sight of the mean reversion argument as the company grow bigger. High profit margins will attract more capital towards the vertical consulting market sector and therefore at some point NV5 will be forced into expensive bids for acquisitions which in turn will lower returns on invested capital. How far we are from that tipping point is anyone’s guess. With over 144 000 independent engineering consulting firms in the U.S. and millions more outside, I think its safe to say we still have a long runway before we get there.
Disclaimer: The author is invested NV5 Global