Limbach Holdings Stock: Assessing Its Rebalancing Objectives (NASDAQ:LMB)

Investment Thesis

Preview

We first covered Limbach Holdings (NASDAQ:LMB) in September last year in “Limbach Holdings: Volatile Cash Flow Here To Stay”. We were overall optimistic about the company’s growth but still had concerns about its volatile cash flow in history, which alternated from positive to negative in a matter of one to two years. Such volatility is inherent to the nature of the company’s workflow and industrial pattern. Although its free cash flow and net income were on a rising trajectory, chances are downward shifts could be embedded due to the volatile pattern. We gave it a hold rating when it was at $36 and recommended investors to see if more structural changes will come about. The stock fell by about 20% in the next two months since our last article, but experienced a jump after the Q3 earnings release to as high as by 25%. Now it is trading at $41 or a 12% increase since last September.

Updates

Since our last write-up, Limbach has made an acquisition of Industrial Air LLC (“IA”), which is an NC-based specialty mechanical contractor. The company is looking to seamlessly integrate IA’s ODR-heavy model with its own ODR (“Owner Direct Relationships”) segment. IA is “an environmental mechanical and air filtration solutions and custom air handling equipment company” with an industrial customer base particularly focusing on the textile industry. It was an all-cash acquisition of $13 million and a niche buy-out. The expectation is coming in 2024, IA will generate $30 million in revenue, and the owner will stay on to manage the business operation with a $6.5 million incentive package payout should the expectation be met or exceeded in the next two years. This is consistent with how it has always structured earned-out packages with its previous acquisitions.

On a higher strategic perspective, previously we pointed out that the balanced segment mix of contribution to revenue/margin has been helpful in achieving better growth. Although this is not a large deal, it indicates the company is continuing this strategy of balancing with a focus on ODR.

This deal also represents Limbach’s geographical expansion objectives. Along with the acquisition of Jake Marshal, LLC, IA helps Limbach to expand the footprint east of the Mississippi River, such as in the Carolinas and the east coast. This is exactly where it wanted to focus on. We noted previously that it is closing out and exiting its Southern California business, and the updates from its presentation in November gave a much clearer picture: it now has no targeted business expansion west of Mississippi, except for some in the south. This shows where its locations are profitable, and where it has losses.

We consider the objective of “50% ODR” achieved by Q3, since ODR’s revenue contribution was 49%. Assuming the added $30 million in revenue materialized, ODR’s revenue contribution will be about 54% by the end of FY ’24 if all other existing units grow 5% annually. For ODR to achieve 70% of the revenue, it will eventually have to grow to about $517 million by the end of FY ’25. If subtracting the $30 million growth contribution from IA again in FY ’25, that will be a net increase of $231 million. This looks significant, that is because the GCR segment is also growing, so ODR will literally need to add up to 20% of the total revenue of FY 2025. We are reluctant to assume a flat revenue growth through FY ’25 since the purpose of the acquisitions should first have the benefit of boosting the top line. Assuming a flat revenue growth will only underestimate how much ODR needs to grow in order to meet the objective. If we assume the acquisition cost is one-third of the additional revenue, it will need about $77 million in funding. Of course, the cost could be higher.

Limbach started accumulating cash at the end of 2019, growing from almost minimal cash on hand to more than 50x more within 4 years. Including IA, it has done 3 acquisitions in these 4 years, total of $38 million all-cash. For Q4 of FY ’23, if taken away $13 million from the all-cash expenses for the IA deal, it still has north of $40 million left, remaining at its historical highs. It is not to say that it will fund all of the future acquisitions through cash. With its debt-to-equity ratio at 33%, it can still use leverage to make the acquisitions needed, but the cash position could be vastly reduced.

The volatility we recognized from the previous write-up is still one of our concerns for the company. The first 3 quarters’ operating cash flow in FY ’23 was $20 million more YoY. The provision to its operating cash flow during this time was mostly due to the increase of about $12 million higher of Net Income. But it also had $21 million lower accounts receivable and $18 million more accounts payable, which canceled out a large part of each other and ended up with a $3 million net contribution.

Limbach’s net income has also been well-matched with its free cash flow on a TTM basis in terms of volatility. Since its revenue has been in decline in the past five years and flat for the past three years, for the volatility of its cash flow to be smoothed out, it will need to continue generating strong net income. The significant pickup of its net income since 2021 has to do with the reduction of the cost of revenue, which has reduced by 20% during this time. The largest part of its cost of revenue is from labor, equipment, material, and subcontract and contract costs. These costs have historically fluctuated, for example, there are occasional incidents in the GCR segment (“General Contractor Relationships”) that projects sometimes can exceed the budget, and it will offer to re-design the project to bring down the costs. Labor and material costs depend on the general market condition. In contrast, the equipment costs, which are related to the ownership costs or company-owned assets, in addition to rental equipment, can perhaps give it better control. This is directly hinging on the ODR’s growth since most of the HVAC, plumbing, Automatic Temperature Controls, and other maintenance projects are likely to be recurring and/or repeatable. The long-term customer relationship, which is at the core of the ODR’s CRM, could help the company avoid frequent changes of different equipment on various tasks, hence the reuse of its equipment or even rental equipment could bring down the costs.

Such benefits are most likely to be long-term and gradual though. Limbach has been seeking organic growth within the ODR units in recent years in addition to the acquisitions, which involves performing contractual work for the buildings that it has never provided services before. New projects could come with new adaptations, especially customization to the building is the key to retaining a long-term customer relationship. Therefore, the initial cost won’t be low. This is perhaps one of the reasons the cost of revenue has been flat instead of continuing its reduction in the past two years. When the rapid expansion is implemented, the next two years are likely to see similar stagnation if not re-growing of the costs, resulting in more volatility to the net income and cash flow.

Last but not least, the industries Limbach serves mission-critical systems in. The company serves Healthcare, Data Centers, Industrial and light manufacturing facilities, Higher Education, Cultural and entertainment, and Life science industries. We talked about this last time and these industries all have one thing in common, they all have their specialties in building usage instead of simply accommodating office staff. There has been a tightening in lending standards for commercial real estate markets since 2022. This wave can be seen as the continuation of the transition from metropolitan office building induced during the pandemic. It jumped from nearly none to 70% of banks in 2020 and then such a jump happened again in 2022. Although Limbach’s industrial focus has a cushion in the face of the cooling of commercial real estate, it won’t be completely shielded from it. This is a macro risk that it will need to be mindful of during its planned expansion.

Financial Overview & Valuation

We maintained our previous assessment that the company’s price is fairly valued after five months. The rebalance of its segments is on the right path towards higher revenue growth, especially when its top line has been in decline and flattened in the past five years. However, such growth does come with financing costs, integration, and operating costs in addition to the overall industrial macro risks in the existing environment. The volatility in its net income and cash flow is likely to continue, although could be to a lesser extent. The market’s optimism has largely priced in at this point.

Conclusion

We review the recent changes and acquisitions of Limbach since our last write-up five months ago and continue to see volatility as part of its natural tendency in the operational results. To focus more on the ODR segment is on the right path and it has the dry powder to execute more acquisitions to speed up such a transition. However, after assessing the overall picture, the costs behind such ambition are still key in controlling its volatility. We think the market price at the moment is fair and investors shouldn’t chase at the highs.