IES Holdings: If You Have A Long-Term Vision, You Haven’t Missed The Train (NASDAQ:IESC)

Opener

The intuition of someone who wants to buy cheap assets is to stay away from skyrocketing assets, stemming from the fear of missing the train. Well, in the case of IES (NASDAQ:IESC), the train turned into a rocket and flew to the sky, with returns of 160%, 510%, and 1600% over 1, 5, and 10 years respectively.

Those are some impressive results, and they derive from two factors. The first is the quality and growth of the business. The second is from multiple expansion. But I would argue that despite short-term headwinds, both on the business side and the technical side (RSI is in the sky, and the stock is high above moving averages), investors with a long-term horizon will do pretty well with this under-the-radar quality company. Let me explain.

Traits I Like In The Business

First of all, when you open IES’s 10K, one of the first paragraphs says this:

While sharing common goals and values, each of the Company’s segments manages its own day-to-day operations. Our corporate office is focused on significant capital allocation decisions, investment activities and selection of segment leadership. The corporate office also assists with strategic and operational improvement initiatives, talent development, sharing of best practices across the organization and the establishment and monitoring of risk management practices within our segments.

We see here a few factors that are common among long-term winners, such as Constellation Software (OTCPK:CNSWF) and Berkshire Hathaway (BRK.B) The business is decentralized, which means that every segment manager has autonomy and the responsibility to succeed. That freedom gives the managers a feeling of ownership, alongside the stock-based compensation they receive. I particularly like the sentence about the focus on capital allocation. Essentially, a CEO’s job is to allocate capital to where it is best for the business, for the long term. In the paragraph, IES describes another advantage of similar companies: they take the experience of one segment of the business and implement it in other parts for combined success.

Jeffrey L. Gendell, who is the CEO and chairman, holds about 57% of the company. According to various sources, IES is his main holding; according to FinChat, that’s about 48% of his holdings. That’s a massive stake in the game right here, and based on past performance, he knows how to manage his business well.

Now, let’s turn to the business: IES operates in four segments, where the residential and communication segments take the lion’s share of the company. Except for the commercial & industrial segment, the other three experienced double-digit CAGR in the last five years. (The last segment is Infrastructure Solutions.)

IES designs and installs integrated electrical and technology systems and provides infrastructure products and services to a variety of end markets, including data centers, residential housing, and commercial and industrial facilities. These end markets experienced solid growth and are expected to continue to do so over the long term, making IES the beneficiary of these trends. For example, U.S. Data Center Construction Spending is projected to grow by around 10% CAGR by 2027. Retail e-commerce Revenue in the United States is also projected to grow at a 14% CAGR by 2027. Both markets will drive demand for IES communication services. On the big residential side (which has been experiencing a slowdown in the last year), there is a demographic shift in population to key IES Residential markets (Texas, Florida, Georgia, North Carolina, and Arizona). IES describes an opportunity on the residential side:

Housing starts remain well below long-term averages since the financial crisis, trailing household formations by a cumulative 2+ million homes since 2009 A return to average, or potentially above average starts, offers an encouraging tailwind for the housing market.

IES claims that a significant portion of the Communications business volume is generated from long-term, repeat customers, some of whom use IES as a preferred provider for major projects. The same is true for the residential market.

Another factor I like is the fact that in the big residential market, the competition primarily consists of small, privately owned contractors who generally have limited access to capital.

In addition to organic growth, as IES stated above, management seeks opportunities to deploy capital, and they have made 16 acquisitions since 2016. These acquisitions are mainly in the four segments’ center of activity.

Numbers & Q-1

I like IES’s numbers. It’s a business that managed to compound its top and bottom lines in double digits over a decade. Alongside this, it managed to achieve high Return on Invested Capital (ROIC) and Return on Capital Employed (ROCE), both of which, in my view, are the most important figures in long-term compounding, alongside revenue growth. When looking into future growth, I will assume growth prior to 2020, as there was a huge jump between 2021 and 2022 that skewed the CAGR a bit to the positive side. Overall, we should expect double-digit top-line growth over the long term, especially considering that in the residential market, the competitors are small and wise acquisitions could propel growth.

I’ll talk about it in the risks section, but it is important to note that IES’s business is quite sensitive to the interest environment. We can see that in the recent quarter where the residential segment revenue dropped 1%. High interest rates can freeze new home building, resulting in lower sales for IES’s residential segment as Residential business is closely correlated to the single and multifamily housing market. But, of course, when interest rates drop a bit (probably in 2024), there will be relief to the residential business side of IES. The thing is, I believe that this return to growth phase is already reflected in the stock price with the 160% rise over 1 year. That doesn’t mean there is no further long-term upside. No, I wouldn’t buy IES for a trade.

Margins grew over time, creating operating leverage. It will be interesting to see if margins will continue to rise. I don’t have any assumptions, and the management does not note that in their reports.

In terms of solvency, IES covered all of its debt and is debt-free as of last quarter. I like to check for shenanigans through trends in Days Sales Outstanding (DSO), Days Payable Outstanding (DPO), and Days Inventory Outstanding (DIO). All of those are pretty stable with no significant changes.

Another thing I like about the management’s actions is that IES has a $40 million buyback program, but it isn’t systematic, which means they try to judge when the stock is undervalued and to deploy capital when it is opportunistic. No dividend here.

In Q1, sales grew by 10%, and margins jumped back to more normal figures. Except for the residential market sales, which dropped by 1%, all other segments experienced meaningful growth. The backlog grew by 10%, giving us a good preview of the short-term growth numbers.

Risks

Despite being a high-quality business, it’s not the ideal business simply because it is highly sensitive to economic downturns. As we have seen in the recent quarter, growth in the residential business was stagnant, which affected the rest of the business and decreased growth numbers to the low teens. A housing crisis could be catastrophic for IES.

Another risk is more short-term and technical. Personally, I think that this shouldn’t be an important factor in long-term decisions, but IES has had a really good run recently, up 34% in the month, and the RSI is sky-high, as well as being significantly above the moving averages. This could mean a short-term selloff, so you might want to wait a bit for it to cool down.

Another risk is valuation. To me, the valuation looks reasonable, but I wouldn’t say the stock is screaming cheap, and multiples aren’t at their lowest; they are about the same as the averages.

Valuation

There are no analyst estimates for IES for some reason, so I don’t have a forward multiple. But let’s assume long-term top-line growth before 2020 of 15%, with the current TTM P/E multiple of 20, and we get a PEG ratio of 1.3, which is pretty reasonable for a stock that returns 20% on invested capital. The FCF yield also looks reasonable at 4.9%. That’s not the 14 times earnings we have seen in September, but it is still a reasonable price to pay.

Similar growth companies usually trade at much higher multiples, sometimes in the 40s and 30s.

Let’s do a simple DCF. Assuming 15% top-line growth, in line with pre-COVID CAGR, 7% EBIT margin, a WACC of around 10%, and a terminal growth of 4% gives us approximately the current price. Of course, changes in margins or lower growth could change the whole picture, but this is the nature of DCFs; they are sensitive to change, and therefore you shouldn’t rely on them. Personally, I’m for buying high-quality businesses at reasonable prices and holding them for the long term. But I see why certain investors wouldn’t see this valuation as appealing.

Conclusions

IES is a high-quality company, led by a manager with a huge stake in the game, and built like other long-lasting compounders. Despite amazing returns in the last decade, I don’t think that long-term investors have missed the train. Yes, we could see short-term headwinds, but looking at the trends IES is benefiting from, I see IES continuing its amazing run. It is very important, however, to consider that this business could be severely hurt in a recession.

Looking forward to your comments.