Limbach: High-Quality Business, I See Strong Upside Potential (NASDAQ:LMB)

Introduction

The unprecedented boom in U.S. non-residential construction during 2023 propelled Limbach (NASDAQ:LMB) to record-breaking heights, witnessing a fourfold surge in stock price from February to December 2023. Although the initial performance of 2024 was subdued, my fundamental analysis suggests this pullback is likely temporary. Bolstered by strong management and favorable macro trends, the business is poised for continued expansion. With a valuation analysis indicating a 40% upside potential, I find LMB to be a compelling opportunity. The pros of investing in LMB outweigh the cons, earning the stock a ‘Strong Buy’ rating.

Fundamental analysis

Limbach is an integrated building systems solutions firm with expertise in the design, modular prefabrication, installation, management, and maintenance of HVAC (“heating, ventilation, and air conditioning”), mechanical, electrical, plumbing, and control systems for commercial, institutional, and light industrial markets. The company performs its contracts both via owner-direct relationships (“ODR”) and as general contractor relationships (“GCR”). Working directly with project owners is more beneficial for Limbach since it creates more cross-selling opportunities. The revenue between the two approaches is split approximately evenly.

According to the Q3 2023 report, Limbach targets diverse end markets, which include healthcare, data centers, industrial and light manufacturing, higher education, cultural and entertainment, and life sciences. That said, it seems that Limbach covers all possible end markets that require sophisticated HVAC and control systems. This comprehensive market coverage is a robust competitive advantage, ensuring stability in financial performance even if one of the end markets experiences temporary softness. The company positions itself as a ‘one-stop-shop’ for building owners, setting it apart in its business approach and providing competitive advantages, particularly in terms of cross-selling. As the company consistently exhibits robust business growth across key metrics, it validates the strength of these two competitive advantages.

As previously noted, Limbach derives a significant portion of its profitability from contracts directly with project owners, constituting about half of the company’s sales. There exists substantial potential to enhance profitability by shifting the revenue mix toward a more project owner-centric approach. Recognizing this opportunity, the management aims to elevate the share of revenue from ODR to 70% by FY 2025. As Limbach expands its operations and establishes itself as a trustworthy partner delivering high-quality services, securing direct contracts will likely become more attainable. This shift benefits the project owners by eliminating the profitability of general contractors, which makes projects more cost-effective. In essence, achieving the target of a 70% ODR revenue share is feasible for Limbach, promising positive outcomes for investors. ODR contracts also provide Limbach with more cross-selling opportunities like HVAC maintenance, which will also be beneficial for the company’s profitability.

Limbach’s strategic focus on enhancing its revenue mix, particularly by increasing the share of ODR, has been a key factor in the notable improvement of its operating margin over the past five years. Despite revenue volatility stemming from challenging macroeconomic conditions, the operating margin remained resilient during periods of significant revenue decline. This trend suggests that as the company further diversifies its revenue mix toward ODR, the positive trajectory of expanding operating margins is likely to persist.

The company emphasizes growth through strategic acquisitions, as highlighted in the latest investor presentation, where successful cases are thoroughly outlined. With a widespread presence across the U.S., Limbach has ambitious plans for further expansion, supported by a clear roadmap and successful integration strategies demonstrated in past acquisitions. This disciplined approach increases the likelihood of successful future expansions through acquisitions.

Now, taking a broader view of Limbach’s prospects, it’s important to acknowledge the cyclical nature of its business, closely aligned with the overall health of the U.S. economy. Despite initial recession concerns, the American economy has displayed significant resilience, surpassing expectations. J.P. Morgan anticipates a significant deceleration in U.S. economic growth in 2024 due to tight monetary policy impacts. Despite this, the economy is projected to continue growing, providing a favorable tailwind for Limbach. Adding to the positive momentum, there is an anticipated 4% growth in nonresidential construction spending in 2024, albeit at a notably slower pace compared to 2023.

Lastly, I want to highlight Limbach’s robust balance sheet. With $57 million in cash at the end of Q3, nearly $20 million exceeding total debt, and current assets significantly outweighing short-term liabilities, the company boasts solid liquidity. Emphasizing the importance of a strong balance sheet, it provides Limbach with financial flexibility to navigate adverse conditions and capitalize on compelling expansion opportunities. In this regard, Limbach’s balance sheet positions the company to weather sudden challenges without sacrificing potential growth prospects.

In conclusion of the fundamental analysis, I am impressed with Limbach’s business performance, and the management’s strategic expansion priorities appear sound and achievable. The company’s consistent performance in recent years heightens confidence in its future success.

Valuation analysis

LMB faced a sluggish beginning in 2024, marked by a 6% stock price decline. Despite this short-term setback, the stock has exhibited robust performance over longer timeframes, boasting a remarkable 231% surge in the past 12 months and a substantial 64% rally over the last six months.

Now, let’s run a discounted cash flow (“DCF”) model to assess whether there is continued momentum after the significant rally. Future cash flows will be discounted using a 9.8% WACC. For FY 2023-2024, I rely on consensus revenue estimates, primarily derived from management’s expectations and deemed the most reliable source. Beyond 2024, I adopt a conservative 2% revenue CAGR, aligning with the Fed’s target inflation levels. I use the same conservative 2% constant revenue growth rate for the terminal value (“TV”) estimation. The levered free cash flow (“FCF”) margin for the base year stands at a TTM 9.53% level, and I anticipate it to remain flat. There are around 11 million LMB shares outstanding as of January 2024.

Based on the analysis above, LBM’s fair share price stands at almost $60, presenting a 40% increase from the current share price, showcasing an appealing upside potential considering the company’s robust fundamentals and sound balance sheet.

Mitigating factors

Investing in a stock that has seen a remarkable 240% surge in the last 12 months carries significant risk, especially considering the potential for profit-taking by investors. The stock’s recent weak performance in 2024 further emphasizes this risk. The upcoming Q4 and full 2023 earnings release on March 7 could serve as a crucial catalyst for the stock. Despite an expected 10% YoY decline in revenue for Q4 2023, the adjusted EPS is anticipated to increase from $0.35 to $0.40. Betting on bottom-line improvement amid declining revenue poses a risk, even for a company with a resilient operating margin. Limbach’s history of earnings beats is not flawless, and a disappointing report could lead to a significant stock decline.

While the U.S. economy managed to steer clear of a recession in 2023, it cannot evade one indefinitely, as economic cycles inherently include periods of recession. The severity of a recession, whether mild or severe, might trigger exaggerated reactions in both headlines and the stock market. Investing in growth stocks like Limbach carries a higher risk than more stable options like dividend aristocrats, potentially prompting a shift in investor capital toward less risky stocks or even other asset classes. While I don’t anticipate significant harm to Limbach’s long-term prospects from a recession, negative investor sentiment could lead to a compression in valuations.

Conclusion

The significant upside potential far outweighs the inherent risks. Limbach stands as a high-quality business, guided by sound management and a clear roadmap for achieving both revenue growth and profitability improvement. Consequently, the stock unequivocally deserves a ‘Strong Buy’ rating.