Hill International Inc. (HIL) – value with a catalyst
Share Price: $3.15
Shares Outstanding: 55.6mm
Market Cap: $175.4mm
Enterprise Value: $193mm
2018 Adjusted EBITDA: $17mm
Q1 2019 FCF: $7.5mm
Hill International is a worldwide leader in project management services and construction consulting. Headquartered in Philadelphia, with offices all around the world, HIL has a long history dating back to 1976, and derives the majority of their revenues (63%) from government related business, with the remaining taking place in the private sector. Hill is one of the largest construction management firms in the US (in the top 8), and has the number one spot in Poland (HIL derives a large chunk of revenues from Europe). Construction management and consulting is a lower margin, cyclical business, so that, and recent corporate governance issues have led to a material decline in the share price, opening up a potential opportunity.
Although there are more nuances here, the situation is eerily similar to that of Ecology and Environment, (although HIL actually ended up getting de-listed last year), and doesn’t yet have the cash flow generation that EEI possesses.
I’ll outline aspects of the opportunity below, but first, a quick overview into Hill’s business.
HIL derives the majority of their revenues from government related work, using cost-plus and time and materials contracts. Basically, a construction project is funded and commenced, and HIL will be hired to give advisory, consulting, budgeting and project management services in an effort so save a client money and avoid cost overruns. The most important business metric for HIL is consulting fee revenue (CFR) which is total revenues less subcontractor costs, and has historically represented 78-80% of total revenues (2018 was 78.7%). Around 75% of HIL’s business comes in the form of longer term time and material contracts, and HIL specializes in advisory services designed to help clients save money before and after projects, which helps offset some of the cyclical aspects of the business.
Typically the construction management and government consulting businesses are lower quality, consisting of mid to high single digit returns on capital, low gross margins (HIL has been in the 28-34% range), subject to wage increases, government regulations and local/federal budget decisions. In addition, although some of these businesses (Jacob’s Engineering as one example) have grown considerably over the past few decades and delivered plenty of value to shareholders, typically you’re looking at a lack of competitive advantages, lower barriers to entry on the smaller end of contracts, and cyclicality tied to new construction activity, as well as – in Hill’s case – oil prices. Despite the above, HIL has built a solid reputation within the industry, and as mentioned, has grown to become a significant player within the US and overseas. To date, Hill has participated in over 10,000 projects with a total estimated value of over $500 billion.
In terms of the investment opportunity, a quick snapshot of HIL’s last four years and one quarter will help explain some of the share price woes.
The recent shareholder experience with HIL has consisted of poor management decisions combined with excessive compensation, under-investment in key segments of their business, cyclical downturns in those same key segments, resulting in the destruction of plenty of value. As a result of that, during the past year, due to both operational and corporate governance issues, HIL has seen its share price decline by over 50%. What’s interesting though, is while things haven’t looked great from an operational standpoint, the majority of the recent selloff can actually be tied to what looks like non-economic selling.
To give you a better picture of how we got to today, let’s go through the recent timeline of events:
2015-2016 – first activist involvement with DC Capital (who offers two go-private bids of $5.50 and $4.75, both rejected by the board) and then Bulldog who wins a proxy battle and adds two board members
You can read more about the Bulldog proxy battle here.
Early 2017 – Construction claims group is put up for sale
Mid-2017 – sale process unearthes some accounting issues tied to foreign exchange accounting
Mid-2017 – sale goes through, Hill pays down their debt
Mid-2017 – former CEO David Richter resigns, activist and current large shareholder Ancora Advisors calls for a sale of the business
Late 2017 – a profit improvement plan is announced by the new management team
Late 2017 – all is going well, then Hill announces that 2014-2016 financials need to be restated due to the 2016 FX accounting issue
Mid-late 2018 – Hill can’t get financials filed in time
August 2018 – HIL stock is delisted, shares plunge nearly 50%
October 2018 – the delisting suspension is lifted, and HIL stock trades once again on the NYSE, shares plunge another 30% below $3.00/share
October 2018 – Raouf S. Ghali hired as permanent CEO from the board and prior operating roles as a VP and Project Management President
So if one were to read between the lines here, you’ve got a group of shareholders forced to sell following the de-listing, another large shareholder liquidating following the re-listing, traders hoping for a quick jump in the share price after the re-listing selling when there was none, and the discovering that HIL is not going to be rejoining the Russell 2000, leading to more selling. That’s about as non-economic as you can get.
Fast forwarding to today, HIL has taken massive efforts to right size their business, including management changes, completing restatements, beefing up corporate governance, reducing costs, attempting to return to organic growth, and winning new contracts. Yet, the share price still remains around $3.00. So what are investors left with, and how likely is this business turnaround?
What we’re left with:
Microcap stock, zero analyst coverage, low float, horrible trailing financials, won’t screen well
Severely depressed stock price due to plenty of non-economic selling
Trough revenues/earnings in some segments due to under-investment/cyclicality
Huge insider/board ownership made up of activists, purchasing more shares and incentivized to sell the company
A business turnaround taking place including a return to organic growth, cost reduction, and increased margin guidance
Huge discount to peers on every relevant metric
So how likely is this business turnaround, and what’s been happening since the stock selloff?
The construction management industry is absolutely massive, estimated to be in the tens of trillions of dollars, growing at around 3.6% through 2030, and made up of both large firms, and plenty of smaller competitors. Despite recent poor operating performance and cyclicality, a look around the industry reveals that these firms have a large amount of strategic value to an acquirer able to eliminate public company costs, reduce staff, and lower operating expenses. In the last two years alone, there have been nearly 1,500 M&A transactions within the industry, with 2018 recording the highest number of deals seen in over 12 years.
Despite Hill’s operating woes as of late, the business should have a ton of strategic value to an acquirer able to strip out unnecessary costs and further reduce SG&A. In a non-sale scenario, if Hill can return to some slight organic growth and continue to keep costs low, there is actually a decent amount of cash flow generation on the horizon.
In the meantime, outside of a business turnaround, you’ve got a stock priced for maximum pessimism, a ton of elevated non-recurring costs flowing through the financials, and multiple years of noise surrounding a sale process and activist involvement that has no doubt frustrated the shareholder base. With that said, I believe the new management team can eventually help turn the business around, and the opportunity lies with the removal of costs from the income statement and a few quarters of positive developments.
Management provided some great commentary during the Q4 call about what’s been taking place:
…there have been a lot of changes, both planned and unplanned and those changes have created a live noise flowing through our financial results. I want to provide an update today on those changes and walk you through financial results for 2018 with a focus on how the noise from those changes have affected the results.
So going back into 2017 and 2018, there were some major events. One, the founding family exited the company and there is now a new management team in place. Two, the company sold its claims business and the focus is now solely on project management and consulting. Three, we embarked on a mission during 2017 to right-size the organization and to implement cost structure that would be sustainable going forward. This has now been completed. Four, finally, on the unplanned side, there were a number of issues in accounting and finance that had to be corrected: a, 3 years of financial statements needed to be restated; b, the financial control framework needed heavy remediation; and c, we need to become current with our SEC filings. Those items have largely been addressed and are behind us at this point. All of these changes came at a cost, specifically a $20 million cost in 2018 alone.
In addition to that $20 million, there were other negative items that affected financial results. We had a performance bond that was called during 2018 that is currently in litigation. However, we do take the expense for the bond in 2018. In the other direction, we collected a large amount of a previously reserved account receivable. The net of those 2 items is about a negative $5 million, and we consider that to be nonrecurring.
In addition, we had about $6.5 million in unrealized foreign exchange losses running through our financial statements. These unrealized FX losses, primarily relate to intercompany loans and balances. The important point here is that these losses will not be realized until and unless the underlying intercompany items are settled. And settling them is completely within our control. As such, we have excluded unrealized FX from adjusted EBITDA as we control when and if we choose to settle them. This year, we are analyzing those outstanding intercompany balances and planning a course forward on how we should best manage them.
So nearly $31mm in non-recurring costs (although $6.5mm were removed from adjusted EBITDA) were added to an elevated SG&A during 2018, resulting in the highest SG&A costs as a % of revenues in five years, as well as the largest EBIT loss ($20mm) during that same time. The 2018 FY did no favors for Hill’s trailing financials.
Management also stated in the 2018 annual report:
Concurrent with the 2017 sale of the Company’s claims business, management recognized the need to significantly reduce its selling, general and administrative costs given the reduced scale of the remaining business. Management developed and announced a Profit Improvement Plan (“PIP”) to address this need. Management recognized that the Company would incur costs during 2017 and 2018 to execute this plan, including consulting fees, severance and retention costs. The Company also experienced significantly higher costs in both years due to the financial restatement and in 2018 due to a performance bond being called. The combination of these events resulted in over $25 million of expenses in 2018 in excess of what management would consider typical. The operating loss and cash used in 2018 were primarily due to these expenses.
As of the date of these financial statements the PIP has been fully implemented and the associated expenses are substantially completed. The financial restatement was completed in 2018. With significantly reduced selling, general and administrative expenses already implemented, the financial restatement completed and the absence of expenses related to these items, as well as management’s expectation that performance bonds will not be called, management believes that cash provided by operations will be sufficient to meet its cash obligations over the next twelve months.
The above statements not only outline the positive changes HIL is implementing to right-size their business, but also help reveal why the opportunity exists. With the restatement behind us, reduced SG&A on the horizon, and the rolling off of significant non-recurring expenses, HIL’s cash generation and profitability should begin to shine through within a few quarters, opening up an avenue to reveal the cheap valuation and cleaned up balance sheet.
To put to rest any notions that Hill’s business is falling apart, solid evidence of operational improvement is beginning to take place through Q1 2019, with increased backlog and CFR which should translate to growing EBITDA and free cash flow.
In addition, as large one-time costs are removed from the income statement, these numbers should improve. The strong backlog, cleaned up by eliminating projects unlikely to be completed, may actually provide for some operating leverage as new contracts continue to increase, due to the now fixed cost nature of SG&A, allowing incremental CFR or gross margin dollars to fall through to the bottom line.
Management and the Board
New CEO Raouf Ghali was a 25 year Hill veteran before being promoted to the CEO role in 2018. Raouf saw the business grow from 250 employees to 2,800 today, and helped drive a lot of the company’s international business development. He is a huge part of why Hill entered into the Middle East, and has been saying and doing all of the right thing since the hire, including focusing on cost savings, profitable growth, and winning new business. Compensation that rewards growth in revenues, EBITDA and improved DSOs (along with his 2% share ownership) help align him with shareholders.
From the Q4 2018 call:
We have realigned our leadership and sales force compensation by significantly increasing the variable component of the compensation. This bonus includes cash and equity and is tied to EBITDA, sales and DSO targets. Clearly, we are incentivized to profitably grow the company and improve collection. We believe this new compensation structure aligns us with shareholders and is better in line with market practice.
Aside from the valuation, the current management team, board members and large shareholders are what is really going to drive the opportunity. The largest shareholders and board members are made up of people who would benefit the most in a sale scenario. This group (made up of insiders who already own 30%+) has been scooping up shares since the end of 2018, representing a high amount of daily trading volume on some days, and since that time has purchased a total of nearly 2.5% additional shares outstanding.
It’s possible that Hill’s business turns around, starts to experience organic growth again, continues to win lucrative business, and increases business value, but in the meantime, the small group of large shareholders appear very incentivized to get this thing sold, and are probably eyeing a price at least near where the shares traded before the de-listing ($5.50 – $6.00).
HIL currently trades at $3.15/share, with 55.9mm shares outstanding, giving us a market cap of $175mm. Cash of $27mm and debt of $45mm gets us to an enterprise value of $193mm. While it’s difficult to use current financials for valuation purposes, and HIL hasn’t provided guidance in quite some time, the company did post $7.5mm in FCF during Q1 2019, and regularly had quarters of $5-8mm in FCF throughout 2018. At one point, Hill guided for around $40mm in EBITDA during 2018, and before experiencing elevated costs due to the above, may have reached to the halfway point of that guide, providing an EV/EBITDA multiple of under 10x. Free cash flow to date has largely been due to better working capital management and deferred revenue, but it wouldn’t be hard to imagine a normalized scenario of $5-6mm FCF per quarter within the next few quarters. That would get us to less than 7.5-8x FCF if one were to annualize those estimates. Peers trade in the 13-35x range.
I modeled a few different situations which include worst case scenarios of management failing to meet cost guidance and backlog projections for 2020, as well as no organic growth and lower EBITDA margins than expected. Assuming revenue growth remains flat through 2020, and HIL only achieves 6% EBITDA margins on consulting fee revenue, there appears to be a 20% downside (or so) to today’s price. However, upside appears to be in the range of 40%-100% within a few years, without giving much credit to any positive capital allocation or significant improvement in certain business segments.
Using consulting fee revenue as a guide, assuming HIL finishes 2020 with $316mm in CFR ($79mm in Q1 2019 annualized, assumes no growth), and can reach 7.5% EBITDA margins, they’d post just under $24mm in EBITDA during 2020. At 8x EBITDA with additional cost savings and margin improvements on the horizon, HIL would trade around $3.05 (right below the current share price), significantly below median peer multiples of 11.5x EBITDA and 1x revenues. In addition, HIL would be trading at 0.6x consulting fee revenues (0.4x TOTAL revenues), while M&A transactions regularly take place at nearly double those sales multiples.
However, HIL management has guided for slight revenue growth moving forward, and 10% EBITDA margins on incremental consulting fee revenue. If they’re able to reach this goal by 2020 on the back of 4-5% growth in CFR, there exists significant upside to the valuation. Using the same 8x multiple on 2020 CFR EBITDA, as well as a 0.75x multiple of consulting fee revenues, HIL would trade somewhere between $3.90-$4.20 per share.
As a sanity check for the above, in 2017, HIL sold their construction claims business, a large segment of revenues at the time (26% of consulting fee revenues), for just under $150mm, or 1x sales. This segment was responsible for $150-$170mm in revenues from 2014 through 2017, and delivered 2.3% operating margins in 2016.
Even if it takes HIL until 2021 to accomplish the not-too-demanding scenario above, assuming the share price reacts favorably, you’re still looking at a 14-18% CAGR over two years. It feels as though not a lot has to happen for things to go well, and my valuation doesn’t give much credit to improved international operations, higher potential revenue growth, or the sale of any under-performing segments.
I like the favorable setup here, and believe HIL is an interesting special situation with a path to decent upside. Disclosure: Long.
Of note, not factored into the valuation is a large outstanding receivable from the Libyan government in the amount of $44mm from completed work that took place in 2012 during a period of civil and government unrest. During accounting restatements, Hill ultimately ended up reserving the receivable in 2012, and will make any future adjustments upon collection of all or part of the note. While I’ve assigned a value of $0 to the receivable for valuation purposes, the collection of all or part of it would result in material cash generation for Hill.
At the time of the restatement in 2015, Hill put out the following statement:
Under the restatement, Hill will reserve the entire net Libya Receivable of $48.1 million, consisting of a gross amount of $59.9 million net of $11.8 million in subconsultant and other contingent expenses then owed, in the year ended December 31, 2012, and adjust subsequent annual and quarterly results as required by GAAP. The adjustment related to the Libya Receivable will result in non-cash financial statement adjustments and will have no impact on the company’s current or previously reported cash position, investing or financing cash flows, or net operating loss carryforward.
“This action is not based on any change in our management’s current view of the collectability of the Libya Receivable, and we intend to continue to pursue collection of the monies owed to us by ODAC,” said David L. Richter, Hill’s President and Chief Executive Officer. “Despite this action, Hill’s underlying business remains strong, and we continue to expect to report record results in 2015,” added Richter.
The most recent update comes from the Q4 call:
Chris Colvin, Breach Inlet Capital Management, LLC – Founder & Portfolio Manager
Okay. And maybe last 1 or 2 is, on the Libya, I think you’ve still got 40 — almost $43 million of receivables that you’ve fully reserved for. What’s the update on potentially collecting those?
Raouf S. Ghali, Hill International, Inc. – CEO & Director
Chris, this is Raouf. We’re still in discussions, in close discussions with our client there. We haven’t reported on it because, till things materialize, we don’t want to be promising. But we feel we’re very close to potentially collecting some more. Last quarter, we collected some of our receivables that they paid certain amount of tax for us — corporate tax for us. So we feel — we still feel very strong that we will be collecting. We cannot talk about timing because it’s more political than commercial.
Overseas business tied to oil prices – started to recover, Middle East revenues at trough
Large receivables balance – working to collect
The business is actually falling apart, and management isn’t disclosing – recent backlog, CFR, and improved quarterly results indicate the business is moving in a positive direction
Cyclical – no way around this, other than to say that HIL may not be directly exposed to construction risk due to their consulting/advisory nature, as well as long-term contracts – 76% of contracts are long-term time and materials agreements. In addition, HIL grew slightly through 2008-2010
International operations are worth nothing – unlikely given turnaround and recovering oil prices, also we are mostly paying for US operations
Call for a sale by management and activists may damage business prospects and employee morale – its possible, but backlog and CFR improvements indicate otherwise
Government budgets decline – HIL is is in the business of saving clients money on projects, not sure this is viewed as discretionary
Backlog doesn’t turn into revenue
No moat/low barriers to entry/competing on price – HIL reputation, size and scale helps here
Business fails to return to growth – what is a normalized growth rate? Failure to return to even low-mid single digit growth would have adverse affect on valuation
Restatements could lead to further problems – the old management team responsible for material weaknesses is gone. The restatement has been conducted by a new board and new CEO