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- Charah will sell 5,294,117 shares at a maximum price of $18.00 per share.
- EV/EBITDA ratio is 8.9x, which seems somewhat undervalued.
- Leverage is very significant. The company will use the proceeds from the IPO to repay the debt.
- Cash flows and capex seem to be very predictable, which is ideal for BCP, the private equity controlling the company.
With a very established business model and stable cash flows, investors will, a priori, appreciate Charah Solutions (CHRA). In this piece, I will show that high leverage and the private equity controlling the company are not ideal. The shares seem to be somewhat undervalued. Also, if everything works as planned, stock returns can be expected.
Remarkable underwriters like Morgan Stanley (NYSE:MS) and Bank of America (NYSE:BAC) are working for Charah. Many investors will appreciate this.
Headquartered in Louisville, Kentucky, Charah Solutions casts itself as a provider of critical environmental and maintenance services to the power generation industry.
What are the services provided? The company has two business segments:
Environmental Solutions, which accounts for 55% of the total revenues and includes the following services:
Maintenance and Technical Services, which represents approximately 45% of revenues. CHRA provides the following information about this segment:
The following are the revenue figures given by the company for the year 2017:
Who are the customers?
The company claims to have built long-term relationships with well-known U.S. utilities like Duke Energy (NYSE:DUK), Exelon Corporation (NYSE:EXC), Dominion Energy, Inc. (NYSE:D), Dynegy Inc., PPL Corporation (NYSE:PPL) etc. Additionally, the company seems to be very well positioned in the industry. It operates in 22 different states, which enables it to easily pursue new business relations at the national level.
How large is the work force? As of March 31, 2018, the company had 3,411 employees.
There is a private equity behind the IPO – Director Independence
Before going through the financials, I need to note that the company was recently acquired by BCP, a private equity firm with $1.5 billion under management:
BCP acquired 76% interest in the company for $104 million. Investors need to be aware that after the offering, this firm will own 51.4% of CHRA’s common stock:
As a result, the Board of Directors may not be independent, which could harm the interests of minority shareholders. In other words, the Board may act in favour of the interests of BCP, but not in the interest of all the shareholders. The following are the words from BCP about this matter:
Along with that, investors need to take into account that this is a new company; formed in January 2018 as a result of a corporate reorganization. Charah LLC and Allied Power have joined forces and now operate together. This means that we don’t seem to have a lot of information about the previous operating performance of CHRA. This is not ideal for decision making, so I expect investors to wait until the market receives a few quarterly earnings results.
The following is the business structure as of today with the stake to be owned by IPO stockholders:
The consolidated revenue of the group was equal to $421 million in 2017. With $82 million in gross profit in the same year, the gross margin equals 19.5%. The operating income was worth $33 million, and the net income attributable to Charah LLC was $18 million.
Please note that the interest expense was very significant, $14 million, which represents 41% of the operating income. In other words, the leverage used by the private equity is quite significant.
Private Equity Type: Cash Flow Generation Stable and Predictable
The cash flow statement looks even better. The company is able to generate a CFO of almost $58 million. Taking into account 30 million shares outstanding after the offering, I obtain a CFO of $1.9 per share. Take a look at the cash flow statement below:
The most interesting for shareholders and the private equity firm is that cash flows are very stable and predictable. Read the following in this regard:
“At the beginning of 2017, 67% of our budgeted revenue for the year was already contracted, not including our Nuclear Services offerings that commenced operations in June 2017, which had 100% of its budgeted revenues contracted. The vast majority of our customers have investment-grade credit ratings and we have never experienced a payment issue with a client. In addition, because our capital expenditures are tied to specific, known contracts and are typically financed, we also have attractive and predictable free cash flow generation.” – Source: Prospectus
The following is the list of assets. Please note that the company has $32 million in cash, or $1 per share. In addition, there is goodwill of $73 million, and trade name accounts for $34 million. These are assets originated in the corporate reorganization.
The liability side is more interesting since it contains massive amounts of debt acquired after the PE firm purchased the company. The amount of total liabilities was $329 million, out of which $227 million is debt.
For readers interested in the type of financing received, have a look at the following text. Please note that the interest rate to be paid is quite high. It could be LIBOR plus 6.25%:
When will be the debt payable? Management is repaying a small amount of the debt each year. With a CFO of $58 million and current cash in hand of $32 million, I believe that everything is under control. In my view, it will be able to repay the debt:
Low Float: Volatility Risk
As mentioned earlier, BCP owns more than 50% of the total shares outstanding. Additionally, the management owns a stake of 19.4%, and there are more shareholders with significant amount of shares. Have a look at the image below:
What’s my take on this situation? The current distribution of shares implies that the float will be low after the IPO. In other words, the amount of shares owned by the public will be low. With this situation in mind, minority shareholders should be ready to suffer large amounts of share price volatility risk.
Competitors and Valuation
The company does not provide the name of any other competitor in the prospectus. This fact makes the valuation process a little bit complicated.
With 30 million shares after the offering, if they are sold at $18 per share, the market capitalization is expected to be $540 million. Subtracting cash on hand of $32 million and the proceeds from the IPO of $76 million and adding debt of $250 million, I obtain an enterprise value of $682 million.
For the fiscal year ended December 31, 2017, Adjusted EBITDA was $76.0 million. Using this figure, I get an EV/EBITDA of 8.9x, which seems somewhat interesting if we don’t consider the financial risk to be quite significant here.
If we compare with the EBITDA multiple of Charah’s customers, the company does not seem expensive. DUK’s ratio is equal to 11.29x, Dominion’s is 13x, PPL’s 9.5x, and Exelon’s 7.7x.
In my opinion, the private equity firm will make great returns on this transaction. Bear in mind that it only paid $104 million for a big stake in the company. New shareholders could obtain some returns too if everything works great and the debt is paid. With that, if there is a minor failure, the financial risk is large, and the value destruction could be very significant.
Use of Proceeds: Repay Debt
Charah will use $45.3 million to repay some part of the debt. The rest could be used for the development of new services or to pursue new acquisitions. Until the company uses the net proceeds, they will be invested in the United States government securities and other investment-grade instruments. The following text provides more details:
What’s my take? I don’t expect investors to appreciate the way the money will be used. I know that some funds will be used to repay debt. It makes sense. With that, I don’t understand why it is raising so much money to save it and invest it in the US government securities. Investors can do that on their own.
Charah seems to be a very solid company. I appreciate the fact that the management will be able to easily predict cash flows and capex. It is the perfect investment for a private equity. Because of this fact, in my view, the transaction is quite beneficial for BCP.
In my opinion, the company seems slightly undervalued. Thus, investors could make small stock returns once the debt is paid out and the financial risk diminishes. In sum, I will not buy shares right now. I will wait a few quarters to verify that the good operating performance continues in 2018 and 2019.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Article by Bilbao Asset Management from seekingalpha.com