Tuesday, August 01, 2017

Good Business in the Environment

Florida Everglades
Humans are a filthy lot, and apparently unwilling to change their ways even in the face of irrefutable evidence that fouling your own nest can put survival in doubt.  That makes for good business for companies like Ecology & Environment, Inc. (EEI:  Nasdaq).  The company provides consulting services to industry on hazardous waste threats such as contamination by petroleum products used in manufacturing or chemicals required for weapons production.   Its portfolio of projects is filled with a variety of projects, ranging from ecosystem restoration in the Florida Everglades to zoning regulations for oil and gas development in Kern Country, California.
It is not a company that appears on lists of hot stocks compiled by analysts or reporters.  E&E keeps low profile as a problem solver for their clients.  However, with a foothold in a growing market and a small dividend as icing on the cake, the company merits consideration.

In the twelve months ending April 2017, E&E reported $100.5 million in total sales, providing $1.4 million in net income or $0.31 per share.  In the same period, the company converted 5.4% of each sales dollar to operating cash flow.  Return on equity was 3.4% in the recent year.
E&E has proven it is possible to make the environment good business.  Keeping it consistently growing and profitable is yet another matter.  The company has reported successive declines at the top-line over the last five years.  Sales in 2012 were $155.4 million compared to $105.8 million in 2016.  Additionally, operating losses were reported in both 2013 and 2014, as sales activity declined and costs soared.  The company has since been successful in right-sizing its operations.  Indeed, in the full year 2016, the operating margin had been brought up to 3.9% compared to 2.8% in 2012.
With a service business model E&E does not have a large capital investment budget, investing on average $1.1 million per year over the last three years.  Cash flows have been more than adequate to finance maintenance investment.  That has left management with some extra funds for strategic decisions.  In recent years deleveraging has apparently been the priority with a total of $7.3 million on net payments made on outstanding debt.  The company ending April 2017, with $951,000 in total debt on its balance sheet, of which $892,000 is due within a year.  With $11.7 million in the bank, that will be an easy bill to pay.
As impressive as it is to be debt-free and cash-rich, investors have to be asking what management has planned for all that bounty.  Are there investment opportunities about that could drive returns on equity to a higher level than 3.4%?
Cash balances net of long-term liabilities is $10.7 million.  Obviously, some of that cash is required for working capital purposes.  One rule of thumb is working capital cash should be equal to one-month of costs and expenses.  Based on recent cost and expense reports, E&E would need about $8.4 million in cash for working capital.  That suggests only about $2.3 million of E&E cash balance is really in excess and not well deployed.  Nonetheless, cash balances are likely to grow if recent trends continue.  After a tough year in 2014 when the company used cash to pay down debt, cash has been building ever since
Management may be looking at the most recent results from the April 2017 quarter when operating cash flow was negative for the quarter.  The quarter ended in a reported net loss and the company had to dip into cash resources to support operations.  It may have been a déjà vue moment for management with a collective memory of periods with falling sales and net losses.  Having some extra cash in the bank might seem like the more prudent choice than a hastily crafted investment in growth. 
That view was apparently not shared by shareholders, at least one shareholder in particular.  Fretting over tepid growth, an activist investor with 15% of outstanding shares had launched a proxy contest with management.  The investor was successful in getting representation on the E&E board of directors in return for discontinuing what had been somewhat shrill criticism of E&E management.  The two representatives joined the E&E board of directors in April 2017.  Only time will tell whether financial partisans with little technical knowledge or experience will be a source of good ideas for growth or a drag on E&E's otherwise ‘good environmental business.’

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

No comments: