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MagicDiligence (< 20)

Magic Formula Stock Review: EMCOR Group (EME)



December 26, 2008 – Comments (0) | RELATED TICKERS: EME

EMCOR Group is a construction contractor that handles installation and maintenance of several building systems, including electrical, HVAC, plumbing, and communications. Some examples of projects EMCOR might handle include: lighting systems, security systems, telephone/internet, ventilation, and so forth. The company primarily services commercial, industrial, and municipal customers - not residential. There is a decent mix of revenue sources here. Last year, about half of EMCOR's revenues were from new construction projects, while a quarter were from renovation and another quarter from maintenance contracts.

There's a lot to like here, starting with the general growth strategy. Management has been trying to move the company away from the heavily cyclical commercial construction market. By focusing on growing maintenance contracts, EMCOR has been able to build a solid base of stable and recurring revenue. Management has also been pointing the company towards the most attractive growth markets. The U.S. oil and gas refining industry has seen almost no new construction in the past 30 years, making maintenance and renovation of the existing facilities of utmost importance. In 2007, EMCOR purchased Ohmstede, a company specializing in refinery maintenance. Ohmstede's business is higher margin than EMCOR's legacy businesses and should be a strong driver of top and bottom line growth over the next several years. Lastly, the incoming Obama administration has floated plans to spend several hundred billion dollars on infrastructure projects, which will lead to more contract opportunities for construction firms like this. The bottom line: there are ample growth opportunities in addition to a solidifying base of recurring revenues.

EMCOR has a solid financial base to grow from. The balance sheet is solid, with $340 million in cash vs. about $200 million in debt. Free cash flow margins are on a 5 year march upwards. The current FCF margin is 4.4%, up from 0.5% 5 years ago. The story is similar for return on capital, where the current figure is over 100%, while the 5 year average is closer to 35%. Profitability trends have all been positive, with all meaningful margins marching upwards over the last several years.

These positive attributes make EMCOR a solid Magic Formula purchase, but I'll stop short of recommending the stock to members. The main reason is that EMCOR's business has no built-in moat characteristics and a ton of competition. Construction contracting benefits from none of the structural and durable competitive advantages such as switching costs or regulatory protections. EMCOR has few advantages in winning new contracts, outside of perhaps size and name recognition, which are both relatively weak factors here. Competition is abundant, from several national and regional competitors down to local "mom-and-pop" HVAC and plumbing companies. With this much competition, prices are driven down to barely profitable levels. This can be clearly seen in EMCOR's financial statements, where the company runs just a 2% net margin even in good years. EMCOR may be a well run company, but the business it is in is low margin, highly competitive, no-moat, and very cyclical. MagicDiligence tends to bet on the horse, not the jockey, and while the jockey here is good, the horse is unreliable.

Steve owns no position in any stocks discussed in this article.

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