Description

Applus Services (APPS) is a high quality compounder operating in the attractive Testing, Inspection and Certification (TIC) industry, selling at a cheap valuation. APPS, the 8th largest TIC provider, along with the other large TIC companies, benefit from multiple barriers to entry from a mix of economies of scale, customer captivity and regulatory sources:

●     Economies of scale: technology and process expertise deployed globally and locally

●     Customer captivity: provide mission critical services with low price relative to risk/asset value, brand, reputation

●     Regulatory: large portfolio of accreditations and authorizations which are required to provide many of the company’s services and vary by industry and region

The TIC industry benefits from several secular growth drivers:

●     Increase in quality, health, safety and environmental (QHSE) standards/regulations in both developed and developing markets

●     Increase in product/asset complexity, infrastructure growth in emerging markets, infrastructure aging in developed markets

●     Shift to outsourcing: outsourcing varies by industry and region but is roughly 10-40% on average; outsourced TIC providers are able to specialize and drive higher utilization rates

The strong moat and secular growth opportunities are evident in the company’s financial results: (a) organic revenue grew 14% from 2011-13 (management expects to report a mid-single digit revenue growth on a constant currency basis for 2014), (b) return on invested capital runs above 30% (pre-tax EBITA / Net working capital + Net PP&E) and (c) the business produces strong free cash flow (around 70% of EBITDA).

APPS trades at 70-75% of my €14-15 per share intrinsic value appraisal. Additionally, APPS trades at a significant discount to its peers/comps (about 4-9 turns of P/E and 1.5-4 turns of EV/EBITA; comps: BVI FP, ITRK LN, SGSN VX). There are several potential areas of concern that may explain some of the discount:

●     Energy: around 29% of revenue is from energy company CapEx. It’s very hard/impossible to forecast/predict commodity prices and energy company CapEx, however, there a few points worth considering: (a) a portion of this CapEx is related to asset maintenance and midstream/downstream projects which are less likely to be cancelled/deferred and (b) one of the company’s energy-exposed divisions only had revenue fall 3-4% in 2008 before recovering.

●     Spain & Europe: APPS is based in Spain, listed in Spain and generates about 17% of company-wide revenue in Spain. An additional 27% of revenue is generated in the rest of Europe. From a fundamental standpoint, concerns regarding European revenue are misplaced.  The Spain revenue appears to be very high quality: (a) about 7% is from the Norcontrol division where the company provides services related to electricity and telecommunications networks and industrial facilities and (b) about 6% is from statutory vehicle inspections which have long-term contracts (see risks below). The balance of the European exposure is split roughly 50/50 between the energy and automotive-related segments (it is unclear how much of the energy exposure is linked to upstream spending but it’s worth noting that the RTD segment was founded and is still based in Netherlands where the company plays an important role in testing the country’s gas network).

●     Broken IPO & P/E Overhang: APPS stock is down around 33% since its May 2014 IPO, compared to around -15-20% for its comps. Carlyle still owns 35% of the company.

While the energy exposure is concerning in the short-run, I believe the current market price more than compensates long-term investors. Over time, revenue should grow organically in the mid-single digit area from the secular/structural drivers listed above (one could argue this is conservative). The impact of reduced energy CapEx is difficult to handicap. I estimate overall revenue will be roughly flat in 2015. This estimate assumes segments exposed to energy CapEx (29% of total revenue) will decline around 12.5% (I estimate half of the energy-exposed CapEx revenue is “maintenance” and it declines 5% while the more new-build/growth-oriented CapEx declines 20%) and the balance grows around 5% organically. From 2016 on, I assume the company grows 5-6% organically and expands margins 60-70bps per year.

My valuation utilizes a 12x EBITA multiple which corresponds to around 16x EPS on my 2018 forecast, discounted back. This valuation approach compares favorably to comp valuations and private market value:

●     Comps trade around 18-23x 2015 EPS and 14-16x 2015 EBITA.

●     Larger acquisitions in the TIC industry have been completed at low-to-mid teens EBITA multiples (Intertek acquired Moody, a close comp to APPS, at over 13x EBITA in 2011).

●     The private equity bid for APPS that was reportedly turned down implies 12.6x EBITA (see “History” below).

End-Market Overview

The company’s TIC services include non-destructive testing (NDT), site inspection, asset integrity testing and certification related to the industrial, energy and automotive industries:

●     53% of company-wide revenue is related to services provided to oil & gas companies, including asset inspection and non-destructive testing (e.g., testing pipeline welds). About 55% of the oil & gas revenue is from energy company CapEx and 45% is from OpEx. Applus is the #1 global provider of oil & gas asset inspection.

●     17% of company-wide revenue is related to statutory vehicle inspection. The company performs around 10 million vehicle safety and emission inspections in many regions. Around 80% of the contracts are regulated (concessions/authorizations) and the average remaining contract life is around 9 years. Applus is the #2 global statutory vehicle inspection operator.

●     8% of company-wide revenue is related to Auto OEMs. The company provides engineering, testing and homologation services for OEMs.

●     the balance of revenue is related to utility, industrial and infrastructure customers.

Currency exposure: 41% EUR, 28% USD, 5% GBP, 4% AUD, 4% CAD, 18% other.

History

●     Carlyle took APPS private in November 2007 for €1.5bn.

●     Private equity firm BC Partners reportedly bid around €2bn (equivalent to €10.30 per share based on the current capital structure and 12.6x 2014 EBITA).

●     Carlyle took APPS public in May 2014 for €14.50 per share (http://www.ft.com/intl/cms/s/0/049f51ec-ba56-11e3-8b15-00144feabdc0.html#axzz3PIu4H0yW).

●     Carlyle now owns about 35% of APPS.

M&A Opportunity

The TIC industry is fragmented (JP Morgan estimates the top 10 companies represent 33% of the outsourced market & 12% of the total market) and the larger players are actively consolidating the space.

APPS has completed over 20 acquisitions in the last 5 years and management has indicated they will seek to acquire companies generating €50-75mm of revenue per year for around 6x EBITDA, which implies a cost of around €35-60mm per year. APPS can easily digest acquisitions of this size due to robust annual free cash flow of around €115-125mm (€95-100mm after the estimated dividend). While the IRR on these acquisitions is likely to be less than 30-40% core ROIC, the acquisitions should still conservatively generate respectable 12+% returns (year 1, unlevered, pre-synergy) and up to the mid-20% range using reasonable growth assumptions. Furthermore, the potential acquisitions could add 3-5% to revenue and EBITA growth. See risks below regarding recent impairment.

Risks / Other

●     Catalonia statutory vehicle inspection -- around 3% of company revenue is generated performing statutory vehicle inspections in Catalonia, an autonomous community of Spain. The current vehicle inspection regime is being challenged in the courts and a final ruling isn’t expected for 1-2 years.

●     M&A - the company recorded over €150mm of impairments from 2011-13 and the attractive acquisition scenario highlighted above may ultimately destroy value.

Note: this summary uses adjusted (not GAAP/IFRS) financials due to the significant amortization from prior acquisitions and some one-time expenses and is pro forma for the recent IPO and current balance sheet. Header above uses EBITA instead of EBIT.

Catalyst

Dividend -- the company intends to initiate a dividend (20% payout of adjusted net income) after announcing 2014 results (per the prospectus)