Summary

Exova is a B2B service provider of specialized material testing. It operates in a diverse set of sub-segments of the testing industry and holds no. 1 or no. 2 market positions within those niches. Demand for Exova’s services is growing at MSD-HSD growth rates and is resilient to swings in the overall macroeconomic environment. The industry benefits from solid LT structural growth due to expanding regulatory standards, growing demand on manufactures to improve product safety on the back of increased recalls and user accidents, and from the continued shortening of innovation cycles. As a provider of outsourced testing solutions, Exova should outgrow the overall market as it takes share from captive in-house testing labs.

Exova is predominantly a people business yet is able to generate high-teens operating margins. These margins are supported by the value of the specialized and relatively scarce knowledge that customers seek from the company’s highly skilled workforce, and by a rational competitive environment. As a fixed cost operation, Exova maintains high operating leverage and should generate high single digits to low teens operating income compounding over the current business cycle with good ROIC. Combined with very manageable financial leverage and reinvestment of cash flows, Exova will compound EPS at more than 20% on our conservative base case. Upside scenarios call for compounding of close to 30% or more with value creation from tuck-in acquisitions as Exova consolidates a fragmented set of industry niches; downside is for mid-teens EPS cagr should the industry’s current sluggishness prove permanent, despite the customers and competitors expectations of acceleration in demand throughout 2014 and beyond.

As a recent IPO where PE ownership creates a technical overhang, Exova trades for an unassuming P/E multiple of about 13X CY2015. This entry multiple provides downside protection but also affords another way to win once Exova rerates closer to its public peers, which trade at around 20X, close to the low end of their historical ranges. 

Background

Exova provides testing services through 117 labs across 22 countries. Close to 50% of revenues are in Europe, 40% in North America, 8% in the Middle East and 2% in ROW. The company’s customers operate in a broad range of niche applications. About 17% of EXO’s customers are Aerospace & Aviation companies, 17% operate in the O&G industry, 16% in the Health Sciences (including Food, Pharama and other), 12% are general industrial manufactures, 10% are in Transportation (including Auto), 10% are customers of Fire & Safety tests across industries, 10% use Exova for Calibration tests mostly in the technology space, and 8% in a range of other end markets in the Middle East and ROW.

Exova was originally a division within Bodycote (a UK based service provider in the industrial space). On Aug 2008 Bodycote sold Exova to CD&R (for 2.4x revenues and 26x LTM ebitda). Under Bodycote, Exova expanded its operations into several niches but spent little time integrating the acquired assets. When CD&R acquired Exova it stopped the use of cash for acquisitions, and spent the next 5 years on internal investments to improve integration and expand the IT, CRM, sales and managerial capabilities. On April 11, 2014 CD&R took Exova public for a price of P2.20 (22% above the current price) and sold down its stake to 57% of the equity. CD&R indicated that it intends to sell down its position over time. The lock-up on its shares expires tomorrow, on October 8, 2014.

Product and Service

Exova focuses on destructive testing of materials.  The tests that Exova runs serve three customer goals: assess the performance of the material in different environments (i.e. how the material performs under heat, fire, pressure, chemical exposure, elasticity and so forth), achieve certification that a material meets industry or regulatory standards (such as ISO), and learn how to improve the use of the material in end systems (an iterative process in which the customer consults with Exova during the testing process).

Exova tests the direct physical characteristics of materials, but does not test entire working systems. The testing that the company performs is destructive and is done on samples of materials that the customers provide. This limits Exova’s exposure to liability to claims against failure of the material in production systems. It also requires transferring sample materials from the customer to Exova, which in many instances requires proximity of the testing lab to the customer’s R&D or manufacturing facilities. Tests last from 1 day to 6 months, and the price ranges from several pounds to hundreds of thousands of pounds.

Exova tends to specialize in complicated materials that require a high degree of technical knowledge. A significant piece of revenues is delivered by technical staff that hold academic degrees at the Master level and above. Often the materials that the customer is testing are new to its engineers, who rely on the experience and datasets that Exova provides to become familiar with the material’s proper application. This tends to put Exova in a consultancy position at the client and fosters recurring relationships. As such familiarity with the personnel at Exova is important to the customer’s engineers who prefer to work with professionals with whom they are already comfortable. In other words, Exova is a people business, and the quality of its personnel is a decisive factor in its success.  Our channel checks indicate that Exova scores highly on this level and its personnel are well regarded by competitors and customers alike.

Business Model

Exova charges customers based on a menu of services and types of material. This menu is built on Exova’s prior experience with the material and its understanding of the application it will have in the end system. The selling process is very technical and requires intimate knowledge of the customer and the product it is developing. This dynamic allows Exova insight into the value of the material for the customer, which in turns supports a Value-Minus pricing model. 

The company generates revenues from follow-on work and open bids. While the majority of revenues are not guaranteed by long-term contracts, they tend to recur on a solid basis with about 85% of a given year’s pool of customers coming from the previous year’s base. Competition is focused on winnng work by offering unique knowledge, quick delivery times and understanding the customer needs. Tests tend to make up a small fraction of the overall cost to develop OEMs systems but are critical to quality assurance and warranty cost reduction. As such Test providers in the niches in which Exova operates have tended to avoid competition on price, supporting operating margins in the high teens to mid-twenties range depending on the niche. About 80% of Exova’s cost is fixed in the medium-term. Incremental margins are high and sensitive to change in revenue (you do not close a lab or fire an expert that quickly). Exova consumes about 2% of revenues on maintenance capex and last year it generated return on capital of 47% with a trend of continuous improvement.

Market and Industry

The testing market benefits from solid structural growth as manufactures need to run more tests due to a steady increase in regulation, growing focus by end customers on safety (on the background of increasing recall counts over the last few years), shortening of innovation cycles and increasing R&D and supply chain complexities.  Over the last decade, demand grew by about 6.5% cagr. Based on 3^rd party research and discussions we have had with industry players, demand for testing in total should support 5-8% growth going forward. In terms of cyclicality the testing business has tended to benefit from resiliency to swings in the overall macroeconomic environment. Constant changes in regulation and OEMs desire to reduce cost by reengineering products during recessions counter balance macro weakness. In the last recession Exova grew organically at 1% in 2008 and in 2009, with similar results at its peers.

The Testing industry as a whole is highly fragmented with the top 5 providers making up less than 30% of the market. SGS is the largest player and holds only roughly 10%. About 50% of the industry is made up of companies that generate sales of less than P10MM per year. The industry is highly fragmented by application and material tested and has meaningful locality to it (customers tend to prefer labs to be within a 50km radius of their offices). Exova is a number 1 or 2 player in 80% of its operation with high single digits to low teens market share by vertical, and number 3 in most of the balance.

Captive labs inside OEMs account for 60% of industry volume. However, outsourcing is taking share has it offers better economics than captive labs, which struggle to keep up with regulatory change, R&D costs and service levels. Our channel checks indicate that there is material room for outsourcers such as Exova to continue to grab share, with some providers talking about the potential to outsource 90% of the total market.

Projections

Base Case: Our base case calls for market growth of 6%, slightly below the midpoint of industry and management projections, and 50bps below the past. We then bake in 65bps of market share gain by outsourcing providers such as Exova; this compares to >100bps per year gains from 2009 to 2013. Combined, we expect the market for outsourced service providers to compound at more than 7% into 2018 (and similarly thereafter for the next cycle).

We are baking in 60bps of annual margin expansion, relative to management’s goal of 50-75bps per year. This assumption appears conservative when we run the math on 80% fixed cost. With revenue growth we get low double digit operating income compounding into 2018. Exova pro-forma financial leverage is >25% and levered compounding is mid teens.  At the current yield of >7.5%, we expect total compounding of more than 20%.

Upside Case and Downside: Management’s goal is to grow 6-8% organically before use of cash for acquisitions and drive operating margins up 50-75bps per year. At the higher end of management’s targets, operating income compounds at 12.5%. After leverage and yield, value creation is in the mid 20%s.  However, should management deliver on its plans to acquire small independent labs at 5-7X EBITDA, compounding can be much higher (tuck in acquisitions have been a successful playbook for  Exova so far). These figures exclude multiple expansion – while EXO trades for 13x fwd P/E, its comps trade at 20x. The discount seems to relate to the PE overhang and lower liquidity on the open market (which is improving). Post the sale of additional shares of CD&R, this discount should narrow substantially.

Given the quality of the business, its competitive environment and resilient end market, downside appears limited. Should the market decelerate towards 4% growth, EBITDA should compound at 5.8% and total compounding before use of cash will be 7.5%. The current multiple of 13x fwd P/E will support 15% total compounding, suggesting limited risk from multiple contraction.

Risks

Business Momentum: the Testing industry decelerated over the last 12 months - all the public companies reported positive but slowing organic growth from HSD rates in 2012 and the first half of 2013 to LSD in the 2H13 and 1H14.  There is no single overriding driver behind this trend, with companies pointing to several specific industries slowing down such as Environmental in North America due to weather, declines in Minerals off a super cycle (not an Exova vertical), production delays at Aerospace customers and some deceleration in O&G. It might be that Testing, which tends to see stronger growth in the later parts of the macro cycle benefited in 2011 and 2012 from a bounce back on the economic recovery in North America but has yet to benefit from a pick-up in Europe (as North America slows to normalized HSD rates).  All the publicly traded players expect acceleration in organic growth in 2H14 and see continued structural expansion of 6-8% LT.

Since there is no single driver that drove growth in the past, nor one driver that the industry is relaying on for the future, it is hard to gain insight beyond comments made by providers, customers and 3rd party research. However, at the current valuation of EXO, a permanent slowdown in the Testing industry seems to be already priced in, and past market resiliency suggests limited risk from sustained declines going forward. In other words, we might find ourselves in a “new” story in which the Testing industry support lower growth than the current estimates, but at 13X P/E, downside from owning Exova seems limited (as opposed for the peers that trade at 20x+)

Public Company History: Exova has never been public and the current management team is new to the public markets, having joined the company as part of the CD&R transformation. From our interactions so far with the CEO, CFO and Controller they appear analytical and fact driven, but it will take time to ascertain how well they manage guidance, and whether they are conservative or promotional.