Description

We believe that Insituform Technologies, Inc. (Ticker: INSU) represents a compelling short idea. Not only do we think INSU is fundamentally overvalued but we also see near term catalysts that could lead to a 30% to 50% repricing of the stock.

Core Investment Thesis (the short version – our analysis is laid out in depth later in this write-up)
• Overvalued on an Absolute Basis: Based on the range of current Street estimates, INSU is trading at 19.5x to 30.0x 2006 earnings estimates. We believe this is too much to pay for a company with a history of downside earning surprises (major shortfalls in three of the last six quarters) and a clear long-term decline in margins and earnings power. Plus, we think that most of the Street estimates are overly optimistic. Also, INSU is trading at 20x TTM EBITDA, a multiple that we believe is excessive.
• Overvalued on a Relative Basis: INSU is basically a contractor specializing in underground work for wastewater and sewer systems infrastructure and should be valued similar to other contractors. Currently it trades around to 1x Enterprise Value to TTM revs whereas other contractors currently trade at 0.35x to 0.75x (e.g., PCR, WGII, FLR, JEC, SGR).
• Increased Competition and Secular Decline in Margins: In general, the industry is increasingly competitive, the proprietary nature of the company’s offering has disappeared and evidence of margin compression is clear. There was a time when trenchless pipe rehab could only be offered by a limited number of players; now there are many contractors showing up for each RFP.
• Impact of Percentage of Completion Accounting: The company’s use of Percentage of Completion (POC) accounting can mask the true profitability of the company’s book of business and there has been a significant disconnect between earnings and cash flow.
• Curious Accounting: The company has been aggressive in recognizing income from non-operating items during 2005 in particular.
• Tunneling Disaster: One of their divisions, Tunneling, (~18% of revs and 27% of backlog) has been very poorly managed and is worth little to nothing.


Company Summary
INSU operates three divisions. While the company uses a variety of trenchless technologies, the Cured-in-Place-Pipe (CIPP) process represents around 2/3rds of revenue.

Rehabilitation (~76% of TTM revs): INSU serves as a specialty contractor for the rehabilitation of underground pipe used primarily in wastewater and sewer applications. They focus on “trenchless rehab” – meaning they fix the pipe without digging up the street. Basically they insert a resin infused sleeve into the old pipe and then use heat (hot water or steam) to cure this resin in place. Thus the old pipe now has a new inside liner fused to it that is more durable and possesses better hydraulic properties. While INSU uses several different trenchless technologies, CIPP is the predominant one. INSU is vertically integrated in CIPP in that it manufactures its own CIPP liners.

Tunneling (~18% of TTM revs): INSU owns boring and other tunneling equipment and maintains crews that dig man-entry sized pipelines underground mostly for municipalities.

Tite-Liner (~6% of TTM revs): This is a specialty liner application for lining new and existing pipe with a corrosion resistant polyethylene pipe. It is used frequently in oil exploration and mining applications. This division posted strong 3Q 2005 revs of $11.7mm on the strength of sales to South America in these two end markets. This is a pretty nice little business with mid-teens EBITDA margins on a TTM basis. However, its sales volume has fluctuated with $33.5mm on a TTM basis compared to $62.4mm in 1997. Q3 2005 backlog was down sequentially from Q2. This write-up does not spend much time discussing the Tite-Liner division.


The Bull Case
One element of the bullish case INSU is the large size of the market for rehabbing wastewater and sewer infrastructure. INSU operates in a multi-billion dollar industry and repairing aging infrastructure will clearly be an ongoing spend for municipalities. Using trenchless technologies like CIPP can be a cost effective alternative to digging up streets and replacing existing pipe. Estimates of industry growth during 2005 have been in the high single digits and INSU has exceeded the industry growth rate thus far in 2005.

INSU is the largest company in the Rehab industry and is several times the size of its nearest competitor. INSU has increased its Rehab segment backlog significantly in the past 12 months, up more than 60% over the 9/30/04 figure. We suspect that bulls believe INSU’s scale should provide some competitive advantages, which, combined with better execution, could lead the company back to its 1999-2000 operating income margins of 15-17% in the Rehab segment (as compared to 6.3% on a TTM basis).

The Bear Case
Rehabilitation
In contrast to the Bull Case, our research leads us to believe that: 1) the business is getting increasingly competitive; 2) the company’s size does not create cost advantages that justify the pricing gap the company has created to win bids; and 3) INSU has been extremely aggressive in bidding for business making the profit margin potential on that backlog very suspect.

In the 1990s INSU was a true leader in the space and was able to claim that some of its processes and technology were truly proprietary. Since that time, the CIPP construction technique has become far more commoditized and some of INSU’s patents have lapsed. A comparison of the narratives in the company’s 10Ks from the 1990’s to 2004 will illustrate the degree to which the phrase “proprietary” has left the company’s business description.

We spoke with a number of competitors to INSU and they almost uniformly said that the industry has become much more competitive and low bid price is what wins. And the sheer number of competitors is increasing with one player saying he’d seen as many as nine CIPP bidders on a recent project. Historically, in many regions there were only one or two players who could do this type of work. Now many large specialty contractors that do sewer, wastewater, and other similar municipal projects offer CIPP and other trenchless rehab techniques. One notable competitor is Reynolds Inc., a vertically integrated contractor through its Inliner division. Reynolds was recently acquired by Layne Christensen Company (LAYN).

With regard to scale advantages, INSU may have a lower cost position by virtue of having more crews around the country so it does not have to incur as much cost in moving bodies around. Being vertically integrated in manufacturing tubes can lower INSU’s material costs, which has greater importance for jobs requiring wider pipes. Also, INSU probably purchases plastic resin at prices more favorable than the competition. INSU has also invested in steam curing equipment (management highlighted this in the Q2 conference call) to replace hot water boiler and steam can raise crew productivity.

INSU has patted itself on the back for its growth in backlog over the past 12 months, up 60% in the Rehab segment. We do not have volumes of hard data to support this, but anecdotal evidence from our diligence sources suggests that INSU has been bidding as much as 50% below the nearest competitor, at times leaving millions of dollars on the table. One competitor suggested that INSU appears to have a “get any job, get every job” approach to bidding.

We asked the same sources whether the scale benefits noted above could justify such a pricing gap. The response was a consistent “No way.” Other contractors, for example, have also made investments in steam curing equipment. We think the company’s Q2 conference call comments regarding the cost benefits of investments in steam were a bit of a red herring. Also, more widely dispersed crews can mean lower crew utilization and, therefore, unabsorbed fixed costs.

We believe that with its aggressive pricing, INSU has sacrificed profitability for growth, continuing the multi-year slide in its margins. This is evidenced by the fact that even though revenues in the Rehab division have increased 60% since 1999, operating margins have declined dramatically: they have dropped from 17.1% in 1999 to 6.3% on a TTM basis (and we believe the latter figure is overstated). At the gross margin level, INSU’s margins in Rehab have declined about 300 basis points since the beginning of 2002 (segment gross margins are not available for 1999).

Simply put – this has become a much lower quality industry and firms must compete on price. The end result is that profit margins have begun to look more like they do in most commodity-like contractor businesses; i.e., negative margins during tough times and low to mid-single digit margins during good times. This is why theses businesses generally do not garner revenue multiples much over 0.3x to 0.5x . INSU currently trades at about 1x revs.

Another potential challenge to margins is the impact of rising crude oil prices, which drives up fuel costs, resin costs, plastic pipe costs and plastic fiber costs. Management acknowledged in the Q2 conf call that the resin price jumps that originated in the second half of 2004 had a 100BPS negative impact on gross margins in the first half of 2005 but added that the gross margin impact going forward would be minimal. On the Q3 call management commented that the company was “working to assess the total and ongoing impact of these [crude oil] price changes” but “we don’t have accurate information to share with you at this time.” Also, management said they were evaluating a formal commodity hedging strategy.

Management had expressed confidence in Q2 that the margin on deals in the backlog would be less impacted by resin costs going forward since they started making forward commitments after 2004’s resin spike. More recently, it sounded to us like those margins in backlog were still at risk from rising crude and resin prices. With INSU’s fixed price contracts, we do not think there is any adjustment for these cost changes. In fact, we are skeptical overall about the gross margin built into INSU’s Rehab backlog. We addressed this issue with management but all they would say is that they won’t know the margin until the work is completed. Not a very satisfying response in our opinion if we were long this stock.

For the above reasons, we believe the Rehab division (which represents the majority of the business) faces some serious challenges. Over the past five to six years this has become a tougher and tougher business to make money in. And given its bidding strategy, INSU appears to be its own worst enemy in terms of trading off profitability for growth. Despite this the market is awarding the company with a multiple that suggests this is a high growth company in a high quality industry. We disagree.

Tunneling
If pipe rehab is a medium quality business with secular declines in profitability then Tunneling is a truly awful business. Over the last 15 quarters tunneling has generated net negative operating income. In some quarters even gross profits are negative due to adjustments made for additional labor and related overhead costs.

Without getting into too much detail, INSU appears to have grossly underestimated the cost of its Tunneling projects. For example, INSU has taken negative gross margin adjustments on its Chicago project of $16mm in the past 18 months, losing a lot of money on the project. The projects continue to lose money but INSU can’t get out of them. Management has stated in a number of cases that they did a poor job of estimating costs because they “did not properly anticipate the geology.” In basic terms this means they have run into a lot of rock while underground. In our terms, this is a bad business that is outside the company’s core competencies. In these instances of cost overruns, the company has made claims against third parties (typically its customers) for “unforeseen and differing site conditions.” While our channel checks suggest it is very difficult to collect these dollars, some have found their way into revenue for INSU (more on this below).

Even under good conditions we understand tunneling to be a capital intensive and highly competitive industry with projects often subject to cost overruns. In INSU’s case, based on the continued weakness in this business and management’s inability to properly bid contracts, we are not sure how to value this business. We asked management if they would be willing to just give the business away if they were not on the hook for the bad projects they improperly bid. They conceded that this is a fair question but believe that at some point they can turn the division around and make it worth something. The timetable remains unclear though. Management has devoted a lot of energy to fixing this business but evidence of progress is scarce.

Is there asset value here in the Tunneling division? One must understand that you can’t simply sell the capital equipment. INSU has committed to the projects and needs that equipment to fulfill their obligations. At any rate this is not stuff you can just sell easily – it is highly specialized, difficult to move (some requires significant disassembly) and at present is deep underground.

If one were to assign a value of zero to the Tunneling business then the implied value assigned by the market to the rest of INSU’s business increases from 1.0x sales to 1.2x sales.

Percentage of Completion Accounting
It is important to note that INSU uses percentage of completion (“POC”) accounting. Under this method, estimated contract revenue and resulting gross profit are recognized based on actual costs incurred to date as a percentage of total estimated costs. In other words, the incurrence of costs drives revenue recognition. This gives management considerable leeway in recognizing revenue since the driving factor is the total estimated cost of a project. Per the company’s 10K:
• The Company follows this method [POC] since reasonably dependable estimates of the revenues and costs applicable to various elements of a contract can be made. Since the financial reporting of these contracts depends on estimates, which are assessed continually during the term of these contracts, recognized revenues and gross profit are subject to revisions as the contract progresses to completion. Total estimated costs, and thus contract gross profit, are impacted by changes in productivity, scheduling, and the unit cost of labor, subcontracts, materials and equipment. Revisions in profit estimates are reflected in the period in which the facts that give rise to the revision become known. When current estimates of total contract costs indicate that the contract will result in a loss, the projected loss is recognized in full in the period in which the loss becomes evident.

The company bids work with a certain estimate of its costs to try to achieve certain gross margin targets. However, management has not provided much insight into what those targets are. During the Q2 conference call, the CEO responded to a direct question on targeted gross margins (long-term) for Rehab by saying, “That’s a closely held concept. But it does change by geography. But I wouldn’t want to answer that question.” The CFO responded to the same question from us by saying that they won’t know the margin on a project until the work is completed.

Management made numerous comments during the Q2 conf call regarding margins that make us skeptical about the profit potential in the backlog. For example, the CEO stated:
• “Simply put, as we experience the surge in revenues, we found weaknesses in our operations management, which have in turn impacted our delivered gross margin.”
• “Our new sales force has been put into place and has been reenergized with a clear mandate to grow our market share while maintaining gross margin levels.”
• “We are now seeing significant growth from an operation standpoint, and that challenges any organization to maintain its gross margins as it grows. So we're sort of into the mode we're selling work, because of the enhanced sales force, at or better margins that we've seen in the past, but because we're now trying to grow rapidly, including deploying new crews and so on, we're having to realign ourselves, so that we can deliver the profit at the same levels that we're selling them at.”

The key here is the potential disconnect between as-bid gross margins and delivered gross margins and when management recognizes the impaired profitability of a project due to higher than expected costs to deliver. It is not terribly clear how much of a project has to be completed before the true profitability becomes apparent. In our opinion, the impact of highly aggressive bidding will be revenue growth sooner and margin issues that arise later.

Disconnect between the Income and Cash Flow
With POC accounting, the company maintains a balance sheet account for “Costs and Estimated Earnings in Excess of Billings.” According to the 10K, “Costs and estimated earnings in excess of billings represent work performed which either due to contract stipulations or lacking contractual documentation needed, could not be billed.” In practical terms, this account reflects the fact that revenue and earnings – because estimates of costs are always going to be lower than estimates of revenue when business is won – are being recognized ahead of billings or cash collections.

On a year-to-date basis INSU has generated $32.7mm of EBITDA. However, Cash Flow from Operations year-to date has only equaled $8.2mm. A significant contributor to this disconnect are the changes in Receivables (including costs and estimated earnings in excess of billings) and Prepaid Expenses and Other Assets which increased a combined $33.3mm in the first nine months of 2005. With POC accounting earnings do not necessarily equate to cash flow.

Lastly, INSU’s businesses do have some capital intensity. The company spent $20.9mm on capex (~5% of sales) year-to-date. Admittedly, we have not separated growth from maintenance capex but subtracting all of this from cash from operations yields negative free cash flow of $12.7mm.

Curious Accounting
While we are not forensic accountants, we found some recent accounting treatment by INSU to be suspect.
• In the Rehab division INSU had a disaster of a project in Boston. It was a $1mm project that required extensive re-work. INSU ended up incurring a $5.1mm loss on the project in 2003. The company incurred another $2.4mm of cost for remediation work in 2005. The company has gone after its excess insurance carrier and determined that the likelihood of recovery is probable and the amount estimable. So in the Q2 2005 INSU recognized $6.1mm of revenue and $2.4mm of costs for a positive gross margin impact of $3.7mm. Putting aside the issue of recoverability (it probably is high), recognizing this income as revenue and gross profit rather than as an extraordinary item seems aggressive to us. This item represented 13% of Q2 reported gross profit. Additionally, the “receivable” for this recovery is not reflected in A/R but in Prepaid Expenses and Other Assets on the balance sheet.
• In the Tunneling division the company has made “claims” against third parties when it experienced certain cost overruns (see above). At 9/30/05 the company had $17mm of outstanding claims. The company’s Revenue Recognition policy states that “claims are recognized when realization is reasonably assured, and at estimated recoverable amounts.” The company has said this year that it is being more aggressive in pursuing these claims; however, we are skeptical about whether they are any more recoverable than before. Year-to-date the company has recognized into income $3.9mm of claims (before reserves) compared to $1.5mm in the first nine months of 2004.
• Overhead allocation: The company’s segment analysis does not have a Corporate or Unallocated Cost category. Such costs look to be allocated to the divisions. In the 10Q for Q3, the company says that “corporate expenses allocated to the tunneling business were higher in the third quarter due to senior management time spent on tunneling matters.” Given how poorly performing Tunneling is, why not pile on as much cost as you can, thereby making Rehab operating income margins just a little bit better.


Potential Catalysts
• Per the 3Q call, management said they will start giving annual guidance sometime in the 1st quarter of 2006. One of two things may come of this: 1) Management is realistic and the true earnings power of INSU becomes clear; or 2) Management is overly optimistic at which point this short could take longer to play out.
• Regardless of what management says, the market will soon change their tune on this name. We think the backlog either has very little margin or is underwater. When the market sees this, INSU will be valued more like other contractors – a challenging, commoditized business – than like a high quality, high growth business with competitive advantages that drive margin expansion.
• Tunneling will continue to be a drag in the business. 2005 might be the year when the auditors finally make the company write down the goodwill on the balance sheet associated with the Tunneling business – this would be about $9mm which would equal a little more than $0.20 per share in EPS. Perhaps the market will see the as an indication of what the Tunneling business is actually worth – on the other hand the market might just shrug this off.

Conclusion
At then end of the day INSU competes in some very tough lines of business. While at one time they were a leader and could command solid margins, those days are gone. Nevertheless the market continues to be enamored with INSU and award it high multiples on both an absolute and a relative basis.

We think $0.60 to $0.65 in EPS is possible in 2006 (maybe generous). This is well below the average of the street of around $0.85 (some analysts are at $1.00). It is pretty hard to know how far down the market would take INSU but at 17.5x 2006 of $0.65 the share price would be $11.40. If the market assigns a 0.5x revenue multiple to $625mm in 2006 revs (Street estimate, not ours) the share price would be about $10.50.

Risks
• Management puts out aggressive 2006 estimates and the market believes they can execute.
• Competitors are wrong and INSU has the ability to make decent margin even with their bidding practices.
• For some reason another company wants to own the Tunneling division. We see this as highly unlikely but it would likely be positive catalyst if the company could shed the business.

Catalyst