Short Dycom Perennially NPV Negative, 60% Downside To Fair Value

Short Dycom: Perennially NPV Negative, 60%
Downside To Fair Value
|Must Read May 19, 2016 9:47 AM ET7 comments
by: Lester Goh
Summary
• Dycom is priced like a fantastic business. Yet, the space enjoys few barriers to entry. I
scale is not a competitive advantage due to the presence of a similarly-sized rival.
• Dycom's unusual growth has been at the expense of competitor MasTec. Going forwar
MasTec will likely be highly irrational, making Dycom's EBITDA margin targets potentia
unattainable.
• Even if we give the Company full credit for growth and margins, there is little evidence
this would result in value creation; Dycom has been perennially NPV negative.
• Fair value of $26-$28, implying ~60% downside. As the growth story seems largely pric
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upside risk is unlikely to be significant.
Dycom Industries (NYSE:DY) ("Dycom", "DY," or "the Company") has supposedly been revital
For much of 2005-2011, growth was anemic and profits were thus representative of a steady-s
business. Suffice to say, shares of Dycom went nowhere during said period.
However, near the start of the current decade, shares have been given a new lease of life, larg
thanks to the ramp-up of capital spending budgets at major telecoms. This resurgence in capit
investment by telecoms has led to unbridled investor euphoria with respect to Dycom, evident
shares tripling in recent years to ~2.6x EV/IC.
Bulls are apparently convinced that the capital spending binge by telecoms would bestow upo
Dycom newfound riches in the form of larger, sustainable, economic profits. The valuation req
that.
That is a big ask, in my view.
The Dark Side Of The Telecom Value Chain
The problem with DY (and its peers) is that they control the wrong slice of the telecom value c
Of the many components that make up the value chain, some are enormously and sustainably
profitable thanks to long-lasting, structural advantages. Alas, Dycom is not in a position to mak
similar claim.
Companies such as Charter Communications (NASDAQ:CHTR), which owns the distribution
infrastructure, are prodigious cash generators because their massive scale, government-grant
protection, and sheer upfront and ongoing capital expenditure requirements deter potential en
and protect profitability.

Content mammoths such as Discovery Communications (NASDAQ:DISCA) (NASDAQ:
(NASDAQ:DISCK) are extremely profitable as they own the intellectual property rights to highl
sought-after content, and their massive scale lowers per-unit costs to levels that new entrants
cannot hope to achieve.
While players like Charter and Discovery are blessed with barriers to entry that stand tall and
protect their respective economic castles, the same cannot be said for Dycom.
Dycom is in the business of digging trenches, laying cable, and doing other related activities th
help telecoms get their networks up and running. Anyone with the capital, manpower, and
equipment can replicate this.
The fact that small firms such as Hewitt Power & Communications, Moll's Utility Services, and
Venture Communications can do well enough to be acquired (for $8m, $6.5m, and $15.6m
respectively) by DY suggests there are few barriers to entry to the space, something that is ad
by Dycom and its peers in their regulatory filings.
But such an assessment is fairly elementary; a first-year economics student could have surmis
much. Thus, there must be something that management is touting to investors (and given the
valuation, investors are apparently believing) as its fantastic competitive advantage which ena
Dycom to earn economic profits to justify the Company's valuation.
The main argument bulls seem to believe, is scale. Management gently implies this in its
shareholder communications. The idea that executives seem to want to convey is that DY's m
scale and national presence allows the firm to, a) obtain equipment, vehicles, and raw materia
prices which are materially lower than its competitors and, b) enable customers to subcontract
upgrading of their networks to fewer firms, simplifying the administrative process. These are th
that smaller firms cannot hope to replicate.
The above explanation makes sense and is something that I do not deny. However, what is om
from management's statements is that similar attributes are enjoyed by DY's key competitor,
MasTec (NYSE:MTZ).
Both are of similar scale (~$2b in 2015 telecom-related revenues), attack similar markets (U.S
Canada), and ride similar growth trends in telecom capital spending (driven by smartphone
penetration, growing demand for voice, video, and data, Connect America Fund II, etc).

The point I am getting at is, relatively speaking, Dycom does not have a competitive advantag
simply, if two players have similar competitive positions, neither would have a meaningful
advantage over the other. The implications of such an assessment is important for the reader
note, as I explain below.
In MasTec's 10-K, the firm concurs that price is "often the principal factor in determining which
service provider is selected." Hence, as Dycom and MasTec's communications segment are fa
similar in terms of scale and presence, they primarily compete on price, making it difficult to en
either player being able to obtain a sustainable profit margin lead over the other.
Putting this in context, MasTec's communications segment revenue has been flat in recent yea
while its segment EBITDA margins have declined from ~12% to ~10%. On the other hand, DY
line has grown at 15%-30% rates while its EBITDA margins have expanded from ~10% to ~12
over the same period.
MasTec attributes flat revenues and declining EBITDA margins to lower-than-anticipated level
wireless/wireline services, which I interpret as the firm not being able to secure additional cont
to grow its revenue base.
The reason for this is because MasTec's "starting" EBITDA margins were higher than Dycom's
since the two compete primarily on price, it is clear that the Company was able to achieve the
unusually high growth rates and EBITDA margin expansion that it did at the expense of MasTe
In this space, contract pricing is fixed in nature. Overall pricing will rise over time to keep up w
costs (or else the entire space would go bankrupt in the long run) - this is illustrated by MasTe
communications segment margins falling on flat revenue. Essentially, MasTec got ahead of its
it was pricing its business higher and Dycom's lower "starting" EBITDA margins suggests it wa
increasing price to match MasTec.
Given the expansion in valuation multiples, bulls are clearly betting on the future looking like th
recent past. With the positions between the two competitors now reversed, assuming Dycom c
continue on a similar 15%-30% top line growth pattern, keeping in mind that price is often the
deciding factor in this space, strikes me as an overly optimistic expectation.
EBITDA Margin Targets Are Potentially Unattainable Due To The Presence Of An Irration
Competitor
Moreover, it seems highly likely MasTec would be extremely aggressive and irrational in comp

with Dycom going forward.
Apart from its communications segment, MasTec also operates two other businesses of note,
of which offers engineering, construction, and maintenance services to the oil & gas industry, w
the other caters to energy & utilities industry. The O&G segment accounts for ~36% of MasTe
sales, while the communications segment's contribution is ~47%.
The carnage in the oil & gas and energy industries is fairly well-documented and has unsurpris
affected MasTec. O&G segment revenues declined ~20% organically in 2015, a trend that wou
likely continue in 2016.
Although the electrical transmission segment is only ~8% of 2015 sales, it has turned hugely
unprofitable, with 2015 segment EBITDA clocking in at a negative ~$71m, pulling the overall fi
EBITDA down to a mere ~$150m.
With ~$150m in annual EBITDA and around a billion in net debt, net debt/EBITDA for MasTe
currently sits at a gut-wrenching ~6.7x. Needless to say, the firm is likely scrambling to redu
debt and grow EBITDA by any means possible.
Against such a backdrop, it does not seem like a stretch to assert that MasTec would likely be
extremely aggressive in undercutting on price in its communications segment. After all, with th
overall energy space in the doldrums, the communications segment seems to be the only aven
MasTec's management can count on.
Management commentary on the 1Q '16 call certainly supports this assertion and suggests tha
firm has reinvigorated its growth profile in its communications segment:

Now, I'd like to cover some industry specifics. Our Communicatio
revenue for the quarter was $512 million versus $470 million last
year. The increase in revenue was driven by strong increases in
wireline and installation businesses and as expected a decrease
our wireless business on a year-over-year basis. In our install-to-
home market, revenues were up 25% year-over-year.
Demand for our installation services is strong. We have seen
increased demand related to the DIRECTV-AT&T merger and ha
continued to grow and diversify our business. We're beginning to
the fruits of how we've leveraged, what we believe to be the large
third-party independent fulfillment company in the United States w
broad geographic coverage.
We're now working with four additional customers on pilot progra
that could build into solid long-term opportunities. There is strong
demand for a customer-touching workforce to help differentiate
product offerings and we believe we're well-positioned to fill this
demand in the marketplace."
Source: MasTec 1Q '16 Earnings Call Transcript

Couple this with my prior assertion that positions have been reversed between Dycom and Ma
and you would be hard-pressed to believe that DY can maintain its current growth trajectory an
achieve its stated mid-teens EBITDA margin targets going forward.
Perennially NPV Negative, Value Creation Through Growth Appears Elusive
Even if we are very kind and assume that Dycom can sustain the growth rates it has achieved
recent past, the overall situation does not appear materially better.
Sure, bulls will cite the following: the Company's top line has grown - sales have more than do
since the start of the current decade. Net income has followed a similar trajectory, rising from
~$16m to the trailing twelve-month figure of ~$100m. Due to the ~5% reduction in shares
outstanding to ~34m, EPS numbers are even better. Backlog numbers are similarly robust, gro
to ~$5b as of 2Q '16.
Given the above performance, investors are likely valuing Dycom using valuation multiples tha
rooted in EBITDA/EPS numbers. Management subtly encourages this, evident by its
detailing quarterly results only focusing on profitability metrics such as EBITDA and EPS.
However, valuing Dycom off EBITDA/EPS-based metrics is the incorrect approach, in my view
EBITDA/EPS figures do not account for capital expenditures, among other items (non-cash
charges, changes in working cap, etc). Ideally, one should only utilize EBITDA/EPS numbers a
valuation multiple if the delta between EBITDA/EPS and unlevered/levered free cash flow
respectively is insignificant. In the context of Dycom, this is not the case.
Despite the aforementioned growth in sales and EPS, FCF (defined as OpCF - CapEx) has no
followed a similar trend. The 2015 FCF number is ~$40m. Now, obviously Dycom's business i
lumpy in nature, so it would be unfair of me to look solely at single-period numbers. Yet, FCF
numbers averaged over different multi-year periods (3-, 5-, 7-, and 10-year) paint a much blea
picture, as seen below.
Dycom
(in
$mm)
2006 2007 2008 2009 2010 2011 2012 2013 2014

Free
Cash
Flow
45 31 32 96 -1 -18 -12 42 -5
3-year
average
25.3
5-year
average
9.2
7-year
average
20.1
10-year
average
24.9
Source: Company filings, author's calculations
From the above table, it is clear that FCF has gone nowhere for years. Thus, despite strong to
bottom line growth, value creation appears elusive, as the growth of these two metrics have no
translated into larger free cash flows. Hence, it appears that bulls are focused on EPS growth,
ignoring the fact that CapEx is a very real expense.
The main culprit preventing FCF from growing is capital expenditures. While net income has
grown from ~$18m in 2006 to the trailing twelve-month figure of ~$100m, CapEx has gro
from ~$57m to ~$155m over the same period, fully offsetting the growth in net income, a
more. There is reason to believe that this trend will continue going forward.

CapEx, in the context of Dycom, comprise primarily of vehicles, machinery and equipment. Wh
the Company does not disclose its suppliers, firms such as Alcatel-Lucent who sell telecom
equipment are likely suppliers for machinery and equipment, while auto OEMs likely supply the
vehicles.
Alcatel-Lucent acknowledges in its 20-F that its products often have short life cycles
industry demanding frequent upgrades) which implies that new products are coming onto the
market at a rapid pace - its expanding gross margin supports this assertion. As for vehicles, du
Dycom's growth, utilization is likely very high, making frequent vehicle replacements necessar
Given such a narrative, it is hard to argue for a reversal in DY's CapEx trend. As a result, it see
highly unlikely that growth would result in significant value creation - indeed, there is little evide
to support this. 3-, 7-, and 10-year average FCF numbers are fairly close (I exclude the 5-year
number to be generous).
Moreover, it is widely known that a significant portion of the capital spending by telecom giants
'growth CapEx' in nature, suggesting that steady-state revenues for Dycom could be meaningf
lower than current numbers.
To make matters worse, Dycom has not been able to earn more than a 10% ROIC in any sing
year throughout the past decade - the 10-year average through 2015 is a measly ~4.6%,
to Morningstar:
Dycom 2006 2007 2008 2009 2010 2011 2012 2013 2014
Return
on
Invested
Capital
%
5.13 8.70 4.92 -6.95 2.85 4.95 8.85 4.82 4.39
10-year
average
4.62

Source: Morningstar
Such low ROIC numbers suggest that it is very unlikely that Dycom is earning greater than its
of capital over the long run. If you agree with my assessment that the Company possesses no
meaningful, sustainable competitive advantages, these numbers should not be surprising.
Consider this: if a firm is unable to turn an economic profit for more than a decade, despite hug
and bottom line growth, when will it actually happen?
Furthermore, the ROIC numbers are calculated based on after-tax operating income - as discu
FCF is the far more important metric to focus on. Suffice to say, if we used FCF as the numera
the ROIC calculation, the numbers would be much, much worse.
Valuation: Fair Value Of $26-$28
Dycom trades at ~2.6x EV/IC (~$2.3b market cap, ~$630m net debt, ~$1.1b invested capital,
defined as fixed assets, goodwill/intangibles included, + non-cash working cap). Generally, an
premium requires sustainable ROIC in excess of the cost of capital, which Dycom clearly does
possess. Assuming multiple contraction to 1x EV/IC suggests ~60% downside from current lev
~$26 per share on 33.5m shares outstanding.
Alternatively, we can value Dycom off its free cash flows. To be extremely generous, let's valu
Company using its peak FCF of ~$96m, which it achieved in 2009. To illustrate the extent of m
conservatism and generosity, note that Dycom had a ~$53m net loss in that year.
How then did it get to ~$96m in FCF? Largely through the add-back of a ~$94m goodwill
impairment charge, a severe tightening of working capital (accounts receivable was a massive
~$29m source of cash compared to ~$500k in the prior year), and a ~60% decline in CapEx.
Clearly, peak FCF is unlikely to recur and is indicative of a best-case scenario, but let's run wit
Since there is little evidence that top and bottom line growth results in improved FCF, we shall
assume that ~$96m is representative of steady-state FCF and assign a 10x multiple (implying
growth, assuming a 10% discount rate), which gets us to ~$28 per share on 33.5m shares
outstanding, even in a "perfect" scenario.
Fair value of $26-$28 is also not an unreasonable expectation considering that during its anem
growth period (2005-2011) where investors likely valued Dycom as a business that is close to
steady-state, shares traded somewhere between the $15-$25 range.
Short Dycom: Perennially NPV Negative, 60% Downside To Fair Value - Dycom Ind… Page 10 of 13

Asymmetry, Catalysts, Risks
Perhaps the most important reason why I believe this short is asymmetric in nature is because
• if a business has been unable to generate ROICs in excess of its cost of capital for more th
decade even despite undergoing a period where sales doubled and net income exploded,
• and there are no radically positive changes to its reinvestment requirements (see CapEx
discussion), among other things (profitability, competitive landscape, barriers to entry, etc.
• it seems quite improbable that Dycom would ever sustainably earn more than its cost of ca
in the future.
Businesses that do not earn more than their cost of capital in the long run are unlikely to comm
premium multiples forever.
Since the Company's growth story seems to be largely priced in, if during the short, all goes w
Dycom, shares are unlikely to appreciate by a significant amount - 2Q '16 was perhaps one of
best quarterly results in the Company's entire history, with backlog growing ~$2b y/y and ~$1b
sequentially. Yet, shares fell ~15% that day due to EPS guidance coming in below consensus.
However, if due to intensifying competitive pressures, growth stalls, resulting in a contraction o
EBITDA margins or a delay in expansion, and/or FCF continues to be uninspiring, the market
likely begin to grasp the reality of the economic situation at Dycom - realizing that little has cha
since 2005-2011, shares should see a massive sell-off. As MasTec appears to have reinvigora
growth in its communications segment, and is likely rushing to grow EBITDA and/or reduce de
these catalysts could materialize over the next few quarters.
The risks here are fairly obvious. The Company has upped its share buyback program to $100
while this may provide some share price support, it is unlikely to be significant given the amou
quite small relative to the current market cap.
While there has been consolidation in the space, firms like Dycom and MasTec, due to their si
are the acquirers not the acquirees, so it is hard to see any meaningful buyout risk. Consolidat
also unlikely to result in a concentrated industry structure (which would theoretically allow
sustainable economic profits) in the long run, as the few barriers to entry would allow small firm
continue entering the space.

If the growth trajectory is sustained, shares will probably rise higher. But again, the growth sto
seems priced in and is unlikely to result in value creation, so upside risk shouldn't be much.
3Q '16 results should be announced in the next two weeks or so if history is any guide, and sin
the Company provides non-GAAP EPS guidance one quarter ahead, one can compare the ful
expected EPS number with the Company's guided raise in capital expenditures for the fiscal y
~$175m, up from $125m expected for 2016 at the end of fiscal 2015.
My expectation is that the incremental CapEx would offset a significant amount of EPS growth
which reinforces my thesis that growth at Dycom would hardly result in value creation, and
consequently, the Company should trade at no more than 1x EV/IC.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate
within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation
(other than from Seeking Alpha). I have no business relationship with any company whose sto
mentioned in this article.
Additional disclosure: Disclaimer: The author's reports contain factual statements and opinio
He derives factual statements from sources which he believes are accurate, but neither they n
author represent that the facts presented are accurate or complete. Opinions are those of the
author and are subject to change without notice. His reports are for informational purposes on
do not offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester") acce
liability whatsoever for any direct or consequential loss or damage arising from any use of his
reports or their content. Lester advises readers to conduct their own due diligence before inve
in any companies covered by him. He does not know of each individual's investment objective
appetite, and time horizon. His reports do not constitute as investment advice and are meant f
general public consumption. Past performance is not indicative of future performance.

Short Dycom Perennially NPV Negative, 60% Downside To Fair Value

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