Harsco Has 40% Upside On Improved Guidance

Harsco Corporation (HSC) was incorporated in 1956 and Mr. Nicholas Grasberger has been its President and CEO since 2014. The company is offering a broad line of engineered products and industrial services primarily in steel, railways and energy industries. Business performance has been struggling over the last several years following the weakness in end-markets with the share price bottoming at $3.79 at the end of 2015. That is why the management team decided on a business transformation that eventually drove the stock price up to $21.92 as of January 16, 2019. Results have been positive so far triggered by industry-specific and macroeconomic tailwinds and margin expansion and growth of ROIC. They have also had 13 consecutive quarterly guidance beats and analyst consensus earnings beats over the last 4 quarters. The current management has been running the company for the last 4 years. We can expect given its deep domain knowledge and long years of experience it can successfully continue to transform the business and change the portfolio mix into higher margin products over the next several years. 

Harsco M&M Segment

Source: Investor Presentation, November 2018

The Metals & Minerals segment is primarily focused on various steel mill services like recovering metal from slag that is a by-product during the steel manufacturing process. The company is also producing roofing granules out of coal slag, road construction materials and is developing several mineral technologies that can be used for fertilizer production. It is shifting away from its core business focus on steel products to environmentally safe solutions that are extracting value from the manufacturing process by-products into high value-added commodities – driven by environmental quality regulations that are becoming stricter about manufacturing by-products and waste streams.

Emerging markets economies will also most likely intensify regulations to curb environmental pollution which creates a great growth opportunity. Harsco has a strong global network that gives it access to tens of millions of by-products and waste streams – making it a global market leader in this niche market.

Therefore, it is well positioned with its global Applied Products business to capitalize on this emerging trend. The continued business transformation will require additional capital intensive investments to enter new markets like aluminium. We believe that Harsco will also become more active in M&A as the most recent ALTEK acquisition was the only one over the last 10 years. It is way easier, cheaper and quicker to acquire new technologies than to build them in-house.

Harsco Rail Segment

Source: Investor Presentation, November 2018

Harsco Rail segment is a global provider of products and solutions for railway track maintenance and construction. It has a broad customer base of over 125 railways and sales representatives are located worldwide. Customers choose its solutions because they can enhance railway safety and improve operational railroad efficiency leading to lower fuel consumption and other operational costs. The rail segment was facing a lower growth trajectory over the last several years because the maintenance of railroads was largely under-invested.

However, North American and emerging markets demand has improved especially for aftermarket parts and equipment addressing increased safety & track awareness. Aftermarket parts are growing at a double rate over equipment sales and achieving double the margins. Its new product innovations include game-changing solutions that lead to better railroad maintenance without intensive use of labor. It expects the rail segment to achieve mid-teen margins and organic revenue growth to $500 million by 2020 or 2021.

Harsco Industrial Segment

Source: Investor Presentation, November 2018

The industrial business includes the key product air-cooled heat exchangers or Air-X, Patterson-Kelley and IKG industries. Air-X is used for the natural gas processing and in the petrochemical industries. Higher natural gas and oil prices result in the larger up-stream and mid-stream investments in the U.S. Energy industry and lead to increased market demand for Air-X. However, the price of crude oil has been volatile lately, so it is difficult to predict how that will impact market demand for Air-X. Over 90% of revenues in the Industrial segment come from North America and the business is not capital intensive, thus achieving an operating margin of ~15% and ROIC of ~29%. The company is offering a strong customer value proposition with constant innovations and strong customer service provided by experienced engineering staff in the industry.  

Market Dynamics

The company is facing global competition from divisions of large companies and several privately held businesses in all its primary segments. The biggest challenge is that customers might perform similar services themselves instead of outsourcing them to Harsco. The company does have a competitive advantage over peers in offering high-quality, energy-efficient and technically advanced products & solutions that create a strong customer value proposition.

Meanwhile, the M&M segment depends heavily on global demand for steel and other by-products like aluminium. Despite a potential slowdown in China, the current global macroeconomic growth outlook for metals remains stable.

Source: World Steel Association, January 2019

According to the October 2018 Report by the World Steel Association, the growth of global steel demand will slightly slow down to 1.4% in 2019. U.S. demand will remain steady at 1.0% while Emerging markets in Asia & Oceania are expected to grow by 1.3%. The World Bank has projected global GDP growth of 2.9% in 2019. With steel demand under-performing global GDP growth Harsco has shifted its focus to environmental solutions to basic industries that are projected to grow at a higher rate.

Source: EIA, January 2019

According to the January 2019 Report by the EIA, the growth of total U.S natural gas consumption is expected to increase by 1.3% in 2019 and by 1.1% in 2020. The largest natural gas consumers in the U.S. are the electric power sector and the industrial sector. The total U.S natural gas production is expected to increase by 8.3% in 2019 and 2.2% in 2020. Positive tailwinds in the U.S. natural gas market should lead to better demand for Air-X product.   

Source: Investor Presentation, November 2018

According to the figure above, the company is highly sensitive to underlying changes in nickel prices and liquid steel production. The company is forecasting market growth of both business variables in fiscal 2019 and that might lead to a ~$5 million operating profit improvement. Nickel is frequently used in the lithium batteries of Electric Vehicles which is an industry in it’s infancy but has huge growth potential. Industrial blue chips like Vale are betting on the nickel industry to capture growth from the EV revolution over the next 5 – 10 years and Harsco is well positioned to benefit from this trend as well.  

Q3 Results

The company reported, total GAAP revenues of $445.5 million in Q3 18, compared to $384.6 million in Q3 17, beating the analyst estimates of $441.9 million.  Both GAAP Gross margin and GAAP operating margin increased 200bps to ~26.6% and 380bps to ~12.8%, respectively. Reported quarterly operating margin was the highest over the last 10 years. The company reported Q3 18 GAAP net income and GAAP diluted EPS of $32.8 million and $0.40, respectively, beating the analysts’ consensus EPS estimate of 0.36 and up 150% compared to Q3 17 numbers. Important financial metrics for industrial stocks, ROIC and FCF increased by 470bps to 15.4% and decreased by 9% to $20 million, respectively. This is a great milestone for the company as ROIC was stuck for many years below 10%. When current investments in growth projects start to pay off in 2019 and beyond ROIC can increase above 20%. Cash and cash equivalents slightly decreased to $61.7 million in Q3 18 and plenty of investors want the management to return capital to shareholders through share repurchases or dividends. The company also reported net leverage of 1.8x and announced share repurchases of $75 million in September 2018.

The Chairman and CEO Nick Grasberger stated:

Harsco’s businesses, once again, delivered strong quarterly performance reflecting successful execution on our strategic initiatives in recent years as well as positive economic trends in each of our business units. We achieved double-digit top line growth in the third quarter, with even greater improvements in profitability and capital returns. Our backlogs also grew significantly in the quarter. This strong business momentum has again enabled us to raise our guidance for the year. Additionally, our visibility has strengthened into 2019, providing us with confidence in our ability to realize further meaningful improvement in revenues and other key performance metrics. Overall, our organization remains focused on developing market-leading innovations and executing against our other growth priorities as we strive to achieve our long-term targets.

Source: Earnings Release, October 2018

The Metals & Minerals segment continues to report revenue and earnings growth over the last several years. Metals & Minerals revenue was $268.8 million for Q318 or up 5.4% Y/Y primarily because of positive macroeconomic tailwinds and higher services demand. The company has also acquired UK-based Altek group that has contributed to a better comprehensive environmental solutions portfolio. The Altek group has built leading products that provide aluminium producers a cost-efficient extraction of value from waste.  Harsco acquired ALTEK in a $60 million deal at 10.0x EBITDA and its salt slag processing technology has a revenue potential of $100 million with a CAGR of 40% by 2023. Such investments in environmental solutions growth projects might take time to realize But there is considerable value creation opportunity. The company will continue to invest in both the core mill services and aluminium business to achieve top-line growth of over 10%.

In the Rail segment, demand has recently improved for maintenance of equipment and after-sales parts resulting in revenue growth of 62% Y/Y. The company reported the highest quarterly operating margin of 23% over the last several years. It is investing in innovative new products while also announcing lower CapEx costs in the rail segment. Because of strong performance in the Rail segment, the company lifted the EPS guidance in 2019.

In the Industrial segment, revenues increased 20% Y/Y and operating profit by 8% Y/Y driven by strong demand for Air-X products. The industrial backlog increased by 120% Y/Y and reached $193 million, showing very strong demand in the segment.

The company has also provided the fiscal 2018 outlook presented in the figure below. The next earnings release is scheduled for February 21, 2019. It has also provided a long-term plan of $2.0-$2.2B of total revenues, adjusted OI margin of 12%-13%, FCF of $195-220M and ROIC of +15%.

Source: Investor Presentation, November 2018

Valuation

It is difficult to value the company with comparable peers since 50% of total revenues comes from the M&M segment, where competition is primarily from private companies. The company is also shifting into the environmental solutions business and is one of the few companies in the world in this particular segment.

However, in its Rail Business, a key peer is Wabtec (WAB) while the Industrial business has plenty of companies that are producing industrial machinery like ITT inc, A.O. Smith and IDEX Corp.

Industrial and rail peers are trading at average forward P/E of 14.0x, EV/Revenues (ttm) multiple of 1.5x and EV/EBITDA (ttm) multiple of 8.0x. Harsco, meanwhile, is currently trading at forward P/E of 14.8x, EV/Revenues (ttm) multiple of 1.4x and EV/EBITDA (ttm) multiple of 7.4x – in line peers.

We believe Harsco is fairly valued at the moment and further stock price increase is largely dependent upon how management will execute its business transformation plan and growth strategies. If successful, then the stock can reach EV/EBITDA multiple ranges of 8.0x-10.0x – resulting in a stock price of $25 – $30. The stock is followed by 4 sell-side firms and the current 1-year analysts average price target is set at $32.67.

Risks

The biggest risks and challenges the company is facing are a global slowdown in both demand and production of metals & minerals, energy, and railroad markets. It is also exposed to unexpected FX fluctuations of the EUR, GBP or BRL that might lead to higher costs associated with risk management.

Given its plan to increase M&A activities the company might also face challenges to successfully integrate acquired companies or to enter new markets. The ongoing U.S. – China trade war is also a risk. Further deterioration might lead to newly imposed tariffs on metal products and negatively impact the overall business performance in China.

Increased customer concentration is also a challenge as the company has signed several long-term deals with key customers like ArcelorMittal. Arcelor Mittal makes up 10% of total revenue, and a loss of such customers or an unexpected increase in CapEx to fulfil contract obligations might adversely affect the business.

Our Take 

Harsco is an interesting industrial small-cap to watch as the company is performing well lately and is shifting into the environmental solutions business. We believe the current leadership has done a good job running the business over the past several challenging years and can successfully transform the company. Considering the overall stretched valuations of the U.S. stock market and increased market volatility any business growth slowdown or lower than expected guidance over the next several quarters might be a trigger for a significant decrease in the stock price. The key bullish catalysts are a successful transformation into the environmental solutions business, a strong demand for Air-X, rail products & solutions, and efficient capital allocation. Key risks are the global macroeconomic and metals market slowdown, deepening of the U.S. – China trade war, and capital destructive M&A activities.

Despite these risks, we rate the stock a buy with a 43% upside return potential.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HSC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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