Hill International Under-Covered, Underestimated, Undervalued

Hill International: Under-Covered, Underestimated, Undervalued|Must Read Oct. 12, 2015 10:07 AM ET1 comment

by: Lester Goh

Summary• Hill International has had a troubled history. A combination of civil unrest in

Libya and a highly-levered balance sheet severely affected its operations, causing the firm to post massive losses.

• As a result, shares of HIL trade at a massive discount to comps. However, the firm is at an inflection point. In my view, the discount is unwarranted.

• Recent business momentum appears to have been largely ignored by the market. Bear case is beginning to seem misguided.

• 2015 Street consensus EPS estimates appear to be understated by a huge margin.

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• If shares trade at the very low-end of peers, HIL has the potential to double. Of course, further upside is not impossible.

At just 7x 2015E P/E, shares of Hill International (NYSE:HIL) trade as if the company is highly distressed, especially if one considers the fact that comps trade anywhere between 12x-19x Street 2015E P/E. Such a description would be apt if it was 2011, but alas, it is not. I believe the shares of HIL represent a significantly mispriced security. In cases like this, it is only appropriate for an investor to ask himself the following:Why does the opportunity exist?

• HIL receives minimal Street coverage - only 3 analysts currently cover the company.

• HIL has been starkly unprofitable on an EPS basis due to difficulties in Libya as well as a levered balance sheet. Given Wall Street's love of EPS, it is not surprising that shares of HIL cratered as a result.

• Due to civil unrest in Libya commencing in February 2011, shares of HIL experienced a nosedive and traded within a wide range (representing the uncertainty regarding the company's exposure to Libya). The company then revealed that it had ~$60m in receivables to be collected from its Libyan operations (which could not be collected) as well as $55m in backlog for work to be completed in Libya. Considering that quarterly revenues were in the range of $120m, this was a disastrous blow to the firm. When it finally seemed unlikely that HIL would ever collect on/resume its operations in Libya, the stock was predictably crushed, falling from ~$6.50/sh to $2.80/sh.

• During late 2013 and early 2014, HIL received ~$10m in payments from the ODAC (its client in Libya), who also posted a letter of credit of approximately $14m in favor of HIL. Naturally, this re-ignited confidence that HIL would be able to collect on its Libyan receivables, and the stock surpassed previous highs in 2011, soaring above $7/sh. However, it was soon evident that HIL was not going to be collecting on its Libyan receivables anytime soon, and the stock retreated and settled in the $3-$4 range.



• During this period, the company was also highly-indebted, which clearly acted as an additional overhang on the stock.

• As a result of difficulties in Libya as well as a levered balance sheet, the company began posting meaningful losses. Many research firms also dropped coverage during the 2011 period, presumably due to the challenges cited above.

• Earlier in May this year, the company received a bid from DC Capital at $5.50/sh, but management rejected the offer, citing that the offer grossly undervalued the company (as an aside, I fully agree with this assessment). Since then, HIL has traded in the mid-$3s range.

In short, HIL has had a troubled history, which caused the firm to post huge losses. Unsurprisingly, its shares have been decimated. However, it is my view that the company is currently under-covered, underestimated, and undervalued.ThesisShares are a compelling long because:

• Due to the above, sentiment for HIL is clearly in the toilet, and the market appears to be ignoring recent business momentum.

• The company has refinanced its debt in late 2014, severely reducing its interest expense. It has also turned profitable in the past two quarters, and management has implemented cost-cutting initiatives to increase operational efficiency.

• In addition, the firm closed an equity offering raising ~$40m. A majority of proceeds were used to pay down debt.

• The few analysts that still cover the name appear to have not been thorough in their coverage - current consensus EPS estimates appear far too low.

• Given the fact that the stock still trades in the mid-$3s, these positive developments appear to be have been ignored by the market.



Ultimately, I believe that HIL would post a hugely profitable 2015. I expect the market to realize that this points to the fact that ongoing uncertainty in Libya, as well as a levered balance sheet, is no longer weighing on the firm's overall profitability.In addition, it is also my view that HIL will beat 2015 Street EPS estimates by a wide margin. As a result, shares of HIL should re-rate to a multiple that is more in-line with its peer group. If HIL trades at the low-end of comps, it would nearly double from current levels. Notably, management owns ~25% of the stock (per the recent DEF-14A), which aligns their interests with shareholders.Company DescriptionHIL provides project/construction management, construction claims, and other consulting services to the buildings, transportation, environmental, energy, and industrial markets.The business is characterized by high levels of revenue visibility, courtesy of long-term contracts (generally 2-5 years, though a term of 6-8 years is not uncommon), which provides the company with a stable, predictable, and recurring income stream.Barriers to entry into the space are substantial. Given that project/construction management involves large-scale projects, clients would only deal with firms on the basis of their reputation and track record. Considering the fact that HIL has been in business since 1976 (nearly 40 years), suffice to say, the company excels in this regard. Its strong backlog (~$1b as of 2Q '15) and consistently growing consulting fee revenues certainly supports this assertion.Note that the backlog includes contracts related to the company's Libyan operations. However, as a result of strong backlog growth, the Libyan number ($44m) currently comprises of a way smaller percentage of the company's backlog than it did in 2011.



Source: Hill International August 2015 Investor Presentation



Source: Hill International August 2015 Investor PresentationThe company is also diversified in the context of geography, client type, and project type. Note that the chart on geographic exposure does not include the company's operations in Libya (the firm suspended operations following the unstable civil situation).



Source: Hill International August 2015 Investor Presentation



Source: Hill International August 2015 Investor PresentationConsidering the fact that Street EPS estimates appear to be grossly underestimated (explained at great length below), it is my view that HIL currently has a substantial margin of safety as it would be a breeze for the firm to outperform Street estimates.This view is bolstered by the fact that HIL enjoys several secular tailwinds such as: the rapid growth in development of shale reserves, the aging of facilities in the energy market which leads to increased spending to modernize outdated facilities, as well as the new transportation bill proposed by the Obama administration (following the MAP-21 which expired in 2014). Given that I have detailed these tailwinds at some length in another article where I examined one of HIL's peers -TRC Companies, I will not rehash them here.



Recent business momentum has been largely ignored by the market - interest burden has masked profitabilityAs elaborated in a prior section, it all went downhill for HIL when civil unrest in Libya commenced in 2011. Couple that with the fact that the company was highly levered at that time, the firm starting posting huge losses ('11/'12/'13/'14 EPS were -$0.16/-$0.73/$0.04/-$0.25 respectively). It should surprise no one that the market reacted by selling off shares of HIL aggressively.Given the sheer size of the detriment the Libyan debacle had on HIL, the market appeared to have concluded that these issues were the cause for the firm's unprofitability. Notably, the company has not written off the receivables related to its Libyan operations. This seems fine given that the amount is currently far smaller as a percentage of quarterly revenue as compared to 2011.However, the days of posting losses are far behind HIL. The company recovered quickly from the crisis it faced in 2011 and started posting strong results on an EBIT/EBITDA basis as seen below.



Source: Hill International August 2015 Investor PresentationThe investor's primary concern with firms like HIL is as follows: is revenue growth (i.e. new contracts) profitable? Some firms - in a bid to show the Street top-line growth year after year - take on unprofitable contracts. Fortunately, this is not the case for HIL. While management does not go into detail as to whether specific contracts are profitable, investors can do a simple check.Consulting fee revenues ("CFR") have grown ~$180m from 2011-2014. Meanwhile, operating profit rose from -$4m to $29m over the same period, which implies operating margins on incremental CFR of ~18%. If management hits the mid-point of its 2015 CFR and operating margin guidance, HIL would see ~24% operating margins on incremental revenue. Considering that the firm has a current EBITDA margin in the high single-digits, the data not only suggests that sustained margin

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expansion is likely, but also points to management being highly selective in the context of contract acquisition, choosing to bid on contracts with higher profit margins.The market appears to have ignored the turnaround in operating (EBIT/EBITDA) results, evident that the fact that the stock has consistently traded in the $2-$3.50 range for the past 4-5 years. Considering Wall Street's love affair with EPS, this should not be surprising.The primary reason why HIL remained unprofitable for the past few years is due to the firm being required to service huge interest payments. Fortunately, these payments have been reduced substantially following a refinancing with SocGen (as well as an equity offering where the majority of proceeds were used to pay off debt) - terms are as follows:

• $45m revolver at ~5% (down from ~8%)• $120m term loan at ~8% (down from ~20%)

As a result of the refinancing, the company managed to more than halve its interest payments (~$28m to ~$12m). Following the refinancing, HIL became net-profit positive instantly - 1Q '15 EPS was $0.02, 2Q '15 EPS was $0.09. Considering that shares of HIL has barely budged in these two most recent quarters (save for the one-time surge to ~$5.50 due to the DC Capital bid), it seems safe to say that the market is still not appreciating the company's turnaround - presenting an opportunity for investors to get in early before the market wakes up.Following the SocGen refinancing, the company announced cost-cutting initiatives to reduce overheads to the tune of $25m+. Per management commentary, these initiatives are highly likely to succeed, given that it revolves around the reducing of headcount in areas that are overstaffed (particularly Brazil, given the ongoing recession).Given a modest deleveraging of the firm's balance sheet, a refinancing which more than halved interest expenses, as well as a prudent cost-cutting initiative, management guidance (slide above) of EBITDA and EBIT within the $52m-$68m



and $42-$58m range respectively seem very achievable (especially when one considers that these metrics have been trending upwards very strongly in recent years).Bear case is beginning to seem misguidedFor much of the past half-decade, the bear case for HIL was fairly straightforward. Many construction companies took on high levels of debt to stay afloat following the 2009 recession. HIL was no exception.Most of the levering took place during the 2011-2013 period. In the prior slide detailing CFR growth, we see that the figure grew tremendously over the period mentioned. Yet, HIL was suffering huge net losses, suggesting that net profit on incremental revenue was negative (and operating profit on incremental was only slightly positive). The fact that CFR grew so fast also suggests that management was bidding on every contract it could, without considering their margins. Moreover, the firm's cash balance was meagre, never exceeding $30m in any year. Using its prior (i.e. before the refinancing) financing terms (above), the firm had ~$28m in annual interest expense.The above data points certainly support my view that as a result of this high leverage, the firm was essentially forced to take on contracts that were low-margin or even unprofitable to ensure that it could service interest payments.Interest expense consumed operating profit, and thus the firm was stuck in a vicious cycle - management probably knew that taking on unprofitable/low-margin contracts was definitely not the way to go, but they simply had no choice due to their levered balance sheet.However, following the SocGen refinancing, the bear case is beginning to seem misguided as in the first two quarters of FY15, the firm posted a net profit. Given that long-term contracts are the bread-and-butter of HIL's business, it seems likely that a significant amount of working capital that had been tied up in low-margin/unprofitable contracts are beginning to be released as time goes on.This assertion is bolstered by the announcement of the firm's cost-cutting initiative, which aims to reduce the size of its workforce. Presumably, this is due to capacity being freed up as old contracts roll off and the firm no longer requiring that much manpower due to a shift in preference for high-margin contracts (contracts that offer



high margins tend to be significantly less in number compared to their low-margin counterparts, hence less manpower is required overall) now that it is no longer forced to take on contracts for the sake of ensuring it could pay interest on its debt.Considering that the firm is no longer forced to take on such contracts due to the refinancing of its debt, these old contracts would begin falling off and be replaced with those that are higher-margin. The fact that operating profit on incremental CFR has been trending up indicate that this process is well underway. Couple this with the fact that backlog growth is projected to slow down compared to prior years, this is evidence that HIL is beginning to focus on high-margin contracts.Lastly, although one can argue that there is a possibility that the firm may revert to taking on unprofitable contracts, I think that the actual probability of such a scenario playing out is very low for two reasons (one of which is explained above). The second reason is due to the fact that the firm experienced a near-bankruptcy situation during much of 2011-2014. Their cash balance could only cover a single year's worth of interest expense. As a result, I believe that it is unlikely that management would want to experience such a dire situation again; the surest way to a repeat of the past is by taking on unprofitable contracts. Moreover, they are incentivized not to - recall that directors and executive officers collectively own ~25% of the company's common stock.In short, the bear case (which revolves around HIL taking on low-margin/unprofitable contracts not by choice, but due to its huge interest burden, resulting in the firm's unprofitability) is beginning to fall apart.Consensus Street EPS estimates appear far too lowCurrently, the 3 analysts that cover HIL have an average 2015 consensus EPS estimate of $0.35 (high estimate is $0.36, low is $0.34). These estimates are far too low in my opinion. The only reasonable way one can arrive at the Street consensus estimate is as follows:

• Assume 2015 EBIT of $42m (the low-end of management guidance)• 2015 interest expense of ~$12m• 40% effective tax rate



• 51m diluted shares outstanding

Math: [($42m - $12m) * (1-0.4)] / 51m = ~$0.352.There are two issues here: in order to arrive at 2015 consensus Street estimates, one has to use an absurdly high tax rate as well as the very low-end of management EBIT guidance. This seems way too pessimistic. Given recent business momentum, it does not seem like a stretch to assert that HIL could probably achieve the mid-point of its EBIT guidance, or $50m.I have a guess as to why the Street used a 40% tax rate. This is likely due to the fact that HIL's historical effective tax rates have clocked in around that number (1H '14/'15 effective tax rates were 39.2% and 41.3% respectively). Prima facie, assuming a 40% tax rate going forward seems fair.However, the analysts appear to have only scratched the surface of the company's tax situation. If one digs deeper (into the notes to financial statements), he would find that the firm's tax rate is inflated due to losses in its US operations as seen below.

Source: Hill International Q2 FY15 10-QEssentially, pre-tax losses incurred for the firm's US operations have been netted against pre-tax profits generated from its foreign operations. As HIL's US operations are not showing a profit, the company pays no taxes in the US. Conversely, as foreign operations are currently positive in terms of profitability, the only taxes that the company pays is foreign.



If an analyst simply nets pre-tax losses on US operations with pre-tax profits on foreign operations, and uses the subsequent amount to calculate the firm's effective tax rate (which appears to be what the Street has done), suffice to say, the rate would be inflated.This "inflation" would not matter if HIL is expected to continue posting pre-tax losses on US operations. However, US operations have been showing strong momentum in recent quarters, as well as in recent years, as seen below.

Source: Hill International Q2 FY15 10-Q

Source: Hill International 2014 10-KWhether one looks at the numbers on a quarterly basis or on an annual basis, it is crystal clear that the firm's US operations is one of its fastest-growing geographic segments, second to its Middle Eastern operations. On an annual basis, US operations have been growing at growth rates of 21%-28%. Given that the segment has continued posting 25%-29% growth rates in H1 '14/'15, it appears that growth is not decelerating but instead remaining rather stable.



These losses have been getting smaller and smaller by quarter, and US operations appear to be nearing an inflection point (in terms of profitability). Using 1H '14/'15 numbers, pre-tax margins on incremental US revenue is ~17%. Assuming the firm's US operations continues growing at 20% (not unreasonable, considering 1H '15 numbers were in excess of this rate), US operations could very well break-even by the end of FY15. Notably, the firm's recent largest contracts are primarily for US clients as seen below, supporting my view.

Source: Hill International August 2015 Investor PresentationIf US operations break-even, HIL would be paying an effective tax rate of anywhere between 14%-20% based on 2Q '15 and 1H '15 numbers (calculation assumes zero profit from US operations, thus the rates mentioned are simply derived by dividing



pretax profit on foreign operations by foreign taxes incurred). It is due to this gross overestimation of the firm's tax rates by Street analyst that I am confident HIL would beat current consensus EPS estimates without much difficulty.Additionally, HIL would have the benefit of paying no taxes on US operations for a while when the segment turns profitable, given that it currently has ~$40m in US NOLs (per the 2014 10-K).In any case, it is evident that assuming a 40% tax rate going forward for the company is a draconian assumption. If one conservatively assumes that US operations narrows its losses substantially in FY15 and the company's effective tax rate is 30% (the rate implies smaller losses on US operations; if US operations were break-even, the rate would be 14%-20%), the firm would beat 2015 Street consensus EPS estimates by ~50%:

• Assume 2015 EBIT of $50m (mid-point of management guidance)• 2015 interest expense of ~$12m• 30% effective tax rate• 51m diluted shares outstanding

Math: [($50m - $12m) * (1-0.3)] / 51m = ~$0.52 (~48% consensus beat).Massive discount to comps seems unwarrantedHIL currently trades at a massive discount to comps - ~7x my 2015 EPS estimate compared to peers such as Tetra Tech (NASDAQ:TTEK), Jacobs Engineering (NYSE:JEC), TRC Companies (NYSE:TRR), Aecom (NYSE:ACM) and ICF International (NASDAQ:ICFI), who trade anywhere between 12x-19x 2015 Street consensus EPS.While it seems reasonable to assign a discount to HIL due to its small size, it is my view that such a large multiple differential (~7x vs 12x-19x) is difficult to rationalize. One could argue that HIL's Middle Eastern exposure should warrant a lower multiple, but even then it seems nigh impossible to justify as its peers are also



exposed to that geography. Another bone of contention investors could have with the company may be its debt levels (nevermind the fact that peers such as Aecom and ICF International are far more aggressively levered), but as detailed above, HIL's interest burden has been substantially reduced.Moreover, considering that it seems highly likely (reasons explained at length in a prior section) that the firm would hit its guidance, a case could be made for HIL to trade around the peer average given that hitting 2015 guidance implies 8%-10% EBITDA margins. Comps - with the exception of ICF International - possess lower EBITDA margins at 4%-7%.In any case, it seems that HIL's massive discount to comps is unwarranted. If HIL trades at the low-end of comps (i.e. 12x my EPS estimate), shares would see ~70% upside from current levels. Suffice to say, upside potential could be far more substantial. That being said, trading at the low-end of comps seem to be far more easily supported.Catalysts

• I expect HIL to beat consensus Street EPS estimates by a wide margin for 2015. This should point to a resumption of profitability at the firm, after years of posting large losses. Furthermore, management has been presenting at numerous investment conferences (see here, here, here, and here) for years, but these presentations do not seem to have an effect on the stock price, presumably due to HIL's unprofitability. Given that EPS should be largely positive for 2015, it is very likely that the HIL turnaround story would be received with open arms by investors, which would result in shares trading higher.

• Although management rejected DC Capital's offer at $5.50/sh, it seems plausible that management would be open to a much higher offer. In response to the offer in May, the firm instituted a poison pill briefly but scrapped it in June, suggesting that if a better offer is on the table, management just might take it. Considering management's 25% ownership of the firm's commno stock, an eventual sale/take-out is likely their choice of exit.



• Finally, while I am in no way an expert at predicting the resolution of civil unrest in Libya (I leave such pursuits to geniuses such as Bruce Bueno), it is clear that the difficulties faced by HIL in Libya (which led to the company posting large losses) are acting as one of the overhangs on the stock. It follows that if the situation is resolved, shares would catalyze higher.

Risks

• A rate hike - while this seems likely given recent Fed commentary (which pointed to a hike by year-end 2015), this risk is partially mitigated by the fact that the hike is likely to be gradual - a 25bp increase in the Fed Funds seems the most plausible scenario. Such a scenario would not drastically harm HIL's profitability.

• A downturn in the business environment - as with any business, this particular risk is unavoidable. Partial mitigants: HIL has a diversified revenue base as seen in prior sections. Moreover, 53% of its revenue is derived from governments - revenue from this source tends to be less susceptible to fluctuations in the business cycle. The existence of long-term contracts is a definite positive as well.

• With emerging market currencies getting pounded recently (particularly the Brazilian real), investors may be worried about HIL's currency exposure, given that the firm only derives ~20% of its revenues from the US and the remainder from its foreign operations. However, HIL has very little exposure to the emerging markets. As an example, APAC, Africa, and Latin America currently account for 6%, 4%, and 7% of revenues. This assertion is further supported by management commentary (emphasis mine):Mike Shlisky - Global Hunter SecuritiesOkay. Then just squeeze more in here. Could you give us the FX impact on your revenues and on your backlog for the quarter?David Richter - President and Chief Executive Officer



The impact on our backlog was minimal because most of the backlog is the U.S and Middle East and the Middle East the currencies are pretty stable with the US and the FX expense for the quarter was around 400,000 which is somewhere to what it was in the first quarter.Source: Hill International 2Q Earnings Call Transcript

• One other concern that investors may have is with the firm's energy operations. As the price of oil continues to be severely depressed compared to its prior highs, this seems to be a valid concern - at first sight. However, this concern is misguided, considering that HIL derives only 12% of its revenues from the energy markets. To the best of my knowledge, the firm does not offer a break-down of its up/mid/down-stream operations. However, it seems possible that most of its operations in the energy markets may be mid/down-stream, where low oil prices actually act as a tailwind, given that TRC Companies, one of the firm's rivals, have >90% of its energy operations in the mid/down-stream markets. In any case, whether this is true or not does not really affect the long thesis for HIL, as the firm's exposure to the energy market is simply too small - if majority of its energy operations are upstream, it would experience a slight headwind overall, while if the majority of energy operations are mid/down-stream, the company would experience a slight tailwind overall.

ConclusionHIL is a company with a troubled past which led to the firm posting massive losses. The market appears to be fixated with these troubles, a view that is unwarranted given that recent business momentum, a refinancing, and cost-cutting initiatives point to the contrary. The bear case - which revolves around HIL being forced taking on unprofitable contracts in order to service interest payments - is beginning to fall apart.Given Wall Street's worship of EPS, the firm's strong operating results appear to have gone unnoticed by market participants. Following a refinancing which severely reduced interest expense, the firm is beginning to post meaningful profits. Perhaps investors are worried that the firm might revert into unprofitability again. As I detailed at great length in prior sections, it is my view that the probability of such a scenario materializing is extremely low.



Although Street estimates point to a profitable 2015, they seem grossly underestimated (thus providing little downside risk because it is highly unlikely HIL does not surpass expectations) as they appear to assume a tax rate (40%) that is unlikely to remain at such high levels as US operations - which have been delivering pretax losses - are on the cusp of inflection.While a resumption of Libyan operations, as well as collection of related receivables, and another PE firm bid are possible, I view those scenarios as the "cherry-on-top". A reasonable base case for HIL is for shares to trade at the low-end of comps. If such a situation materializes, shares would see 70% upside from current levels - a compelling return by any measure.Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.Additional disclosure: The author's reports contain factual statements and opinions. The author derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. The author's reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. The author accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. The author advises readers to conduct their own due diligence before investing in any companies covered by him. The author does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.



Hill International Under-Covered, Underestimated, Undervalued

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