TerraVest Stock: Solid Q1 Results, But It’s Time To Take Profits (Rating Downgrade)

Introduction

I’ve written three articles on SA about industrial equipment company TerraVest Industries (OTCPK:TRRVF) (TSX:TVK:CA), the latest of which was in August 2023 when I said the Q3 FY23 financial results were disappointing, and that the valuation was starting to look stretched.

In my view, the Q1 FY24 financials were strong thanks to recent acquisitions as revenues rose by 28.7% year on year while net income soared by 47.5% to C$19.3 million ($14.3 million). That being said, the market capitalization has surpassed C$1 billion ($740 million) and this seems like a good time to trim or close positions. I’m cutting my rating on the TerraVest’s stock to sell. Let’s review.

Overview of the Q1 FY24 financial results

If you’re not familiar with the company or my earlier coverage, here’s a short description of the business. TerraVest was established in 2004 and is a Canadian compounder focused on acquiring manufacturing businesses. Its product offering includes residential refined fuel tanks, compressed gases transport vehicles, and water treatment equipment among others and the business is split into four segments – HVAC and Containment Equipment, Compressed Gas Equipment, Processing Equipment, and Service. Typically, the first and fourth quarters of the fiscal year are the strongest in terms of revenue as there is significant seasonality here. You see, demand for heating products usually rises in the winter and this affects the HVAC and Containment Equipment, and Compressed Gas Equipment segments. In addition, the Processing Equipment, and Services segments focus on the oil and gas sector and the drilling season in Western Canada occurs in the first half of TerraVest’s financial year.

Looking at the growth strategy, I mentioned in my first article about TerraVest in March 2023 that it bought 14 companies for over C$230 million ($170.2 million) between FY14 and FY22. TerraVest looks for businesses without a succession plan or that are in distress and often pays low single digit EBITDA multiples. According to data from Fairway Research, the company can generally achieve returns of investment of about 17% on its acquisitions (pages 13 and 14 here). TerraVest’s latest purchases included fuel and chemical storage tanks maker Highland Tank Holdings for $78 million and water management firm LV Energy Services for C$25 million ($18.5 million), both announced in November 2023. The price paid for Highland Tank Holdings translated into 4x EBITDA on a TTM basis.

Q1 FY24 income statement

Looking at the Q1 FY24 financial results of TerraVest, we can see that revenues increased by 28.7% to C$228.1 million ($168.8 million) while adjusted EBITDA soared by 62.2% to C$49.1 million ($36.3 million). The majority of the revenue growth came from Highland Tank Holdings and LV Energy Services, which were included in the HVAC and Containment Equipment and Services segments, respectively. Excluding these two companies, sales were up by 7% year on year to C$189.5 million ($140.2 million). The adjusted EBITDA also soared thanks to the contributions from Highland Tank Holdings and LV Energy Services as well as strong demand for oil and gas processing equipment and services in Western Canada, and LPG storage and distribution equipment. Despite the strong financial results, I find it worrying that financing costs went up by 72.7% to C$6.4 million ($4.8 million) due to rising interest rates as well as the higher debt level.

Digging deeper into the performance by segment, we can see that the HVAC and Containment Equipment business accounted for close to half of adjusted EBITDA for the quarter. In my view, almost all of the growth here is likely due to the addition of Highland Tank Holdings as organic sales growth for this segment was negative 1.2% for the period.

Q1 FY24 balance sheet

Looking at the balance sheet, net debt soared by C$92.9 million ($68.7 million) quarter on quarter to C$303.7 million ($224.7 million) due to the November 2023 acquisitions. This puts the net debt-to-EBITDA ratio at 2.37x based on the TTM adjusted EBITDA. While this level isn’t high, I’m concerned that it could put the C$0.15 ($0.11) per share quarterly dividend in danger if it continues rising in the near future. Another possible scenario is that TerraVest might limit the amount of acquisitions over the coming years to in order to reduce its debt burden.

Future of the company

Looking at what to expect for the future, I think that organic revenue growth could remain at a high single digit percentage level over the next few quarters as drilling activity in the oil and gas industry in Canada is strong at the moment. According to data from the Canadian Association of Energy Contractors, there were with 236 active drilling rigs across Alberta, British Columbia, and Saskatchewan on February 27. The number stood at 177 at the time of my previous article about TerraVest in August and I think adjusted EBITDA for FY24 could surpass C$150 million ($111 million).

Valuation

I think that TerraVest is starting to look overvalued based on fundamentals. In my view, there aren’t any suitable peers to which to compare TerraVest, but the company is trading at 10.4x EV/adjusted EBITDA on a TTM basis, which I think is high for a cyclical business whose performance is dependent on oil prices and drilling activity in Canada. Looking at the company’s historical valuation, we can see that the EV/EBITDA ratio has rarely surpassed 9x and that the EBITDA margin usually drops below 14% during market downturns.

In my view, TerraVest should be valued at about 6x EV/EBITDA as it has fallen below 5x during bad times and I like a margin of safety. In addition, I usually avoid investing even in mature businesses with low cyclicity at above 8x EV/EBITDA. Yet, keep in mind that these levels reflect my personal risk tolerance level, which makes them somewhat arbitrary.

Upside risks

I think the major one is that rising geopolitical tensions around the world could keep oil prices high over the coming months, which would boost drilling activity in Canada. This could provide a decent boost for TerraVest’s Processing Equipment, and Services segments. Another risk here is that the stock is thinly traded even on the TSX with the daily trading volume rarely exceeding 3,000 shares. Positive news and events (such as strong quarterly financials) can create significant upward momentum for such stocks, and a good recent example is Hammond Power Solutions (HPS.A:CA) (OTCPK:HMDPF), which I’ve covered here. The latter’s market valuation has soared by 35% since the January 16 article.

Investor takeaway

TerraVest booked solid Q1 FY24 financial results thanks to the acquisition of Highland Tank Holdings and LV Energy Services, as well as decent organic growth due to strong drilling activity in Western Canada. In my view, adjusted EBITDA for FY24 could surpass C$150 million ($111 million) but the company is starting to look overvalued at above 10x EV/adjusted EBITDA on a TTM basis. This is a cyclical business, after all, and I think that a market capitalization of above C$1 billion ($740 million) is likely unsustainable in the long term.

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