Transcat (TRNS): A Business Shifting from Distribution to Services and a Stock Shifting from Unknown and Unloved to Known and Loved
Transcat is an interesting stock for me to write-up, because I probably have a bias here. Quan and I considered this stock – and researched it quite a bit – several years back. We were going to write it up for a monthly newsletter I did called Singular Diligence. All the old issues of this newsletter are in the stocks “A-Z” section of Focused Compounding. And – you’ll notice, if you go to that stocks A-Z section of Focused Compounding – that there’s no write up of Transcat there. I’ve never written about the stock. Why not? Back then, Transcat was a somewhat smaller company with a much, much smaller market cap. It didn’t do the kind of investor relations stuff it does now. Quan and I could read what management was saying and see the company was trying to move from being a distributor of test equipment to being a service company focused on calibration. Quan and I MIGHT have bought the stock for our own personal accounts (I’m not sure we would have, but I am sure we would’ve had an open mind about Transcat). But, those Singular Diligence newsletters were 10,000+ words long. I didn’t see how we could gather enough info on Transcat to write something that long. So, maybe it was a good stock. But, it probably wasn’t a good newsletter issue.
How does that make me biased now?
Well, in the years since I chose NOT to write it up for Singular Diligence – Transcat’s management did what they said they were going to do. The company has now transformed itself from mainly a distributor of handheld measuring equipment to mainly a calibration service provider. I don’t want to overstate this “mainly” part. If you look at each of the last two full years, I think Transcat got something like 48% and then 50% of its revenue, operating profit, EBITDA, etc. from the service segment and about the same amount from the distribution segment. However, looking at this fiscal year – Transcat is only 6 months into it in terms of what it’s reported so far – I’m getting a number for “adjusted EBITDA” (basically, EBITDA with stock compensation added back – Transcat has a lot of stock compensation) that tells me about 60% of the company’s profit is now coming from the service segment. The other 40% is coming from the distribution segment. That didn’t happen entirely due to a revenue spike in services and a decline in distribution. Part of what has happened this fiscal year is something Transcat’s management has been talking about for a very, very long time and only now really started to deliver on: margin expansion.
Margin expansion is probably the key to deciding whether or not to invest in Transcat. Right now, it’s a good and growing business. But, it’s not a great business. The company has never had amazing returns on capital. It does now use some debt (though usually closer to 1.5 times EBITDA in debt than 3 times EBITDA in debt – which is pretty manageable for a company as predictable as this). Gross margins in both the service segment and distribution segment are pretty low (25% is common). Operating margins aren’t super high either (5% was common till recently). The odd part is that the calibration service segment has usually had both gross and operating margins right in line with the distribution segment. How can that be?
I don’t think the calibration service business actually has similar economics to the distribution segment. However, there are definitely some scale issues with calibration. The company operates more than 20 service centers. It operates some on-site calibration centers (that is, inside a customer’s plant). And then it also has “mobile calibration centers” (basically trucks you can park outside a customer site that doesn’t have the room in the plant needed to do calibrations). This business segment has been growing very fast. They must be hiring a lot of new employees all the time. New employees may not be as productive as employees the company has had for a while. Likewise, there may be start-up costs associated with bringing on new customers, putting sites inside their plants, servicing them for the first time, etc. All the things I’m saying are things the company says in its 10-K, press releases, etc. I think they make sense as an explanation for why the service segment’s margins haven’t looked that different from the distribution segment’s margins. A long time ago, they did. When the service segment was clearly subscale, it had very poor margins. That was to be expected. But, it also gives a hint that today’s margins may not be the top margins this company can achieve in the service segment. That’s important, because as the service segment becomes the majority of Transcat’s overall business – and because it is growing faster than the distribution segment, it’ll keep getting to be a bigger and bigger piece of the overall pie – the future economics of Transcat are going to look more like the future economics of the service business than the distribution business. The service segment has pretty considerable depreciation and amortization expense. They do acquire things above book value all the time. And then they have leased sites full of some leasehold improvements and equipment and so on. There’s also capitalized software that was developed internally by Transcat. Why does this matter? Well, Transcat is making more of an investor relations push than it has in the past. I wouldn’t be surprised if investors in the company started focusing more and more on the company’s figure for “adjusted EBITDA” (this always seems to be the number investors in most stocks where management does a lot of presentations use when talking with me about the value of the company). I wouldn’t be surprised if Transcat’s “adjusted EBITDA” growth rate was really strong in the years ahead. I think the service segment can grow adjusted EBITDA – and especially adjusted EBITDA margins – quickly through both organic growth and some debt financed acquisitions. And then I think that the service segment has now reached the point where it is providing the majority of Transcat’s adjusted EBITDA and growing faster than the legacy business. Whenever a company has two or more business segments in it and investors start to focus exclusively on the good, growing business – you’re a lot more likely to have expanded price multiples on the stock.
Which brings me to Transcat’s price multiple. It isn’t cheap. The P/E is 27. The price-to-book is between 3 and 4. However, price-to-book is honestly meaningless here. Transcat’s book value is mostly goodwill and intangibles from acquisitions of other distributors and calibration service providers. Actual investment in this business is just receivables and inventory and some PP&E offset by some (much lower) current liabilities. I calculate the net tangible assets of this business to be very, very low compared to the market cap. I’d ignore book value. We could use enterprise value to sales. That ratio stands at 1.5. The long-term average operating margins here have been around 5%. We’ll assume a tax rate of 21% (the statutory federal rate). Reality is probably between 21% and 25% (the company does pay some state taxes). So, that’d be about a 5% EBIT margin turns into about a 4% after-tax margin. So, you are paying $1.50 (including debt) for ever $1 of sales. And every $1 of sales is producing 4 cents of after-tax earnings. So, you are paying 150 cents for 4 cents of annual earnings. That’s 150/4 = 37.5. Paying almost 38 times earnings (to be fair, we’re using enterprise value compared to after-tax earnings here) is not something value investors like to do.
But, there are a bunch of reasons why that might seriously overstate Transcat’s price. Let’s look at this fiscal year alone. The “adjusted EBITDA” of the service segment was $5.2 million in the first two quarters of the current fiscal year. The business is somewhat seasonal. It usually makes more money in the back half of the year than the front half. It’s also growing. And fast. So, it’s very conservative to assume that just doubling the first 6 months of EBITDA will give us the likely full year 2020 results for the service segment. That would be $10.4 million of “adjusted” EBITDA. What is that worth on its own?
On a trailing twelve month basis, service segment revenue is up 13-14%. Its adjusted EBITDA margin also expanded. That segment made about 2% more per dollar of sales this year than last year. That’s a huge improvement. It means that 13-14% growth in segment revenue could really understate future growth in earnings from this segment. However, some of the 13-14% growth in segment revenue was from acquisitions. Still, the organic growth rate in the service segment has rarely been below 6%. The segment has grown – year-over-year – in each of the last 40 plus quarters. It has 10 straight years now of growing. And it’s usually been growing the top line by more than 6% per year organically. Acquisitions have bumped growth in this segment up to double-digit type annual rates. And now we’re seeing margin expansion. So, what could that like $10 million or more in adjusted EBITDA be worth on its own?
The company has a market cap of about $230 million. Net debt is about $25 million. That’s about $255 million in enterprise value. Compare that to $10 million of “adjusted EBITDA” in the service segment – could this business really be worth 25x EBITDA?
That seems hard to believe. It’s not impossible though. To see if it’s impossible we need to look at enterprise value relative to sales in the service segment. I think service segment sales could be close to $100 million by the end of this year. That’d make the enterprise value to sales – of JUST the service segment – 2.5 times. Is that an impossibly high price?
It might not be. The adjusted EBITDA margin for the service segment already rose above 13% this quarter. Now, this is not an EBIT number. It’s EBITDA. And there’s the stock comp problem I’ll talk about in a second. But, could this margin eventually exceed 15%? Sure. I think it could. Could it exceed 20%? That’s harder. Gross margins are only like 25%. But, gross margins could expand in a widely scattered service business like this. So, it’s kind of difficult to tell how high margins could get in this business.
It’s not impossible that the service segment alone could justify the current enterprise value of like $250 million on Transcat. Then you are getting the distribution business for free.
What’s this “stock comp” issue I keep talking about. It’s the issue that I believe – based on past use of stock options, restricted stock awards, etc. – that Transcat may dilute its shares outstanding by as much as a 1-2% growth rate indefinitely into the future. The way I like to think of this is not as an expense the company has to pay in cash (because it doesn’t). But, rather, as an expense borne by the shareholder in the form of 1-2% lower returns every year I own the stock.
Transcat has never paid a dividend and has no plans to pay a dividend. The company has debt. It could certainly double and maybe eventually triple the amount it’s borrowing. It doesn’t have to deleverage while you own the stock.
However, the 3 things I pointed out just now are a bit of a problem in owning a stock long-term. One, you’re going to get diluted. Two, you’re not going to get a dividend yield. To put this in perspective, it’s not hard to find stocks that PAY YOU a 2% annual dividend without increasing their share count. If, instead, Transcat both doesn’t pay you any dividend and does increase the number of shares out by 2% a year – you’d then be 4% a year behind where you’d be in a stock that pays a dividend and doesn’t dilute. This isn’t an impossible drag to overcome. I don’t think it’d be hard for Transcat to grow earnings 4% a year faster than most stocks while you own the business. But, keep in mind it’d have to do that to get you to the same place as a more traditional value stock.
Finally, there’s the debt issue. It’s not dangerous. But, Transcat owes $25 million. If the company chose to pay this debt off while you owned the stock, that’d eat up earnings that could otherwise be used to pay you dividends, buy back stock, acquire other companies, etc. Now, Transcat could go the other way and increase leverage while you own the stock. My own impression of management and their plans is that Transcat is as likely to INCREASE leverage while you own the stock as to DECREASE leverage. Nonetheless, it’s always easier to be certain a company will not de-lever while you own it, if there’s nothing to de-lever.
I like Transcat’s service segment business. I’m not sure the stock is too expensive. But, I am sure the hurdle it has to clear given today’s stock price, the fact it pays no dividend, and the fact it might dilute me means I’d be betting on that service segment hitting a specific growth rate.
It’s possible.
The business quality here is high. I didn’t get into it in this write-up. But, Transcat focuses on calibrating instruments for companies regulated by the FDA (life sciences, biotech, etc.) and the FAA (aerospace, defense, etc.). It does work for oil and gas companies and things like that. But, a lot of the business is very non-cyclical. The distribution business is selling durable instruments. A typical order Transcat fills is in the $2,000 to $2,500 range. The company sells used equipment. It also rents equipment. So, distribution is more cyclical because you can put off new testing equipment purchases but can’t put off calibration. We can see this in past results. So, Transcat’s future earnings won’t just be marching steadily higher – they’ll also become more predictable.
I wouldn’t be surprised if this company eventually becomes a small cap (it’s still a micro-cap at present) darling of those looking for “compounders”. The bigger the service business gets relative to the distribution business, the more people will be attracted to this stock.
I like the business. I expect good things for it. The price seems like a pretty big hurdle for me to clear right now. So, I’m not as confident in an investment in this company as I am in its business model.
Geoff’s Initial Interest Level: 70%
Geoff’s Revisit Price: $15/share (down 51%)