Interesting company, page-3

Last update of Sohra Peak (published on May 19, 2023) regarding Duratek

"In our memo released earlier this year, which you can find here, we organized our thoughts as to why we believed Duratec represented a compelling investment opportunity. Since then, the company’s shares have performed well, and through continued research our conviction in the long-term prospects of Duratec has grown stronger.

Breaking Down MEnD Consulting: A Competitive Advantage
One aspect that received relatively less attention in our initial memo than it should have, and deserves further discussion given its importance to the overall business, is Duratec’s subsidiary MEnD Consulting. I thought it would be worthwhile to provide a more comprehensive overview of MEnD Consulting in orderto better complete the discussion on Duratec.

As a brief refresher, Duratec is an Australian company specializing in infrastructure remediation services for asset owners with a roster of over 900 project staff and engineers. MEnD Consulting, a wholly owned subsidiary and division of Duratec, provides value-added services to Duratec’s prospective and existing clients in the form of comprehensive asset evaluations and laboratory petrography.

Of all of the components that comprise Duratec, management considers MEnD as its most valuable asset
and the component that gives Duratec a true competitive advantage within its industry. Historically, MEnD’s value to both Duratec and its clients have appeared evident: 80% of MEnD’s clients have converted into Duratec clients, every $1 of MEnD revenue has converted into $25 (and increasing) of
Duratec revenue, and the retention rates of clients who transition from MEnD to Duratec have been aboveaverage. 1 Moreover, MEnD’s state-of-the-art technological capabilities have helped to reduce project remediation risk and costs for its typical client.

This last item, MEnD’s industry-leading technological capabilities, is worth expanding upon, given its importance to Duratec’s business as well as the lack of communication that I have found regarding the advantages that MEnD Consulting provides Duratec.

Proprietary 3D Geospatial Modeling Software

MEnD’s crown jewel, AnnoView, is the consultancy’s proprietary 3D geospatial modeling software. To fully appreciate AnnoView’s significance to MEnD and Duratec’s competitive standing, it is key to first understand exactly what is being modeled, and how MEnD obtains this information.

When MEnD begins its work with a client, its objective is to ultimately provide the client with a comprehensive, complete assessment of the client’s asset in order to identify all existing and potential defects requiring remediation in order to prevent structural damage. An asset may include a bridge, a
military wharf, a port, a mining plant, or an aircraft hangar.

Once the client accepts MEnD’s services, MEnD employees will show up to the client’s site and begin to deploy airborne drones equipped with high-resolution cameras. The purpose of these drones is to capture every square inch of the client’s asset, from multiple angles, in order to gather a complete set of data needed to later re-create the client’s asset in MEnD’s proprietary 3D software.

Once the drones capture the data they need, MEnD uploads this data to AnnoView, which then re-creates the asset with remarkable accuracy. Actual samples of AnnoView’s models can be found here, as well as the above real-life screenshot of an AnnoView 3D geospatial model. At this point, MEnD’s in-house PhDs utilize AnnoView to analyze the asset, identifying and flagging defects directly within the software itself. Following this analysis, MEnD returns to the client, they jointly review the AnnoView model together, and MEnD provides a copy of the model to the client which they can use in collaboration with their chosen asset remediator. 80% of the time, that remediator turns out to be Duratec.

The outcome of this process, in our view, is exceedingly valuable to the client for several reasons:

1. Reduced Risk and Cost Overruns: First, MEnD’s comprehensive analysis allows the client to derisk the asset as much as reasonably possible. With a comprehensive 360-degree virtual model of the asset, the client can rest assured that all identifiable defects will be addressed, regardless of whether they hire Duratec or another contractor for the remediation project,. Additionally, the remediator benefits from higher margins as MEnD’s work helps minimize the number of “surprise” defects that were not specified in the initial contract, which are also a common source of cost
overruns for the remediation contractor.

2. Considerable Time and Money Savings: Second, MEnD’s work often saves the client a great deal of time and money. Due to the lack of 3D-modeling offered in the industry, the inspection phase for many asset owners consists of a traditional manual inspection process. This requires field engineers to spend significant time, often months for more complex assets, before a complete assessment can be made. MEnD’s technology, on the other hand, allows clients to substantially complement or substitute this process.

In a recent example, Duratec purports to have begun a project with mining giant BHP which they had won following successful client conversion from MEnD. After BHP and MEnD had reviewed BHP’s 3D asset model together, BHP apparently found the model so thorough that they felt comfortable proceeding directly to the asset remediation phase with Duratec and skipped the traditional inspection stage entirely.
BHP mentioned that skipping this phase saved them ~$1MM in cost and 12 months of work that they would have otherwise spent on engineers.1 Given these savings and the positive experience BHP had with MEnD, what is the likelihood that BHP’s site manager in this example will continue hiring MEnD and Duratec for future asset remediation projects? I would wager quite high.

3. Absence of Formidable Competition: Third and lastly, MEnD’s services hold particular value for
its clients for the reason that there are very few other firms that offer MEnD’s capabilities within
the asset remediation space in all of Australia, and there are no other companies of its kind that are
also vertically integrated with an asset remediator such as Duratec.1,2 The combination of MEnD
and Duratec is the only vertically integrated company of its kind in Australia.

Within the industry, the other firms who offer 3D-modeling solutions of comparable quality to MEnD are standalone consultancy firms. In my view, having a vertically integrated, highly reputable asset remediator in Duratec is beneficial for the client, because it allows the client to seamlessly transition between two firms that work smoothly together, which minimizes coordination costs. The alternative scenario, where an asset owner is handed a model from a standalone consultancy and is left to contact asset remediators, is by all means a workable method. However, it appears to add friction to the client experience, and could add unnecessary risk to the project if there were any misinterpretation of the consultancy’s model by the third-party remediator.

Aside from the comparable standalone consultancies, there are other “competitors” who attempt to offer similar drone and 3D-modeling solutions like MEnD, but their offerings are reportedly inferior, with their 3D-modeling not nearly as high-quality as AnnoView’s, and therefore lacking
a compelling value proposition to the client.

As a recent anecdote and evidence of MEnD’s services being at the frontier of its industry, Duratec recently met with a U.S.-based 3D geospatial data software firm who informed them that, based on the geospatial models they have seen working with their multi-national clients, MEnD is “doing the biggest, most complex structures anywhere in the world at the moment.”Whether or not this is precisely accurate, it appears to further the viewpoint that MEnD is providing unique, valuable work for its clients, to the ultimate benefit of Duratec and the entire combined company.

MEnD’s contribution to Duratec’s revenues and profits has historically been strong, and appears to only be increasing. According to management, of Duratec’s $310MM of revenue in FY 2022, roughly $100MM was generated through projects that began by working with MEnD, and every $1 in MEnD revenue translated into $25 in Duratec asset remediation revenue. This implies $4MM in MEnD revenue for the year FY 2022, which management believes is on track to grow to $6MM in FY 2023.

In addition, as Duratec’s size allows it to scale to bigger projects and work with bigger clients, MEnD’s services are being introduced to industry stalwarts such as the Department of Defense (DoD), BHP, Rio Tinto, and others. For instance, a $600,000 revenue project for MEnD recently converted into an $80MM contract for Duratec, or a $1 to $80 conversion ratio.1 This has included stealing contracts from other leading asset remediators, such as Monadelphous, which suggests that Duratec is becoming increasingly viewed as a high-quality alternative to other leading brand names in the asset remediation space.

Laboratory Petrography Services
Aside from its 3D geospatial modeling, MEnD Consulting’s other valuable offering is its laboratory petrography service it providers for third-party clients across Australia. Petrography as applied by MEnD is the study of rock and mineral samples from infrastructure assets under a specialized microscope.

Before or during an asset remediation project, one helpful tool that project engineers use to make decisions is a petrography analysis of the asset’s rock or mineral samples. For instance, a petrographer can help conclude whether a crack is benign and surface-level, or a more serious structural issue; or, to help confirm the identity of the underlying substance present in a portion of the asset.

While MEnD’s petrography services may not add distinct value to the typical client in the way its 3Dmodeling does, the petrography lab’s true value to Duratec lies in its capacity as a robust client lead generator. Presently, MEnD captures 10-15% of the entire Australian petrography market for infrastructure
assets, meaning that 10-15% of all infrastructure asset samples in Australia are analyzed through MEnD’s labs.This is powerful, because by analyzing these samples, Duratec has amassed a database that it can use to effectively determine when any given asset within this database might be due, even years in advance, for a remediation project. This allows Duratec the ability to engage with prospective clients before competitors can, or even before the client themselves may be aware that their asset is due for maintenance.

Within the large total addressable market of Duratec’s asset maintenance industry, which we estimate to be $50B, this lead generation tool at Duratec’s disposal could provide them with insights into the remediation schedule for a substantial number of projects, amounting to $5.0-7.5B.2 It is easy to see how this strategic advantage could further give Duratec a leg up over its competitors and a sustainable pipeline for growth.

According to MEnD, they have built this market share by focusing on high-end, specialized petrography, rather than commodity petrography sampling which most petrography labs focus on. For instance, MEnD’s in-house lab recently became the first lab in Australia to receive NATA-accreditation (Australia’s leading national accreditation body for laboratories) for concrete petgrography. In addition, MEnD points out that there are only two other petrography labs in Australia capable of analyzing high-end, expensive concrete samples to the degree they can, and that both are independent labs not owned by Duratec’s competitors.

Tying all of the above together, Duratec and MEnD Consulting appear to complement one another to create a unique, dominant vertically-integrated business in Australia’s asset remediation industry. While there are subsets of quality competitors that exist within each vertical of 3D-modeling, laboratory petrography, and contractors who provide remediation services, no other Australian firm combines all three under one roof. As noted in my initial memo, too, executives at both Duratec and MEnD feel strongly that it would take years for any competitor to replicate Duratec’s current setup with any degree of success.

Assessing Valuation
At the moment, at a price of $0.93 per share, Duratec’s market cap stands at AUD $227MM. After subtracting $33MM of net excess cash, we arrive at a market cap of $194MM.

Based on management’s recent upgrade to guidance for FY 2023 ending June 30, I expect the company to produce $20MM of net income, $25MM of Owner’s Earnings, and EBIT of $28MM. This implies a 13% Owner’s Earnings yield, P/E of 9.7x, and EV/EBIT of 6.9x.

Although shares are not as cheaply priced as they were five months ago, I think Duratec’s shares still contain substantial long-term upside. From a fundamental perspective, my view is that profits should continue to grow at high rates for a number of years to come, for a variety of reasons:

• Management is confident that FY 2024 will see continued growth over FY 2023, which is supported by Duratec’s current order book and tenders. As stated in the company’s most recent update on April 24, its orderbook stood at $495MM and tenders at $748MM.4 Given order book projects must be completed within 1-2 years and tenders historically have a ~1 in 3 win rate, this suggests that the lion’s share of FY 2024 revenue and profits may already be secured, with a whole year ahead during which the company can pick up additional projects. Given this visibility, I would not be surprised to see revenue growth of +20-30% or greater next year.

• Department of Defense business continues to grow strongly, most recently growing +104% YoY as of 1H FY 2023, and shows no signs of slowing down. Duratec is winning greater market share with the DoD in an expanding pie as the Australian government has budgeted sustainment spend to almost double over the span of this decade. Additional DoD tailwinds continue to surface, such as the AUKUS military alliance which has guaranteed $8B of DoD maintenance spend at the HMAS Stirling navy base, which Duratec has been servicing since 2015 and which management
believes could easily lead to an additional $500MM-1B of revenue for Duratec over that span.

• Annual growth is generally contained due to the importance of avoiding high levels of project concentration, implying that Duratec generally has the ability to win more business in any given year, and therefore in future years, than any given year’s revenue growth rate might suggest.

• Duratec has recently been winning more, and larger, contracts with blue chip clients (e.g., DoD, BHP, Rio Tinto), and occasionally at the expense of larger, respected competitors, suggesting Duratec is establishing important future revenue streams along with a strong brand name for itself.

• The runway for buildings & façades refurbishment remains lengthy, with billions of dollars in mandatory remediation required across the sector. Duratec’s revenues in this segment have expanded at a +65% CAGR since FY 2019 and should continue to grow.

• MEnD Consulting’s services have not yet penetrated much of Australia’s east coast, which the company views as a significant opportunity over the intermediate-term.

• Wilson's Pipe Fabrication has been, in my view, by all measures a home run of an acquisition. Duratec expects Wilson’s to trigger its full contingent consideration threshold, which suggests Duratec will have paid AUD $18MM all-in for Wilson’s which is expected to deliver over $5MM of EBITDA for FY 2023. Duratec expects strong continued growth ahead for Wilson’s through geographic expansion across Australia, cross-selling its capabilities to the DoD, layering MEnD’s entire set of value-adds to Wilson’s clients, and organic growth within its segment. The success of this acquisition also fosters confidence in management’s ability to run this playbook for any future tuck-in acquisitions that would allow it to efficiently enter new remediation sectors.

• DDR, which has grown revenue rapidly from $10MM in FY 2019 to $73MM in FY 2022, should continue to expand its profit contribution to Duratec over time.

• Approximately 80% of Duratec’s business each year is derived from repeat clients, suggesting that the company should continue to maintain a lumpy but fairly stable existing book of business going forward, to which it can continually add new clients.

• As speculation entirely on my part, future optionality could exist for Duratec to leverage MEnD’s best-in-class 3D-modeling and laboratory services on a global scale, given a large portion of these processes can be performed remotely. Whether Duratec would decide to expand its core engineering and contracting business beyond Australia’s borders makes for a separate discussion, but with respect to MEnD, it could become a high-end consultant to international clients through its 3D-modeling service or partner with select asset remediators to serve as a lead generator and earn a share of remediation economics. MEnD’s laboratory petrography business can be performed completely remote with the option of also somehow monetizing its lead generating capability.

Considering the various ways that we believe Duratec can continue expanding its business, it is reasonable to see for us how this business could do quite well in the foreseeable future, and why we think paying a 7.8x multiple of Owner’s Earnings for this business today could prove to be a bargain in retrospect.

It is worth noting that despite its upward valuation re-rating over recent months, Duratec still maintains the lowest set of valuation multiples among its peer group of Australian E&C companies including Monadelphous Group, SRG Global, and Saunders International.

Examining Monadelphous specifically, with whom Duratec competes directly in mining and now oil and gas and from whom Duratec has been recently stealing business, Monadelphous trades at 24x P/E. This is despite having arguably a lower quality business than Duratec given its 50-50 split of remediation (higher quality)-construction (lower quality), and despite Duratec possessing what we consider a competitive advantage over Monadelphous in its MEnD Consulting business. Surely, Monadelphous having a revenue base 4-5x larger than Duratec’s and a market cap higher up the liquidity spectrum are of benefit to Monadelphous. Though, it also gives you a sense of where Duratec’s valuation multiples could be headed as the company continues to grow in size."