Mistras Group Inc.(MG) April 11, 2016

Transcription

1 The Henry Fund Henry B. Tippie School of Management Wallace King Mistras Group Inc.(MG) April 11, 2016 Industrial Mechanical & Industrial Engineering Services Stock Rating Buy We recommend a buy for Mistras Group because the firm is a market leader in an industry with a strong growth outlook. The firm is also more diversified than its peers. Half of the its revenues are tied to end markets which will demand more Non-Destructive testing services due to an expected increase in the age of public infrastructure as well as high asset utilization rates. Competitors on the other hand have significantly higher exposure to the contracting oil & gas sector. Drivers of Thesis The Non-Destructive testing industry is expected to grow at a CAGR of 4.8% over the next five years. Mistras is an industry leader and benefits from a strong reputation, long customer relationships and a large suite of proprietary technology products. The increasing age of critical fixed assets and public infrastructure will increase the demand for the firm s asset protection solutions The firm has low debt levels relative to its peers. This is a distinct advantage in an industry that is consolidating through M&A activity Risks to Thesis Investment Thesis Target Price $29-31 Henry Fund DCF $30.56 Henry Fund DDM $14.28 Relative Multiple $14.58 Price Data Current Price $ wk Range $ Consensus 1yr Target $26.17 Key Statistics Market Cap (B) 0.70 Shares Outstanding (M) Institutional Ownership 57.1% Five Year Beta 1.0 Dividend Yield 0.0% Est. 5yr Growth 18.68% Price/Earnings (TTM) Price/Earnings (FY1) 26.9 Price/Sales (TTM) 0.94 Price/Book (mrq) 2.55 Profitability Operating Margin 5.09% Profit Margin 3.13% Return on Assets (TTM) 4.48% Return on Equity (TTM) 8.63% Approximately half the firm s revenue is tied to the oil & gas sector. A longer than expected downturn in oil prices could constrain firm revenues over the medium term. Rising labor costs due to lower unemployment, increased inflation and a low supply of skilled technicians could severely hurt the firm s earnings. The firm earns 31% of its revenue from overseas and if the US dollar strengthens significantly it will negatively impact foreign revenue. Earnings Estimates Year E 2017E 2018E EPS $0.41 $0.79 $0.56 $0.90 $0.96 $1.10 growth -46.8% 92.7% -29.1% 61.5% 6.3% 14.5% 30% 10% -10% -30% -50% Source: Yahoo Finance Important disclosures appear on the last page of this report P/E ROE EV/EBITDA Source: FactSet 12 Month Performance Company Description MG S&P 500 A M J J A S O N D J F M MG Industry Sector Mistras Group provides asset protection solutions to customers in the energy, aerospace and industrial sectors. Mistras conducts destructive and non-destructive testing to assess the structural integrity of its customer s infrastructure and other key assets thus ensuring that they meet established safety standards. Mistras also provides predictive maintenance services to help its customers to increase the useful life of their assets. The firms earn 70% of its revenue from operations in the United States and most of its international revenue from Europe.

2 EXECUTIVE SUMMARY We believe that Mistras Group represents a good investment opportunity due primarily to the growth potential of the Non-Destructive Testing (NDT) industry. We forecast that there will be an increased demand for NDT services as rising cost of capital and slow global demand make it more prudent for firms to forego new capital outlay and instead choose to increase the utilization of current assets. This choice will lead to increased demand for a suite of asset protection solutions including but not limited to NDT and predictive maintenance services. The increasing age of US public infrastructure and power generation assets and the low likelihood of large scale replacement will also provide more demand for NDT and predictive maintenance solutions. Mistras is a market leader in this industry and has more of its revenues tied to high growth NDT areas like aerospace, processing and public infrastructure than its major rivals who are more exposed to the energy industry. Mistras also benefits from strong reputation and customer relationships; key competitive advantages in this industry. We believe that Mistras holds a strong position in the growing NDT industry and will outperform its peers in the coming years. Our valuation model indicates a potential 20% price upside; we therefore recommend a buy for this stock. COMPANY DESCRIPTION Mistras Group was founded in 1978 by Sotirios J. Vahaviolos who still serves as the firm s chairman and CEO. Mistras is headquartered in Princeton Junction New Jersey USA. The firm provides asset protection services primarily to customers in the energy and industrial sectors. Mistras asset protection solutions include Nondestructive testing (NDT), destructive testing (DT), predictive maintenance services (Pdm) and proprietary data analysis software. 1 NDT & DT testing are a suite of services that seek to evaluate the components of new construction to ensure that they meet established safety standards and tests that assess the structural integrity of infrastructure or other key fixed assets to determine whether they will require repair or replacement. Pdm services help firms to determine the ideal times to conduct maintenance services so as to reduce equipment downtime and increase the useful life of their fixed assets. Mistras s proprietary data analysis software analyses historical and real time testing and maintenance data to provide firms with optimal maintenance and asset retirement schedules. Mistras hires skilled technicians to carry out its NDT services and less than 10% of its labor force is unionized. Mistras is organized into three operating segments; Services, Products & Systems and International. 800, , , , ,000 40,000 20, ,000 Source: Mistras Group 10-k 2015 Services Segment Revenue Services International Products and Systems Segment Operating Income Services International Products and Systems The services segment consists primarily of NDT and DT inspection and testing services and account for over 70% of Mistras revenue and 95% of its operating income. The services segment generates most of its revenue from North America, the bulk from the USA and a small portion coming from Canada. This segment is heavily tied to energy, with 64% of services revenue derived from oil and gas customers. 1 Revenues from the services segment have grown at a CAGR of 19.1% over the past 3 years while operating income has grown at a CAGR of 10.4%. 1 Revenue Page 2

3 growth over the 3-year period has been derived almost evenly from organic sources and acquisitions. 1 International Source: Mistras 10k-2015 Revenues by Region 10% 19% 2% 69% United States Other Americas Europe Asia-Pacific Mistras currently has operations in 16 countries. The bulk of the firm s international earnings are derived from its European operations with Germany, UK and France accounting for the lion s share of earnings. The firm s Brazil location accounts or the bulk of its Latin American earnings. Most of the firm s international customers are concentrated in the aerospace and defense industry (41%), oil and gas (17%) and industrials (15%). 1 Revenues from international operations fell by 9% between 2014 and 2015, 7% of this decline was due to unfavorable exchange rates caused by the strengthening US dollar. The remaining 2% reduction was due to a reduction in revenue from UK, Japan and Russia. 2 Mistras does not currently enter into forward contracts to hedge their foreign currency exposure. The international segment experienced an operating loss during 2015 due in large part to the aforementioned reduction in revenue from foreign currency effects. As the firm s operating expenses were unchanged YoY. In 2013 the international segment experienced an operating loss due a goodwill impairment charge form the firm s Brazil operations. A goodwill impairment charge of 9.9 Million was recognized due to an economic downturn in the Brazilian economy and a contraction in the country s oil and gas sector. 1 Management has indicated that they will seek to improve the operational efficiency of the international division and During 1Q of the firm divested its international subsidiaries in Russia and Japan. Revenues for the first 3Qs fell by 5% due to the strengthening US dollar but the firm increased its operating margins from 4% in 2014 and -2% in 2015 to 6.5% at the end of 3Q We expect that International revenues will continue to be negatively impacted by the strengthening US dollar as the fed increases interest rates and as global investors move funds to the US dollar. Management has taken decisive steps during the past financial year to rein in operating costs in this segment and thus improve margins. We believe that management will be able to continue to improve operating margins in the international segment in the near to midterm. Products & Systems This segment designs and manufactures the firm s proprietary asset protection solutions. These include the software and physical equipment that monitors and provides real time structural integrity analysis of a customer s fixed assets and other infrastructure. The majority of the revenue from this segment is earned from the United States. This segment accounts for approximately 4.5% of Mistras revenues and 5% of its operating income. 1 Mistras typically sells these products to customers as a value added to their testing and inspection services. As such they are often bundled and form part of the firm s suite of asset protection solutions. Given the strong relationship and complementary nature of this segment with the services segment we expect it to grow in line with services revenue. Revenues by End Market Source: Mistras 10-K 2015 Page 3

4 Oil & Gas 450, , , , , , , ,000 50, % 12.2% 15.4% Source: Mistras 10K-2015, HF Forecast Oil & Gas Revenue Mistras has historically earned approximately half of its revenue from the oil and gas sector primarily through inspection and testing services. The shale boom and the rapid expansion of the oil and gas industry over the past 4 years lead to strong growth in revenues from the energy end market. The increasing use of low grade crude oil particularly from the shale region also led to an increase in the corrosion of oil related infrastructure and thus more demand for asset protection services from the energy industry. 4 Since June 2014 oil prices have tumbled precipitously from $104 per barrel to $39 per barrel as of April Despite the decline, oil and gas companies continued operations at high capacity until mid-2015 when the sustained period of low prices finally took their toll and drilling activity began to decline rapidly. 5 Mistras oil and gas revenue peaked in FY 2015 before the energy industry began to right size. We expect that revenues from the oil and gas end market will decline by 4.5% in 2016, remain stagnant in 2017 before beginning a slow 4.0% recovery in Terminal growth will be achieved in 2020 at a rate of 6%. Our growth forecast for this end market incorporates our expectation that oil prices will recover to above $50 per barrel by 2018 which will be sufficient to spark drilling activity back to moderate levels. We believe that Mistras is slightly insulated from the oil market decline because the difficult economic climate will force many of the firm s customers to forego infrastructure expansion and choose instead to increase the utilization rates of their current fixed assets in order to 21.1% -4.5% E 2017E 2018E 2019E 2020E Oil & Gas Growth 0.0% 4.0% 5.3% 25% 20% 15% 10% 6.0% 5% 0% -5% -10% Page 4 achieve scale and mitigate the effects of the low oil prices. Higher asset utilization rates require more inspection, testing and predictive maintenance services. We also anticipate that the firm will generate strong revenue growth from this end market when oil prices rise and oil and gas firms began to reactivate dormant assets. Inspection and testing services will be critical in this process. Energy revenues also benefit from the fact that refineries in the US are old. The last major refinery with downstream capacity in the USA was built in Old infrastructure and high demand for refined products leads to high utilization rates at these refineries leading to consistent demand for asset protection services. Aerospace & Defense 120, ,000 80,000 60,000 40,000 20, % 122.1% 39.2% 5.3% 4.0% 4.5% 5.0% 5.5% 6.5% 0% E 2017E 2018E 2019E 2020E Source: Mistras 10-k 2015, HF Forecast Aerospace & Defense Revenue Aerospace & Defense Growth Revenues from this sector have grown at a CAGR of 49.8% over the past 5 years. 1 High safety standards and the increased use of advanced composite materials are strong drivers of continued demand for asset protection services in the aerospace industry. S&P Capital IQ s outlook for the aerospace & defense industry is positive, based on increasing revenues and profitability that will likely persist for the next several years. 6 S&P also projects that the commercial aerospace sub-industry is likely to see a long cyclical uptrend. In light of this, we anticipate that revenues from aerospace will continue to grow albeit at a slower pace. 6 We forecast that revenues from aerospace end market will grow at a CAGR of 5.1% through to 2020 before settling at a long term growth rate of 6.5%. 140% 120% 100% 80% 60% 40% 20%

5 Power Generation & Transmission Public Infrastructure Research & Engineering 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 - Source: Mistras-10K Power Generation & Transmission Revenue 29% 8% 33% Revenue in this segment have grown at a CAGR of 20.4% 1 over the past five years due in large part to aging infrastructure in the power generation and transmission sector. 14% 8% 8% 7% 7% E 2017E 2018E 2019E 2020E Power Generation & Transmission Growth 35% 30% 25% 20% 15% 10% 6% 5% 0% 60,000 50,000 40,000 30,000 20,000 10,000 - Source: Mistras-10K Infrastructure Research & Engineering Revenue 29.0% 45.4% -1.8% 14.1% 10.00% 6.0% 6.5% 7.0% 7.5% 8.0% E 2017E 2018E 2019E 2020E Infastructure Research & Engineering Growth 50.00% 40.00% 30.00% 20.00% 0.00% % This segment has grown at a CAGR of 20.4% 1 over the past five years due in large part to increased demand for inspection and testing services due to the United States aging public infrastructure. Average Age of US Infrastructure Source: Energy Information Administration According to the National Association of Regulatory Utility Commissioners, 51% of the US s electricity generating capacity was built before Approximately 74% of all coal-fired power plants are at least 30 years old, and the average life of such plants is just 40 years. 7 The high average age of electricity generation equipment generates more demand for inspection and testing services to ensure that these fixed assets meet established standards. We forecast that The high cost of replacing the aging infrastructure, especially since interest rates are expected to rise, will lead to increased demand from this end market. Predictive maintenance services will also be in high demand in this environment. In light of the foregoing we anticipate that revenues from this end market will grow at a CAGR of 7% through to Source: Goldman Sachs investor presentation We project that this end market will continue to exhibit strong growth because of the high safety standards necessary to ensure that aging infrastructure can be used by the public. Given the enormous capital outlay required, we do not anticipate that neither the states nor the US government will make the investment necessary to replace aging infrastructure in the near to midterm. We instead expect states and the managers of public infrastructure to expend more on testing and inspection services to proactively identify and repair deficiencies. In light of this we expect revenues from this end market will grow at a CAGR of 7% through to Page 5

6 Industrials & Other Process Industries RECENT DEVELOPMENTS 120, ,000 80,000 60,000 40,000 20,000 - Industrial & Other Process Industries Revenue E 2017E 2018E 2019E 2020E Other Process Industries Industrial Q Earnings Mistras missed 3Q revenue estimates by 3.85M. Total revenues for 3Q declined 1.7% YoY. The firm did however beat earnings estimates by $0.07 per share. The revenue decline was driven primarily by the downturn in the oil and gas sector. The firm was able to beat earnings estimates through cost cutting measures which saw year to date operating income margins increase by 270 basis points. 8 Management credited the margin improvement to improved staff utilization and better matching of changes in labor rates with changes in pricing. Cost reductions from the divestment of the struggling Russian and Japan operations also boosted operating margins. 8 Source: Mistras-10K Industrial and other process industries include companies in a wide range of industrial processing business lines which include but not are not limited to: raw materials treatment and processing, chemical production and processing, pharmaceuticals, food processing, paper and pulp manufacturing and metals and mining. Revenues from the industrials end market grew at a 5-year CAGR of 34.8% while revenues from process industries grew at a CAGR of 20.4%. 1 The recent growth in these industry segments have been driven by in large part by high asset utilization rates as firms seek to delay outlay on new capital equipment and choose instead to utilize current equipment more heavily. The chemical processing industry in particular has high established standards which drive a continued demand for asset protection services. We forecast that demand for asset protection services will continue to grow from these end market segments due to continued high asset utilization rates. We forecast that 10- year bond yields will increase by over 120 basis points over the next two years. Higher interest rates will limit capital outlay and make fixed asset replacement more expensive. In light of the following we forecast that revenues from the industrials end market will grow at CAGR of 5.8% through to 2020 while revenues from the other process industries end market will grow at a CAGR of 7.6% through to Management lowered full year guidance with revenues expected at 715M. We believe that this revenue target is feasible and thus incorporated this forecast in our model. Consolidation INDUSTRY TRENDS The Industry has seen a steady uptick in consolidation as larger players buy up smaller competitors in a bid to expand into new geographic locations, improve scale and/or acquire new technology. Team Inc. s (TISI) recent purchase of Furmanite Corporation (FRM) in February 2016 is an illustration of this trend. We anticipate that this consolidation trend will continue and larger players like MG and TISI with superior access to capital markets will increase their utilization of this growth channel. Technological Innovation Technology has developed rapidly in the industry and this has led to improvement in the speed of testing, increases in the number of automated processes and a reduction in the need for skilled labor. Firms have also developed data processing software and remote devices that provide real time analysis of fixed asset structural integrity.10 These technological enhancements have increased the demand for NDT testing services and have mitigated the effects of rising wage costs. Firms that develop superior Page 6

7 technology will have a strong competitive advantage in the market. MARKETS AND COMPETITION Industry Overview Source: IBISWORLD The Nondestructive Testing industry had revenues of approximately 2.6B in 2015 and grew at a CAGR of 6.8% between 2010 and There are currently over 1,800 firms that provide NDT services in the USA. 10 Most of these are small to midsized private operators. The majority of these small to mid-sized firms operate in niche geographic segments and service lines. Currently there are only a handful of firms that provide NDT services on a national scale. Mistras is the largest of these national operators. As a result, despite the large number of players, industry competition is only moderate. 10 Major Players Source: IBISWORLD The industry is highly fragmented due to the large number of players that operate regionally. Mistras Group is the current industry leader with Team Inc. and Rockwood Services Corp following behind. Together these major players account for over a third of the industry s revenues. 10 Over the past 5 years the three largest firms have widened their market share, and we anticipate that these large players will continue to dominate more of the industry due to the benefits that come with large scale such as more bargaining power with employees, established customer relationships, reputation and better R&D. The major players in the industry seek to differentiate themselves from the smaller competition by combining NDT testing services with other products. These firms typically leverage their relationships with their customers to sell value added products and services that include but are not limited to: predictive maintenance services, proprietary software, real time fixed asset monitoring equipment and database management and analytics services. Major firms also seek to differentiate themselves through developing improved NDT testing methods which increase testing speed as well as required downtime to conduct testing. High Barriers to Entry Barriers to entry are relatively high in the NDT industry. Testing equipment is expensive and new entrants have to compete with established firms for the limited supply of skilled NDT technicians. The industry is also highly regulated and new entrants have to obtain expensive accreditations and other qualifications from relevant governing bodies in order to operate. 10 The largest barrier to entry however is reputation. Customers utilize the results of NDT tests to make expensive capital expenditure decisions as well to maintain compliance with established regulatory standards. Established NDT firms already have a track record of accuracy and strong customer relationships. These serve as a strong barrier to new entrants. Large players like Mistras Group, Team Inc. and Rockwood Services Corp have long histories, strong reputational capital and long customer relationships Industry Outlook Revenue for the NDT industry is expected to grow at a CAGR of 4.8% 10 between 2015 and 2020 due in large part to aging infrastructure and increased government regulatory standards for health, safety and the protection of the environment. The increased complexity of building materials will also generate demand for NDT testing methods to ensure structural integrity of these new materials. 10 Page 7

8 3, , , , , , Source: IBISWorld NDT Industry Revenue Outlook The industry s high growth rate is expected to attract new entrants, but we believe that the aforementioned barriers to entry, coupled with industry consolidation trend, will mitigate increased competition and allow industry players to retain their share of industry revenue. Peer Comparison While there are many independent NDT and DT service providers operating locally, there are only a handful of companies that provide asset protection services on a nationwide scale. These include but are not limited to: Team Inc. Acuren Group, Inc., Furmanite Corporation, Guardian Compliance, and T.D. Williamson, Inc. Of this list Team Inc. and Furmanite Corp are the only two publicly listed competitors. Team Inc. acquired with Furmanite Corp in Feb Consequently, Team Inc. is the firm s closest publicly traded competitor. 11 End Market Revenue Team Inc. Technological advancement will be an important driver of industry profitability. Technological improvements serve to improve the speed and lower the cost of NDT testing. Faster testing reduces the downtime that companies suffer when testing materials and will also boost demand for NDT services. 10 Most importantly technological improvements automate testing and reduce the demand for skilled technicians. Wages account for almost half of industry revenues due to the low supply of skilled technicians caused by very stringent training requirements. Mistras Group has a competitive advantage in the market due its R&D department that develops new technological solutions. Team inc. on the other hand lags in technological investment. Company Avg. R&D/Sales last 3 Years Source: Mistras 10K, Team Inc. 10K Carrying value of Intangible Technology (Million) Mistras 0.45% 15,738 Team Inc. n/a 5,112 Source: Team Inc. Investor Presentation 2016 Team Inc. generates approximately 75% of its revenues from the oil and gas sector compared with 50% for Mistras Group. 11 Team s large exposure to the energy industry will hurt it in the near mid-term due to sustained downturn in the energy industry. Mistras more diversified end market revenue stream will be an advantage in the near term. Mistras is also more exposed to high potential market segments like infrastructure and aerospace. Team Inc. earns approximately 61% of its revenue from Non- Destructive testing services. Page 8

9 Profitability Company Source: Factset MV MISTRAS Group Yr. Sales Sales Growth % Employees Sales Per Employee 5, x Team % 6, x Furmanite % 2, X Mistras and Team Inc. are comparable in terms of market size and revenue. Mistras however has seen much stronger revenue growth over the past 5 years due in large part to its diversified end market revenue stream. We anticipate that Mistras diversified revenue stream will mitigate the expected downturn in the oil and gas sector where Team Inc. has high exposure. Team Inc. s higher sales per employee is a strong advantage due to rising cost of skilled labor in the industry Year Price Chart 4/10/2015 5/10/2015 6/10/2015 7/10/2015 8/10/2015 9/10/ /10/ /10/ /10/2015 1/10/2016 2/10/2016 3/10/2016 Team Inc. Mistras Group Source: Yahoo Finance ECONOMIC OUTLOOK Oil Prices Gross Margin Net Margin ROE EBIT/Interest Debt/Total Equity Company MISTRAS Group 25.3% 3.1% 8.7% 7.16x 45.0% Team 29.5% 3.1% 8.4% 11.00x 108.3% Furmanite 24.8% 2.4% 7.0% 11.64x 47.6% Souce: FactSet The two firms have comparable profitability metrics and equal profit margins however Mistras has a lower Debt/Equity ratio which will be beneficial as interest rates increase in the near to mid-term. Significantly lower leverage will provide Mistras with superior access to capital markets which put the firm in a better position to complete acquisitions; a key growth strategy for large players in this industry. Source: Nasdaq Company Cash Con Version Cycle Current Ratio 5 Year Beta MISTRAS Group Team Furmanite Source: FactSet Team Inc. s higher Beta relative to Mistras reflects its higher risk due to its large exposure to the oil and gas sector relative to Mistras. Source: Baker Hughes Page 9

10 Approximately half of Mistras revenue is generated from the energy industry. The severe decline in oil prices has constrained industry earnings and has led to a reduction in drilling activity as evidenced by the steep decline in the rig count between 2015 and Although Mistras saw strong revenue growth of 21% YoY in , we anticipate that the firm will feel the effects of the downturn in the energy markets during FY16 & FY17. We forecast that oil prices will rise to $51 per barrel in 2018, at this price we anticipate that drilling activity will begin to recover and Mistras will benefit from increased revenue growth from this end market. We anticipate that US real GDP will grow at 2.6% over the next 2 years and will continue to be soft in the medium term. GDP growth has a strong impact on Mistras industrial and processing customers whose earnings are strongly tied to the macro-economy and consequently above average GDP growth will spark greater demand for Mistras services from these end markets. US Public Infrastructure Spending Interest Rates Over the next two years, we forecast a 75 basis point increase in the federal funds rate and a 120 basis point increase in 10-year bond rates. Higher interest rates will serve as an impediment to the replacement of infrastructure and expensive fixed assets because these large capital outlays usually require financing. More aging infrastructure will require increased demand for asset protection services and will thus boost revenues for Mistras. US Real GDP growth We anticipate that public infrastructure spending will continue to be muted due to the large capital outlay required and the political challenges that accompany initiatives requiring significant government spending. The US GDP outlook will also be modest and will not facilitate a significant uptick in infrastructure spending. Limited public infrastructure spending will lead to an increase in the average age of public infrastructure and consequently more demand for inspection and testing services. Eurozone Economy Page 10 Source: tradingeconomics.com

11 Approximately 20% of the firm s revenues are from its European operations. 1 The Eurozone has seen very slow growth over the past 5 years and most recently GDP grew by 1.5% in We forecast that Eurozone GDP will average 1.5% over the next 3 years. This level of GDP growth will cause muted earnings from European operations. Euro to USD exchange rate Source: European Central Bank The strengthening US dollar has hurt the firm s foreign revenues over the past 2 years. We expect that the dollar will continue to strengthen against the Euro due to the sustained negative interest rates in the Eurozone and the planned interest rate increases by the FED. We expect the USD per Euro exchange rate to move to $1.05 from its current level of $1.14. A weakening Euro will negatively impact revenues from Mistras European operations. Unemployment and inflation affects Mistras primarily through increased labor costs. The unemployment rate has declined steadily over the past 5 years while inflation has remained below the Fed s target of 2% since During FY 2015 Mistras saw its services operating margin decline by approximately 80 basis points compared with fiscal 2014, 1 due primarily to wage increases that exceeded price increases. We forecast that unemployment will fall 10 basis points to 4.9% by 2018 and that inflation will rise 70 basis points to 1.70% by These two developments will put upward pressure and wages in the near to mid-term. The chart below chart illustrates that wages form a larger portion of this industry s costs than most other firms in the industrial sector which are more capital intensive. Unemployment Rate and Inflation Page 11

12 CATALYSTS FOR GROWTH Oil price increasing above $50 per barrel in the short term would spark a recovery in the oil & gas sector More stringent regulatory standards for infrastructure and other critical fixed assets will increase the demand for NDT services. A strong increase in US and global GDP will drive demand from customers in the firm s industrial, energy and process end markets. A weaker US dollar will reduce the negative foreign currency headwind that has constrained international income. INVESTMENT POSITIVES The NDT industry is expected to grow at a CAGR of 4.8% of the next five years. 10 Mistras has a more diversified revenue stream that its peers. Increasing age of critical fixed assets and public infrastructure will provide a growing source of revenue from the firm s end markets. The firm is a market leader in the NDT industry 10 and benefits from a strong reputation, long customer relationships and a large suite of proprietary technology products. The firm has low debt levels which provide it with a competitive advantage in the acquisition space. INVESTMENT NEGATIVES Over half the firm s revenue is tied to the oil & gas sector. A longer than expected downturn in oil prices could constrain firm revenues over the medium term. 1 Rising labor costs due to lower unemployment, increased inflation and a low supply of skilled technicians could severely hurt the firm s earnings. The firm earns 31% of its revenue from overseas 1 and a strengthening US dollar has negatively impacted international earnings. The dollar could strengthen at a faster pace if the Fed initiates more rate hikes than anticipated or due to other macro-economic factors. VALUATION We expect 2016 revenues to increase to management s guidance of $715M. We also forecast that revenues will grow at a 5 year CAGR of 4.2% this is slightly below the IBIS world industry CAGR forecast of 4.8% 10. Revenues will be driven primarily by increase demand for NDT services which will drive growth in the key end markets of aerospace, industrial, processing and infrastructure as previously discussed. Our model assumes that oil and gas revenue does not recover until 2018 when oil prices increase to $51 per barrel. We anticipate that gross margins will increase by approximately 215 basis points from We expect the firm to maintain these margins throughout the forecast period. Our gross margin improvements include our expectation that management will continue to take measures necessary to cut costs as they have done through the first 3 quarters of FY We also anticipate that the firm will improve SGA/Sales margin by 50 basis points in 2016 and maintain these levels throughout the forecast period. Our SG&A/ Sales assumption is consistent with how management has reduced costs throughout FY 16. We forecasted that the firm s CAPEX budget will be 3% of sales annually. This was the midpoint of managements guidance of 2-4% annually 1. We expect the firm to continue to see R&D expenditure in line with sales at a rate of 0.5% annually. Consistent R&D spend is necessary for continued revenue growth through improved technology and innovation. We assumed a terminal growth rate of 3% for NOPLAT. This is in line with long run real GDP growth rate. We assumed a CV of ROIC of 11.50% in line with industry ROIC decomposition rates. The pre-tax cost of debt was found by adding a synthetic spread of 1.25% to the 30-year treasury bond rate of 2.55% A Beta of 1.0 was calculated using 5 years of monthly returns. Using this Beta, a risk premium of 5% and current 30-year T bond rates we determined a cost of equity of 7.6%. We calculated a WACC of 6.5%. Our DCF model determined a price of 30.5 while or relative valuation model determined a price of We do not believe that Page 12

13 our relative valuation model accurately reflects the firm s intrinsic value because the peer group had different market exposures and business lines from Mistras, Team Inc. Is Mistras closest publicly listed pure play competitor and Mistras trades at a higher P/E because it has less exposure to oil and gas than Team does. Our DDM model determined a price of $ We do not believe that our DDM Model accurately reflects the firm s intrinsic value because Mistras does not pay dividends and has no plans to do so. We estimated a hypothetical dividend payout ratio of 45% in the terminal forecast year based on the industry average dividend payout ratio for engineering firms. We believe that our DCF model is the most accurate measure of the Mistras intrinsic value. Sensitivity analysis revealed that our target price was heavily dependent on our choice of beta. Mistras 5-year monthly beta of 1.0 was used for the model however the firm s 3-year weekly beta of 1.4 would have resulted in a value of $ We believe that the 5-year monthly beta is the best measure of the firm s risk. KEYS TO MONITOR Over half of the firm s earnings are linked to the oil and gas sector and we anticipate that an increase in oil prices above $50 in 2018 will spark a recovery in revenues from this sector. It will therefore be prudent to monitor oil prices to see if they reach this level by Increasing age of public and other critical infrastructure is a strong driver of NDT demand therefore it is necessary to monitor the average age of public infrastructure as well as plans to replace the country s capital stock. 4. Baker Hughes: Overcoming Shale Oil Processing Challenges 5. US Energy Information Administration. 6. S&P Capital IQ Industry Surveys:Aerospace & Defense Mistras Group 3Q 2016 earnings release. 9. Team Inc. Investor Release- Team Announces Successful Acquisition of Furmanite 10. IBISWorld Industry Report OD5540: Non-Destructive Testing Services in the US 11. Team Inc K IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. Infrastructure replacement trends in the power generation and industrial sectors should also be closely monitored. Any large uptick in infrastructure replacement will negatively impact firm earnings. The firm s earnings are heavily linked to GDP given its beta of 1.0 and its cyclical end markets. Consequently, GDP expectations should be closely monitored as a significant decline would negatively impact the firm. REFERENCES 1. Mistras Group 10-K Mistras Group 2015 earnings call 3. Mistras Group 3Q earnings call Page 13

14 Mistras Group Revenue Decomposition Fiscal Years Ending May E 2017E 2018E 2019E 2020E Oil & Gas 264, , , , , , , ,818 Growth 12.2% 15.4% 21.1% -4.5% 0.0% 4.0% 5.3% 6.0% Power Generation & Transmission 42,343 56,110 64,013 68,814 73,975 79,338 84,891 89,985 Growth 8% 33% 14% 8% 8% 7% 7% 6% Other Process Industries 47,635 56,110 64,013 69,774 75,356 81,384 87,081 92,306 Growth 21.2% 17.8% 14.1% 9.0% 8.0% 8.0% 7.0% 6.0% Industrial 63,514 68,579 78,238 82,932 87,908 93,182 98, ,712 Growth 45.4% 8.0% 14.1% 6.0% 6.0% 6.0% 6.0% 5.0% Infastructure Research & Engineering 31,757 31,172 35,563 37,696 40,147 42,957 46,179 49,873 Growth 45.4% -1.8% 14.1% 6.0% 6.5% 7.0% 7.5% 8.0% Aerospace & Defense 58,221 81,048 85,350 88,764 92,759 97, , ,432 Growth 122.1% 39.2% 5.3% 4.0% 4.5% 5.0% 5.5% 6.5% All Other 21,171 24,938 14,225 14,367 14,798 15,538 16,393 17,376 Growth -30.8% 17.8% -43.0% 1.0% 3.0% 5.0% 5.5% 6.0% Total Revenue 529, , , , , , , ,503 Growth 21.2% 17.8% 14.1% 0.6% 3.2% 5.3% 5.9% 6.1%

15 Mistras Group Income Statement Fiscal Years Ending May E 2017E 2018E 2019E 2020E Revenues 529, , , , , , , ,503 Cost of Revenues 363, , , , , , , ,027 Depreciation 17,866 17,809 20,238 20,607 20,830 21,172 21,729 22,496 Gross profit (loss) 148, , , , , , , ,980 Selling, general & administrative expenses 101, , , , , , , ,957 Research & engineering 2,447 2,995 2,521 3,578 3,691 3,886 4,113 4,363 Amortization 8,781 10,620 13,048 10,137 8,460 6,583 5,519 4,708 Acquisition-related costs (income), net (2,141) (2,657) (5,167) Goodwill impairment 9, Legal reserve Income (loss) from operations 27,554 38,295 30,353 46,179 50,061 57,730 65,305 70,952 Interest expense 3,288 3,192 4,622 3,631 3,993 4,006 4,087 4,212 Gain (loss) on extinguishment of long-term debt Income (loss) before provision for income taxes 24,266 35,103 25,731 42,547 46,068 53,724 61,218 66,740 Provision (benefit) for income taxes 12,627 12,528 9,740 16,168 17,506 20,415 23,263 25,361 Net income (loss) 11,639 22,575 15,991 26,379 28,562 33,309 37,955 41,379 Less: net income (loss) attributable to noncontrolling interests, net of taxes 7 (57) 90 11,646 22,518 16,081 26,379 28,562 33,309 37,955 41,379 Weighted average shares outstanding -basic 28,141 28,365 28,613 29,166 29,720 30,273 30,826 31,380 Net income (loss) per common share -basic

16 Mistras Group Balance Sheet Fiscal Years Ending May E 2017E 2018E 2019E 2020E Cash & cash equivalents 7,802 10,020 10,555 50,950 73, , , ,076 Accounts receivable, net 108, , , , , , , ,014 Inventories, net 12,504 11,376 10,841 12,164 12,549 13,211 13,986 14,833 Deferred income taxes 2,621 3,283 5,144 7,286 10,320 14,618 20,705 29,327 Prepaid expenses & other current assets 8,156 12,626 11,698 12,386 12,777 13,451 14,240 15,102 Total current assets 139, , , , , , , ,351 Property, plant & equipment, gross 150, , , , , , , ,045 Accumulated depreciation & amortization 81,603 99, , , , , , ,842 Property, plant & equipment, net 68,419 77,811 79,256 80,116 81,430 83,572 86,524 90,203 Intangible assets, net 52,428 57,875 51,276 41,139 32,679 26,096 20,577 15,869 Goodwill 115, , , , , , , ,414 Deferred income taxes - 1,344 1,208 1,148 1,090 1, Other assets 906 1,297 2,107 1,942 2,003 2,109 2,233 2,368 Total assets 376, , , , , , , ,140 Accounts payable 8,490 14,978 10,529 14,578 15,039 15,833 16,761 17,776 Accrued expenses & other current liabilities 47,839 54,650 55,914 61,462 63,403 66,751 70,664 74,943 Current portion of long-term debt 7,418 8,058 17,902 11, , Current portion of capital lease obligations 6,766 7,251 8,646 6,076 4,094 1, Income taxes payable 1,703 1, ,587 2,801 3,266 3,722 4,058 Total current liabilities 72,216 86,791 93,523 95,954 86, ,992 91,681 96,890 Long-term debt, net of current portion 52,849 68,590 95, , , , , ,294 Obligations under capital leases, net of current portion 10,923 13,664 10,717 16,603 17,127 18,032 19,089 20,245 Deferred income taxes 11,614 15,521 16,984 20,539 24,837 30,035 36,321 43,922 Other long-term liabilities 18,778 17,014 9,934 18,991 19,591 20,625 21,834 23,156 Total liabilities 166, , , , , , , ,508 Common Stock & Additional paid-in capital 195, , , , , , , ,387 Retained earnings (accumulated deficit) 18,982 41,500 57,581 83, , , , ,165 Accumulated other comprehensive income (loss) (4,452) (1,511) (21,113) (21,113) (21,113) (21,113) (21,113) (21,113) Total Mistras Group, Inc. stockholders' equity (deficit) 210, , , , , , , ,440 Noncontrolling interest Total equity (deficit) 210, , , , , , , ,633

17 Mistras Group Cash Flow Statement Fiscal Years Ending May Net income (loss) 16,431 21,353 11,639 22,575 15,991 Depreciation & amortization 18,592 22,024 26,647 28,429 33,286 Deferred income taxes 1,779 (984) (1,732) (621) (1,745) Stock compensation expense 3,751 5,097 6,285 6,261 6,579 Goodwill impairment - - 9, Changes associated with the exit of foriegn operations ,516 Fair value adjustments to contingent consideration liablities - - (3,727) (3,937) (5,382) Provision for doubtful accounts Loss (gain) on extinguishment of long-term debt - (671) Loss (gain) on sale of assets 21 (90) (35) - - Amortization of deferred financing costs Interest rate swap (210) Foreign currency loss (gain) (335) (508) Other net income adjustments ,647 Accounts receivable (22,664) (18,030) 4,772 (23,857) 3,982 Noncontrolling interest (95) (7) Inventories (77) (1,708) 525 1, Prepaid expenses & other current assets - (1,503) (1,042) (4,059) (288) Other assets 47 (8) (821) Accounts payable 1,904 3,149 (5,478) 6,125 (6,281) Accrued expenses & other liabilities 6,203 5,698 (3,832) 4,532 2,500 Income taxes payable (515) (3,036) (1,426) (431) (1,748) Net cash flows from operating activities 25,254 31,402 43,503 36,873 50,624 Purchase of property, plant & equipment (10,075) (9,592) (12,530) (16,871) (15,104) Purchase of intangible assets (520) (813) (993) (708) (866) Acquisition of businesses, net of cash acquired (26,195) (29,216) (33,122) (21,924) (34,967) Proceeds from sale of equipment 312 2,109 1,166 1, Net cash flows from investing activities (36,478) (37,512) (45,479) (38,005) (49,941) Repayment of capital lease obligations (6,230) (6,984) (6,972) (8,139) (8,653) Repayment of long-term debt (7,141) (12,346) (5,075) (8,830) (9,224) Net borrowings (payments) from revolver 3,850 (3,850) Net borrowings from current revolver - 25,000 14,568 21,580 21,914 Net proceeds (repayments) from other short-term borrowings 45 (1,868) Payment of financing costs - (623) Proceeds from capital contribution from noncontrolling interests Acquisitions of noncontrolling interest in subsidiary - (75) Net proceeds from issuance of common stock 14, Payment of contingent consideration for business acquisitions - - (1,892) (1,678) (3,213) Taxes paid related to net share settlement of equity awards - (283) (809) (1,007) (1,481) Excess tax benefit from share-based payment compensation Proceeds from the exercise of stock options 95 2, Net cash flows from financing activities 5,344 2,009 1,144 3, Effect of exchange rate changes on cash & cash equivalents 722 1, (629) Net change in cash & cash equivalents (5,158) (2,469) (608) 2, Cash & cash equivalents, beginning of period 16,037 10,879 8,410 7,802 10,020 Cash & cash equivalents, end of period 10,879 8,410 7,802 10,020 10,555

18 Mistras Group Cash Flow Statement Fiscal Years Ending May E 2017E 2018E 2019E 2020E Net Income 26,379 28,562 33,309 37,955 41,379 Depreciation 20,607 20,830 21,172 21,729 22,496 Accounts Receivable (21,786) (4,895) (8,445) (9,870) (10,791) Inventory (1,323) (384) (663) (775) (847) Prepaid Expenses (688) (391) (675) (789) (862) Change in deferred taxes 1,473 1, (971) Accounts Payable 4, ,015 Accrued expenses & other current liabilities 5,548 1,941 3,348 3,913 4,278 Income Taxes Payables 2, Net cash flows from operating activities 36,314 47,659 50,261 53,799 56,033 Capital Expenditure (21,467) (22,144) (23,314) (24,681) (26,175) Change in intangibles 10,137 8,460 6,583 5,519 4,708 Change in other Assets 165 (61) (106) (124) (135) Net cash flows from investing activities (11,165) (13,746) (16,837) (19,285) (21,602) Change in current portion of long term debt (6,651) (10,529) 82,613 (83,086) (249) Change in Long term debt 9, ,132 3,305 4,439 Change in current portion of capital lease obligations (2,570) (1,982) (2,287) (1,522) (171) Change in long term portion of capital lease obligation 5, ,057 1,156 Change in other long term liabilities 9, ,035 1,209 1,322 ESOP Exercises Net cash flows from financing activities 15,246 (11,036) 84,404 (79,029) 6,504 Net increase (decrease) in cash & equivalents 40,395 22, ,829 (44,516) 40,935 Cash & equivalents at beginning of year 10,555 50,950 73, , ,141 Cash & equivalents at end of year 50,950 73, , , ,076

19 Mistras Group Common Size Income Statement Fiscal Years Ending May E 2017E 2018E 2019E 2020E Revenues % % % % % % % % Cost of Revenues 68.59% 69.40% 71.18% 69.00% 69.00% 69.00% 69.00% 69.00% Depreciation 3.38% 2.86% 2.85% 2.88% 2.82% 2.72% 2.64% 2.58% Gross profit (loss) 28.03% 27.74% 25.97% 28.12% 28.18% 28.28% 28.36% 28.42% Selling, general & administrative expenses 19.23% 19.84% 20.24% 19.75% 19.75% 19.50% 19.25% 19.25% Research & engineering 0.46% 0.48% 0.35% 0.50% 0.50% 0.50% 0.50% 0.50% Depreciation & amortization 1.66% 1.70% 1.83% 1.42% 1.15% 0.85% 0.67% 0.54% Acquisition-related costs (income), net -0.40% -0.43% -0.73% 0.00% 0.00% 0.00% 0.00% 0.00% Goodwill impairment 1.88% 0.00% 0.00% 0.00% 0.00% 0.00% Legal reserve 0.00% 0.00% 0.00% 0.00% 0.00% Income (loss) from operations 5.21% 6.14% 4.27% 6.45% 6.78% 7.43% 7.94% 8.13% Interest expense 0.62% 0.51% 0.65% 0.51% 0.54% 0.52% 0.50% 0.48% Gain (loss) on extinguishment of long-term debt 0.00% 0.00% 0.00% 0.00% 0.00% Income (loss) before provision for income taxes 4.58% 5.63% 3.62% 5.95% 6.24% 6.91% 7.44% 7.65% Provision (benefit) for income taxes 2.39% 2.01% 1.37% 2.26% 2.37% 2.63% 2.83% 2.91% Net income (loss) 2.20% 3.62% 2.25% 3.69% 3.87% 4.29% 4.61% 4.74% Less: net income (loss) attributable to noncontrolling interests, net of taxes 0.00% -0.01% 0.01% 0.00% 0.00% 0.00% 0.00% 0.00% Net income (loss) attributable to Mistras Group, Inc. 2.20% 3.61% 2.26% 3.69% 3.87% 4.29% 4.61% 4.74%