The Henry Fund Henry B. Tippie School of Management Sam Norman

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1 The Henry Fund Henry B. Tippie School of Management Sam Norman Mistras Group, Inc. (MG) March 1, 2017 Industrials Engineering & Construction Services Stock Rating Sell Investment Thesis Target Price $22-24 Henry Fund DCF $23.27 Henry Fund DDM $13.78 Relative Multiple $23.80 Price Data Current Price $ wk Range $ Consensus 1yr Target $26.40 Key Statistics Market Cap (M) $ Shares Outstanding (M) Institutional Ownership 64.90% Five Year Beta 1.14 Dividend Yield 0.0% Est. 5yr EPS Growth 10.51% Price/Earnings (TTM) Price/Earnings (FY1) Price/Sales (TTM) 0.95 Price/Book (mrq) 2.34 Profitability Operating Margin 6.00% Profit Margin 3.43% Return on Assets (TTM) 4.16% Return on Equity (TTM) 7.46% The Henry Fund recommends a sell rating for Mistras Group. Mistras Group is one of two major competitors in the growing Nondestructive Testing (NDT) industry and boasts the industry s most diversified revenue streams. However, the firm s persistent reliance on oil and gas customers and our expectations for weakness in oil and gas demand limit the company s upside. Drivers of Thesis We project that Mistras Group s revenues will grow at a CAGR of 3.34% over the next five years, as we believe that slow recovery in oil and gas revenues will be offset by growing demand from secondary end market industries such as industrials, power generation, process industries and public infrastructure Our model assumes that COGS as a percentage of sales will decrease by 30 basis points in each of the next five years, driven by management s commitment to waste reduction and increased automation in the company s service offerings Risks to Thesis 56% of the company s revenues were derived from oil and gas customers in 2016 and we expect the company s reliance on these customers to continue in the future We expect oil and gas revenues to decline by 4.5% in 2017 and not resume growth until 2019 Team Inc. (TISI) has surpassed MG as the industry s largest player after a series of significant acquisitions that expanded its service offerings geographically and across end market industries MG has struggled to capitalize on high growth end market industries in the last year, reporting revenue declines in industrial, power generation, process industry and public infrastructure end markets Earnings Estimates Year E 2018E 2019E EPS $0.79 $0.56 $0.86 $0.86 $0.98 $1.12 growth 91.9% -29.2% 52.0% 0.5% 13.8% 14.6% 20% 10% 0% -10% 12 Month Performance Company Description S&P 500 Source: FactSet MG Mistras Group is a global provider of technologyenabled asset protection solutions used to evaluate the structural integrity of critical infrastructure and fixed assets. The company specializes in providing nondestructive testing (NDT) services, which allow assets to be examined without compromising their future usefulness. The firm relies heavily on oil and gas customers for its revenues, but also receives revenues from other end market industries including power generation, public infrastructure, industrial and aerospace and defense. M A M J J A S O N D J F MG Industry Sector P/E ROE EV/EBITDA Source: Bloomberg

2 EXECUTIVE SUMMARY We recommend a sell rating for Mistras Group common stock based on a target price of $ Mistras Group is one of two major players in the North American NDT market, competing mainly against Team Inc. (TISI). The company has exposure to end market industries with high growth potential in the coming years, such as industrial, power generation, public infrastructure and aerospace and defense. However, the firm recently lost its position as an industry leader, faces declining demand from oil and gas customers and has failed to achieve growth in key secondary end markets in the last year. Despite serving a more diversified group of customers than its closest publicly-traded competitor, Mistras Group is still reliant on the oil and gas industry for over half of its revenue. Oil and gas revenue is expected to suffer in fiscal 2017 due to weakness in oil markets that persisted until calendar The company is also expected to suffer from the emergence of Team Inc. as the dominant industry participant, particularly in the oil and gas segment. We expect that Mistras Group s revenue from oil and gas customers will not return to growth until 2019, which significantly limits the firm s near-term growth potential. COMPANY DESCRIPTION Mistras Group is a leading global provider of technologyenabled asset protection solutions and offers customers a single-source asset protection provider. The company combines products and technologies in mechanical integrity, destructive testing and predictive maintenance solutions. However, the foundation of Mistras Group s business is nondestructive testing (NDT), which is the examination of assets without impacting current and future usefulness or impairing the integrity of these assets. When used effectively, NDT can help customers comply with governmental safety and environmental regulations, extend the useful life of assets, increase productivity, minimize repair costs, manage risk and prevent catastrophic infrastructure failures. 2 Operating Segments The company divides its operations into three reportable segments: services, products and systems and international. In 2016, Mistras Group reported approximately $720 million in total revenues. The following chart shows the company s 2016 revenue broken down by operating segment: 2016 Revenues ($719.2M) by Operating Segment Source: MG K The company s services segment provides asset protection services in North America, mainly in the United States. These services consist primarily of NDT inspection and engineering services that are used to evaluate the structural integrity and reliability of critical energy, industrial and public infrastructure. The company offers traditional and advanced NDT services. Traditional NDT uses mainly qualitative testing methods to detect defects in tested materials. Advanced NDT services employ automated digital sensor technologies accompanied by enterprise software, allowing customers to capture, store, analyze and report inspection and engineering results electronically and in digital formats. 2 The products and systems segment designs, manufactures, installs and services the company s asset protection products and systems predominantly in the United States 2. Mistras Group s international segment offers services and products and systems to global markets, including Europe, the Middle East, Africa, Asia and South America 2. Target Markets International 20% Products and Systems 4% Services 76% Services Products and Systems International For forward-looking estimates and valuation, we examined the company s operations primarily through its target end markets. The following chart shows Mistras Group s revenues in each target market as a percentage of total revenues in fiscal 2016: Page 2

3 Source: Mistras Group K Revenues from each target market are driven by unique business and economic factors. Oil & Gas In Mistras Group s 2Q 2017 earnings call on January 5 th, 2017, management s guidance indicated that they expect fiscal year total revenues to come in at or slightly below $720 million 4. This projection is primarily based on expectations for shrinking oil and gas revenues throughout the fiscal year, as the firm has experienced lagging oil and gas demand after the low oil price environment that persisted until calendar Our model projects that total revenues will decrease by 0.50% to approximately $716 million in fiscal 2017, driven primarily by shrinking revenues from oil and gas customers. Our model assumes that oil and gas revenues will contract by 4.5% in fiscal Our model also assumes that oil and gas revenues will stabilize in fiscal 2018 with 0% growth and return to growth at 3% in 2019, 5% in 2020 and 4% in Aerospace & Defense Oil & Gas Revenue Aerospace & Defense Revenue % 20% 10% 0% % 100% 50% 0% % Oil & Gas Revenues YoY Growth Aerospace & Defense Revenue YoY Growth Source: MG Annual Reports, Henry Fund Estimates Oil and gas revenues accounted for roughly 56% of Mistras Group s revenues in 2016 after growing 8.89% over the prior year. 2 Oil and gas revenues have grown at a CAGR of 14.29% over the last five years. Oil and gas businesses are asset-intensive and must adhere to strict infrastructural requirements mandated by regulatory agencies that require the use of NDT services. In general, oil and gas revenues are tied to movements in oil prices and drilling activity. Oil prices fell precipitously from over $100 per barrel in mid-2014 to roughly $35 by the end of This drop in oil prices was accompanied by decreased drilling activity. Oil prices rebounded beginning in 2016 and currently sit at roughly $54 3. We predict that oil prices will remain stagnant in the next 6 months and stabilize at around $60/barrel by the end of 2018 (see economic factors for more detailed oil price and drilling projections). Page 3 Source: MG Annual Reports, Henry Fund Estimates Aerospace and defense revenues grew 1.11% in fiscal 2016 and boast a 5-year CAGR of 38.51%. 2 The aerospace and defense industry is subject to strict quality control requirements to ensure the safety, reliability and structural integrity of aircraft. Aerospace and defense customers primarily use NDT services to perform inspections upon delivery and during the operational service of aircraft. Aerospace and defense firms also use NDT services to test raw materials for structural deficiencies, which is becoming a more common application as firms experiment with advanced materials, including synthetics and composites, in manufacturing. 2 Applications for NDT services in the aerospace and defense industry are expected to continue growing due to increasing use of synthetics and composites in the manufacturing process, as well as the growth of advanced NDT systems that allow aircraft to be monitored for

4 structural integrity and performance in real time. Our model predicts that aerospace and defense revenues will grow by 5% in 2017, 6% in 2018, 7% in 2019 and 2020 and 5% in Industrials Industrial Revenue Power Generation & Transmission Power Generation & Transmission Revenue % 20% 50 0% 0-20% % 50% 0% -50% Power Generation & Transmission Revenue YoY Growth Source: MG Annual Reports, Henry Fund Estimates Industrial Revenue YoY Growth Source: MG Annual Reports, Henry Fund Estimates Industrial revenues shrunk by 17.27% in fiscal 2016, as overall industrial production shrunk throughout the year after peaking near the end of fiscal 2015 (see economic outlook section for more information on industrial production). However, the company s industrial revenues have grown at a 5-year CAGR of 22.25% since Industrial revenues are driven by the industry s quality control requirements that require low defect rates when using automated robotic equipment. These quality control requirements are especially stringent in automotive, consumer electronic and medical manufacturing. We believe that future growth in this segment will come from increasingly stringent quality control requirements, as well as the growing prevalence of robotics in the manufacturing processes 5. Power generation and transmission revenues declined by 10.12% in fiscal 2016, driven primarily by the low commodity price environment experienced by customers throughout the year 2. However, power generation and transmission revenues have grown at a 5-year CAGR of 13.55% since The power industry has traditionally used asset protection to inspect piping, boilers, rotating equipment and other plant components for nuclear and fossil-fuel based power plants. Demand from this segment is expected to grow as critical power generation and transmission infrastructure continues to age. For instance, the average age of a nuclear power plant in the United States is over 30 years. 2 The following chart gives more detail about the age of power generation infrastructure in the United States as of the U.S. Energy Information Administration s most recent infrastructure age study in 2012: Our model predicts that revenue from industrial customers will return to modest growth in 2017 at a rate of 3%. After fiscal 2017, our model assumes 4% growth in 2018, 6% growth in 2019 and 2020 and 4.5% growth in Source: U.S. Energy Information Administration Page 4

5 The power generation and transmission segment also has the potential to grow in the future due to growing demand for energy in emerging economies such as China and India. 2 Our model predicts that power generation and transmission revenues will return to growth at 4% in fiscal Our model also assumes that power generation and transmission end market revenues will grow by 5% in 2018, 6% in 2019, 5% in 2020 and 4.5% in Other Process Industries Other Process Industries Revenue Other Process Industries Revenue YoY Growth 40% 20% 0% -20% -40% Source: MG Annual Reports, Henry Fund Estimates Infrastructure, Research & Engineering Infrastructure, Research & Engineering Revenue Infrastructure, Research & Engineering Revenue YoY Growth 50% 0% -50% Source: MG Annual Reports, Henry Fund Estimates Infrastructure, research and engineering revenues shrunk by 19.11% in fiscal 2016 but have grown at a 5-year CAGR of 11.19% since Asset protection solutions are increasingly used throughout the construction of new public infrastructure and to monitor the structural integrity of existing public infrastructure. The following chart illustrates the phenomenon of aging public infrastructure in the United States: Revenues from other process industries shrunk by 21.36% in fiscal 2016 due to low commodity prices and weaker industrial activity than in fiscal However, revenues from other process industries have grown at a 5-year CAGR of 10.56% since Process industries are those in which raw materials are tested or prepared for a series of stages, including chemicals, pharmaceuticals, food processing, paper and pulp and metals and mining. These facilities require significant spending on maintenance and monitoring. Process industry revenues are expected to continue growing as firms are facing high utilization rates, growing capacity constraints and increasing capital costs. Our model predicts revenue from other process industries will grow by 4% in fiscal 2017, 4% in 2018, 6% in 2019 and 2020 and 4.5% in Page 5 Source: Bureau of Economic Analysis As infrastructure ages, the need for NDT services increases to keep infrastructure functional and safe for the public. President Trump campaigned on a promise to rebuild America s crumbling infrastructure, but has yet to lay out a firm plan of action. Trump s advisors have indicated that an eventual agreement between the President and

6 Congress could budget up to $1 trillion to rebuild America s roads, bridges, airports, etc. 6 However, this proposal will likely face bureaucratic delays and is still far short the American Society of Civil Engineers estimate of $3.6 trillion needed to maintain American infrastructure by Therefore, we predict that infrastructure will continue to age in the years to come, which suggests that the demand for NDT services will continue to increase from public infrastructure related testing. Our model predicts that infrastructure, research and engineering revenues will achieve 5% growth in fiscal 2017, 6% growth in 2018 and 2019, 5% in 2020 and 4.5% in All Other Source: MG Annual Reports, Henry Fund Estimates Revenues from all other end market industries grew by % in fiscal 2016 and have grown at a 5-year CAGR of 16.26% since We expect this segment to continue growing rapidly in the future as new applications for NDT continue to be discovered in a broad range of end market industries. Therefore, all other revenue is expected to grow at 8% from 2017 through 2020 and 6% in Q Earnings All Other Revenue All Other Revenue YoY Growth RECENT DEVELOPMENTS 150% 100% 50% 0% -50% -100% On January 4 th, 2017, Mistras Group reported EPS of $0.26 for the second quarter of 2017, down from $0.39 last year. Analysts were expecting EPS of $0.31. The company reported revenues of $ million, down from $ million last year. Analysts were expecting revenues of $ million. 3 Management cited challenging market conditions imposed by low oil prices as the main reason for its disappointing Q2 results. 4 Management also provided revenue guidance of $720 million or slightly below for the full year ended May 31 st, Despite its Q2 underperformance, the company s gross profit margins exceeded prior year levels for the sixth consecutive quarter, growing roughly 30 basis points over the prior year s results. Management reiterated its focus on reducing costs by eliminating wasted time, wasteful process or wasteful managers who choose not to focus on either of these priorities. 4 Management also noted that long-term outlook continues to be promising, as customer assets are aging, inspection and maintenance needs are growing and projects that were initially deferred cannot be deferred indefinitely. 4 We predict that the company will continue to suffer from weak oil and gas demand throughout the rest of fiscal Therefore, our model projects that the company s revenues will total roughly $716 million in fiscal 2017, an annual decrease of 0.50%. Our model also incorporates our expectations that margins will continue to expand moving forward. We expect COGS as a percentage of sales to decrease by 30 basis points in each of the next five years, as the company continues its efforts to eliminate wasteful processes and reduce wage expense by automating a larger portion of its service offerings. Our expectations for 30 basis point annual margin expansion are in line with the firm s recent history of margin growth. Rising Cost of Capital INDUSTRY TRENDS Federal Reserve officials have hinted at three rate hikes throughout While rates were left unchanged in the Fed s first meeting of 2017, the FOMC acknowledged rising business and consumer confidence following the election of Donald Trump as president and reiterated its expectations that rates will rise gradually in We expect rates to remain relatively unchanged over the next 6 months, but foresee 2-3 hikes in the Fed Funds rate by the end 0f 2018 that would bring the target Fed Funds rate between 1% and 1.25%. Rising rates increase firms cost of capital and discourages capital outlay for new equipment and infrastructure. This trend bodes well for Mistras Group and other NDT service providers, as the demand for NDT services stands to increase with more firms seeking avenues to increase the livelihood and utilization rates of aging fixed assets. In Page 6

7 many cases, NDT services can serve as an intermittent capital expenditure to avoid the costly purchase of entirely new infrastructure. M&A Growth Users of NDT technology have become increasingly likely to seek a one source provider of asset protection solutions. Although this shift began in the early 1990s, it has accelerated in recent year. More and more firms are seeking out NDT service providers that can not only provide testing capabilities, but can also provide enterprise software that allows testing results to be captured, stored, analyzed and reported in a single electronic format. As more advanced testing solutions take hold, vendors offering broad, complete and integrated services will continue to grow their competitive advantage 2. In line with this trend, existing players in the NDT services industry have sought out growth through acquisitions of smaller NDT providers serving unique geographic regions or niche markets. Team, Inc. recently surpassed Mistras Group as the industry s largest player with a pair of significant acquisitions. Team acquired Qualspec Group in July 2015 for $255 million and, in February of 2016, completed a merger with Furmanite Corporation in which Team acquired all outstanding shares of Furmanite Corporation for $355 million 9,10. Mistras has had less significant acquisition activity, acquiring two companies in fiscal 2016 and four companies in fiscal 2015 for a total of only $37.6 million 2. Both firms list acquisitions as a major source of growth moving forward, which indicates that this trend will continue in the coming years 2,10. Our expectation of rising interest rates poses a threat to rapid industry consolidation through M&A. Rising rates increase the cost of borrowing and can affect the value of M&A deals, especially if the deals are being financed with debt. However, we believe that the fragmented nature of the NDT industry will continue to provide ample opportunity for consolidation in the coming years as larger firms seek to diversity revenue streams geographically and across end market industries. Technological Innovation We believe that technological innovation will drive future growth by making NDT safer, more effective and more cost conscious. The biggest factor to monitor regarding technological innovation is automated NDT technology decreasing the need for skilled technicians, whose wages increase prices and cut NDT profit margins. Currently, wages account for a significant portion of operating expenses for NDT service providers, as demonstrated in the chart below: Source: IBISWorld The industry is currently experiencing reduced need for skilled technicians due to decreased demand from the oil and gas industry. However, industry competitors face the threat of wage pressure and increased labor costs as the demand for NDT services, and therefore the need for skilled technicians, increases 2. We believe that NDT service providers will be subject to increased labor costs in the coming years because of growing demand for NDT services. However, we also believe that technological innovations leading to automated services will allow competitors to maintain or even slightly expand operating margins in the coming years as the industry s reliance on wage labor becomes less profound. In the case of Mistras Group, we believe that the company s cost-cutting measures and growing automated service offerings will allow for annual margin expansion of 30 basis points despite expectations for slightly rising labor costs. The evolutionary nature of NDT also gives an advantage to more established industry players with strong customer relationships, significant R&D spending and existing proprietary technologies. Companies such as Mistras Group and Team Inc. are in the best position to take advantage of technological advances and product improvement in the NDT space. Page 7

8 Large and diversified firms will also have an advantage in capturing market share of new and emerging end market industries. These companies have the potential to leverage their intellectual property, reputation and a broad range of products and services to appeal to first time users of NDT technology. MARKETS AND COMPETITION NDT service providers operate in a competitive, but highly fragmented, market. Few providers offer a broad range of NDT services across expansive geographic regions. Instead, many competitors offer unique or specialized services focused on a niche market or geographic region. The following chart shows the market share, as a percentage of total industry revenues, of the three major players in the industry compared to all other operators: Source: IBISWorld As demonstrated by the chart above, the three largest players in the industry are Mistras Group, Team Inc. (TISI) and Rockwood Service Corporation (privately held). These three firms account for nearly half of NDT revenues. In fact, this number has increased after Team s significant acquisition of Furmanite in the current fiscal year. We expect industry concentration to grow in the years to come, as consolidation and technological advancement will benefit large and diversified NDT service providers. In the current NDT market, service providers often compete on specialty due to the dynamics of the industry and its host of small, niche, operators. Outside of specialty, traditional NDT providers compete mainly on project management and execution, price, reputation and quality. In the advanced NDT market, reputation, quality and firm size are more important than price 2. NDT firms typically enter into service agreements with customers that may be terminated by either party on short notice 9. Competing firms also enter into a select number of long-term contracts. However, these long-term service agreements constitute a smaller portion of revenues and typically involve engineering and manufacturing of custom products and services 2. Therefore, much of a firm s success depends on its ability to consistently manage projects in a timely and cost effective manner. Barriers to Entry One barrier that new entrants face in the NDT industry is the need to develop or acquire significant technology to compete against more established industry participants. These technologies, particularly those needed to deliver advanced NDT solutions, often develop over several years of customer engagement and R&D. Proprietary technologies used by established industry participants can greatly enhance the accuracy and timeliness of testing results. When conducting NDT testing, firms must also have a knowledge and understanding of complex safety codes and regulations that affect testing as well as the end market industry. In many cases, NDT firms and technicians must go through extensive certification and licensing processes to ensure their understanding of these safety codes. Furthermore, large customers want NDT testing administered by companies with an established reputation and with whom they have conducted business in the past 2. These factors contribute to the already strong barriers to entry that result from the value of proprietary technology in the market for NDT services. Life Cycle Stage We expect the NDT industry to grow at a 4.0% CAGR over the next five years that will slightly outpace annual GDP growth 1. Recent industry growth has been accompanied by consolidation, which is a trend we expect to continue in the near term. In particular, the demand for advanced NDT services is growing rapidly, as its widespread benefits are being realized by consumers from a broad range of end market industries. The high-growth stage of advanced NDT technology is evidenced by the fact that firms compete on the quality of the service offering and company reputation more than the price of the service itself 2. We expect advanced NDT to be a strong contributor to the NDT services market outpacing GDP over the next five years. Industry Outlook We believe that oil and gas customers will continue to be the industry s main source of revenue over our five-year Page 8

9 forecast horizon. We believe that oil and gas revenues will stabilize in calendar 2018 and contribute modest growth in the years to follow. We expect the most significant growth in NDT services industry to come from secondary markets such as public infrastructure, power generation, industrials and aerospace and defense. We believe that each of these end market industries have the potential for mid to high single-digit growth over the next five years. While the exact future of regulation is always uncertain, we believe that the general trend towards increasing regulatory standards for the health, safety and the protection of the environment will bolster the demand for NDT services. We also expect demand for NDT services to continue growing because of more complex infrastructure and the need to test for the reliability of more advanced machines, automobiles, and airplanes employing a wide variety of synthetic raw materials. Lastly, as public infrastructure continues to age, we believe that NDT will play an increasing role in monitoring for potentially harmful defects and preventing infrastructural failure. Large NDT service providers with diversified geographic and service offerings are in the best position to take advantage of growth in the broader NDT market. These firms will benefit from proprietary technologies, stronger R&D, prior relationships with customers and the ability to offer a multitude of NDT solutions to customers. The advantage of the largest NDT service providers will continue to grow as these firms consolidate small competitors and expand integrated service offerings and geographic reach. Peer Comparisons The NDT services industry is extremely fragmented, with over 1,600 providers. However, most of these providers offer specialized or localized services 1. There are very few firms that offer broad coverage in terms of product and service offerings, as well as geographic reach. The three largest players in the North American NDT market are Mistras Group, Team Inc. and Rockwood Services Group. These firms offer NDT services to a broad range of end market users throughout the United States and abroad. Of these three competitors, Mistras Group and Team Inc. (TISI) are the only two that are publicly traded in the United States. The following chart shows the performance of each firm s stock over the past year: 50% 30% 10% -10% MG TISI M A M J J A S O N D J F Source: Yahoo Finance When comparing Mistras Group and Team, Inc. it is evident that Team is more reliant on oil and gas revenues than Mistras Group. The following chart shows Team s revenues by target market industry in the partial fiscal year from June 1 st until December 31 st, 2016 (Team is currently in the process of transitioning to a December 31 st fiscal year-end): Source: Team, Inc Investor Presentation Team generated roughly 70% of its revenues from oil and gas customers in its most recent partial fiscal year, while Mistras Group relied on oil and gas customers for roughly 56% of revenues in fiscal ,11 Team s exposure to the oil and gas industry makes the firm and its value more reliant on the state of oil and gas markets. Important operating and valuation statistics for Mistras Group and Team can be found in the following charg (all figures are on TTM basis): Page 9

10 MG TISI Operating Margin 4.98% 2.48% Profit Margin 2.93% 1.08% Return on Assets 4.16% 1.45% Return on Equity 7.46% 2.81% P/E EV/EBITDA Source: Bloomberg As evident in the chart above, Team has lagged behind Mistras Group in operating performance over the last twelve months due to the firm s heightened reliance on oil and gas customers. In calendar 2016, oil and gas revenues began to experience the effects of weak oil and gas markets throughout Both Mistras Group and Team Inc. have seen oil and gas revenues underperform throughout calendar 2016 and fiscal However, Team s increased reliance on the oil and gas sector caused its operating performance to suffer more than that of Mistras Group. Despite its recent struggles, Team has excited investors with a pair of significant acquisitions. The company s $255 million acquisition of Qualspec in mid-2015 and its $355 million acquisition of Furmanite in 2016 generated significant momentum for the company s stock. While Mistras Group used to be the biggest player in the asset protection industry, these acquisitions have helped Team s market cap grow to over $900 million. 3 Within the asset protection and NDT industries, a firm s portfolio of intangible assets is extremely important in its ability to provide high-quality and differentiated services. Prior to Team s recent acquisitions, the company carried only $20.27 million of intangible assets on its balance sheet. 9 This number has grown substantially after Team s acquisitions of Qualspec and Furmanite. The following chart compares the current intangible asset portfolios of Mistras Group and Team Inc. (all figures in $M): MG TISI Customer Relationships Software/Technology Non-Compete Agreements Other Total Intangible Assets Source: MG and TISI Q Q Team s intangible asset growth has largely been the result of acquiring significant customer relationships from Qualspec and Furmanite. These relationships are important due to customers desire to receive NDT services from a trusted provider, as well as the crossselling capabilities of the industry s one source asset protection providers. Another important piece of a firm s intangible asset portfolio is its proprietary technology, as enterprise software is often the point of differentiation between two competing firms. Despite its smaller size, Mistras Group boasts more valuable proprietary software and technology. Mistras Group has routinely invested $2.5-3 million annually into research and development efforts, while TISI does not provide specific information about its R&D budget in its annual reports. 2,9 Overall, Mistras Group appears to be better positioned to navigate various economic environments than Team due to its more diversified revenue streams and valuable proprietary technology. We believe that Mistras Group is less risky than Team moving forward because of these factors, which is confirmed by Team s five-year weekly beta of 1.28 and its two-year weekly beta is 1.40 (as compared to Mistras Group s five-year weekly beta of 1.14 and its two-year weekly beta of 1.23). We also believe that the firm s secondary end market industries present better growth opportunities for NDT than the oil and gas industry if the company can grow its market share in these industries. However, Team s recent acquisitions have created a firm with significant earnings power if our expectations for renewed oil and gas demand by 2018 come to fruition. We are also concerned about Mistras Group s ability to capture renewed growth from oil and gas customers due to the recent expansion of Team s business and customer base. Nevertheless, we believe that Mistras Group is in the best position to take advantage of NDT industry growth in the years to come by serving a broader range of end market industries. ECONOMIC OUTLOOK Mistras Group faces pressure from numerous economic factors, including interest rates, oil prices, oil rig counts, GDP growth, unemployment and industrial production. Page 10

11 Interest Rates Oil Prices Source: Federal Reserve Economic Data (FRED) While interest rates remain low relative to historical figures, rates have been trending upward over the last year with a current target Fed Funds Rate of 0.50%-0.75%, a current T-bill yield of 0.92% and a current 10-year T-Bond yield of 2.46%. We expect rates to remain relatively stagnant in next six months. However, we expect 2-3 rate hikes over the course of the next two years that will bring the target rate between 1% and 1.25%. We expect T-Bill yields to increase to roughly 1% over the next two years while we expect 10-year T-Bond yields to increase to roughly 2.8%-2.9% during that same period. In general, rising interest rates pose a threat to the cyclical industrials sector. However, we believe that Mistras Group and other NDT service providers are slightly insulated from this risk. Rising rates generally lead to delayed capital expenditure and companies looking for ways to improve asset performance and livelihood without significant capital outlay. Therefore, we believe that the NDT industry is in better position to navigate a rising rate environment than more traditional industrial firms. Source: Nasdaq Crude oil prices rebounded slightly in 2016, after a precipitous fall spanning from mid-2014 through We expect crude oil prices to remain near $55 per barrel in the next 6 months. However, we expect a slight increase in price to $58-60 per barrel over the next two years driven primarily by OPEC supply cuts. Increasing oil prices are a positive sign for MG, as roughly 56% of the company s revenues come from oil and gas customers. Higher oil prices incentivize increased production that ultimately leads to wear and tear on oil and gas infrastructure. Oil Rig Count Source: Baker Hughes Page 11

12 As of Feb. 3 rd, 2017, the US oil rig count reached its highest level since October of This comes after nine months of recovery in drilling activity, aided by OPEC s decision to cut supplies last November 12. Increasing drilling activity is a positive sign for the NDT industry, as drilling activity leads to wear and tear on capital assets and ultimately the use of NDT services by oil and gas firms. Increased oil drilling also leads to more demand for NDT services further downstream. We believe that drilling activity will level off in the near term, but increase slightly over the next two years in line with oil price appreciation. We also believe that the NDT services industry stands to benefit from new pipeline projects, such as the Dakota Access and Keystone XL oil pipelines, launching in the coming years. Because of these factors, we believe that the NDT industry will begin to recover some of the revenues that were lost from oil and gas customers during 2016 by GDP Source: FRED U.S. GDP grew at an annual rate of 1.9% in the fourth quarter of 2016 after a promising 3.5% annualized growth rate in the third quarter of All told, U.S. GDP grew at an estimated annual rate of 1.6% in 2016, its worst performance since Slow economic growth was caused primarily by weak oil prices, a strong dollar and efforts by businesses to reduce a large inventory overhang 13. We believe that GDP growth will improve to an annualized rate of 2.5%-3% in the next six months and an annualized rate of 3%-3.5% in the next two years. This prediction is driven primarily by expectations for a more businessfriendly tax code, relaxed regulation and improving consumer confidence. Unemployment Source: FRED Unemployment rates have been steadily dropping in recent years and currently sit around 4.7% 14. We expect unemployment rates to remain relatively flat in the foreseeable future, as improving GDP growth continues to be met with interest rate hikes. NDT service providers are affected by unemployment rates in the form of wages paid to employees. As mentioned, wages are a key input in the delivery of NDT services given the training and certification process necessary to become a technician for certain NDT service offerings. As unemployment remains at relatively low levels, Mistras Group may face wage pressure from skilled laborers. However, we believe that this threat is somewhat mitigated by the shift to more automated NDT services in the future. Furthermore, increased revenues from advanced NDT services stand to increase the firm s margins and make up for any increases in wage expenses. Page 12

13 Industrial Production Source: FRED Industrial production peaked in mid-2015, but has remained relatively strong since. However, industrial production levels face the threat of rising interest rates in the years to come that could slow the economy and decrease asset utilization. Further decreases in industrial production could hurt NDT revenues from industrial or other process oriented industries. CATALYSTS FOR GROWTH Oil prices rising above our two-year target of $60 per barrel would be extremely beneficial for MG and other industry participants, as demand from oil and gas customers would return stronger than expected Rising interest rates stands to decrease the amount of firms investing in new infrastructure and increase demand for intermittent asset protection solutions MG has the potential for margin growth based on its growing advanced NDT services offerings and increased automation that will reduce the firm s reliance on skilled labor, as well as management s commitment to expanding margins through costcutting INVESTMENT POSITIVES The NDT industry is expected to grow at a CAGR of 4.0% over the next five years MG is the most diversified of the industry s two largest competitors based on current revenue streams We believe that MG s secondary revenue streams have greater growth potential than oil and gas revenues, which benefits more diversified providers INVESTMENT NEGATIVES 56% Mistras Group s revenues currently come from oil and gas customers, which makes the company susceptible to any significant downturn in oil and gas markets Demand from oil and gas customers is projected to decrease in fiscal 2017 and oil and gas revenues are not expected to resume growth until fiscal 2019 MG has underperformed in key growth end markets, including industrial, power generation, process industries and public infrastructure The industry s reliance on M&A activity for growth becomes risky if firms are unable to find suitable acquisition targets. MG has also significantly lagged behind its major competitor, Team Inc., in acquisition activity in the last two years. VALUATION Revenue projections for fiscal 2017 are based on management s revised guidance of revenue near or slightly below $720 million. Oil and gas revenues are the main driver of the expected decrease in revenue in fiscal Oil and gas revenues are expected to decrease 4.5% in 2017, remain stagnant in 2018 and return to modest 3-5% growth throughout the remaining forecast horizon. Other end market industries are projected to grow more rapidly in accordance with expectations described earlier in this report. Cost of goods sold is expected to decrease as a percentage of sales by 30 basis points in each of the next five years, resulting in a total decrease of 150 basis points by the end of This projection is based management s commitment to cost-cutting, expectations for growth in advanced NDT services that command higher margins, as well as increased automation decreasing wage expense. The firm is expected to invest in capital expenditures at a rate of 3% of annual revenues throughout the forecast horizon. This figure is the midpoint of management s expectations of capex at a rate of 2-4% of annual revenues given in the company s K. Our model projects that MG will repurchase $12 million of common stock in fiscal 2017 and fiscal 2018, respectively. The company has announced and begun its plans to repurchase up to 1 million shares from its chairman and CEO, Dr. Soritios Vahaviolos, totaling up to $2 million in Page 13

14 repurchases per month. 15 Vahaviolos has voiced his desires to diversify his net worth, as the original owner of Mistras Group still holds roughly 38% of the company s outstanding shares. MG s cost of equity was estimated based on the CAPM. The 30-year U.S. Treasury Bond was used as a proxy for the risk-free rate. The T-Bond yield currently sits at 3.05%. A beta of was used in the cost of equity calculation, which is MG s 5-year weekly beta. The company s 2-year weekly beta of was also considered as a possible input. However, uncertainty in oil markets over the last two years resulted in a two-year beta that is not reflective of the firm s risk in a normal economic environment. Our model also incorporates a market risk premium of 4.8%, which reflects our expectations of forward-looking market conditions. Because MG does not have public debt outstanding, the firm s cost of debt was estimated by adding a synthetic spread of 1.5% to the risk-free rate. This synthetic spread was determined based on the long-term borrowing costs of firms with betas similar to that of Mistras Group. Our model assumes a 3% terminal growth rate of NOPLAT. This growth rate was chosen based on long-run GDP growth expectations. Our DCF model results in a target price of $23.27 based on the assumptions outlined above. We believe that the DCF model gives the best estimate of the intrinsic value of Mistras Group stock. Our dividend discount model results in a target price of $ However, we believe that the DDM does not give the best possible estimate of the firm s intrinsic value because MG has not paid dividends in the past and has no plans to do so in the near future. Relative valuation yields a target price of $23.80 based on the firm s peer group. However, we believe this model is difficult to rely on because Mistras Group has few, if any, pure-play competitors with which to compare the firm. Sensitivity analysis shows that our target price is highly dependent on our CV NOPLAT growth assumptions, margin assumptions, cost of equity assumptions and capex assumptions. We believe that our NOPLAT growth assumptions are reliable given historical growth rates of the U.S. economy. We believe that our choice of beta most accurately reflects the firm s risk moving forward and our expected market risk premium is reasonable based on historical levels and the current state of the U.S. economy. Lastly, we believe that our 3% capex assumption will prove to be accurate based on management s guidance of capex at a 2-4% rate in the future. Our target price of $22-24 is slightly below the analyst consensus target price of $ Some analysts predict faster recovery in oil and gas revenues, as well as margins improving on a slightly larger scale. However, we believe that our growth and profitability estimates are appropriate given our company, industry and economic expectations. KEYS TO MONITOR Over half of Mistras Group s revenues come from oil and gas customers, so oil prices are a key factor to monitor going forward. While we believe that oil prices will inch closer to $60 per barrel over the next two years, any significant decrease in the price of oil will hurt revenues for NDT service providers. Conversely, a significant increase in oil prices above our $60 per barrel expectations will likely drive accelerated revenue growth. Infrastructure spending should also be monitored in the coming years. NDT services are expected to grow in this segment due to the trend of aging public infrastructure but Mistras Group s infrastructure revenues declined in Returning to growth in this market, as well as other secondary end market industries, will help the firm s profitability immensely. Investors should also monitor capital expenditure trends in industrial and power generation markets, as increased capital expenditure for new infrastructure and machinery would likely hurt MG s revenue from these industries. Lastly, investors should monitor the progress of NDT growth in new and emerging end market industries. For instance, growth in areas such as aerospace and defense, manufacturing and medicine is important to diversify revenues and reduce Mistras Group s future reliance on oil and gas customers. REFERENCES 1. IBISWorld Industry Report, Nondestructive Testing Services in the U.S. 2. Mistras Group K 3. Bloomberg 4. Mistras Group Q Earnings Call Page 14

15 5. The Wall Street Journal: Meet The New Generation of Robots for Manufacturing 6. Bloomberg: FedEx Pushes for Infrastructure as Trump Weighs Investment 7. American Society of Civil Engineers: American Infrastructure Report Card ( 8. Bloomberg: Fed Nods to Improving Sentiment While Leaving Rates Unchanged 9. Team, Inc KT 10. Team, Inc. Investor Relations Release (11/2/2015) 11. Team, Inc Investor Presentation 12. Reuters: U.S. Oil Rig Count Rises to Highest Since October Yahoo Finance: U.S. Economy Slows on Wider Trade Gap; Business Spending Rises 14. Federal Reserve Economic Data (FRED) Federal Reserve Bank of St. Louis 15.Mistras Group Q Earnings Press Release 16. U.S. Energy Information Administration Current Capacity by Initial Year of Operation and Fuel Type 17. Baker Hughes: The Baker Hughes Oil Rig Count 18. Nasdaq: WTI Crude Oil Price Chart 19. FactSet 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. Page 15

16 MISTRAS Group, Inc. Revenue Decomposition Fiscal Years Ending May 31st E 2018E 2019E 2020E 2021E Oil & Gas YoY Growth 15.44% 21.07% 8.89% -4.50% 0.00% 3.00% 5.00% 4.00% Power Generation & Transmission YoY Growth 32.51% 14.08% % 4.00% 5.00% 6.00% 5.00% 4.50% Other Process Industries YoY Growth 17.79% 14.08% % 4.00% 4.00% 6.00% 6.00% 4.50% Industrials YoY Growth 7.98% 14.08% % 5.00% 6.00% 6.00% 5.00% 4.50% Infrastructure, Research & Engineering YoY Growth -1.84% 14.08% % 5.00% 6.00% 6.00% 5.00% 4.50% Aerospace & Defense YoY Growth 39.21% 5.31% 1.11% 5.00% 6.00% 7.00% 7.00% 5.00% All Other YoY Growth 17.79% % % 8.00% 8.00% 8.00% 8.00% 6.00% Total Revenue Yoy Growth 17.79% 14.08% 1.11% -0.35% 2.64% 4.65% 5.48% 4.38% Segment Percentage of Total Revenue Oil & Gas 49.00% 52.00% 56.00% 53.67% 52.29% 51.46% 51.23% 51.04% Power Generation & Transmission 9.00% 9.00% 8.00% 8.35% 8.54% 8.65% 8.61% 8.62% Other Process Industries 9.00% 9.00% 7.00% 7.31% 7.40% 7.50% 7.53% 7.54% Industrials 11.00% 11.00% 9.00% 9.48% 9.79% 9.92% 9.87% 9.89% Infrastructure, Research & Engineering 5.00% 5.00% 4.00% 4.21% 4.35% 4.41% 4.39% 4.39% Aerospace & Defense 13.00% 12.00% 12.00% 12.64% 13.06% 13.35% 13.54% 13.62% All Other 4.00% 2.00% 4.00% 4.34% 4.56% 4.71% 4.82% 4.89%