Harsco: Well-Equipped for Transition
We believe Harsco (HSC; recent price, $54), a provider of industrial services and products to the steel, energy, and infrastructure markets, is well-positioned to benefit from long-term capital spending trends around the globe in these industries.
Based on our outlook for each of Harsco's business segments, its growing order backlog, and what we see as a compelling valuation, our recommendation is strong buy. Our 12-month target price of $73 implies potential upside of 36% from recent levels.
Harsco traces its roots back to 1742, when it began as an iron-forging operation, mostly making farm tools. Since that time, the company has expanded operations into 45 countries and generates more than $3.6 billion in annual revenues.
Over the past decade, the company has focused its efforts around three business platforms: Mill Services, Access Services, and Minerals & Rail Services. At the same time, Harsco has actively been shifting the mix of its business portfolio from manufacturing toward services, reflecting trends in its end markets. Services have risen to 85% of net revenue in 2007, from 48% in 1997 and 20% in 1990. We believe the services side of the market is less volatile than manufacturing and tends to have more long-term contracts.
The Mill Services Div., at 41% of 2007 revenues, provides raw material handling, slag-pot carrying, and conveyor belt maintenance to steel mills. Harsco is considered the largest provider of outsourced services to mills, with a presence at more than 170 customer sites around the world.
The Access Services Div., which accounted for 39% of 2007 revenues, is targeted at the construction market, and rents concrete shoring and forming systems, scaffolding, and access equipment, as well as provides erecting and dismantling services. The majority of its revenues are generated in the nonresidential and infrastructure segments of the market, and come from new construction as well as maintenance activities. Harsco has a working relationship with five of the six leading global contractors.
The Minerals & Rail Services unit, providing 20% of 2007 revenues, comprises six companies operating in niche markets. In general, these companies provide services to the mineral and railroad industries, and manufacture products used by the oil and gas and industrial construction markets.
About 66% of Harsco's revenue was generated outside of the U.S. and Canada in 2007: 47% in Western Europe, 6% from Latin America, 5% from the Middle East and Africa combined, and 4% each from Eastern Europe and Asia.
We see considerable opportunity for the company to add to its services offerings and broaden its potential customer base. For example, much of the work it does at steel mills can also be useful at facilities processing other metals. We also expect an expansion in Harsco's geographic footprint, with a focus on faster-growing markets in Eastern Europe, Latin America, and Asia.
Harsco has augmented its growth over the past four years with fill-in acquisitions. In our view, these carefully screened purchases have strengthened its core business segments by adding technological expertise and new products and boosting overall scale. In turn, Harsco has been able to inject additional growth capital into the acquired businesses and sell its offerings into other territories. While we have not factored additional acquisitions into our estimates, Harsco's management has said it continues to scout opportunities.
Finally, production shutdowns in the U.S. and unusual cost items during 2007 contributed to weaker revenues and margins in the company's Mill Services Div. As production returns to normal levels, supported by ongoing strength in U.S. steel production, we see an added boost to revenues and margins.
We forecast 9% organic revenue growth during 2008, similar to the level achieved in 2007, with cross-selling initiatives in the Access Services Div. and new contract wins as the main contributors. We see much of Harsco's revenue growth coming from outside the U.S., where trends in infrastructure and industrial spending appear favorable. A review process under way in Mill Services, partly in response to the unit's 2007 underperformance, will likely prompt the exit from some low-value add contracts, in our view. Still, we expect this business unit to achieve a modest revenue gain.
As of Dec. 31, 2007, Mill Services had contracts representing more than $5 billion in future revenues, up from $4.4 billion at the end of 2006. Likewise, the order backlog in the Minerals & Rail Div. was $448 million compared to $237 million a year earlier. The largest portion of the increase in the latter is related to an order by the Chinese Ministry of Railways for track maintenance equipment and services.
We anticipate wider margins in 2008, on increased penetration of new services and a slowing in the rate of increase for fuel and steel. Further, we expect a partial margin recovery in Mill Services due to adjustments to the cost structure.
We see 2008 earnings per share of $3.50, representing an increase of 16% over the $3.01 reported in 2007. Our estimates assume Harsco makes no additional fill-in acquisitions. The company completed the sale of its Gas Technologies unit in December, 2007.
With the divestiture of its Gas Technologies unit, we believe Harsco has completed the majority of its portfolio repositioning. We now expect the company to shift its focus more toward business optimization, which includes increasing its share within current markets, expanding the geographic coverage of its existing businesses, and increasing the integration of its businesses through enterprise-resource-planning initiatives.
One area Harsco has focused on recently is the sharing of technology between its operating companies. This allows it to deepen the portfolio of services to clients in any of its markets and creates an opportunity to add new clients and build market share.
Management has set the objective of expanding the percentage of revenues from outside North America and Western Europe, where it sees higher rates of growth over the long term, to 30% of total revenues.
Underpinning Harsco's growth strategy is a strict adherence to Economic Value Added (EVA) criteria, an approach to calculating corporate performance that takes into account the cost of capital. It is a method for management to ensure a division, or a specific project, generates returns that exceed a required minimum rate of return. The company adopted an EVA structure in January, 2002. The operating margin in 2003 was 8.7%, but has since widened to 12.4% in 2007, in part due to careful allocation of growth capital, by our analysis.
The shares recently traded at a price-earnings ratio of 15.3 times our 2008 forecast of $3.50 a share. This is down from a high of 18.8 times reached in December, 2007, and is near the five-year historical average p-e multiple of 15.1 times four-quarter forward earnings (i.e., on reported earnings that have been shifted forward by 12 months). We note the S&P MidCap 400, of which Harsco is a member, recently traded at a p-e of 15.2 times expected 2008 earnings.
We apply a p-e multiple of about 21 times to our 2008 EPS forecast since Harsco has beaten the Street's consensus estimate in each of the past eight quarters. Our EPS estimate does not factor in any stock buybacks or additional acquisitions. Using the multiple of about 21 times, we arrive at a value of $75.
Our discounted-cash-flow (DCF) model calculates an intrinsic value of $70. Equally blending our relative p-e and DCF methodologies, we arrive at our 12-month target price of $73.
We have a favorable view of Harsco's corporate governance practices. All members of its board of directors must stand for reelection each year. Of the 10 members up for reelection this year, eight qualify as independent. Further, all directors had an attendance rate at board meetings exceeding 95% during 2007.
However, we would like to see a higher level of stock ownership among the directors and officers. According to the latest proxy statement, collectively, the directors and officers owned 0.99% of the shares outstanding. We note that directors are compensated with a mix of cash and stock.
Primary risks to our recommendation and target price include a greater-than-expected slowdown in industrial construction activity or annual maintenance activities, particularly in Europe. Another risk is a strengthening in the U.S. dollar relative to other currencies, as we calculate that currency conversion contributed about 5.5 percentage points of the 21.9% revenue growth achieved in 2007.
Overall, we view Harsco as a low-risk equity due to its strong market share and solid balance sheet. While we see Harsco's operations as relatively capital intensive, with capital expenditures, both maintenance and growth spending, exceeding 10% of sales in each of the past three years, it has instituted strict EVA hurdles. In our view, this reduces the risk of Harsco weakening its capital structure by investing in poor return projects or making an overly aggressive acquisition.