DIRTT Environmental Solutions: Waiting For The Right Time To Buy In

This kicks off our pipeline of 2014 posts on UI, including several internship reviews, additional educational posts, and a special primer on the financial technology sector.

We mark our return with a thoughtful, in-depth analysis of DIRTT Environmental Solutions (TSX: DRT) by guest contributor Amir Ahmad. We’re thrilled for this feature because it will introduce our readers to the challenging yet enjoyable research that goes into a professional investment thesis. This is a critical skill in the finance world so we’re glad Amir took the time to post this. Enjoy!

Summary

  • I rate DIRTT Environmental Solutions (DRT-TSX) as neutral with a $4.20 price target, an 18% upside, due to my belief of a mismatch in its risk-reward profile.
  • I would wait for a pullback (of ~12%) prior to investing in this name (barring any changes in fundamentals).
  • DIRTT is a technology-driven manufacturer – with a focus on prefabrication and modularization interior construction. Its core advantage is its proprietary software, ICE.
  • ICE is an unrivaled software which handles the entire construction process, from sales to installation (barring manufacturing). DIRTT is taking on shortcomings in the traditional construction industry.
  • After finalization of an order, the company can manufacture and install its interior solutions within 3 weeks typically. The firm is well-capitalized.

Report Priced as of September 24, 2014
Latest Stock Close: $3.55 (TSX: DRT)

Rating & Target: Neutral, $4.20
Risk: High

Executive Summary

The construction industry has long been plagued with inefficiencies. Post-financial crisis, construction firms are finding there is a growing need to reduce project schedules and costs as margins begin to be squeezed. A firm that stands out and is making a change in the industry is DIRTT Environmental Solutions (DRT-TSX). Through use of its own proprietary software, the firm is combating many of the shortcomings of the construction industry. DIRTT is a transformational and disruptive company, and contains a very promising future as it continues to innovate.

I rate DIRTT Environmental Solutions (DIRTT or DRT) as neutral with a $4.20 price target. I value the company based on a three-stage DCF model (13% WACC) and 11.0x 2015E EBITDA. Though, upside remains in the price target – I believe the potential reward does not match the risk profile of the stock. It is a fairly volatile stock, and I recommend waiting for a pullback in stock price (with fundamentals largely not changed) prior to initiating a long position, for the following reasons:

  1. DIRTT’s core advantage creates a barrier to entry: DIRTT’s ICE software handles the entire sales, design and installation process of an project. It organizes the whole process through one platform, reducing project schedules and cost. DIRTT has invested $17 million into its software thus far over 8 years, and it will take time for any competitor to replicate ICE.
  2. DIRTT’s prefabrication and modularization processes are proven to offer cost advantages while allowing customization (“mass customization”). DIRTT builds design components offsite, and delivers them to the project site for immediate installation. The ICE software provides installation instructions (allowing for easier and inexpensive customization), and can be installed by cheaper general labourers, as opposed to specialists. In addition, FMI Corp. and McGraw-Hill both confirmed (via studies) the benefits of prefabrication work in reducing costs and time, while increasing quality, margins and safety.
  3. The company should benefit from its operating leverage. The firm begins to enjoy higher margins from operating leverage after $40 million in quarterly revenue. This year, the firm is just beginning to cross that mark, and margins should improve as the business is scaled. I forecast long-term EBITDA margin of 15%.
  4. The non-residential construction industry is forecasted to grow at 4.7% CAGR over next five years, and short-term indicators are favourable. DIRTT was also able to grow its revenues during industry downtimes. The most recent Architect Billing Index is pointing at increasing orders, which is a leading indicator for construction activity in 9-12 months.
  5. The firm’s strong run, coupled with the forecast sensitivity to cost and revenue assumptions, has led to the neutral rating. I remain very optimistic on the long-term prospects of DIRTT, but acknowledge the importance of the firm meeting its 2015 forecast. The market is expecting a 15% EBITDA margin, which is aggressive considering DIRTT is still investing into its expansion and historically has only achieved a 4%-5% margin (quite a large jump). At this time, due to the sensitivity of the target price to failure in achieving the forecast – I would not buy this stock given the risk.

Company Overview

DIRTT (stands for “Doing it Right This Time”) is a technology-driven manufacturer of customized interior solutions for commercial markets. Through the use of proprietary technology, ICE, it is able to walk customers through an automated manufacturing process that allows them to customize and instantly see the impact of their interior design decisions in terms of aesthetics, logistics and cost. DIRTT is taking on the traditional construction industry by providing modular and prefabricated products with custom dimensions. The first sales were in May 2005.

DIRTT Combines Mass Production with Customization to Produce Mass Customization

Source: Company AIF

DIRTT is Disrupting and Changing the Industry

The core competitive advantage is in its ICE software. Of the competitors, none of them have their own proprietary software which manages the whole process. Competitors use multiple software platforms. ICE handles the whole process from design to installation (barring the actual manufacturing of the products), and allows for easy management of projects. ICE maintains a bill of materials (finalized after a purchase order) and creates installation instructions. Moreover, general contractors typically use 2D drawings and finish schedules to guide the various trades. Through 3D video-game technology (patented, see below), customers are able to see the impact of the decisions in real-time and the cost sensitivity to various design decisions.

A Sophisticated 3D Rendering of Project done in ICE Software

Source: Ostermancron.com

The ICE software development kit is to be rolled out later this year. DIRTT is looking to take the core engine of ICE and transition its code in order for it to be resold by value-added vendors. Management notes not to expect any significant revenue in the short term, and it is expected to see a larger impact in 2015 and beyond.

The construction industry is resistant to change. Typically, construction involves coordinating various specialists and suppliers to complete the required work for a project, and is usually done at the project site. This creates a great amount of waste, and much of the work done is installed on a permanent basis. In addition, customization can be expensive and limited. The main competitors to DIRTT are conventional construction firms and individual tradespeople.

DIRTT’s manufacturing practices provide many efficiencies and future flexibility. On receiving the purchase order (ICE file is generated), the company begins to manufacture its custom solutions (on average, DIRTT manufactures and delivers products within three weeks or less). To reduce waste, DIRTT components arrive on-site to be installed immediately (take a week typically). Due to the efficiency of the ICE software, the company is able to reduce cycle times and perform rush orders. Furthermore, modularization makes it easier to be reconfigured later, if need be.

Production Facilities

DIRTT has four plants with a capacity up to $250 million in installed capacity. The firm currently employees 528 production employees throughout Kelowna, Calgary, Phoenix and Savannah. Production for components are allocated among manufacturing facilities based on proximity and capacity.

The company’s new Enzo approach is changing how modularization is viewed. A concern of modularization is that it gives a temporary look to the interior because of how they are built. Through its new Enzo approach, the company is looking to change those perceptions by offering solutions with a more permanent look (while retaining its modularity – making it easier to remove). Enzo was launched in June 2014. Thus far, management has indicated there has been a strong response from clients.

Enzo will add three to four new machines to the line. The new machines will add to capacity, which is likely needed after 2015 as we project sales to exceed its current $250 million capacity. The new machines are expected to be added in late 2014 and throughout 2015.

Distribution Partners and Green Learning Centers

DIRTT’s primary channel of distribution is through distribution partners (DPs, independent dealers). To alleviate some of the fixed costs on the company, it distributes its products and solutions through 99 DPs in 184 locations throughout 8 countries. It provides marketing and sales support to its dealers, and does monitor their performance and is not afraid of changing weak-performing dealers. The DPs are responsible for providing local support to that region.

Majority of DPs are furniture stores who are marketing DIRTT as a construction and repair solution. Due to the financial crisis, many DPs saw their core business contract. In spite of reduced construction spending, DIRTT was able to grow its revenues in that time. These DPs now see DIRTT solutions as a means of growth (rather than revert to traditional products). To ensure quality customer service, each DP is required invest in their regional DIRTT team and hire at least one DIRTT champion (local ambassador), one designer and one project manager to maintain high standards. They must also invest in GLCs and purchase the ICE software package. On the most recent conference call, management noted DPs are investing into more team members and GLCs.

Along with distribution partners, DIRTT invests in Green Learning Centers (GLCs) to educate potential customers of its solutions. On average, over the past three years, DPs have invested ~$1.5 mln per year for their own GLCs. Given DIRTT’s new technology, establishing GLCs is important to creating brand awareness. Not only are GLCs important to brand awareness, but more general contractors are visiting DIRTT production facilities to better understand its solutions. In 2014, DIRTT intends to open GLCs in Seoul (opened), London (cater to European and Middle Eastern market) and Toronto to better expand its brand globally.

DIRTT’s Growth Strategy

DIRTT is focusing on continuing to penetrate existing markets, and emphasizes the importance of repeat business. The current average size of a contract, as of Q214, was $81,000. Management has noted a lower figure does not necessarily mean bad, as lower-bid work typically leads to repeat business, which is critical in driving sales forward. Management is looking to expand sales to general contractors (which DIRTT markets itself to as a sub-trade) and the construction industry as a whole (for those who lack their own prefabrication facilities). There is a stronger focus on investing in further sales and marketing to carry out this plan.

Critical growth areas for DIRTT are to expand into new vertical markets and geographies. As shown in the industry overview and trends section, the four key subsectors identified have been healthcare, education, hospitality and residential (multifamily units), due to their requirement of consistent and standardized designs. Furthermore, key geographical areas that been identified by DIRTT are Kuwait, Saudi Arabia, UAE, India, Singapore and South Korea. DIRTT already services Saudi Arabia through a US-based distribution partner, and recently set up distribution partners in South Korea and India to cater to the Asian market.

Key Vertical Markets (US-Only) in USD Billions

Source: FMI Construction Outlook Report Q2 2014, HTRTBC

DIRTT Products

DIRTT Walls

  1. Designed to replace conventional walls of drywall, studs or gypsum board with environmentally friendly finishes.
  2. Can be reconfigured prior to installation. Walls are pre-finished, and can incorporate DIRTT Power and Network solutions.

DIRTT Power

  1. Modular plug-and-play system designed for installation of electrical wiring. Can be used for prefabricated or conventional constructed interiors.
  2. Its factory-tested assemblies are incorporated in overall design of space, and can be completed by trained construction labourers (as opposed to certified electricians typically) – reducing cost and time.

DIRTT Networks

  1. Complement DIRTT Power, provide modular plug-and-play system; provides ongoing flexibility and reduced cost through plug-and-play functionality.
  2. Data solutions are pre-built and pre-tested prior to arrival at job site (reduce costs).

DIRTT Millwork

  1. Fully customized cabinetry and woodwork. ICE provides design capabilities of millwork, allows flexibility for new or existing spaces without the additional cost or time typically associated with customization.

DIRTT Floors

  1. Typically in conjunction with Power and Network solutions; plug-and-play systems embedded in-floor in an effort to provide future flexibility for integration with technology.
  2. Floors are designed to be installed quickly and keep network and power components easily accessible.

Stock Overview

DIRTT began trading on November 28, 2013, raising gross proceeds of $45 million at $3.00/share. The stock has reached a high of $3.95 and a low of $2.30. It is up ~18% in value since trading, and has slightly outperformed the S&P TSX Composite, which record a gain of 14% in the same period. The stock trended downwards after the severe winter weather restricted orders, but has since been volatile, with large movements up and down as sales momentum returned; prior to settling around its current level. On average, 194K shares are traded per day (removing the first two days of trading, due to increased interest in an IPO). Insiders own ~4% of current shares outstanding.

Stock Price Has Been Volatile Since The IPO

(click to enlarge)

Source: Bloomberg, HTRTBC

Investment Highlights

I am rating DIRTT Environmental Solutions (TSX: DRT) with a NEUTRAL rating, with a price target of $4.20. The stock currently trades at a $3.55, presenting an 18% upside. However, given the stock volatility due to its small-cap market capitalization, I do not believe the potential reward matches the risk profile. DIRTT is a disruptive company to its traditional industry, and entails exciting prospects for the future. Nonetheless, the stock has had a strong run since its IPO in November 2013, in which time it dipped to a low of $2.30, but overall is up 18% from the initial IPO price (+33% from after the first day of trading). Thus, there may be a potential trading opportunity on a pullback if fundamentals do not largely change (as was the case during the winter).

DIRTT is Disruptive to the Traditional Construction Industry

DIRTT is taking on the traditional construction industry and changing the way it operates. DIRTT does not view itself as a traditional manufacturer, rather a firm that is driven by technology to combat inefficiencies in an industry long plagued by them. Through its proprietary ICE software, the company standardizes and only utilizes one software platform in its sales process from design to installation. ICE feeds off real-time data to provide immediate aesthetic and cost trade-offs to assist clients in their decision-making process.DIRTT protects its technology and manufacturing practices with 78 patents (124 pending).

DIRTT’s manufacturing practices overcome many shortcomings facing the construction industry today. DIRTT’s core offering is prefabricated and modular products, while still allowing client customization (“mass customization”). ICE organizes a project’s bill of materials required and provides installation instructions. Components are built at DIRTT’s manufacturing facilities, and are delivered on-site for installation (typically a three-week turnaround). DIRTT’s practices reduce labor costs, as only general trade labour is required to complete a project, as opposed to a specialist (critical in a time when there is a shortage of skilled labour). Furthermore, on-site waste (and hazards) are reduced, since components are built off-site. Customization is timely, expensive and limited in the traditional construction industry; however, DIRTT has developed a way to overcome those inefficiencies with ICE and its manufacturing practices.

FMI Corp. and McGraw-Hill confirm the benefits of prefabrication and modularization. Both organizations carried out their own studies, stating the benefits of these two manufacturing practices to be: reduced project times and construction costs; increased profit margins, competitive advantage, quality and worker safety. To read more detail on these studies, please visit the General Industry Overview and Trends section.

DIRTT’s solutions are designed for both new and repair projects; offering synergies when mixed together, and future flexibility. DIRTT’s solutions offer a degree of flexibility not achieved by traditional practices. Traditionally, construction is permanent – making it more costly and timely to renovate. With DIRTT’s modularization, interiors are able to be changed quicker. Furthermore, its products are largely designed with environmentally friendly raw materials and finishes providing more durability (which is crucial in key growth verticals such as hospitals and hospitality). When DIRTT’s solutions are used together – it adds another layer of efficiency. For example, if a project utilizes DIRTT’s wall system (which are easily reconfigurable) with its Power solutions – it can easily relocate the electrical source because of it being a modular plug-and-play system (as opposed to hard wires running through the wall). For full details on its solution suite, please visit the Company Overview section.

DIRTT’s distribution network reduces the CapEx requirement. DIRTT’s 99 distribution partners (DPS) are required to invest in DIRTT solutions, and are emphasized to continue to invest in their locations. DIRTT hold the right to remove weak-performing DPs. This significantly reduces CapEx for DIRTT, as setup costs are borne by the DP, while allowing the firm continue to expand its regional presence. DIRTT is finding more DPs are relying on DIRTT solutions to drive growth for their businesses (post-financial crisis), and thus, has been investing in more team members and GLCs.

There are no exact competitors with DIRTT at this moment. Typical competitors of DIRTT at the moment are construction firms and tradespeople. The market is highly fragmented. Though these competitors could be larger in size and resources, none of them currently possess software similar to ICE. Competitors typically use multiple sales platforms and 2D drawings to illustrate design interiors. Furthermore, they are required to manage multiple parties, in addition to handling design work – meanwhile ICE centralizes this through one software. We also noticed a lot the competitors invest in R&D and try to anticipate trends in the industry. DIRTT does invest in R&D, which is ICE – thus, in turn, has the customer more involved in that process.

List of Close Competitors

Knoll

  1. Manufactures furnishings, textiles & fine leathers for the workplace and home
  2. Offers modular and movable workspaces (competes with DIRTT Millwork), power (DIRTT Power) and data systems and lighting (DIRTT Networks)

Herman Miller

  1. Researches, designs, manufactures and distributes interior furnishings for use in office, healthcare, educational and residential settings
  2. Principal business is office furniture systems (DIRTT Millwork)
  3. Looking to expand outside the office segment (similar to DIRTT) – looking at healthcare, education and SMBs

Steelcase

  1. Provides furniture settings, user-centered technologies and interior arch products, lighting (DIRTT Millwork, Power and Networks)
  2. Focus on education and healthcare

Haworth

  1. One of the top US makers of office furniture (DIRTT Millwork)
  2. Heavily involve client in design process – use scientists to help integrate offerings with company culture of the client
  3. Offer integrated and adaptable palette that gives back design time and provides flexibility to make changes during the design process

Allsteel (HNI Corp.)

  1. Build movable walls, systems, storage, desk, seating (DIRTT Walls, Millwork, Networks, Power)
  2. Panel-based and freestanding furniture systems, and complementary products such as seating, storage and tables

Teknion Corporation

  1. Manufactures mid- to high-end office systems, including cubicles, cabinets, desks, lighting and movable walls (DIRTT Walls, Millwork)

Source: Company Reports

There are also other competitors that specialize in niche areas, such as Acuity Brands (lighting solutions), Kingspan (insulation via panels, boards, access floors), Interface (modular carpet) and Apogee Enterprises (window and curtain wall systems).

Market Opportunities

The US non-residential construction market is expected to grow at 4.7% CAGR over the next five years (FMI Corp.). This growth figure is contingent upon the continued economic recovery in the US. As of 2013, $562 billion was spent on new building and renovation projects within the non-residential sector. This is expected to grow to $708 billion by 2018 due to population growth, deteriorating infrastructure and changing needs for buildings (given the integration of technology into daily tasks, such as the Internet of Things). Though the sector is highly sensitive to macro-economic factors, DIRTT did grow its revenues by a healthy rate during down periods in the industry (2009-2012).

Non-Residential Construction Spending in USD Billions

Source: FMI Construction Outlook Report Q2 2014, HTRTBC

The ABI’s most recent score at 55.8 as of July 2014 indicates increased architectural inquiries and billings. DIRTT and its competitors source ABI as a 9-12 month leading indicator for upcoming construction projects. The index was flat-to-negative from Q4/13 to Q1/14, most likely due to the severe winter weather, but has since recovered. DIRTT management did indicate a return in demand in May and June, and have indicated Q3 has continued its strong momentum, consistent with the reading in July 2013. Given that July 2014 is around a similar level, this bodes well for the industry in the upcoming year.

Key vertical markets for DIRTT are healthcare, education, hospitality and residential (multifamily units), due to their requirement of consistent and standardized designs. DIRTT is already obtaining significant healthcare contracts, with a good portion internationally. The residential market is more of a longer-term focus, as the firm continues to focus on commercial opportunities in the short term. It should be noted, the forecast below differs from company presentation materials, as the forecast for healthcare and education was downgraded recently, but hospitality significantly increased. However, this forecast is only for the US, and many of the healthcare opportunities are international.

Key Vertical Markets Forecast (US-Only)

Source: FMI Construction Outlook Report Q2 2014. HTRTBC

The company is also looking to expand geographically; current focus markets are Kuwait, Saudi Arabia, UAE, India, Singapore and South Korea. DIRTT has been performing well in Saudi Arabia recently, obtaining large healthcare contracts. Furthermore, it recently set up distribution partners in South Korea and India to cater to the Asian market. And opened a business development office in Singapore to pursue significant healthcare opportunities. The firm is near completing a green learning center (GLC) in London, which is critical in showcasing DIRTT solutions and building brand awareness.

Upside Remains in Valuation but at a Risky Cost

My valuation is based on a three-stage DCF model and on 11.0X 2015E EBITDA; yielding a blended price target of $4.20. My three-stage DCF model assumes a 5-year period of high growth, followed by a 5-year period of declining growth (H-model) and a steady state of growth. I value the DCF based on a WACC of 13%, using a beta of 1.5. According to financial publications, DIRTT has a negative beta but its trading history is limited, and thus I feel it is not reasonable to use. Looking at other small-cap manufacturers (offering a improvement in their current industry), I found the beta to be around 1.5, and thus chosen as a comparable figure for DIRTT. I assumed a steady state of growth of 2.5% (for terminal value), which is the historical CAGR of non-residential constructing spending.

DIRTT Target Price Valuation

Source: HTRTBC

DCF Valuation Yields a Target of $4.35

Source: HTRTBC

The 11.0X 2015E EV/EBITDA multiple is based on a mix of manufacturing comps and technology-driven disruptive companies. I used a mix of the two sets because DIRTT’s core advantage is its technology (similar to the two comps), and it should trade at a premium to interior manufacturers given its higher growth and margin potential. ProtoLabs (NYSE:PRLB) and Pure Technologies (PUR) both leverage their own proprietary software, and are attempting to improve an inefficiency in their industry. PRLB is online and technology-enabled quick-turn manufacturer of custom parts for prototyping and short-run production (similar to DIRTT). PUR, through its use of proprietary technology, looks to build applications for inspection, monitoring and management of physical infrastructure (such as water, wastewater, pipelines, bridges and buildings). These two firms trade at a premium to DIRTT due to their higher forecasted margin; the anticipated 2015 EBITDA margin for PRLB is 37% and for PUR is 27%. Thus, it is reasonable for DIRTT to trade between the two groups (in line with the niche-building comps who are looking to innovate within their industry).

Comparables Table

Source: Bloomberg, HTRTBC

Market projections may be a little aggressive. Market analysts are currently expecting 15% EBITDA margin in 2015, which I find to be aggressive considering DIRTT’s current expansion plans, and over the past three years, the margin has been between 4%-5%. It is unreasonable to expect that trend to continue, as the firm should enjoy higher margins from its operating leverage with an increase in sales. Furthermore, interior building comps have an average margin ~10%, and these are much larger companies with efficiencies in scale and a long history of production. Nonetheless, I do believeDIRTT will eventually achieve higher margins than these comps because of the efficiencies in its process, but expect a 15% margin to be achieved in the longer term (2017). I forecast 2015 EBITDA margin to be 11.3%.

Two differing bear-case scenarios show downside sensitivity to EBITDA margins. In the first bear-case scenario, I maintained my revenue forecast, while decreasing the 2015 EBITDA margin to 9.0%. I proceeded to cut the margin further to 6.7% (still the highest EBITDA margin achieved for the firm). The scenarios presented a downside ranging from 9% (9% margin) to 30% (6.7% margin). This exercise demonstrates the sensitivity of failure in achieving the market-expected margin in 2015. In a span of 460 bps, the target price difference was 61%.

EBITDA Margin Reduction of 230 and 460 bps Ranges Into a Downside of 9%-30%

Source: HTRTBC

In a third bear-case scenario, I reduce my growth forecast by 5% in every period going forward post-2014. I only increase my cost assumptions in 2015; yielding a multiple-driven target of $2.40 and DCF target of $3.35. The DCF target presents reasonable downside, but articulates how sensitive the target is to achieving its forecast. Thus, it is important for management to successfully execute on its growth plans. At this time, there have only been three quarters of financials (and historical negative ROIC due to the early stage of the product life cycle); thus, it is hard to subscribe a value at this time to management. Though, I am cautiously optimistic in their abilities, as they have not disappointed thus far and are vastly experienced in interior construction; I am neutral due to the limited upside exposed to the sensitive forecast.

Bear-Case Scenario of 5% Reduction Growth Forecast Presents a 6% Downside

Source: Company Financials, HTRTBC

Investment Risks

Replication of the ICE software could significantly damage DIRTT’s main competitive advantage. There is no direct competitor to DIRTT, as no one has a software like ICE that standardizes the whole process. It is currently patented and protected, but any replication would significantly damage DIRTT’s core advantage. Nonetheless, it is not easy to replicate, as DIRTT has invested $17 million over 8 years. If it were to be replicated, it would take some time. DIRTT continues to invest in its ICE software – thus, in a scenario of replication, ICE may still be ahead because of its continuous investment.

The construction industry is very sensitive to macro-economic factors. The non-residential US construction industry contracted by 25% from 2007-2011. It is typically amongst the earlier sectors to feel the squeeze of macro-economic factors. During the severe winter weather in 2014, DIRTT saw a reduction in sales activity for two months, which adversely impacted the stock’s market price (without any large change in fundamentals). To DIRTT’s credit, it grew its sales during industry contraction, suggesting it is able to snare market share away from traditional construction firms. While it may be able to grow sales and be profitable, macro-economic pressure can reduce anticipated forecasts and lead to poor stock performance. As evident by FMI Corp.’s recent forecast of key growth verticals was significantly reduced.

Increasing interest rates may hurt construction forecast. The construction industry could be impacted by rising interest rates, as most projects are financed using loans. The current FMI forecast incorporates an increase; however, a larger-than-expected increase could reduce construction spending. This may not be a large factor to DIRTT, as its average contract size as of Q214 is $81,000. Not significantly, large and many clients could potentially pay with cash.

Lumpy revenues and a small backlog make earnings visibility difficult. Quarterly revenue tends to vary, as it can be lumpy due to bigger projects; making it difficult to properly assess growth. It is better to look at annual figures to get a better sense of a sustainable growth figure. Furthermore, due to its quick turnaround on projects, DIRTT does not maintain a large backlog. The lack of a large backlog hampers both short- and longer-term visibility in terms of revenue and earnings. It is difficult for management to provide guidance, and thus, investors are dependent upon street projections. Failure to meet these projections (with little management help) may hamper stock performance.

Aluminum represents its largest and most significant variable cost. 50% of COGS is fixed, with the other 50% being variable; a good portion of that is in sourcing aluminum as a raw material. The aluminum price has been fairly stable over the past year, up until May 2014 (but has increased since on the LME). Management do not feel it poses any risks to its structure at this time. Further material increase in commodity price could increase COGS and reduce EBITDA margins (as shown previously, are fairly sensitive to the targeted valuation).

A perception of prefabricated products is that they are made of poor quality. The construction industry is slow to adapt to prefabrication and modular projects, though they are beginning to grow in acceptance. Nonetheless, one of the factors holding its progress back is the perception that prefabrication leads to poorer-quality products. Recent studies by FMI Corp. and McGraw-Hill found that to be untrue. Furthermore, DIRTT prides itself on its quality products. It will take time to educate the industry, which DIRTT is investing in through its GLCs. A continued perception of poor quality could hurt DIRTT’s sales.

The company’s recent employee share ownership plan (ESOP) could be dilutive. At this time, the ESOP represents a small portion of shares. YTD, stock-based compensation has only amounted to $103K. A significant increase in ESOP could be dilutive to current shareholders.

80% of DIRTT’s revenue is hinged to the US dollar, and poses a forex risk. DIRTT has benefited from the strong US dollar over the past year, due to its large exposure in revenues. Some of this is offset with costs associated with the US dollar (but the % is unknown). A declining US dollar will hurt DIRTT’s financials (which reports in Canadian dollars).

For the General Industry Overview & Trends, Full-Detailed Financial Forecast, detailed look at Valuation and a PDF copy of the analysis above, pick up the full report.

Disclaimer: This investment may not be suitable for all investors. Please review your risk profile before investing. It is recommended you carry out your own due diligence prior to investing.

Amir Ahmad is creator of investment blog, How to Ride the Buy Cycle (http://ridebuycycle.com). He was previously a Equity Research Associate with Scotia Capital and Dundee Capital Markets in Toronto, Canada. During his tenure in research, he has covered stocks of all market capitalizations in a diverse set of sectors such as industrials, mining and fertilizers. He sees himself as a longer-term investor, with a focus on company fundamentals. He graduated from Wilfrid Laurier University in 2010 and has since completed all three levels of the CFA program. In his spare time, Amir enjoys reading other financial blogs (like the great Underage Investor!) and playing and watching sports such as cricket and soccer.

For any inquiries, Amir can be reached at amir@ridebuycycle.com

Leave a Reply

Your email address will not be published. Required fields are marked *