Modular Fabrication And Data Center Demand Will Drive Balanced But Limited Upside Potential

Catalysts

About Legence

Legence provides engineering, installation, maintenance and fabrication services for mission critical building systems across sectors such as data centers, technology, healthcare, education and government.

What are the underlying business or industry changes driving this perspective?

• Although demand from data center and technology clients is currently strong and supports a record US$5.4b backlog, a heavy reliance on very large projects and awards above US$100 million could expose revenue to timing swings if customers slow ordering patterns or push project schedules.
• While modular fabrication for technical cooling and other systems is gaining traction across data center, pharmaceutical and semiconductor clients and currently supports revenue in the low 20% range of the Installation & Maintenance segment, any slowdown in the adoption of offsite modular approaches could limit further mix benefits and keep segment margins closer to current levels.
• Although the company is largely up and running on 1.3 million square feet of fabrication capacity and is using automation, extra shifts and learning curve gains to improve throughput, delays in fully optimizing this footprint or needing further capital spending for expansion could weigh on free cash flow and EBITDA conversion.
• Despite strong recent growth in Installation & Maintenance and cross selling into high tech clients, the Engineering & Consulting segment is operating with adjusted gross margins in the low to mid 30% range and a greater mix of lower margin Program & Project Management work may limit overall margin expansion and earnings growth if higher margin Engineering & Design activity does not rebound.
• While net leverage of 1.8x and over US$400 million of liquidity provide room for future M&A, larger transactions similar to Bowers or a series of bolt ons in data center focused mechanical and fabrication businesses could increase amortization, integration costs and TRA outflows, which may cap net margin improvement and temper growth in earnings per share.

Assumptions

How have these above catalysts been quantified?

• This narrative explores a more pessimistic perspective on Legence compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Legence's revenue will grow by 19.5% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from -0.5% today to 6.7% in 3 years time.
• The bearish analysts expect earnings to reach $427.5 million (and earnings per share of $4.5) by about September 2029, up from -$19.1 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $544.9 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 23.1x on those 2029 earnings, up from -207.2x today. This future PE is lower than the current PE for the US Construction industry at 30.9x.
• The bearish analysts expect the number of shares outstanding to grow by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.41%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The data center and technology market is currently described as very healthy, with large modular fabrication projects, strong order activity and record backlog, so if this demand level is sustained or grows further, revenue and earnings could rise more than expected and support a higher share price through stronger cash generation.
• Legence is already largely up and running on 1.3 million square feet of fabrication capacity, is adding automation, extra shifts and learning curve benefits, and is seeing modular work rise into the low 20% range of Installation & Maintenance revenue. Continued efficiency gains and a higher mix of this business could support margin expansion and higher EBITDA and net income.
• Backlog and awards are at US$5.4b with a 1.2x book to bill in the quarter and management expresses confidence in growing backlog as the year progresses. If this level of visibility and new awards persists across data centers, life sciences, healthcare and public sector clients, it could underpin higher medium term revenue and earnings than implied by a flat share price view.
• The company is increasingly cross selling Engineering & Consulting into existing high tech, semiconductor and data center relationships and is also seeing life sciences and healthcare activity improve from prior softness. If this broader end market penetration continues, it could provide multiple growth drivers for revenue and help support or lift segment margins and overall earnings.
• Net leverage is about 1.8x with over US$400 million of liquidity and management highlights flexibility for future M&A after successfully integrating Bowers. If further acquisitions add scale in higher growth or higher margin areas and are integrated effectively, they could contribute to faster growth in EBITDA, net income and free cash flow than a flat share price scenario assumes.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Legence is $80.0, which represents up to two standard deviations below the consensus price target of $102.53. This valuation is based on what can be assumed as the expectations of Legence's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $130.0, and the most bearish reporting a price target of just $80.0.
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be $6.4 billion, earnings will come to $427.5 million, and it would be trading on a PE ratio of 23.1x, assuming you use a discount rate of 9.4%.
• Given the current share price of $51.35, the analyst price target of $80.0 is 35.8% higher.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.