Target Hospitality is the largest vertically integrated specialty rental and hospitality services company in the United States. The company owns an extensive network of geographically relocatable rental accommodation units comprised of ~13,000 beds across 22 sites serving the country’s highest producing oil and gas basins.

Most of the company’s revenues are generated under multi-year “take-or-pay” contracts, providing Target high visibility into future earnings and cash flows. The company went public via SPAC merger with Platinum Eagle Corp and Signor Holdings and is trading for an incredible discount to just a middle-of-the-road valuation.

We believe one can purchase shares of a business generating over 50% EBITDA margins, 90%+ FCF conversion and a 26% 3-year EBITDA CAGR for 60% off — getting all future growth for free.

Is This a Good Business?

The modular accommodations business is a great business with enviable unit economics. There are predictable up-front fixed costs (like the initial build out of the site and beds) with very minimal ongoing maintenance expenditures. This trend translates into high margins with incrementally higher return on invested capital over the course of a project’s lifetime.

Let’s look at Target’s lodging business performance from 2018 to paint a clearer picture. In 2018, the company generated a little over $186M in accommodation revenues on $93M of operating expense, giving us $93M in gross profit (over 50% margin). Backing out the depreciation of the accommodation assets gives us around $134M in EBITDA.

Most of these margin advantages are exclusive to the modular style of construction. Horizon North (HNL), a Canadian builder of modular homes and accommodations, did a fantastic job of outlining the benefits of switching to a modular construction style in their latest investors’ presentation. According to HNL, there are four main advantages to switching to modular: Time Savings, Cost Certainty, Sustainability and Quality Control. The biggest (and most important) advantage to modular homes is the extreme savings on project development.

How can a company achieve such high savings on time? The typical construction site build schedule goes as follows:

Design & engineering –> permits & approvals –> site developments & foundations –> building construction –> site restoration.

Modular combines of both the Site Development & Foundations and the Building Construction. Modular buildings are built off the job site and usually indoors, enabling the construction to both develop the buildings while making the build site ready to receive the buildings. Further, since the buildings are constructed indoors, build development isn’t stunted from adverse weather conditions. Reducing construction build time by 30 – 50% translates into faster return on investment, which creates a positive feedback loop where that returned capital can be deployed into new modular projects at those same high rates of return.

Another benefit of modular construction is lower waste levels per project (read: less money spent on unnecessary items). A company using modular construction processes knows exactly how much of each component is being built and can scale seamlessly.

For example, a company might need to order 15,000 lbs. of lumber for 400 modular buildings (completely arbitrary figures — I apologize to my former construction workers in advance). If they then go on to receive an 800-building contract, they know exactly how much material they will need to complete the job. WRAP, a UK company specializing in waste efficiency research, reported that an up to 90% reduction in materials can be achieved through modular construction. That 90% reduction in material costs drops straight down to bottom-line earnings.

Signor Holdings: Incremental Cash Flow at Low Cost

The merger of Signor Holdings (the hospitality segment) adds significant incremental earnings and cash flow for very little capital expenditures to an already high margin, high earning lodging business.

Operating independently, Signor’s financials were rock solid. For the period Jan 2018 – Sept. 2018, Signor generated $61.2M in revenues, $30.5M in gross profit (50% margins) and $32.8M in EBITDA with over 90% FCF conversion. Signor (on its own) generated roughly $0.52/share in operating earnings. The company is a high margin value-add that costs Target (the parent) almost nothing in additional expense.

By combining the two businesses, Target Hospitality owns the entire process from manufacturing / supply of accommodations to catering, amenities and hospitality services within its owned and operated communities. The combination reduces expenses (removing the need to outsource various services) and removes the guesswork for its customers on how they’ll be able to fill all the aspects of rental / accommodation services for their workers.

What happens when you combine a high margin, high cash generative lodging business serving blue-chip customers with another high margin, high cash generative hospitality business providing turnkey catering, security, recreational and other amenities?

You get a robust business providing clients with 100% of their needs while achieving substantially higher margins than competitors.

Impressive Growth & Break-even Reduction

Between 2014 – 2016, Target was a small, albeit growing company with a network of just 5,500 beds. These beds were distributed 56% in Bakken Basin and 44% in the Permian Basin serving (for the most part) upstream oilfield services and midstream companies. Utilization rates were at a decent 65%, and the company’s average daily rate came in at $86. Cost of production wasn’t great by any stretch of the imagination, with break-even rates between $70 – $90 oil prices. This was great, of course, until oil peaked in June of 2014 — falling from $106bbl to the February 2016 low of $30bbl

The company has undergone drastic changes since to drive production costs lower, increase utilization rates while adding more beds in higher growth areas thus lowering their overall break even rates.

Seeing the growth prospects in the Permian Basin region (something we’ll touch on in a little bit), Target altered its concentration, putting 81% of its buildings in the area to create the largest and closest accommodation site in the entire Basin. Target’s main customers remain Upstream Producers, Oilfield Services, Midstream Owners and Government entities. Break-even rates are around $44/barrel in the Willston Basin and an impressive $32/barrel in the Permian Basin — representing a 60% cut in production costs over the last two years.

Industry Leading, Enviable Unit Economics

A leading driver of our bullish thesis is the incredible unit economics of Target’s vertically integrated business.

In February of 2018, Target won a contract to build 400 beds in the Carlsbad region in Mexico — located within the Delaware Basin — one of the hottest basins in the Permian landscape. The company’s average project is around 500 beds with $50K/room in CapEx. Average daily revenues are between $86 – 95 per bed, and COGS per bed is $35. Capping it all off, the company spends $3M total in maintenance capital expenditures during a given year. All capital expenditures are underwritten by Target’s contracts, so the risk for speculative building is (for the most part) nullified.

In Target’s latest contract, 400 beds at $50K per room gives us total upfront investment of $20M. Assuming the company’s historical EBITDA margins (and reaffirming that percentage with our median ADR/COGS figures), the $20M investment will generate roughly $7.2M in EBITDA per year. $7.2M EBITDA/year translates into an IRR of 36% annualized.

Due to the extremely low maintenance annual capex spending, over 90% of that EBITDA will drop down to free cash flow to the firm (read: over 12% FCF yield). Target should expect to receive $144M in EBITDA over the course of their latest contract (assuming a typical project lasts 20 years). This means that for every dollar the company spends on investment, they receive over $7 in unlevered cash returns.

To quote Charlie Munger, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

We believe Target offers the best of both worlds in Munger’s scenario: a business compounding capital at high rates of return while at the same time trading for a huge discount.

Contracted Revenues & Future Growth Prospects

The company’s already raised guidance higher for 2019 revenues and EBITDA, $340-$350M and $175-$180M respectively.

The increased guidance comes off the heels of renewed contracts with four of Target’s largest customers, representing nearly $45M in incrementally higher earnings. According to management’s press release, the contracts will add over $200M in cumulative value with all renewals signed on a multi-year agreement. The contracts extend the existing contracts by a minimum of two years and include the full-scale accommodation services from Signor Holdings (read: incrementally higher revenues per contract extension).

The upward guidance introduces our second largest driver of value: long-term contracted revenues. When looking back on the last few write-ups we discovered we really like long-term, contracted revenues. That long-term revenues provide high visibility into future earnings and cash flow makes these types of businesses some of our favorite to invest in.

Increased visibility offers us a better chance at achieving a more accurate fair value range over the next 3 – 5 years. The latest extended contracts lock up 90% of Target’s revenues for 2019. We’re highly confident these revenue sources will continue to expand as growth in the Permian Basin region picks up, with much of the growth coming from its two largest players: Chevron & Exxon Mobil.

Will Growth in The Permian Hold?

There’s arguably no area in the United States that’s reaped the benefits of a US Energy Exporter in Office than the Permian Basin. According to a Forbes article (dated 02/09/19), the Permian Basin is now the world’s second most productive oil and gas resource. We are confident that growth in the Permian Basin will continue its historic pace. But don’t take our word! Here’s what the US Energy Information Administration (EIA) had to say on the matter:

Growth in the Lower 48 onshore crude oil production occurs mainly in the Permian Basin in the Southwest region. This basin includes many prolific tight oil plays with multiple layers … making it one of the lower-cost areas to develop.

The EIA projects that domestic crude oil production will surpass 15 million barrels per day by 2022 (which would be years before their earlier projected figures) and will remain producing over 14 million barrels per day through 2040. Target’s latest investors presentation paints the TAM for the Permian Basin at $1B and has grown their share from 2% in 2015 to 20% today.

Touching on the two largest players in the Permian; Chevron supported their increased exposure to the Basin due to their past success. Over the last two years there, Chevron added almost 7 billion barrels of oil and doubled its portfolio value. ExxonMobil revised its Permian growth plans to produce more than 1 million barrels per day by as early as 2024 — which reflects an increase of nearly 80%.

Multiple Ways to Win (Organic Growth, Pipeline Catalysts and M&A)

There are multiple ways for Target to win over the next five years.

We’ve touched on the Permian Basin and the renewed multi-year contracts, but there’s more room to grow. As a near term catalyst, the company’s identified close to 5,000 beds that will come online during 2019 — all through organic growth. Target’s spent $213M in CapEx on these beds and will generate a minimum contracted EBITDA of close to $260M — a 30% return on their investment within 2.8 years.

The companies also engaged in three major projects (each coming online in 2019): US Government contract, Services Contract and LOI Awarded. The government contract is for multiple, large scale communities supporting a host of US federal agencies. Target estimates contract value for this project to be between $85M – $100M.

The services contract was awarded for work in the Keystone Pipeline, where Target will provide catering and facilities services. Work started on the project in 2018 and is awaiting full release. The company estimates around 5 million meals will be served over the duration of the contract (read: high margin, low capex revenues).

Target was also awarded a Letter of Intent to support the construction of a brand-new oil refinery in the North Dakota Bakken region. Total contract value is estimated between $35M – $45M with minimal capital expenditures (highly accretive free cash flow).

Finally, the company’s targeted (no pun intended) four regional accommodations providers for acquisition. Should Target go out and acquire all four of these local players it would add over 6,000 beds to the company’s network. At Target’s historical rate of $18K in EBITDA per bed in their network, those acquisitions translate to roughly $108M in potential EBITDA expansion.

Valuation

When estimating our conservative fair value for Target, we decided to exclude the multiple avenues of growth (i.e., M&A, organic bed growth and pipeline contracts) in order to give ourselves a clearer base rate range of valuation. The company’s been able to grow EBITDA over 20% annually over the last three years, but will this truly be the company’s growth prospects going forward? In valuing Target Hospitality we’ve projected three different futures: pessimist, neutral and optimist trajectories.

Pessimist Valuation

For our pessimistic view of Target’s future, we’ve assumed the following outcomes:

Top-line revenue growth: -10% annually after 2019

EBITDA margins: 35% after 2019 (this represents a 15% margin compression from current levels

Capital Expenditures: 2% of revenues (slightly above historical figures)

Tax rate of 25%

Discount rate of 10%

Net debt: $340M and EV/EBITDA

Multiple: 10.2x (comparable average).

Using the above assumptions, we arrive at 2023 FCF of around $65M, $391M sum of present values, and $972M Enterprise Value. Dividing by the total number of shares puts us at ~$6/share. Shares are trading for around $9.80 (as of 04/05), which represents a 40% downside in this given scenario.

Neutral Valuation

Assuming that Target doesn’t do anything over the next five years. They don’t grow, they don’t shrink, they remain in this static environment of top-line stagnation. For our neutral valuation we’re assuming 0% top-line growth, 40% EBITDA margins (10% lower than historical averages) and an EV/EBITDA multiple in line with industry averages — 10.2x.

Using the above assumptions, we arrive at 2023 FCF of $122M, $525M sum of present values and $1.6B in Enterprise Value. Taking the mean figure between our EBITDA approach and DCF gives us fair value of ~$11/share, or 20% higher than current prices.

Optimistic Valuation

We would argue that this isn’t an optimistic valuation in the sense that we don’t think it will happen — in fact — if each scenario could be put into probability buckets of potential outcomes, we would put this scenario into the bucket of “most likely to happen”.

We’re assuming top-line revenue growth of 15% (given the 3 year 28% EBITDA CAGR, it seems reasonable), EBITDA margins at historical 50% and an EV/EBITDA multiple of 12x. In this example, we’re projecting the market will realize the value of the company not only through share appreciation but multiple expansion.

The above assumptions spit out around $236M in 2023 FCF (8% FCF yield), $673M sum of present value and a near $3B Enterprise Value. At $3B EV, the company would have an exit EBITDA multiple of sub 10x, which we think is too cheap. Attaching a multiple that’s geared towards industry leading gives us a price of over $20/share, in line with our DCF estimation. At around $20/share you have a chance to 2x your initial investment.

Risks

Anytime you have a company that is tied to a commodity (i.e., oil) there is the chance of commodity price risk. Target’s been able to reduce this risk dramatically as the company’s been able to cut their breakeven prices from $76 in 2014 to $32 today.

Declining oil prices lead to capital and labor leaving the industry. This cycle ends up costing Target Hospitality the chance at filling their beds and generating revenues / cash flow. Target can mitigate this risk due to their long-term take-or-pay contracts. TH solidifies their contracts with their customers at certain oil prices — which are fixed in the contract. This means that for the life of the contract, it doesn’t really matter what oil prices do because Target locked in its contract at that fixed oil price during the time of signing.

Growing Pains in Basin

While all this growth is extremely bullish for Target, the major problem the Basin faces is in Takeaway Capacity. The basin saw early signs of this towards the end of 2018 with Midland – Cushing spreads hitting as low as $20bbl as every pipeline was full. If production continues its expansion as planned, there will once again be a need for increased takeaway capacity — or suffer backups.

SPAC Stigma & Liquidity

Another risk to share price appreciation is the fact that Target went public via SPAC IPO. SPACs have a sketchy history (at best) of post-IPO performance, which can dissuade many investors from becoming part owners. In other words, yes, over time the market is a weighing machine. However, if there isn’t a market of willing and able buyers, share prices might never truly reflect the underlying value of Target’s business.

Liquidity is also a risk when dealing with newly IPO’d SPACs, and TH is no exception. The company averages 30k – 70k shares in daily volume. At current shares prices its between $300K – $700K of daily volume. Again, not bad for the smaller investor — but for an institution or larger fund, it will take some time to build into a full position.

Buying Value, Get Growth for Free

To conclude, here’s a business that’s trading around 8x 2019 EBITDA with a current enterprise value that implies the company won’t be able to achieve any top-line growth in EBITDA over the next 5 years. Mr. Market is giving the investor an opportunity to own a high margin, high FCF conversion business with long-term take-or-pay contracts business for less than 8x next year’s EBITDA.

Target has many levers to pull to expand earnings, cash flows and multiples over the next five years. Over time, we believe the market will value this business closer towards (and even potentially higher than) its intrinsic business value. The company is an industry leader in vertically integrated specialty accommodations serving some of the hottest end markets in the United States — and current prices on both the warrants (which are 3-for-1) and the common stock offer a chance to buy the business while getting all its future growth for free.