Runnin’ Up That Hill International With Tim Heitman (Podcast Transcript) – Hill International, Inc. (NYSE:HIL)

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Editors’ Note: This is the transcript version of the podcast we published on Hill International earlier today. We hope you enjoy it.

Introduction

Mike Taylor: Hi, Behind The Idea listeners, and happy Friday. We’re trying something new here on this show, bonus episodes. We’re interviewing authors of Seeking Alpha PRO Plus Top Ideas about their thought processes, to give you an inside look at professional caliber equity analysis.

We kicked off last week with Jorge Robles and his coverage of Gym Group Plc and it went pretty well. So we’ll do our best to make this a regular thing. These will come out on Fridays, to help you gear up for your weekend 10-K reading, filings, all that kind of stuff. All right, let’s get it.

Podcast

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Welcome to Behind The Idea. I’m Mike Taylor. Today we’re talking about Hill International ticker symbol, HIL. It’s an unloved construction management company with an unglamorous business model and a history of management difficulties. Joining me is Tim Heitman of Investing 501 to give us some details about why he believes this ugly stock may deliver attractive returns for investors.

Before we begin let me remind you that Behind The Idea is the podcast that looks at ideas from around the Seeking Alpha ecosystem to find out what makes great investment analysis work. Behind The Idea is brought to you by Seeking Alpha PRO Plus, PRO Plus Subscribers get early access to Seeking Alpha’s top ideas, including this Investing 501 thesis on Hill International. They also get lots of real time alerts and exclusives on Seeking Alpha’s best research.

I have no positions in any stocks we plan to discuss and Tim is long Hill. Nothing on this podcast should be taken as investment advice of any sort.

Okay, welcome, Tim.

Tim Heitman: Thanks for having me, Mike.

MT: Yeah, so let’s dive right in. What — just give me the basic brief recap of your thesis on Hill, what’s going on here?

TH: Well, at Investing 501, one of the things we like to do is look for companies that are ugly, and you are probably going to be stick to your stomach, or certainly at least uncomfortable if you consider investing in them. And we look for ideas though, where inflection points from the underlying business standpoint are happening, but they really don’t show from maybe a top line or a traditional screen basis. And Hill fits that thesis.

So a little background on the company, revenue has declined about 40% or more since 2015, so that doesn’t look too good from the top.

MT: Yeah, that’s not great.

TH: The revenues are still declining. As a matter of fact, year-over-year, they’re still down 14%. So again, optically, as the young’uns like to say, it doesn’t look too good.

So we’re going to get into the problems that got Hill to where it is today. But what attracted us to Hill was, if you look at underlying numbers, for example, they post backlog numbers and there’s growth in the backlog, year-to-date. We look at things like gross profit dollars, not necessarily gross profit margins. And cost structures, if you look at things of that sort, free cash flow. The company is finally getting close to an inflection point, where from a top line example, they should start to grow. For example, one of the big problems was the cost structure was totally out of control. They hadn’t made money for years. But now that’s definitely under control and we’ll talk about that later.

Basically, you’ve got a business that generates 40% gross margin, for the cost structure that’s basically flat going forward. So you can see how there’s a great deal of operating leverage in the business if revenue starts to grow, which we think it will. So investors are rather skeptical of the sustainability up to this point, because we’ll talk about all the problems they had. And I think that gives investors who are willing to be patient, an opportunity to get involved in a company that has been historically attractive to other companies from an acquisition standpoint. And is in a business that, as you mentioned, clearly people aren’t interested in at this point in time, but we’re getting close.

MT: Great. So real quick, I’d like to just take pause and ask, you mentioned, you look at gross margin dollars instead of gross margin percentages. Can you explain a little bit, why you take that approach, or what the advantage is there?

TH: Sure, see a company like Hill has two revenue components. One is called consulting fee revenue, which is — they are kind of cost plus where the gross margin is. Plus they also have a component of revenue, which is really fixed costs, pass-through costs that are subcontractor fees that they hire for their business and things of that sort.

So if you look at a company that has gross profit margin revenue business combined with a non-gross profit revenue margin business, and you’re just looking at gross profit margins, because there’s a mix shift between the two. You really don’t have a good understanding of the underlying profitability of the one division that’s profitable. So for example, aggregate gross profit margins are in the 20% to 30% range. But in the CFR business, they’ve been consistently 38% to 40%, 41%. So as the mix shift changes around, the gross margin percentage is much more volatile than the actual business. So that’s why we like to look at gross profit dollars.

MT: Great, yeah. Good answer. That’s interesting and something to keep in mind. Like you said, screens can mislead people in that regard. And certainly my own top line, high level look at the financial statements led me down that track.

TH: Yeah, if you look at — like Seeking Alpha does a great job with their financials, and you can convert the numbers to percentages. So if you’re just looking at percentages all the way through the income statement, but don’t understand how the revenue is generated, it can be misleading a lot of times, and there’s a lot of these little companies that have multiple revenue streams, were once a small division that may be just starting, and they’re generating lots of losses, and they’re hiding a very profitable nugget in there as well.

MT: Yeah, great note for me. I often boast, Tim that I’m a gross margins guy, that I love gross margins, and you’re giving me a good cautionary note on that approach. So I appreciate that.

So one thing, I think we should stop for a minute to kind of clear up is Hill’s business model from kind of the real world standpoint. If you go to Hill Internationals website and you go to their services section, they list like 12 different things that are all similar to each other. And the general impression you get from looking at the site is they provide sort of consulting and project management services for construction projects. What do you think investors need to know about their business activities and their customer relationships?

TH: Again, a very good question, because again, you have to kind of understand a little bit of what’s going on here. So Hill is like the eighth largest company in that space. But that’s a bunch of gobbledygook. I like to call it basically a construction risk management company. I think that simplifies the description, and people can get a hold on that.

So basically what happens is, companies that are — or governments, about 63% of their business is government. So for example, recently, Hill was part of a joint venture that was hired by the New York Department of Design and Construction. They’re going to build a multi-billion dollar. They’re going to build four new facilities that are going to cost multi-billion dollars for correctional facilities in Manhattan, and Brooklyn Queens and the Bronx.

So Hill is hired by the New York Department of Design and Construction to sit between them and whomever they hire as the general contractor for the construction business and that sort of thing. Plus they’re involved in the planning.

So Hill’s basic function is to be the policeman, so to speak, for the company to make sure that the budgets that are being presented by the construction company make sense. They’re trying to avoid cost overruns. So it — they’re really kind of an advocate for the entity that has hired the company to construct whatever it is. They’ve got about 10,000 projects total, since the company was founded some years ago, with about $500 billion in aggregate value. So they’ve been involved in a lot of little projects, but also a lot of very big projects.

MT: Yeah, that’s wonderful. Yeah. And I’m heartened to hear. I saw on social media, some issues with some of the Brooklyn jails, especially the heat was out there. So hopefully, they can get some of that issue fixed, or be part of that process.

TH: This will replace Rikers. So that’s part of the…

MT: Oh! Really. Wow. That’s a big deal. Yeah. Yeah, it’s funny how these investment ideas trickle out into the real world.

TH: So in terms of strengths and weaknesses, we always like to be fair, and kind of look at both hands. We’re not the one handed economist. We are — we do have two hands. And so some of the things we like strength wise, is they do have long-term relationships with some of these governments and companies. I mean, up to 20 years, and with all the turmoil they went through, they didn’t really lose a major client at all through all that.

We like the fact that they are kind of an advisor. So even though it’s a cyclical business, there’s no doubt about that, when you’re on the cost saving side, you’re probably one of the last guys to get fired on a project. So we like that, and probably one of the most important things is at the old firm I was at, and I was a Director of Research, we looked at a lot of the energy and construction companies, Shaw, Jacobs, all these companies. And one of the big risks for these companies is, they’re on the other side of that of the desk, right. And one of the things that always seems to happen with these companies is at the end of projects, they have these huge write-downs, because of these dramatically over — cost overruns, right.

MT: Interesting.

TH: We used to follow a company called McDermott and I’m not going to, I don’t wish to disparage them, but their symbol is MDR, and we used to call it murder. When they — there was a chance when they would report their earnings that it would murder your portfolio. So again, no specific offense to them, but that kind of illustrates what happens in that business. And so they’re not exposed to that. So you don’t have these projects that go on for three years that look tremendously profitable and then the end they realize no money on it.

And probably the final strength that we like is, it is a pretty diverse revenue stream, for example, 42% of the revenue is from buildings, 43% of the revenue is transportation. Think of things like model rails, airports, they’re involved in those kind of expansion. Energy directly, think refineries, that kind of thing is only 4% of their business. And a lot of these big E&C companies, right, the big problems they have are around these refineries and things of this sort that are very cyclical.

Now having said that, 50% of their business used to be in Middle East, now it’s only 30% and we can talk a little bit later about that. So even though it does have an energy component, and there is something that’s kind of big, in terms of the Middle East, which is energy oriented. So I’ll give you an example. They are also part of the project manager on a company, or I mean the project. It’s called the King Salman Park project in Saudi Arabia. It’s a $23 billion project, that basically they’re building the largest — it’s actually the — they are building like the largest city park in the world in the middle of desert.

That’s not truly oil dependent, but if oil goes to $20, that’s probably a project that gets downsized in scope.

MT: The second biggest in the world.

TH: Well, I’ve seen some pictures of it. It’s typically what you see the islands — like the islands that they build over there and all that stuff. Is that — the scale is — is that times two. So that’s a plus and a minus, right. I mean, a long scale project, one of the things that’s good about long scale projects in the Middle East is the longer the project goes, the more opportunity Hill has for additional scope of work. And so that’s a plus. The downside is, there’s a lot of the, I don’t want to call them vanity projects, but clearly they’re that sort.

The weakness is, real simple, the weakness is, they are relatively small still. They are only the eighth largest, about $300 million $400 million of revenue. The business is cyclical. And it’s pretty lumpy, too, right? That’s the other problem is $23 billion projects don’t come along very often. And usually, when a project is big, it’s big for a reason. And then once you finish it, I mean, if you’re building it, you’re not going to have to build a second park in Saudi Arabia.

So some of the projects that are really large are really kind of one-offs. There’s not a lot of repeat business for that. And then, I guess one other risk, if I can think of it would be there is some receivable risk. They had a $60 million receivable back in 2011, go to zero when Libya was put in disarray.

MT: Yeah. Some comments mentioned that.

TH: Yeah. So there’s — it can definitely, we don’t count it as anything. It’s definitely a zero in our models, but on a $160 million market cap company, if you can get some of that back. I’ve talked to the management. The management basically says it’s not a solvency issue, because it’s kind of a — it’s a division of the government, or department of the government. So it’s not really a solvency issue in getting that money. It’s just there’s no government, which could go on for hundreds of years. But…

MT: Yeah, that lumpiness, maybe that helps explain why, again looking at taking, looking at the financial statements from kind of a high level it — and I think part of this is probably you’re going to talk about a turnaround story. But just operating margins look really narrow and net margins look really narrow, and it’s just kind of you say, lumpy. It looks, it doesn’t — this doesn’t look like a consistently profitable business over the past 10 years or so. But I mean…

TH: No, it really hasn’t been and part of it is management, which is no longer there. Part of it is the lumpiness, I mean inherently, it’s not a double digit operating margin business. It’s a — it is a lower margin business, because it is basically cut.

If you think about this model is very simple way, it’s a bunch of consultants and accountants and engineers, that when they’re out on the job, they’re getting paid X dollars time some gross margin — some markup, and when they’re not on a project, they’re sitting at their office at home, under SG&A.

MT: Right.

TH: Right, so it’s one of those businesses where the utilization rate for lack of a better description can go up and down. And that’s where the problem is. Part of the problem with lack of profitability was the previous, the Founder and his son were the CEO and another officer, and they seemed to be able to take kind of an inordinate amount of the profits in compensation.

So — and we’ll talk again, I’m sure we’ll get into that. But that was certainly a problem. They have gone. The management has made a lot of promises that we can talk about in terms of what a run rate of SG&A should be going forward, and they’re so far living up to their terms. So there really was a lot of waste and fat. But one reason why it was an attractive acquisition candidate is, if you — lot of that SG&A can just be absorbed by whomever. So 40% gross margins is pretty nice if you can just strip out a lot of the other costs.

MT: Yeah. So let’s get into some of this father-son duo, I think you called it, as you called it four years of chaos and distraction, from which Hill is now emerging? So tell us a little bit about the chaos and distraction?

TH: My goodness. For a $160 million company, it’s had as much drama probably as GE has, although Mr. Markopolos has not called them an outright fraud yet. So starting — I’ll just start, it goes way farther back than this. But we’ll just start in 2015. DC Capital, a private firm offered $5.50 a share. DC Capital owns Michael Baker, which is a company that’s similar in scope. So it would have been a really nice strategic fit and wiped out a lot of that SG&A we were talking about, plus, the father-son was still there. So some of those costs were embedded in there. That one is 0.6 times revenue. So clearly, it was a little offer, for example, Michael Baker eventually got taken out twice the initial bid.

So we think that — if you just kind of look at strategically how things play out, that was really a lowball bid. And there was plenty of opportunity for them to make a higher bid. One of the activist investors, Bulldog Investors, who also runs a closed end fund, called the Special Opportunities Funds. And it was actually — their stock was in that fund. They started a proxy battle, because it was clear that the Board of Directors was not going to vote for it. In fact, they didn’t vote for it. And we’ll talk about that in another section.

They lost. So DC Capital eventually came back and said, okay, we’ll pay you $4.75, which obviously, no one was going to take. So in 2015, you were dealing with a proxy battle and an aggressive takeover in it.

2016 rolls around Bulldog comes back with a proxy battle, said some very critical things about the CEO, David Richter, including saying quote, that he was making misleading and outright false statements in their proxy presentations. And we’ve a link to that in our report.

Bulldog finally won, got three members on the Board. One of the Board members that got replaced was David’s father, Irvin. So you had kind of a sweet — and the guys around the Board now are almost all activists and all 2% to 10% shareholders. With lots of relationships in the industry, whether it’s with Jacobs, or Primoris or MYG, there’s — MYR , there’s a bunch of relationships there, which I got in the report.

2017, the company decided to sell — they had a business that was a construction claims management business that didn’t really fit with their business. They sold it for one times revenue. Again, remember, TC was bidding two-thirds revenue for the whole company. But in the process of going through that sale, they discovered some accounting irregularities, which were really minor inter-company currency translation problems, because they have a significant, 60% of their businesses international.

That got David Richter thrown out as the CEO of the company. The activist said, you still have to sell the company. They did sell the claims business, which paid off a ton of debt, which was another problem the company had. But if you think about it, a $400 million and $500 million revenue company with $200 million in debt, it’s probably not the best situation to be in when you’re a low margin cyclical business.

So they got that sold. But they were unable to get their financial done in time. They had to restate at least three years. So August last year, they were delisted. That was tough. You know, they’re not even in the Russell 2000 anymore. So I mean, the stock was 550 when they got delisted. So I mean that’s a benchmark for where the stock could be now. The business was actually fundamentally better than it was when it was $5.50.

A bunch of investors bought in thinking it was going to go on the S&P or in the Russell 2000 didn’t make it, because the market cap at that point was too small. Bulldog actually sold at least half the position of probably for tax purposes, because they still own it in their fund. And they still say that they love what the business is doing.

And then of course, you had oil prices collapse, they had airport project in Oman, that was a in 2018 it was $26 million, all by itself. That got completed. In 2015 I think it was they had $73 million worth of contracts cancelled out of the backlog because of the collapse of oil prices.

So yeah, I think that there was a little bit of chaos for the — I mean, that’s just — it’s incredible they’re still around. I mean, it’s amazing that they didn’t end up worse financially.

MT: So with all that, I think it’s easy to imagine that the market doesn’t love the stock. In fact, it seems like the pricing reflects lack of love and perhaps even worse. Do you think that there are going to have to be additional events or catalysts besides an increase in profitability or sort of improving financials to get the stock relisted?

TH: Yes, I — when you go through all of that and you are a small company, you definitely become a show me. Plus you had — not only took over the Board, you had to turn over the three of the top five guys in the proxy in terms of management, there’s no doubt this is a show me name.

So, when I look at thing — like to me, until the company shows maybe four quarters right, of sustained improvement in gross profit dollars, you know, the backlogs up 12% year-to-date, they’ve announced a couple of wins since then. So the company really needs to show that these three quarters of improvement, three quarters improvement that they’ve had, is not just all low hanging fruit, easy business that was put off because people didn’t know what the heck was going at the company. So yeah, all those things have to happen.

But if you — one of the things you learn with small companies is you got to really evaluate management, right. I mean, these are small companies that have narrow focus as a business. And I’ve invested in enough companies where management tried to do a turnaround, and they were clearly not tasked — their skillset was not what you would want for the task at hand. And the company’s failed.

So you kind have to benchmark the company by each quarter. And one thing that’s kind of interesting is, there’s never more than three different people asking questions on the conference calls. This last one there was one. So clearly a bunch of people have no interest in it whatsoever, and that’s where the opportunity lies.

But they definitely have to have four or five quarters in a row of sustained improvement, plus they’ve had this goal, was called profit in performance, I think, PIP. They were going to get to $120 million annualized run rate, $30 million a quarter. They were below that last quarter, they’re probably — there’s some noise in the numbers, but they’ll be — they’ve been at $30 million for two quarters in a row. And their guidance was to be at $120 million.

So if they can keep their SG&A and other costs at $120 million and you can grow your revenue by 10% with 40% gross margin flow through, then I think people will start to say, oh, this is a real business, it is a turnaround. And then when you just start using modest numbers, you get 40% to 50% increase in the price just on an operating business.

And you know, and eventually if DC Capital comes back, or Jacobs or someone like that says, wow, this is still a real business, and they still have this great backlog of business. And even though it’s certainly more profitable, it would certainly continue to fit where we’re at. So and then that that would be, you know, 2x but you never invest in a company with primary thesis being a takeout, but it’s certainly its plausible. And like I said, it’d be 2x where it’s today for sure.

MT: Yeah, where are we? You mentioned management a couple times. Where are we with management now? The track record isn’t great with maybe some inflated SG&A expenses and then some rejected takeovers, and some governance related issues and proxy battles. So where are we today with management?

TH: All right, let’s give you a little hint of where we were, to show you why it’s so much better now. When the Richters were in-charge, their total compensation from 2007 to 2014 tripled to about $6 million, okay. In 2015, David’s compensation alone was 50% of net income. And his father’s was 20%, right.

MT: That’s nice work if you can get it.

TH: They got it. Well, it gets better. Each of them got new cars, $100,000 vehicle allowance between them, a $22,000 Country Club expense. And now when David left the CEO position, he got $1.2 million for his vacation time.

Non-employee directors were making a $170,000 a year. So yeah, like you said, nice job if you can get it, right. So that’s one of those places where — you actually have to read financial statements and proxies, and boring things like that, because that just doesn’t show up anywhere. And so that’s a tremendous, I mean, $6 million, is a tremendous amount of money, in a company that just made $1 million or whatever it was, $1.7 million in the last quarter.

So they had an Interim CEO, that was appointed by one of the, I think it was by Bulldog. But the new CEO was appointed in October 2018. Name was Raouf Ghali. And he’s been with the company for 25 years. He also was — he was the President before that, the COO, before that, he spent 10 years on the international project management side of the business. When he started, there was like 250 employees, now there’s 2,800.

So I like the fact that he has been here through everything, the good times, the bad times, and hopefully the good times, right. So he has hands-on experience with this company, all the relationships that he developed over the years, with all these companies and all these governments that hired Hill. There’s a comfort factor for them. There’s a coherence in that amount.

The CFO, Todd Weintraub, he was hired in November 2018. What I liked about him was he has 30 years of experience, including he’s worked for six publicly traded companies, couple of them. One was in aviation, the other one’s, Macquarie, which everybody knows, their renewable energy, worked for Hawaii Gas. So he has both public company experience and accounting experience in companies that are involved in construction.

And then finally, the new Vice President in the Middle East, the other guy was making a really nice salary as well. He left and so basically, his junior is now in-charge. So again — so the management has a basic understanding of the company, a strong understanding of financials and the content.

One thing that also makes it better for them is the CEO took a 15% reduction in salary. You read the proxy, their compensation is tied to EBITDA growth, increased sales, but also a reduction in days of sales outstanding. So they can’t just go on and get a bunch of business that eventually doesn’t materialize, obviously be nice to have some kind of ROA or ROE metric in there too.

But they’ve agreed to a compensation package that is cheaper than the old one, and actually has tangible goals in the areas we want to see. Increasing sales without paying attention to DSOs is a terrible compensation package. And…

MT: Got it. Hopefully also, they’re taking all their vacation time. Not too much, but you know…

TH: Yeah, so, I tell you, I guess I’m in the wrong business. Oh, they moved into — another thing, they moved into this new building in Philadelphia, Downtown Philadelphia to a trophy property and their lease expenses went up like 20%, and they spent $13 million on improvements. This was — now they’re still there, but that was paid for under the old regime.

MT: That’s always kind of — I guess you can get a lot out of that and your experience at your work. I just — as a guy who works from home, it’s tough for me to picture using money in that way. But that’s neither here nor there.

TH: I work at home too and I would love to spend $13 million on my house.

MT: Yeah, I guess when you think about it that way, a $13 million home office would be pretty, the second swimming pool would be another.

TH: Exactly, this is a stressful business. So you know, a good place to relax and like a Zen Garden, like that.

MT: Oh, okay. Yeah, all right. Well, maybe we can tap the equity markets after we get off.

TH: Well, we just need low minutes of use, or things of that sort. We don’t want to show any profitability, god forbid, otherwise, we will get a terrible valuation.

MT: Speaking of not showing profitability. Let’s talk a little bit about the Middle East revenue story and what’s going on there. Just what’s — the Middle East side of the business we touched on earlier, we have this kind of big vanity project going on now. But what’s behind the Middle East revenue declines, what do investors need to know about that side of the business? It sounds like it’s shrunk already as a proportion of the total business. But what can you tell us about that?

TH: Yeah, it definitely shrunk although it is starting to grow again. And that’s kind of the known unknown, to use a cliche, that part of what drives the business. So if you’re dealing with governments like Saudi Arabia, or Oman, or Arab Emirates, clearly, oil revenue is driving their capital expenditures in their social projects.

So when oil prices collapse in a short period of time, they have — it does impact them and they can subsidize this for a while, but it — revenue is lost. So that is a part of it. But at the same time, these countries are trying to balance that with this social revolution that’s going on and or what we can call as a vanity project per se. I mean, they are trying to move forward on social issues and things of that sort, because I mean, look what happened to Libya.

So there’s this — there’s always going to be this overhang. There’s no doubt about it. About what is the truce long-term sustainability of the government’s in these countries and their spending, but it — there’s almost no way around it. I mean, it’s the chicken and the egg, you’re going to have — it’s a necessary evil.

And like I said, they had a $73 million project fall off. They cancelled. They had a $23 million project $26 million project that came to a conclusion with a beautiful airport. So it’s just kind of a necessary evil. But if revenue hadn’t already fallen 50%, I’d probably be a lot more worried than I am now. Because there’s always going to be this base level of business that they’re going to have to have in the Middle East.

So like Dubai Monorail was another thing they did, so I don’t want to pitch this as an infrastructure play per se. But there is this underlying demand of things that they are involved in, that should get supported regardless. It’s certainly easier to build a monorail before it is another refinery.

MT: Okay, so sticking with this, I have a sentence here from your article, Tim, that I’d like to quote to you, and then we can talk about it. So you write that, “for example, and nearly two-thirds of the decline in Middle East revenue year-to-date is due to a 33% decline in fixed price revenue, (non-gross margin) generating revenue.”

How did you determine that the revenue declines had no gross margins, no embedded markups and how does that affect the overall business? I think we keep sort of circling back to this idea of different quality of revenue and gross margin dollars. But what’s going on there with this revenue that seems to be booked basically at the same level as COGS no gross margin, what’s up with that?

TH: Well, first I do apologize, that hearing that out loud, it’s one of those terrible sentences like you can even imagine being written. I’m little bit confused by it. I have to think about that for a while. So mea culpa on that one.

But when I was at David Tice & Associates, so basically, we had an institutional independent research product called, Behind the Numbers. And one of the things that we used to do there, which was kind of cutting edge, this was the early 2000 was what people now commonly call forensic accounting techniques. You’re looking to uncover situations where investors are overestimating or over extrapolating recent trends, because they’re just looking at the gross numbers or the numbers, right.

So we were trying to look behind the numbers. So it is case I was trying to look behind the numbers in terms of this giant revenue decline and see what’s going on. Like I mentioned, there’s only one or two analysts on any call, and they don’t ask the toughest questions all the time, either. So it seems like people are just looking at this on spreadsheets.

So let’s see if I can walk this through. So as I mentioned before, there’s two components of revenue. One is consulting fee revenue, CFR. And typically, that’s about 80% of total revenue. The rest is basically reimbursable expenses like subcontractor costs, like they may hire contractor to watch the subcontractor, or maybe I don’t know this for a fact, but you know, could be transportation costs are just passed through, that they’re just paying for the time for the person.

So, that revenue just gets billed, it’s just like turning in your expense account, whatever it is, is whatever it is.

So if you look year-to-date, at total revenue, let’s see if I get this right, at total revenue, the Middle East is at $54 million for six months versus $75 million last year, big drop off. The CFR revenue also dropped off pretty good $68 million to $48 million. So that was terrible.

But if you look at the gross profit going back to our point, at the beginning, if you look at gross profit dollars, they only declined from $20 million to $18 million. So that’s only 12% decline. So basically $20 million of revenue went away and only 10% of gross profit dollars went away. So as I mentioned earlier, 40% gross margins are kind of typical.

So very low gross margin business has been burned off over the year, otherwise, you’d see gross profit dollars decline commensurately. And now another way to look at it is in Q2…

MT: Right, in proportion.

TH: CFR revenue only dropped $9 million, or about $27 million year-over-year. But gross profit, and the company does a great amount of disclosure, it’s fantastic. I give them high marks for the amount of detail that they provide in terms of segment analysis, gross profit dollars gross profit margins at each segment, whether it’s US or Africa or the Middle East, phenomenal, and I applaud them for that.

The gross profit’s only dropped $1.2 million. Again, about 12% versus 40% gross margin. So again, when people are looking at IT year-over-year to call, you know, look at the headlines that you always see on Seeking Alpha, and then this and everyplace else, revenue declines, blah, blah, blah, they may have beat revenue by a million dollars, but then you go, Wow, declined by 30. That’s good.

But if you can look at the numbers, you can see that the gross profit dollars are and implied back of the envelope gross profit margins are higher than what was burned off, plus the company actually reported a $1.5 million in net income, its first profitable quarter since mid-2016. And it had $7.5 million in free cash flow in the quarter. Some of that’s working capital. But none of those numbers would be going in that direction, if profitability was commensurate with the revenue that went away.

So those things all kind of flipped together, to show me that it is going in the right direction. But again, how many people are going to invest in a company where that’s happened for just one quarter in the last four years? They have to show sustainability.

Now one of the things that I didn’t mention on my report that also was interesting is, I put in my report, I calculate what percentage of the backlog gets realized over the next 12 months. They tell you the dollar amount. They tell you that X number of millions of dollars should be realized over the next 12 months. Well, one of the things that I noticed was that percentage was going down. So I don’t know the numbers off the top my head, but it was going down. And that concerned me a little. That should be kind of a stable number.

Well, I asked management about that. And they said that because the Middle East backlog is starting to increase as a percentage of the total, when we’re talking about mix, and you have projects like the $23 billion Park, those are longer in duration, and bigger in scope. And for a company like Hill, putting those in the backlog are actually beneficial from the standpoint of the longer the contract is out there and the more scope there is, the more opportunity there is for extra work.

So it’s actually something that I thought was kind of a negative to start with. But it turns out I would rather see that for now. And the answer they gave was certainly reasonable explanation from my experience. Does that makes sense?

Actually, the Middle East backlog is actually the highest it’s been in two years. So again, it’s coming down on an absolute basis, as some of those long-term projects rolled off, but in the backlog, it’s higher than it’s been in two years. And that’s not showing up anywhere.

MT: Well, let’s sort of circle back then, as we head towards the wrap up. That question sort of looms large in my mind. The years of difficulty management, you mentioned that people have been promoted from within the company. There’s a sort of — you’ve outlined the case of sort of gross margin dollars improving, the revenue mix tilting in a more favorable direction, SG&A costs coming back more into line, it looks like the balance is shifting a little bit in favor of the shareholders and favor of the activists. But how can we really be sure that we have a different situation now? What evidence can you point to, or what can you point to in terms of going forward for investors to look out for?

Management seems like such a key piece of the story. How do you sort of assess that element from where we stand today?

TH: I thought investors were supposed to embrace uncertainty. I mean isn’t that way– isn’t why in the long run growth stocks don’t outperform value, or hopefully don’t — and they have been for a long time now. But you know, isn’t that the premise, that value stocks have tended to work because expectations are low, and they just have to stumble over that bar to get a better multiple, and that lot of expectations are embedded in high PE stocks.

But more seriously, to answer your question, one, this is a tough one. I mean, this is a tough one. But it’s kind of like playing poker. You have a certain amount of information that’s known and you have a certain amount of information. I know what my cards are, I don’t know what yours are. I know the cards are on the table, I know how you have bet and people have bet, but I really don’t know what cards you have. So I have to make my bets based on Duke’s book, Annie Duke’s book.

MT: Thinking In Bets, or something like that.

TH: Yeah, Thinking In Bets, and it talks about how do you make bets with partial information? It’s a phenomenal book.

MT: Daniel also really likes it. Yeah.

TH: It’s a great book and it’s taken it from a — it’s almost like Applied Behavior theory versus some of the stuff maybe Danny Kahneman and some of those guys in favor do, just kind of doing Applied Behavioral Finance.

So one we have to embrace the uncertainty that it does not prove. And frankly, if it was so obvious, the stock would be four bucks, probably. But here’s a couple of things. In 2015, the company had a stated goal of reducing SG&A costs by $25 million. And this is on a run rate that was like $180 million. SG&A was $170 million to $180 million. It’s $120 million now, all right, much lower hurdle revenue wise to get over to make it profitable.

The analyst on one of the calls, David Richter, and I don’t know him personally, and I don’t know — he could be a great guy. I’m not trying to slay him. I’m just kind of reporting the facts that, as I know, one of the analysts, he had touted that they had already generated $21 million in savings out of the $25 million. Well, SG&A costs year-over-year were up and the analysts just — I don’t understand where — show me the numbers.

So that’s what they had before. I guess the SG&A run rate was a $170 million. It’s $120 million now. I mean, so that’s $50 million in SG&A that’s gone, if you want to gross up –40% gross margins, what kind of revenue, that’s couple of hundred million dollars in revenue, that they don’t need to achieve the same profitability that they might have in the past, right.

So get people go the other way up the income statement. I’m a lot more confident that they can — at $400 million, $320 million or let’s say $350 million to $400 million run rate, think about that $300 million to $400 million run rate in CFR revenue only on $120 million in SG&A versus $170 million in SG&A at a 40% gross margin. You can see right there what it could be.

And not that — they are not that far away. Already they are like $75 million run rate a quarter. So the company said, we’re going to reduce our costs by $25 million. They did. Now part of that was easy, because they were spending $20 million or $15 million on accountants, right, to get reinstated.

So all I can judge them on is, it’s small sample size, but so far, what they said they’re going to do, they’re going to do. The backlog is growing, which tells me that the business model is still viable. So I may not be going all in on the river, but I feel comfortable at making a three bet on the river, like, what’s the downside? The — what’s the downside? The stock traded at a low of $2.50, I guess. And Ancora one of the — he’s a 9% holder, that firms a 9%.

They have bought 50,000 to 75,000 shares between $2.50 and $2.85, including they filed two SEC Form-4 since I wrote the report. So what’s the downside $2.50, $2.20? I mean, it’s still — it’s certainly going to be more profitable now than it was, on the upside is $4 to $6. It seems like an asymmetrically rewarding bet for something that does have a lot of uncertainty.

Now people can write comments and say I’m an idiot. And that’s why there’s a two sided market. And maybe they’re right.

MT: Well, okay, so but that’s — I mean, it’s fair. And it’s — acknowledging uncertainty is, I think, something that we try and do a lot when we talk about these ideas. So I think that that’s — it’s a fair point. And at some point, you are taking a risk. So I get it.

TH: Yeah, I mean one of the things, I’ve been in the business since ’83. So one of the things that I wish I would have learned earlier in my career was sometimes it’s okay to say, I don’t know. Because I think people will and if people go back and read some of our articles, I wrote about the Illusion of Control. And I think that there is — I’m not the only one that’s written that, but I think that’s true that people think that the more knowledge they have, I mean, there’s those studies that show that after a point, more information doesn’t make better decisions.

So you have to kind of trust your sense. I don’t want to say that this is just your guesswork, but I’ve seen a few companies business models in 39 years or 36 years, and you start to recognize traits of companies and management’s that you can, that’s probably the wrong word. But you know, they get a little bit more of a benefit of that than some of these other guys. That’s why I think in the small cap space, some of the most successful investors on Seeking Alpha, and other places are these guys that do read the proxies. And they look at the history of the CEO.

And I mean, look at some of the frauds that have been exposed on Seeking Alpha or just companies that have failed and like, wow, the guy running the company has failed at three other companies. So — or has — the company has a history of overstating revenue or whatever. So you have to get down to the management and then you have to see that if the words match the deeds. So far the words are matching the deeds.

MT: Okay. Tim Heitman of Investing 501, thank you very much. Great conversation.

TH: Mike I appreciate it. Thank you.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Tim Heitman of Investing 501 is long HIL. Nothing on this podcast should be taken as investment advice.

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