Lonestar West Inc.

(TSXV: LSI)
“There can be no LSIF without LSI”

Company Report

Price Target: $4.64

Upside: 76%1

Analyst: Tyler Burke

Professor: Dr. Brian Smith
Portfolio Manager: Srin Sridharan
March 18, 2014

1
Based on March 17, 2014 Closing Price
Table of Contents
1.0 Introduction .................................................................................................................................................................. 2
1.1 Investment Thesis.................................................................................................................................................... 2
2.0 Company Overview ................................................................................................................................................... 3
2.1 Lonestar West Inc. - the “Mini-Badger” ........................................................................................................... 3
2.2 What is Hydro-Excavation?................................................................................................................................. 4
2.3 The Hydro-Excavation Value Proposition ....................................................................................................... 4
2.4 Business Segment Overview .............................................................................................................................. 7
2.5 Ownership ............................................................................................................................................................. 12
3.0 Industry Overview .................................................................................................................................................... 13
3.1 Sizing the Market ................................................................................................................................................. 14
3.2 The U.S Market ..................................................................................................................................................... 17
3.3 The Competitive Landscape A.K.A Badger Daylighting............................................................................ 19
4.0 Discounted Cash Flow Valuation ......................................................................................................................... 21
4.1 Sales Forecast ........................................................................................................................................................ 21
4.2 Margin Forecast ...................................................................................................................................................23
4.3 Selling, General and Admin (SG&A)...............................................................................................................24
4.4 CAPEX.....................................................................................................................................................................25
4.5 Sustainable Cash Return on Capital Invested (SCROCI) Forecast ..........................................................27
4.6 Weighted Average Cost of Capital (WACC) ................................................................................................30
5.0 Alternative Valuation Methodologies ................................................................................................................. 31
5.1 Relative Valuation................................................................................................................................................. 31
5.2 Lonestar as a Takeout Target...........................................................................................................................32
Appendices...................................................................................................................................................................33

Page 1
1.0 Introduction
Lonestar West Inc. is a provider of hydro-excavation services across Canada and more recently in the
United States. Using hydro-vac trucks, the company is able to safely, effectively and precisely daylight
buried infrastructure and pipelines. Lonestar and its hydro-excavation peers have been experiencing
rapid growth in recent years as greater awareness of this technology is generated. I am initiating
coverage of Lonestar West Inc. (LSI) with a BUY.

1.1 Investment Thesis

The investment thesis of Lonestar is that the business will generate economies of scale through
increased growth of its hydro-vac fleet. Several components make up this investment thesis, including:

A Paradigm Shift in Excavation Technology

I believe that we are only now beginning to see what will be known in a few years as a paradigm shift
in excavation technology. As detailed below, hydro excavation is an extremely disruptive piece of
innovation to the traditional methods of excavation such as a backhoe or shovel. As more and more
of the North American excavation industry becomes aware of this superior technology, the demand
for hydro-vac trucks will skyrocket, particularly in the United States, where the “Hydro-Vac Revolution”
is only now beginning. This, coupled with potential future regulation of excavation methods, will
provide Lonestar with a long term runway for continued growth as it expands its fleet of trucks.

Continued End-Market Spending and Aging Infrastructure Provide Attractive Growth Opportunities

Historically, LSI has derived 75%1 of its revenues from the Canadian oil and gas industry. While
management intends to diversify away from this end market, the North American oil and gas growth
opportunities are material. According to the Canadian Energy Pipeline Association (CEPA), its
members plan to invest more than $22 billion in pipeline projects from 2012-20172 to construct an
additional 51,000km of pipeline. Unearthing infrastructure and trenching these pipelines will be
necessary. Additionally, aging underground infrastructure in many major North American cities
provide a massive opportunity for hydro-vac technology. An estimated $3.6 trillion in infrastructure
spending is required by 2020 in the US alone3 to restore and re-configure aging pipelines and utilities.
Lonestar stands to be a direct beneficiary of this end market spending.

The Fund Flows Argument

Many pure value investors will contest that only the fundamental operating aspects of a business
should be considered when formulating an investment thesis, and that something like fund flows do

1
Steve Li, Industrial Alliance, March 2013
2
About Pipelines – 2012, Our Energy Connection, CEPA, Oct 2012
3
Badger Daylighting Investor Presentation, Jan 2014

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not qualify. When it comes to the hydro-excavation industry, however, I would argue that investors’
choices are limited to Badger Daylighting when trying to expose themselves to this space given that
LSI does not trade very well. As Lonestar continues to grow, and most importantly, the stock’s liquidity
improves, I would argue that investors will rotate out of Badger and into Lonestar to experience
similar growth to Badger’s early stages. LSIF benefits from being a smaller sized fund that can take a
moderately-sized position, whereas large institutional investors will struggle to take a meaningful
position in the company for the time being.

2.0 Company Overview

2.1 Lonestar West Inc. - the “Mini-Badger”

Lonestar is a provider of excavation services using hydro-vac technology to the oil and gas and
utilities sectors in Western Canada and the United States. Since 2000, LSI has grown its fleet of hydro-
vac and vacuum trucks from just one, to over 77 (and growing at a pace of 2-3 per month), at the
time of writing this report. Management’s focus is on the prudent and diligent growth of this fleet of
trucks in order to capitalize on the increased use of hydro-vac technology as an alternative means of
excavation.
Fleet Breakdown as of Q2 2014E
Founded in 2000 by current owner and
operator James Horvath, Lonestar has gradually
expanded its North American presence over
19
time. More recently, management has
recognized the massive potential south of the Canada
border, and in March 2013 began an aggressive
United States
push into the United States by deploying two
trucks in California. Since then, their US fleet has 58
grown to 19 trucks.

In addition to serving the state of California,

Lonestar currently has operations in Texas and
Oklahoma to service the oil and gas sector.

Although highly levered to oil and gas activities,

LSI, through its expansion into California, has
diversified some of its focus onto the utilities
and infrastructure sectors. It is management’s
goal to diversify the business’ revenues to a
roughly 50/50 split between oil & gas and
utilities end markets.

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 2.2 What is Hydro-Excavation?

Hydro-excavation is essentially the process of using a pressurized water stream to break up rock and
soil (hydro), while removing this debris through air conveyance (vacuum) into a debris tank. The
process, commonly referred to as “daylighting,” provides for a non-destructive method of excavation
in order to expose pipelines, utility lines and other buried treasures, to daylight. While the birth of
hydro-excavation technology can largely be attributed to the Canadian oil and gas industry in the
1960’s when hydro-vacs were used as a means of exposing underground gas lines, the technology
has been successfully adopted in the utilities and construction sectors as a safe, effective and
economical way to expose buried infrastructure. Refer to Appendix 1 for additional hydro-vac
applications, and visual representations of the hydro-excavation process.

2.3 The Hydro-Excavation Value Proposition

Traditional excavation methods include manual digging via shovel and the use of heavy equipment
like a backhoe. The use of Lonestar and other hydro-vac providers’ disruptive technology has
numerous benefits including:

Safety and Damage Prevention

In the oil and gas industry, one of the single greatest causes of pipeline related injuries and fatalities is
from damage while excavating the pipeline (Figure 1). These injuries and fatalities lead to slowdowns
and increased costs, decreased employee morale, but also lead to a damaged explorer and
producer’s reputation, which, in a relationship-driven business such as the oil sands, can be extremely
detrimental to a company’s growth. As such, a premium tends to be placed on a hydro-excavator’s
ability to safely, precisely and effectively expose the buried assets. The water pressure used by hydro-
vacs to break up the dirt and soil is typically between 1,200psi to 3,000psi, enough to loosen the soil
but not to damage the assets. In fact, the truck’s water pressure can be dialed up or down to
penetrate harder ground if required4. In addition, the operators of the hydro-vac are above ground
when performing the excavation, which mitigates the risk of injury in the case of the collapse of a dig.

According to the US Department of Transportation Pipeline and Hazardous Materials Safety

Administration (PHMSA), over the past five years, excavation related damages to pipelines have
totalled just under $10 million while causing nearly 78 serious injuries and fatalities. In 2013 alone, 56%
of total reported fatalities were caused by current excavation methods.5 These figures highlight the
serious financial and non-financial need for a shift from traditional excavation methods to the safer
and more cost effective method of hydro-excavation.

4
Michael Evink, Super Sucker Hydro-Vac, Feb 2014
5
Serious Pipeline Incidents by Cause, PHMSA, Feb 2014

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 Figure 1: Total Reported Pipeline Incidents in the United States (2013)
140 $3,500,000
120 $3,000,000
100 $2,500,000
80 $2,000,000
60 $1,500,000
40 $1,000,000
20 $500,000
0 $0
2009 2010 2011 2012 2013

Excavation Related Total Incidents Property Damages ($)

In addition to the inherent increased safety through the use of hydro-excavation technology, Lonestar
prides itself on being an industry leader through a number of Health, Safety and Environmental
initiatives. Through its memberships to ISNetworld6, Complyworks7, and Pics8 auditing sites, LSI
participates in an extensive evaluation of its safety program in order to be verified as a low risk
supplier of hydro-excavation technology. These programs cost Lonestar about $500,000 per year and
allow the business to be pre-qualified for major corporate accounts in the exploration and production
component of the oil and gas sector.

While there have be no reported incidents associated with hydro-vac technology that I was able to
find, one of the biggest risks that I view of the technology itself is an operator not dialing down the
pressure of the water stream enough and cutting through the pipeline. This, however, is more
attributable to human error than to the technology itself.

Hydro-excavation is more Cost-Effective vs. Traditional Methods

While the use of a hydro-vac may seem inherently more expensive in comparison to a shovel or a
backhoe, let’s consider the costs associated with using the more traditional methods.

In a 2004 report published by the Federal Signal Corporation, more than 40% of pipeline system leaks
and ruptures are caused by damage from outside force, and more than half of all cable service
outages are caused by excavation damage9. This results in costly and inconvenient outages that are
extremely difficult to quantify in a catch-call figure. Additionally, strikes on natural gas lines are

6
ISNetworld is an online contractor management database, collecting health and safety, procurement, quality and
regulatory information
7
Complyworks connects ensures these suppliers meet corporate, legislative and regulatory requirements
8
Pics is a globally renowned contractor prequalification company
9
Hydro-Excavation, A safe, cost-effective alternative for underground construction and municipal use, Federal Signal
Corporation, Jan 2004

Page 5
particularly hazardous and expensive. In Ontario, the Technical Standards & Safety Authority could
fine a business up to $1,000,000 if a natural gas line is struck10. As an illustrative example11 of the cost
and time savings for companies which can be driven by the use of hydro-excavation technology,
please refer to the cost-benefit analysis below. Assume a 2ft. x 2ft. area that will be dug to a depth of
6ft, then backfilled in order to restore the area to its original condition.

Figure 2: Conventional Method of Excavation

Operation Time Cubic Yards No. in Crew
Unchain, unload and stage equipment 0.5 hours
Uncover utility 3 hours 13.3 4
Backhoe, dump truck
Backfill 2 hours 12.1
Restoration (196. sq. ft.) 1.5 hours
Reload equipment 0.5 hours
Total 7.5 hours 25.4 4
@ $50-$70/hour (manual digging) $375 - $525
Note: hole must be open with slopped sides to allow for hand digging

Figure 3: Hydro-Excavation Method

Operation Time Cubic Yards No. in Crew
Park truck, turn on vacuum and water 5 minutes
Uncover utility 0.5 hours 0.9 yards 2
Backfill 25 minutes 0.9
Restoration 1.5 hours 1.2
Total 2.5 hours 3 2
@ $250/hour (standard rate) $625
Note: there is no need to slope the sides as the operators are on the surface during excavation

At first glance, the cost savings may not seem that significant as method 1 was done through manual
labour. However, when excavations reach a large enough scale, manual digging largely becomes
infeasible. Additionally, rates for backhoes will depend on whether one rents or hires a contractor, but
a per hour cost of $50 - $200 is not unreasonable depending on one’s geography. However, if we
consider the potential liabilities and damages associated with striking pipelines, using a backhoe could
be exponentially more expensive. Lastly, reported increases in productivity from switching to hydro-
excavation technology range from 60% to upwards of 900%, with cost savings of upwards to 90%.12

10
The Real Dirt on Pipeline Strike, TSSA, March 2014
11
Hydro-Excavation, A safe, cost-effective alternative for underground construction and municipal use, Federal Signal
Corporation, Jan 2004
12
Badger Daylighting Investor Presentation, Jan 2014

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Year Round Application

Historically, explorers and producers (E&Ps) could not excavate in the cold winter months due to the
frozen ground, necessitating the need for an innovative technology. Now, however, the majority of
hydro-vacs come with heated water tanks, equipping them with the ability to thaw frozen ground and
excavate year round, an additional advantage over the traditional methods. Year round hydro-
excavation is the primary reason why this technology was first adopted in Canada. Many of the U.S’
resource plays, however, do not suffer such harsh winters as their Canadian counterparts and can
excavate year round regardless. I believe this is the primary reason as to why the U.S’ rate of adoption
of hydro-excavation technology has lagged Canada’s, as there has been no direct catalyst, regulation
or drastic need for innovation.

2.4 Business Segment Overview

Hydro-Vac

Hydro-excavation trucks are your traditional “daylighting” trucks using the aforementioned process of
uncovering buried assets. Of Lonestar’s current (Q2 2014) 77 truck fleet, 79% of their trucks are hydro-
vac trucks, contributing to 85% of Lonestar’s consolidated 2013 revenue.

Figure 4: Historical Hydro-vac Revenue

50 $25,000,000
45
40 $20,000,000
35
30 $15,000,000
25
20 $10,000,000
15
10 $5,000,000
5
- $0
2008A 2009A 2010A 2011A 2012A 2013A

Hydro-Vac Revenue Fleet Size

Since the business’ IPO, it has been management’s focus to aggressively grow the size of its hydro-
vac fleet in order to meet anticipated market demand. Management has guided that they will grow
their hydro-vac fleet by 2-3 per month, but naturally do not specific a time period over which we can
expect that build-out rate to continue. Based on my research and discussions with management,
though, I believe Lonestar can grow at a rate greater than 2-3/month, particularly since their supplier

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has additional capacity of 12 trucks per month. However, I model no increase in fleet growth rate in
my Steady State Growth scenario.

A typical Lonestar hydro-vac truck costs approximately $475,000 with an initial capital outlay of
$95,000 (assuming a 5 year lease period) and generates annualized EBITDA of $110,000 to $120,00013,
implying a roughly 4 year payback of the entire amount of the truck.

Figure 5: The Economics of a Hydro-Vac

HVAC Trucking Economics
Initial Capital $95,000
Annual EBITDA (Low) $110,000 A
Annual EBITDA (High) $120,000 B

Discount Rate 11.16%

15 Year A B
One Year CoC Return 115.79% 126.32%
Full Truck Payback 4.32 yrs. 3.96 yrs.
Lifetime Value of Truck $770,027 $840,029

12 Year A B
Lifetime Value of Truck $697,769 $761,203

10 Year A B
Lifetime Value of Truck $634,700 $692,400

Guidance and visibility on the useful life of these hydro-vacs is sub-optimal, however. Each operator’s
hydro-vac has different utilization levels and as such, the wear and tear on these trucks will vary. This
problem is compounded by the fact that in such a nascent market, many of these operators have not
had these trucks for very long, and don’t actually know how long they will, on average, last. Lonestar

13
Kristina Scade, Lonestar CFO, Opportunity Knocks V Investor Conference, Nov 2013

Page 8
management has a targeted useful life of 20 years, supported by the fact that management still has a
1989 hydro-vac in their fleet, which “[they] can’t tell apart from the other trucks from a distance.” On
the other hand, however, Badger trucks have a reported 10 year useful life, which, as one sell side
analyst covering the name admitted, is probably low balling it. She mentioned that Badger is likely
squeezing more useful life out of these trucks than 10 years (12 is more accurate). Channel checks
have yielded no more of a concrete number, as I have heard as low of a useful life as six years, and of
course, as high as 20 years from Lonestar. While I believe that 20 years is a stretch, even at 15 years
this implies that Badger trucks have at best an equal economic life. For the purposes of my model, I
have assumed an estimated useful life of 12 years, taking roughly the approximate mid-point of the six
and 20 year useful life range yielded from channel checks, and closer to the estimated useful life out
of Badger’s trucks. The model, though, is built with the optionality to target a useful life of 8, 10, 12, 15
and 20 years. You may find this optionality on the Toggle Page in my model.

In Figure 6, I detail the target price’s sensitivity to both the percent of new truck additions attributed
to the U.S, as well as the estimated useful life of the trucks. As you can see, the stock is highly sensitive
to the amount of life that can be squeezed out of these trucks, and monitoring Lonestar’s truck
disposals in the future will be key to remaining convicted on this name. In my Steady State Growth
model, I estimated a useful life of 12 years with 70% of new additions going to the U.S.

Figure 6: Target Price Sensitivity to U.S Additions & Useful Life

I will note that the current share price of Lonestar is pricing in a truck useful life of 10 years, with ~5-
10% of additions flowing to the U.S; contradicting both management and logic; as the economics of
operating in the U.S are far superior to Canada which I detail later on in my report.

Vacuum

While representing a much smaller portion of the business at 16% of the fleet size, Lonestar also
provides industrial vacuum related services, primarily to the oil and natural gas industry. Together with
a crew, these trucks are designed to remove drilling fluids from well sites and dispose of them at
authorized disposal facilities for impure waste. Drilling fluids are used by drilling companies to
lubricate the drill bit, stabilize the surrounding rock, control subsurface pressures and ultimately
enhance drilling rates. The primary revenue driver of LSI’s vacuum operations is the number of wells
being drilled by oil & gas explorers and producers, which directly impacts the utilization rate of these
trucks. Lonestar’s vacuum operations are highly levered to drilling activity in the oil and gas sector,
and more specifically dependant on revenue generated at the drill bit. As this tends to be the most

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volatile component of an E&P’s budget, it is not unusual to see cyclicality in the earnings generated
by this operating segment. It is interesting to note that the majority of E&P’s are drilling wells using
the relatively new technology of horizontal drilling, which requires more specialized drilling fluids and
in greater quantities. This provides Lonestar’s vacuum segment with a strong tailwind as it continues
to penetrate and win business in the WCSB and U.S resource plays.

Figure 7: Continued Horizontal Drilling Benefits LSI’s Vacuum Segment

70%
60%
50%
40%
30%
20%
10%
0%
2005 2006 2007 2008 2009 2010 2011 2012
Vertical Horizontal

Based on discussions with management, there are no further plans to immediately add any vacuum
trucks. The reason for this is that management desires to reduce the cyclicality in Lonestar’s business
and feels that by growing their vacuum fleet they are inherently levering themselves to the oil & gas
end market. As such, growth in their fleet will be, for the foreseeable future, entirely hydro-vac.

The typical vacuum truck costs approximately $400,000 with an initial capital outlay of $80,000
(assuming a 5 year lease) and generates annualized EBITDA of $110,000 to $120,00014, implying a
roughly 3½ year payback of the full value of the truck.

Figure 8: The Economics of a Vacuum Truck

VAC Trucking Economics
Initial Capital $80,000
Annual EBITDA (Low) $110,000 A
Annual EBITDA (High) $120,000 B

Discount Rate 11.16%

15 Year A B
One Year CoC Return 137.50% 150.00%
Full Truck Payback 3.64 yrs. 3.33 yrs.
Lifetime Value of Truck $783,977 $855,247

14
Kristina Scade, Lonestar CFO, Opportunity Knocks V Investor Conference, Nov 2013

Page 10
 12 Year A B
Lifetime Value of Truck $708,685 $773,110

10 Year A B
Lifetime Value of Truck $643,441 $701,936

Lease Operators

Similar to Badger Daylighting, Lonestar’s largest competitor, LSI generates revenues from dedicated
sub-contractors that have signed a lease operator agreement with the business. These entrepreneurs
own and operate their own hydro-vacs, while LSI leverages its scale and expertise to manage their
invoicing, aid in customer acquisition, and dispatching of fleets. Utilizing these lease operating
agreements allows Lonestar to generate revenue with minimal capital expenditure on its end. While at
first glance the economics of this segment seem superior on a per-truck basis (average revenue of
$99,580 per truck/month in 2013), the gross margins generated by this segment are capped at about
15%. Lease agreements stipulate that Lonestar will manage the back-office functions of the sub-
contractor in exchange for a 15% cut of all gross revenues generated. The remaining 85% of revenue
is charged to operating expenses.

Other

In additional to hydro-vac and industrial vacuum services, Lonestar also provides ancillary operations,
categorized as “Other.” This catch-all bucket is comprised of operations including sump reclamation
services, aluminum shoring boxes for rent, as well as drilling fluid and environmental consulting
services. Other than the information found on Lonestar’s website concerning this operating segment,
we have minimal visibility into the fundamentals of this portion of the business. However, by my
estimates, gross margins of this segment are approximately 62%, likely driven by the higher margin
business of consulting services. Historically, Other revenue has never exceeded 7% of consolidated
revenue, and in 2013 was a mere 2.5%.

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 2.5 Ownership

By investing in such an early stage and small-cap company (<$60mm market cap), one is by
extension also investing in the people behind the company. With a little under 43% ownership,
insiders and executives have a clearly vested interest in the success of Lonestar. In addition, CEO
James Horvath is an actual operator himself, with boots on the ground and a working knowledge of
the entire company, all the way to the front line. He has an active voice in any design changes of
these trucks and leverages his 13 years in the oil & gas industry to win Lonestar business.

7% Figure 9: Top Holders of Common Stock

51%
Holder % of CSO
James Horvath, CEO 32
David Prussky, Director 8
43% Tracy Graf, Independent Director 1.5

Asset Managers Insiders Public

The management team is highly approachable and can be contacted quite easily. Our talks with
management and the business’ investor relations team have been very fruitful, and now that our
research is close to being completed, we plan on reaching out again to ask about more questions
that have come up.

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3.0 Industry Overview

The North American hydro-excavation market can be described as both nascent and experiencing
rapid growth. The industry is fairly fragmented as 5 large players control an estimated 54% of the
market’s current capacity (which is rapidly expanding), with the remainder of the market going to
smaller operators.

Figure 10: Current Estimated North American Market Share

1,000 940
900 798
800
700
600
500
400
300
200
70 77 80 90
100
-
Hydrodig Lonestar Big Eagle Clean Badger Other
Harbors

Both the Canadian and U.S markets are at two different stages of their development, however. The
U.S market represents a massively under penetrated growth opportunity, while the Canadian market
is saturated to a greater degree, but still has room to grow. Further, both markets have vastly different
economics and competitive landscapes. It will be a useful exercise to distill the market into these two
geographies and explore the intricacies of both markets. First however, we will examine the similarities
across the entire excavation industry itself.

I must confess that the more I researched this industry, I viewed it less and less favorably. Firstly,
barriers to entry are low given that only a source of capital is needed to enter, and after entering,
incumbents rapidly scale up given the favorable economics of operating a hydro-vac. Based on my
discussions with many smaller “mom & pop” operators in Canada and the U.S, all of these operators
are growing for growth’s sake; ordering trucks to meet demand they see six months down the road
without knowing how large, in fact, the market really is. The single most worrying conclusions drawn
from my research into this industry is that no one truly has an idea of how large the opportunity really
is. The only thing saving industry incumbents from head-to-head competition at this point in time is a
rapidly expanding pie, where everyone seems to be getting their fair share. But therein lies the
problem. Once this pie stops growing and demand begins to slow, excess market capacity will drive
fierce price competition. Forecasting when this will happen is an exercise of determining the Total
Addressable Market (in terms of trucks), and forecasting incumbent’s fleet growth rates. I attempt to
do this in the Market Sizing tab in my model.

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Secondly, I view the industry as commoditized. Through channel checks, no single truck is viewed as
better or worse, and they all largely offer the same value proposition. As management of Keyera (one
of the largest midstream operators in Canada’s oil & gas industry) noted, “we don’t really care who
we call, they all do the same thing.”

Key takeaway: the low barriers to entry and commoditized nature of this industry breed a recipe for
fierce competition when the market begins to slow.

3.1 Sizing the Market

Given the early stages of the hydro-excavation market and the speed at which it is currently growing,
no one has a precise sense of just how large this market currently is, and how large it is going to be.
Not only is the rate of adoption from traditional excavation methods to hydro-excavation technology
increasing, but new uses of this technology are being discovered as well, such as tree root excavation
and lock/canal cleaning. This makes sizing the market a challenge. There are, however a few proxies
available that I used in order to get a rough sense of the size of this market. In order from least to
most accurate, I classify them as follows:

1. The Badger Rule of Thumb (RoT)

Badger management has a proxy that they use when determining how many Badger hydro-vacs a
typical market can support15. Their rule of thumb is 1 hydro-vac for every 100,000 people in a given
market (I am assuming the denser, more heavily populated areas like Toronto, Edmonton, etc.). Given
their market leading status, if we know how large Badger is aiming to be in certain markets, we can
get a better grasp of how big the market will grow to be. This assumes, of course, that Badger seeks
to maintain their current share of the market in the future.

If we put this rule of thumb to the test for the select markets in which we know Badger’s truck count,
however, we find that the ratio is not entirely precise, but comes in at a fairly tight range:

Geography Population16 Badger RoT Badger Count Actual Ratio

Downtown Toronto 2,615,060 26 trucks 35 trucks 74,716:1
Ottawa-Gatineau 1,282,500 12 trucks 17 trucks 75,441:1
KW, Guelph & Cambridge 980,837 5 trucks 11 trucks 89,167:1

If the Badger RoT is applied to the entire North American hydro-excavation market, we would find
that the total North American hydro-vac market has a capacity for roughly 3,139 Badger hydro-vacs
in America, and 352 in Canada. We can back out a rough estimate of total N.A capacity by applying
Badger’s estimated current market share of both of these markets, at 42% and 27%, respectively17. In

15
Sarah Hughes, Cormark Securities, Phone Conversation, March 2013
16
Population numbers obtained from 2011 Census Data
17
There’s a New Sheriff in Town, Clarus Securities, March 2013

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doing so, we arrive at a total capacity of 8,778 hydro-vacs (7,475 in the U.S and 1,303 in Canada). This
method has a few drawbacks, however, including:

Greatly undershoots the size of the Canadian market: as of March 2013, there were already an
estimated 1,000 hydro-vacs in Canada in March 2013. Further, the commentary from both
Lonestar and Badger is that they will continue to add hydro-vacs to the Canadian market and
are seeing no reason to slow their build rate
Ignores “special” (i.e.: oil & gas) markets that will require a greater number of hydro-vacs, and
applies the same catch-all rule to every geography

I do, however, see the merit in applying a refined Badger RoT to a “utilities market” where population
density and the size of a city will generally dictate the amount of buried infrastructure such as
pipelines, fiber optic cables, etc.

2. Sizing the Utilities and Oil & Gas Opportunities Separately

Two of the largest end markets for hydro-excavation technology are utilities (infrastructure) and oil &
gas. Getting granular on both markets will help us better size the market opportunity.

Utilities / Infrastructure

As mentioned, I see the logic behind Badger management’s decision to size a market based on the
population in a given geography. As such, I will be using a refined Badger rule of thumb to size the
North American utilities and infrastructure opportunity. Instead of Badger’s catch-all ratio of 1 truck for
every 100,000, I will attribute trucks between what I label as Tier 1 cities, and Tier 2 cities.

Tier 1 cities have populations >1,000,000. A Badger truck to citizen ratio of 75,100:1 will be
applied to these markets: the average of Toronto and Ottawa’s ratio
Tier 2 cities have populations <1,000,000 but >500,000. A ratio of 90,000:1 is applied to these
cities: a rounded-up version of the KW, Guelph and Cambridge ratio

My approach involved screening for North American cities that had a minimum population of
500,000. Why the cut-off? Well, as I detail in section 4.3 SG&A Forecast, a typical hydro-vac base
needs 6 trucks operating off of it to be profitable. Assuming 1 base per city, the refined rule of thumb
is roughly in line with this.

Once these cities were screened and placed into their respective buckets, Tier 1 and Tier 2 ratios were
applied to them, and after backing out Badger’s market share of these markets, it resulted in a total
North American utilities opportunity of 1,787.

Please refer to the Market Sizing tab in my model for the methodology behind this exercise.

Page 15
Oil & Gas

According to the Canadian Energy Pipelines Association (CEPA), there is an aggregate 830,000km
worth of underground natural gas and liquids pipeline in Canada18. The vast majority of these
pipelines run through the WCSB (AB and SK), as shown in Figure 11.

Figure 11: Canada’s oil and natural gas infrastructure (L/R respectively)

Today, there are an estimated 1,145 hydro-vacs operating in the WCSB19, or about 1 truck for every
725km of pipeline. Given that hydro-vac technology was born and bred in Alberta, the province is a
great case study for a mature market. By extension, applying the same ratio of trucks in the WCSB to
America’s oil & gas pipeline infrastructure will give us a ballpark figure for the amount of hydro-vacs
needed to service this end market.

Canada U.S
Amount of Pipeline (km) 830,000km 3,660,000km20
No. of Trucks 1,145 5,049
Multiple 725x 725x
Revised trucks 1,145 5,000

Should the U.S ramp up use of hydro-vacs in their oil and gas industry in similar quantities to Canada,
it would equate to demand for approximately 5,000 hydro-vacs, up over 500% from the estimated
826 currently in use. On the aggregate, therefore, total North American capacity for hydro-vacs in the
oil & gas industry is 6,145 trucks.

When combined with the market opportunity of 1,787 in the N.A utilities sector, I have effectively sized
the total opportunity at 7,932 hydro-vacs.

18
Facts, Canadian Energy Pipelines Association, 2013
19
Clarus Securities, March 2013
20
There’s a New Sherriff in Town, Clarus Securities, March 2013

Page 16
 Figure 12: The North American Hydro-Excavation Opportunity

23%
13% 14%
CA O&G
10%
U.S O&G
CA Utilities
77% U.S Utilities
63%

Oil & Gas Utilities

3.2 The U.S Market

The U.S market can be characterized as the land of opportunity for your typical hydro-vac company.
Sized at approximately 6,035 hydro-vacs, I estimate this market to be only 14% penetrated from
current levels, leaving plenty of room for companies like Badger and Lonestar to grow. Similar to
Canada, the top 3 players in the U.S account for 58% of the fleet count, with the remainder attributed
to smaller owner-operators.

Figure 13: The United States Hydro-Vac Market

450 407
400
350
350
300
250
200
150
100
50
50 19
0
Lonestar Clean Harbour Other Badger

The key differences between the U.S hydro-vac market and the Canadian one are as follows:

1. Higher degree of fragmentation driven by spread of resource plays

2. Less seasonality in operations due to lack of spring break-up

Page 17
 3. A better cost base
4. Greater degree of pricing power

One of the largest differences between the Canadian and U.S oil & gas markets is their relative
geographic spread. In Canada, many of the Canadian oil and natural gas plays are concentrated in
the Western Canadian Sedimentary Basin (WCSB). As such, it is economical to move trucks from, for
example, a Lonestar base in Conklin, Alberta, to Fort McMurray, Alberta. However, in the U.S,
resource plays have wide geographic spreads, and moving trucks from the Eagle Ford shale play in
southern Texas to the Bakken in North Dakota is infeasible. As a result, a number of regional
competitors have entered the market to selectively service these resource plays, further fragmenting
the U.S market. Lonestar has the ability to selectively enter underserved resource plays and establish a
reputation in these areas, securing long term relationships in the process.

Additionally, the U.S does not suffer from the same degree of seasonality as Canadian operations,
given that there is no spring break up in the U.S. Although data out of Lonestar’s U.S operations from
Q2 ’13 – Q1 ‘14 tell a different story (with revenue/truck/month ranging from $32K to $98K), I largely
attribute this to growing pains as management familiarizes itself with the geography and gains
traction in the market, and I expect stable revenue levels out of this region going forward. Please refer
to section 4.1 Sales Forecast for my methodology in smoothing out this revenue stream. The key
takeaway, however, is that we will not see the same cyclicality in earnings out of the U.S as we have
seen in Canada.

Operating in the U.S not only provides a more stable earnings profile, it is also much more
economical to do so compared to Canada. Gross margins receive a double leg-up driven by a
cheaper labour pool, cheaper fuel and better pricing power south of the border. One mid-sized (40
trucks) Texan owner commented that salaries for his operators start at $12/hour, compared to the
$45/hour that Lonestar currently pays its work force in Canada. Although this is only one data point,
this operator is one of the largest private American operators I discovered. It would, therefore, not be
unreasonable to expect other similarly sized operators to be paying similar wages. Not only does
operating in the U.S provide a better cost base, but based on discussions with management, Lonestar
has been able to charge upwards to double the rate they charge in Canada as the demand for this
technology has bid up the price.

I do not, however, expect that these conditions will last forever, and in fact, forecast a reversion of U.S
gross margins on a per truck basis to their Canadian counterparts through both decreased pricing
and increased COGS. For greater details on this margin compression, please refer to section 4.2
Margin Forecast. Lastly, the cost of maintaining trucks is cheaper south of the border given the more
favorable weather conditions (less salt on the roads = less wear and tear on the body, warmer
weather, etc.), and would even likely lead to these trucks having a longer useful life.

Given these favorable market conditions, I expect Lonestar to add 70% of all new truck additions to
their U.S operations. While the exact number is not disclosed (and would likely be fluid in any given
year), this assumption is supported by discussions with management and an analyst covering the
name who commented that the majority of new trucks are going to the U.S. I note that the % of

Page 18
additions attributed to the U.S can be changed in the model to suite any assumption. The optionality
can be found on the Toggle Page tab in my model.

On Weather and Demand

While the need to be able to excavate in frozen conditions was the catalyst for hydro-excavation
demand in Canada, I do not believe this is necessarily what is driving sustained demand for the
technology. Safety and precision are the primary drivers of this demand. While the U.S’ rate of
adoption has lagged Canada’s to date, I believe we are in the early to mid-stages of rapid hydro-vac
demand in America where weather and geography are less catalysts than safety.

3.3 The Competitive Landscape A.K.A Badger Daylighting

Allow me to address the elephant in the room. At an estimated 798 trucks, Badger is the undisputed
king of the North American excavation market. I do not see Lonestar, or any other company coming
even close to touching Badger in sheer size at any point in the future. Badger has greatly benefited
from the first mover advantage, and is firing on all cylinders.

Both Badger and Lonestar will claim that they have trucks superior to the competition, and can out
dig each other on any given day. Given the commoditized nature of this industry, I find it difficult to
claim that either company’s competitive advantage is derived from their trucks. Innovation of these
trucks has been stagnant for years after heated tanks and extended blowers were implemented. In
fact, other than edging Badger’s trucks out in terms of water capacity and aesthetic design, I contest
that Lonestar’s trucks are nearly the exact same as Badger’s and every other market participant. I
should note, however, that one month ago there was an alleged “dig off” in which 2 trucks each from
Clean Harbours, Badger and Lonestar dug to win a contract from Keyera, a midstream oil and gas
company in Canada. It is further alleged that Lonestar won the dig off and subsequent contract.
Although I have not been able to substantiate this claim (I called Keyera, they were not aware of such
a competition), even if it were true, Lonestar has no durable competitive advantage as their trucks are
purchased from third party suppliers, and thus anyone can buy them – although LSI does claim that
they do make very small modifications to the trucks before sending them into the field.

Operator reputation, and by extension, safety policies, are both integral to winning business in the
hydro-excavation industry. Lonestar spends approximately $500,000 - $600,000 per year on safety,
audits, training programs and memberships to various organizations. In doing so, it allows LSI to work
directly for large firms like BP, Shell, Suncor, etc., rather than go through sub-contractors as Badger
allegedly does. This makes a typical Lonestar job more economical than a Badger job as sub-
contractors will not be collecting a premium. The amount of money needed to maintain this safety
record is the only “barrier” to competing with the big boys that I have discovered, as smaller
operators are unable to pay such fees and will be subsequently squeezed out from working with large
firms.

Page 19
Key Takeaways from Industry Analysis:

Market opportunity is currently nascent and underpenetrated, which is allowing for strong
trucking economics and allowing Lonestar and Badger to avoid price competition

A conservative market sizing exercise conducted by myself sizes the North American market
opportunity at just under 8,000 trucks. Lonestar management estimates that there is capacity for
2,000 hydro-vacs in the state of California alone, which is greater than my estimate for the entire
North American utilities market. That being said, I would rather work off a smaller base that I can
justify, instead of a hypothetical number that I cannot

At current expected growth levels (Badger 20 trucks/month, LSI 3/month), my estimated market
size is large enough that the potential price competition that could arise in the future would likely
not be seen until 2021. This is centered on the assumption that the industry would only experience
price competition when it is 75% penetrated

If the industry were to experience hyper growth, with Badger and LSI deciding to ramp up their
growth targets even faster, then pricing competition could be seen as soon as 2019.

Implications

Should the fund purchase Lonestar, LSIF must monitor the growth of both Badger and LSI
consistently. Hyper growth in this industry, causing pricing declines driven by competition, makes
new trucks value destroying, instead of value creating. To illustrate how, please refer to 4.5 –
SCROCI Forecast
o I note that in a Hyper Growth scenario, the downside in Lonestar is ~36% from the March
17 share price

Using the Hyper Growth Scenario section of my model, several such scenarios can be run to
assess the impact of faster penetration, which will drive subsequent pricing declines and effect the
valuation.

Page 20
4.0 Discounted Cash Flow Valuation
4.1 Sales Forecast

Hydro-vac

Hydro-vac revenues are driven entirely by the growth of Lonestar’s hydro-vac fleet. Revenue per
truck/month was calculated by dividing Canadian and U.S hydro-vac revenues by the average
number of hydro-vacs in their respective geographic fleets for that quarter.

Canadian hydro-vacs

As described, Canada can be thought of as a more mature market compared to the U.S and as such,
is more likely to face competitive pressures in the medium term. As a matter of conservatism and
perhaps even a little punitive, I model a 2% YoY decline in Canadian revenue/truck for the duration of
the forecast period while holding margins constant beginning in 2015. This is reflective of both
potential increased competition and management’s desire to diversify into utilities, which will bring
along with it a lower utilization per truck and thus, lower revenue per truck.

On a separate note, due to the effects that spring breakup have on the drilling season, as well as the
traditionally strong winter that many hydro-excavators in Canada experience, Lonestar’s Q4 (Apr.-
June) Canadian sales tend to be the weakest, whereas Q3 (Jan. - March) tends to see the highest
revenue per truck. I saw it as more accurate to reflect this seasonality in my forecast period and as
such, is the justification behind forecasting quarters. Total yearly sales were pulled higher by the
strong Q3 if an average of the quarters was taken.

U.S hydro-vacs

Given the relatively few data points out of the U.S and the effect weather had on Q4 numbers, getting
a good grasp on the figures coming out of the U.S is challenging. Sales out of the region have been
particularly volatile, and I attribute this to growing pains and weather. Lonestar began U.S operations
with a revenue/truck/month figure of $97K, while kicking of Q1 2014 (after having added an additional
10 trucks in the quarter, and thus utilization would be poor) with $63K of the same figure. I chose to
grow U.S revenues at the low end of the mid-point of these two numbers, and settled at
$70,000/truck/month. This is roughly in line with management’s commentary that they have been
able to charge as much as double the rate they charge their Canadian customers. The smoothing out
of U.S revenues is to reflect the lack of seasonality in this geography’s operations due to no spring
break up as experienced in Canada.

It is management’s goal, however, to model their revenue split between end markets off of Badger.
That is, instead of deriving a roughly 75/25 revenue split between oil & gas and utilities as they
currently do, Lonestar’s consolidated revenue will be a 50/50 split between those end markets. One
key point that should be noted is that utilization of hydro-vacs in oil and gas runs much higher than

Page 21
utilities, as the latter’s work and revenue tends to be quite lumpy given the nature of contracts in the
sector. To reflect this, I model a 2% YoY decline in monthly revenues in the U.S beginning in 2015.

Vacuum

As previously mentioned, the primary driver of Lonestar’s vacuum segment is drilling activity, which
directly impacts the utilization of its vacuum fleet. Given recent management commentary
surrounding their decision to focus on exclusively growing their hydro-vac fleet in the near term, I
decided not to model any additional vacuum trucks added to LSI’s fleet. I have held the current
number of vacuum trucks at 16 constant for the duration of the forecast period, assuming only that
management maintains this amount of vacuum trucks in their fleet. To this revenue stream I applied a
0% growth rate.

As part of the PLJ acquisition, Lonestar obtained 2 vacuum trucks. Management does not openly
disclose the revenue composition/split between hydro-vac and vac of the U.S fleet, so I have taken an
average per truck revenue of LSI’s Canadian vacuum trucks and applied it to the 3 U.S vac trucks in
Q1 2014. Similar to its Canadian counterpart, the U.S vacuum revenue stream was not grown at all
throughout the forecast.

Lease Operators

Given a combination of unfavorable economics on this revenue steam, as well as the inability to
forecast when and in what quantity lease operators will be added, I forecast no lease operator
additions. Instead, a 2 year average of this revenue stream is taken and subsequently grown at 0% for
the duration of the forecast period.

For the purposes of my model, I have held the current number of lease operators 10 constant. I deem
it a reasonable business assumption that Lonestar would not actively seek out lease operators (unless
there is a change to the lease agreements on a go forward basis that would make sub-contracting
more economical), and will instead seek to add corporate owned hydro-vacs on a go forward basis as
the economics are much more favorable for the business.

Other Revenue

Given the lack of visibility and management guidance into this segment, I have assumed in my model
that once Lonestar becomes a 100 truck company, management shifts its focus onto becoming a pure
play hydro-vac/vac company. In assuming so, I have effectively removed this revenue stream from the
company’s earnings profile in Q2 2015. Up until that point, however, prior quarter revenues out of this
segment were taken as “placeholders,” so to speak. This revenue stream is immaterial on the
aggregate.

Page 22
 4.2 Margin Forecast

Operating Expenses (COGS)

Lonestar’s COGS consists of variable expenses related to the operation of its fleet, such as fuel, repairs
and maintenance, lease operator expense, field office rent, etc. As such, these costs are driven by the
amount of trucks in Lonestar’s fleet. Similar to monthly revenue per truck, COGS was decomposed on
a per truck basis.

Canadian COGS

COGS was derived by taking a 4 year average of Canadian cost of goods sold per truck (as a % of
sales per truck), and applying those margins on a go-forward basis. The maturity of the Canadian
market is reflective in my modelling of steady margins, neither increasing nor decreasing as a
percentage of sales in the forecast period.

U.S COGS

As previously discussed, operating in the U.S provides both a better cost base (through cheaper fuel
and labour) and better pricing power given the early stage development of this technology. As such,
U.S gross margins come in much higher than Canadian margins on a per truck basis. However, as the
market south of the border matures, LSI diversifies its revenue stream to the lower utilization sectors
of utilities and infrastructure, and labour becomes increasingly difficult to source, I expect gross
margins to revert to Canadian levels. As such, I model a 2% lift in U.S COGS per truck until 2021,
matching the average Canadian COGS/truck of 72% (as a percentage of sales).

Figure 14: U.S Truck Gross Margin Forecast

80,000 50%
70,000
40%
60,000
50,000 30%
40,000
30,000 20%
20,000
10%
10,000
- 0%
2014 2016 2018 2020 2022 2024 2026 2028

Revenue/truck/month Gross margin/truck

Lastly, as discussed, lease operating margins have a gross margin of 15%, and I hold this margin level
for the duration of the forecast period.

Page 23
 4.3 Selling, General and Admin (SG&A)

A large proportion of Lonestar’s SG&A consists of fixed costs such as executive management, investor
relations, head office costs & staff, etc. It would therefore be reasonable not to see these expenses
increase in direct proportion of revenue. It should be noted, however, that as Lonestar builds out its
infrastructure in the U.S and Canada, additional corporate costs will be incurred which will
subsequently flow to SG&A.

According to an analyst close to the names of both Badger and Lonestar, in order for a base to be
profitable, a minimum of six trucks need to be operating out of it, which is in line with Badger’s 798
trucks operating off of 100+ bases. This analyst provided further commentary that once a base has
~12 trucks running off of it, additional infrastructure and personnel are needed to support and
manage the growing fleet, such as an additional regional manager. In order to reflect the escalating
cost of a build-out of infrastructure, I have held 2013 SG&A expenses (7.13% in Canada and 8.61% as
a % of respective geographic revenue) constant throughout the forecast period. 2013 was a period of
heavy corporate spending:

The hiring of a full time CFO

The hiring of a Director of U.S Operations who was previously employed at Badger
Infrastructure build-out in Oklahoma, Texas and California (5 additional bases), and with them,
I assume, regional managers

By holding a margin level reflective of heaving corporate spending, I add an element of flexibility and
conservatism to the model. At Lonestar’s current fleet run rate of 2-3/month, only 2-3 bases would
need to be added every year. Only when/if Lonestar increases its fleet run rate to 5-6/month would
the “actual” SG&A level even begin to reflect what is forecasted in the model.

Applying these SG&A margins yields, on average, an incremental $2.3mm in corporate expenses
every year. This is enough to support two acquisitions every year of similar size as their 2013 PLJ
acquisition. Recall that the PLJ acquisition was for total consideration of $1.6mm, provided Lonestar
with two additional bases, and included a total of 4 trucks. Thus, ex-trucks, a typical 2 base acquisition
would likely be in the range of $700,000 to $800,000, giving Lonestar the flexibility to add up to 5
bases every year, plus room for $300,000 in incremental salaries.

Figure 15: Total SG&A

25,000,000

20,000,000

15,000,000

10,000,000

5,000,000

-
2014 2016 2018 2020 2022 2024 2026 2028
Page 24
Total SG&A
As the company stops adding trucks to its fleet, however, corporate expense buildout should reflect
the slowdown. As such, when growth of the Canadian fleet decelerates and retirements begin in 2024,
I model a decline in SG&A from 7.69% to 6% (as a % of Canadian sales). I perform a similar exercise
for U.S SG&A in 2026, reducing SG&A from 9.37% to 8.5%.

4.4 CAPEX

Recall that a hydro-vac currently costs Lonestar an all-in $475,000 and that a vac truck costs all-in
$400,000. However, Lonestar leases the vast majority of its fleet over 7-9 years, paying those amounts
out evenly over the life of the lease. However, I model a conservative 5 year lease pay down on
Lonestar’s trucks. By leasing, Lonestar is smoothing out the capital requirements of the business,
essentially earning greater than their ‘cost of capital’ in the first year which, on a per truck basis, can
be thought of as the first year’s lease payment: remember, trucks earn ~$115,000 of EBITDA/year.

Lonestar’s total cash CAPEX figure is essentially just a function of total lease payments and the
amount of trucks retired in a given year. I will note that I grow the cost of the trucks by inflation (2%)
every year. Based on discussions with management, as Lonestar continues to order trucks from its
suppliers in ever greater quantity, volume discounts are a real possibility and the price of these trucks
may actually decline in the future. Forecasting either the timing or magnitude of these discounts
would be arbitrary, however, and so I have opted for conservatism by increasing prices.

Maintenance CAPEX

Lonestar’s mCPX consists of two things:

1. Regular expenditures related to the upkeep of the fleet (think repairs and maintenance)

The Badger Factor: in order to get a sense of the cost of regular upkeep and maintenance of these
hydro-vacs, an average of Badger’s mCPX per truck per year from 2004-2012 was calculated and
applied to Lonestar’s fleet on a go-forward basis. The figure, $12,785 per truck per year, is inherently
conservative for my model given that the average age of a Badger truck across that timeframe was
4.5 years old, whereas Lonestar’s fleet is currently much younger. Recall that my model has the ability
to target a useful life of 8, 10, 12, 15 and 20 years for these trucks. If a user is seeking to target a useful
greater than 12, consider using a higher “Badger Factor,” say, 10% of the cost of a truck, or $40,000 -
$47,500.

2. The replacement of any trucks that have reach their targeted age of retirement

Traditional maintenance CAPEX is a function of the number of trucks being retired and the
replacement cost of a truck in that year. While the amount of trucks being retired will differ with the
targeted useful life, the mechanics remain the same. In the “Model for Ageing” section of my model, I
track the age and retirements for Lonestar’s hydro-vac and vacuum trucks.

Page 25
Growth CAPEX

Lonestar has financed the vast majority of the growth of its truck fleet using term debt (vehicle
financing) and capital leases. In doing so, Lonestar is able to essentially defer the payment over the
life of the lease, smoothing out and reducing the strain on cash flows. Giving them credit for
engaging in this type of financing was essential in my DCF. As such, all truck related cash CAPEX in a
given quarter was subsequently modelled to be paid back evenly over the next 5 years.

Page 26
 4.5 Sustainable Cash Return on Capital Invested (SCROCI21) Forecast

I note that while I forecast SCROCI for my Steady State Growth case, this write-up is geared towards
explaining the structure of my Hyper Growth scenario and its effect on value destruction. It has no
weight and is in no way levered to my Steady State Growth model.

Given the capital intensive nature of Lonestar’s business, and more importantly, the amount of
maintenance CAPEX needed to support the upkeep of the business’ fleet, SCROCI is a more accurate
measure of the cash returns LSI will generate in the future. As with any market/industry in which
incumbents earn returns in excess of their cost of capital, competitors tend to enter at a steady clip
(depending on barriers to entry) until returns are driven down to the cost of capital. A similar case
study in which this has occurred would be pressure pumpers. The hydro-excavation market will be no
different, as both Badger and Lonestar have been earning stable, impressive returns as of late, while
smaller operators continue to enter the market.

Figure 16: Lonestar and Badger Historical ROIC/WACC Ratio

6.0

4.0

2.0

-
2009 2010 2011 2012 2013
(2.0)

LSI BAD

Given what I believe to be this industry’s low barriers to entry and commoditized structure,
competitors will continue to enter the space and scale up, saturating the market with hydro-vacs. This
will eventually increase competition, drive down asset utilization and prices, and cause incumbents’
SCROCIs to dip below their cost of capital for a period of time. Asset rationalization, consolidation
and bankruptcies will eventually restore companies’ SCROCI to their WACC.

Increased Incumbents destroy

Low barriers to entry
competition: poor value before earning
lead to market
asset utilization and their approximate
saturation
lowered prices cost of capital

21
SCROCI defined as (after-tax EBIT + D&A –mCPX) / (non-cash net working capital + net PP&E)

Page 27
I see this as a highly likely scenario given that as of right now, incumbents really have no idea how
large this market is and are simply growing for growth’s sake. It’s only when hydro-vac demand
beings to slow, however, that we will start to see rationalization and industry consolidation as a result
of value destruction. This now becomes an exercise of forecasting when this will happen, and at what
speed the market will rebound from it.

If you recall, I have sized the entire North American hydro-excavation market opportunity at 7,932
trucks. Since we only have fleet run rates for Badger and Lonestar, we can manipulate their growth
rates to reflect an all-out “arm’s race” and the resulting penetration rate of the entire market.

More detail on the following scenario is provided in the Growth Rates tab in my model, but if we flex
Badger and Lonestar’s growth rates to reflect a Hyper Growth scenario, we can estimate that by 2023,
they will have grown to be approximately 53% of the market, and between the two of them and
Other incumbents, the market will be 104% saturated.

Figure 17: BAD and LSI’s Estimated Truck Run Rate

4,500
4,000 3,672 3,552
3,336
3,500 3,240
3,000 2,664
2,500
2,088
2,000 1,560
1,500
1,056
1,000 661 626
566 568
432
500 185 293
95
-

Badger Lonestar

Price competition, however, will have begun long before 2023. At a chosen, although arbitrarily, 73%
total penetration rate in 2019, I believe the market will begin to feel crowded and incumbents will start
to compete on price. This is supported through my belief of the commoditized and highly
fragmented nature of this industry. Price competition continues to intensify over the forecasted next 5
years while incumbents continue to grow until the market reaches peak capacity and firms begin to
destroy value, or, in other words, Lonestar’s SCROCI falls below its cost of capital.

After this Value Destruction period, however, in 2026 a period of stabilization characterized by
consolidations, bankruptcies and exits of smaller operators occurs, rationalizing the industry.

Page 28
After this point, a Natural Order state occurs where I believe we’ll start to see remaining incumbent’s
returns begin to track their cost of capital.

Hyper growth and price competition lead to value destruction

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%

2030
2020

2022
2023

2025
2026

2029

2032
2033
2024

2027
2028

2034
2021

2031
2014

2017
2015
2016

2018
2019

SCROCI WACC

How quick will the actual recovery be? Well, I don’t see the barriers to exit particularly strong in this
industry, and well-capitalized companies like Lonestar and Badger will have ample dry powder to
consolidate the space at that point. This consolidation, however, would only be to restore pricing
power and to rationalize the industry’s assets. I model no acquisitions.

Key Takeaways:

Hyper growth, while I believe highly likely of occurring, is in fact value destructive to firms like
Lonestar in the long run

Implications:

Again, if LSIF owns Lonestar, incumbent growth rates will need to be very closely monitored,
while keeping a “pulse” of the overall health of the industry (pricing, takeovers, size, etc.)

Page 29
 4.6 Weighted Average Cost of Capital (WACC)

The assumptions underlying Lonestar’s WACC of 11.16% are outlined below:

Market risk premium: LSIF’s standard 7% market

risk premium was used Lonestar WACC
Weight of Equity 90.59%
Risk free rate: Government of Canada 10 year Weight of Debt 9.41%
yield was used
LSIF Market Risk Premium 7%
Cost of equity: The CAPM model yielded a cost of Risk Free Rate 2.44%
equity of 6.15%, which proved insufficient. As Beta – Cap IQ 0.53
such, a cost of equity of 12% was chosen. This is Beta – Badger Daylighting 0.85
reflective of LSI’s risk profile, earnings cyclicality Cost of Equity (CAPM) 6.15%
and early stage of development Cost of Equity (as used) 12%

Cost of debt: given that ¾ of Lonestar’s debt is Pre-tax Cost of Debt 4.13
through term debt (vehicle financing), the Statutory Tax Rate 25%%
midpoint of the range (0% - 8.25%) provided by Tax Rate (as used) 25
management for these payment instalments was After-tax Cost of Debt 3.10%
used WACC 11.16%

Tax rate: Lonestar’s statutory tax rate of 25% was used

Page 30
5.0 Alternative Valuation Methodologies

Given the lack of public pure-play hydro-vac companies in North America, building a peer group large and relevant enough to value
Lonestar on a relative basis proved difficult. As such, additional valuation methodologies were explored.

5.1 Relative Valuation

Aside from its most obvious competitor, Badger Daylighting, I have expanded Lonestar’s peer group to include oilfield services companies
that are similarly sized and operate with a degree of cyclicality.

Valuing Lonestar using a comp group is a catch 22 as I believe the business does not, in fact, deserve Badger’s multiple (this assuming
Badger is not even overvalued which one could make the case it is), and valuing the business against other oilfield companies discounts the
company’s growth profile and is punitive. It is appropriately placed in the middle and I further note that the company has the ability to grow
in order to support the multiples placed on the business today.

I would personally put far less weight on a relative/multiple based Lonestar valuation that a strict DCF valuation.

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 5.2 Lonestar as a Takeout Target

In January of 2011, Clean Harbors Inc. (NYSE: CLH), a provider of environmental and related services,
tendered a bid to buy Badger for $222mm, valuing the company at 6.4x 2010 EBITDA. A Lonestar
takeout at this multiple would never happen, as this values the business at $1.26 per share. A more
likely multiple to reflect Lonestar’s growth profile would be in the 15-18x EBITDA range, valuing
Lonestar at $3.32 - $4.03/share. Who would pay such a multiple and more importantly, who could
realize the synergies needed to make such a deal accretive? We can immediately cross other pure-
play hydro-vac companies off the list (Badger) as I view the synergies associated with such a deal as
virtually non-existent, and the $80 - $95mm would be far better spent on actual hydro-vacs.

A company like CAT or John Deere, however, whose traditional backhoes stand to lose a great deal of
market share to hydro-vacs may be more likely suitors. These companies are well-capitalized but
more importantly have the dealer networks, footprint and relationships to realize real synergies from
a Lonestar acquisition. They would be unlikely to operate the business, however, and leave Lonestar’s
existing management team intact to lead the business.

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 Appendices

Appendix 1

End Market Applications

Oil and gas Pipeline excavation
Pipelines trenching
Tank cleaning
Facility maintenance
Utilities Piling
Pole hold excavation
Telecom Excavting buried utilities
Environmental cleanup Debris removal
Cleanouts
Construction Shoring
Slot trenching

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