Combining municipal construction operations with mineral exploration sounds like it should be something out of a Dickens novel ("It was the best of times ..."), but that's the basic story at Layne Christensen (Nasdaq:LAYN). While mineral exploration activity continues at a strong pace, municipalities are spending less on water projects. While Layne Christensen has an interesting mix of businesses and seems undervalued today, management must prove that it can consistently deliver free cash flow, if this stock is going to work.

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A Disappointing Result
Layne Christensen did not post an especially strong third quarter. Though this relatively under-followed company beat the revenue expectation and posted 9.3% top line growth, margins and earnings were disappointing.

Revenue growth was driven almost exclusively by the mineral exploration business, where revenue rose almost 40%. Water was quite a laggard, with reported revenue growth of under 3% and acquisition-adjusted "growth" of negative 6%. The company's unconventional energy business chipped in about 3% growth, as well.

Margins were a disappointment; gross margin slid nearly a point and operating income declined almost 5% from the year-ago level. Although the energy business reversed a year-ago loss and posted a small profit, the water business was a big disappointment. With margins pressured by tough budgetary environments and cost overruns, segment income fell 67%, offsetting the 79% income growth in mineral exploration. (To know more about income statements, read Understanding The Income Statement.)

Mining Good, Municipalities Bad
Mining activity is still moving along at a very healthy pace. So long as copper stays above $3 a pound, miners are interested in advancing projects. Keep in mind, though, that Layne does not deal so much with the Freeport-McMoRan's (NYSE:FCX) or Rio Tinto's (NYSE:RIO) of the world; their focus is more on the junior miners in copper and gold. However, so long as copper and gold prices can clear the production costs of junior miners, Layne Christensen's exploration rigs are likely to be busy. Although there is some risk of saturation, competitors like Boart Longyear (OTCBB:BLGPY) and Major Drilling Group (OTCBB:MJDLF) have survived past market gluts and won't be looking to kill the golden goose.

The water side of the ledger is a much different story. Special projects like Afghanistan are winding down for Layne Christensen and the general state of municipal water markets is poor, as state and local budgets remain under pressure.

Are investors still even interested in the water story? It seems like this has been the next great market for years now, and sources like Forbes, Wall Street Journal and Barron's have flogged the story relentlessly. Now, that story may eventually play out, but it won't likely happen any time soon and investors in names like Mueller (NYSE:MLI), Badger Meter (NYSE:BMI) and Aegion (Nasdaq:AEGN) have to be getting a little tired of the wait.

The Bottom Line
There is a lot to like about the Layne Christensen story. Municipal water infrastructure should be a solid (if slow-growing) long-term business, while mineral exploration offers some boom/bust excitement. Moreover, the company's returns on capital are not terrible.

What's problematic, though, is the record of free cash flow performance, or rather the lack of it. Layne Christensen has posted negative free cash flow in four of the last 10 years, and basically insignificant amounts in three other years. This has to change, for the stock to work as a long-term holding. The stock could certainly rebound from here, if and when municipalities start spending again, and metrics like P/E and enterprise multiple look reasonable, but long-term success has to be predicated on good economic returns and cash flow. For investors willing to believe that new management can guide the company in that direction, these shares are worth a serious look today. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.