Description

AECOM is a leading engineering and construction firm that has significantly improved its business in the last two years, is undervalued in its current structure, and is poised to unlock additional value through the early 2020 spin-off (or sale) of its government services segment -- and potential other actions, as the company is being targeted by more than one activist investors. I believe the company has at least 50% upside to fair value without assuming any additional strategic actions beyond the announced separation of the government services business. 

The presence of activists (Starboard and Engine Capital), given a backdrop of several years of underperformance, increases the urgency for management to deliver, be forced to take additional actions, or be replaced.

ACM is a rollup of rollups (the last major acquisition was of URS Corp in October of 2014) that has tried to expand to a fully integrated design, build, finance, operate, maintain model. However, it has found that the marketplace didn’t want to adopt this model, nor could they execute well on it, and has, in their words, done a 180, and begun to pare down its operations to a more focused model with less fixed price contracts, less sprawling geographic exposure, less construction exposure, and less oil and gas exposure. The objective of this transformation is to become a professional services focused company with higher margins and smoother, more predictable results. So far, the company has made a lot of progress toward this goal.

This chart from Credit Suisse lays out the company’s current segments quite well:

I won’t elaborate much in describing the business, as ACM has been written up on VIC several times before. The most recent was in February of 2015 by VQRP99 (author closed position in Nov 2016). Unfortunately, the company did not deliver on its own guidance, nor on the author’s earnings growth estimates, which called for ~$3 of earnings power in 2015, growing significantly in the future. The company is now expected to earn just $2.76 for fiscal Sept 2019, and $3.26 for fiscal Sept 2020 -- far below these prior expectations. 

The company has underperformed for several main reasons:

• ACM increased its exposure to the energy and infrastructure construction markets with the acquisition of URS in 2014, just as these started to decline 
• ACM has had high exposure to fixed-price contracts (which, with poor execution, led to cost overruns, especially in fiscal 2018) 
• ACM management has not executed particularly well

Combined, these issues reduced EBITDA by hundreds of millions of dollars versus the company’s post-URS growth model, and led to multiple years of massive stock price underperformance. 

In response, the company embarked on a transformation plan in the fall of 2018 which has led to significant operational progress and lends credibility to the company’s current plan.

The transformation plan announced in November of 2018 had the following objectives:

• $225 mm in G&A reductions 
• Leadership and strategy change in the Construction Services segment to avert future fixed-price project losses like what occurred in fiscal 2018
• Plan to exit 30 countries with high operational risk and management time demands but little contribution to results (<1% of revenue and break-even or negative profit)
• Portfolio review of non-core and high-risk businesses for possible divestment

As of June 2019, the company has made significant progress:

• Announced the 2020 spin-off of the government-focused Management Services business
  • This business could earn near double the company’s current multiple, based on comparables
  • ACM appears to be running a sales process concurrently with the spin, as the business should offer significant synergies to acquirors in the same space
• Achieved full $225 mm of G&A reductions 
• Increased DCS margins by 100 bps, while targeting another 110 bps of margin expansion by fiscal 2020
• Sold oil and gas production services and international development businesses
• Over 40% complete in exit of 30 countries
• Currently reviewing all at-risk construction exposure with the goal of exiting all at-risk, self-performed construction by the end of this fiscal year

This progress is very encouraging and points to structural improvements in the business which should lead to better long-term profitability and predictability.

However, there may be room for significantly more operational improvements or strategic actions. Starboard posted this letter in June of this year, after taking a reported 4% stake in the company: https://www.starboardvalue.com/wp-content/uploads/Starboard_Value_LP_Letter_to_ACM_CEO_and_Board_06.20.2019.pdf

Starboard argues that the company has poorly executed over the last 5 years and has significant room for margin improvement and strategic actions to unlock value. It appears that ACM got ahead of Starboard with their announcement of the spin-off of the MS business, but Starboard does identify other areas for improvement, and suggests that a sale of MS may drive more value than a spin-off, because of potential margin improvements another company might identify. From my conversations with ACM, it seems clear that they agree and are running a dual process. In their spin-off call they said they believe the segment would offer “sizable synergy opportunities” to a strategic buyer, but it seems few paid attention to this comment. 

For the remaining company, Starboard argues that the DCS segment has the most room for improvement, pointing to margin comparables at Jacobs Engineering and others that appear several hundred basis points higher. The 100 bps of yoy margin improvement that ACM just reported in August for this segment, combined with the 110 bps of additional expected gains through the next fiscal year should close much of this gap. 

Furthermore, Starboard argues that the already achieved $225 mm of G&A reductions are actually quite minor and significantly more should be possible. 

While I have been a long-term investor and my thesis on the company and its upside was never based on a break up or an activist campaign, I appreciate the pressure that they are applying to the company to perform, or else.

Valuation:

There are a variety of ways to estimate ACM’s intrinsic value and upside. My base case scenario assumes no change in the business structure (no spin-off or sale). 

The company’s current operating plan calls for 5% revenue growth, 9% EBITDA growth, and 12-15% EPS growth through fiscal september 2022. With revenue and profits growing significantly faster than long-term market averages, no major competitive threats, and no end in sight to growth in demand, it seems the company should easily earn a market multiple or even a small premium to the market. Since ACM currently trades at ~11.4x forward earnings, vs. the market at 16.9x, this would imply about 50% upside to fair value today. This is a rough method, but I believe it’s in the right ballpark, and it matches up with my internal, long-term DCF model.

The catalyst in this scenario is simply that the operational improvements the company has made and is in the process of completing will enable the company to better deliver on its operating plan, and eventually its earnings growth profile will drive a multiple re-rating. Meanwhile, intrinsic value will be increasing with earnings growth each year. 

Another way to consider the potential upside is based on the assumption that the government services business is sold next year at similar multiples as peers, and proceeds are used to reduce leverage and buy back shares in the remaining company.

Management Services, the segment that will be spun off or sold, generates about 25% of the company’s ebitda. ACM is currently projected to generate just over $1 bn in ebitda in fiscal 2020, so MS should contribute about $250 mm next year. Government services peers (BAH, CACI, LDOS, SAIC) currently trade at roughly 13x 2020 ebitda. ACM’s MS business has slightly lower margins, but better free cash flow conversion than peers. Perhaps it gets a 12x multiple. That results in ~$2 bn of after-tax proceeds. After paying down some debt to reach target leverage of around 2.0x, the company expects they would have over $1 bn available to repurchase stock. If the MS business gets a 12x multiple, that would imply the remaining business (generating about $800 mm of ebitda in 2020) currently trades very cheaply, at just over 7x. And $1 bn of additional buybacks (on top of the $800 mm remaining in their current authorization) could generate substantial accretion. Meanwhile, the remaining professional services business, post the ongoing transformation, should have highly stable cash flows and itself earn a better multiple.

I am not betting on how the spin or potential sale will play out, but the accretion or improved combined valuation that could occur from either scenario provide free potential upside to my base case.

The bottom line for ACM is the following:

• The business is on the path toward significant structural improvements which should allow it to deliver above-market earnings growth with much more stability and less severe or frequent losses, and should therefore earn a much higher multiple
• The planned spin-off or sale of the MS unit should unlock additional value through multiple appreciation, and/or deployment of proceeds
• Management is highly motivated to execute on both operational and strategic actions with more than one activist holding their feet to the fire

Catalyst

• Continued execution on margin improvement and business de-risking efforts
• Sale or spin of MS unit in 1H 2020
• Multiple re-rating as a smoother, more predictable professional services business emerges