|Shares Out. (in M):||112||P/E||6.5x||5.8x|
|Market Cap (in $M):||1,823||P/FCF||6.5x||3.9x|
|Net Debt (in $M):||795||EBIT||435||495|
|TEV (in $M):||2,618||TEV/EBIT||6.0x||4.3x|
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AECOM is a diversified professional services firm with 45,000 people across a network of 450 offices in 130 countries. The services they provide are architectural and engineering design and construction management. 42% of the business is in the U.S., 10% is in Europe, with the rest based in developed countries that are mostly driven by emerging market economies – in Australia, Canada, Middle East and developed Asia ex-Japan. About half of the business is cost-plus and the rest is fixed-price, but each contract is typically very small and fixed prices usually cover services only, not the cost of overall projects. As a result, only 25% of revenue has construction related fixed price risk. ACM’s clients are 2/3 governments and 1/3 private clients. The markets served are non-residential facilities, environmental and transportation. ACM’s market share is tiny, no more than 1-2%, and its services are a commodity, but it’s the largest company in the industry with the best global presence.
Why the stock is where it is today:
Revenue headwinds. Government clients are facing substantial headwinds in their budgets, and the market is betting that ACM’s revenue has just started a secular decline.
The flaws of acquisitive growth have been revealed. Most of ACM’s growth has been a result of a rollup strategy that has recently back-fired, with two of the large deals from 2010 contributing losses in the first half of fiscal 2012.
Cash flow has collapsed. The rollup strategy led to deteriorating cash flow: free cash flow was on average 92% of net income in ’04-’09, then 38% in ’10, 20% in ’11, and -28% in the first half of fiscal ’12. Part of this deterioration is due to a one-time event: $150mm cash outflow in 2011 due to termination of deferred compensation plan liability. Adjusted for that, free cash flow in 2011 would be 74%.
Started missing earnings. Since it went public in 2007 and through November ’11, AECOM beat or met Street’s expectations 17 times and only missed once by less than a penny. It was routinely raising its guidance as it was going through each year. The last two quarters, it missed earnings by 4-9% and lowered guidance for this year. Most investors believe that even that earnings guidance is extremely aggressive and can’t be achieved.
As a result, the stock is trading at the lowest level since it went public in 2007. P/E on fiscal 2012, including restructuring charges, is 6.5x, and EV/EBITDA at 4.9x. On Street consensus NTM earnings, the stock is trading at 6x vs. the last (and only) time when the stock was trading at this price in early ’09, when it was at 9x. On EV/EBITDA the all-time trough in early ’09 was 4.6x, and the stock is at 4.8x now.
1. Cash flow should improve: these businesses are usually very consistent cash flow generators and ACM is overhauling compensation, linking it to cash flow.
Change in compensation structure. This year 40% of short-term bonus for regional and division managers was linked to DSO’s (vs no such link last year), and it’s increasing to 50% next year. The company has engaged its largest shareholders to overhaul compensation for the CEO and CFO as well, starting in fiscal 2013 (begins with December ’12 quarter), linking it to three metrics: free cash flow generation, EPS growth and ROI – in contrast with EBITDA growth being one of key metrics in management compensation until now, incentivizing the roll-up strategy that destroyed value.
All competitors have very stable DSO’s—less than 80 days most of the time. We have studied the DSO’s of ACM’s closest comparable public and private competitors. The reason AECOM gradually moved up from the pack is because it was acquiring many companies and didn’t integrate them properly. It’s usually cited that AECOM’s DSO’s are high because of extended receivables in the Middle East, but Middle East infrastructure business is a very small part of this company: only 7% of total net service revenues, so its importance is misunderstood by the market. 80 days DSO’s has been the goal at ACM for many years and they are planning to get back there in the next two years.
Normalization of DSO’s at 80 days should release $400mm of working capital, which should improve ROTIC to ~24% from ~18% in 2011. One DSO day is over $20mm. We’re 19 days over the normal 80 days DSO right now. Normalizing DSO’s should therefore release almost $400mm of working capital, ~23% of ACM’s market cap and ~13% of EV.
We’ve looked at DSO’s of ACM over time and compared them to DSO’s of CH2Mhill, Stantec, TetraTech and URS. All of these peers have DSO’s that are 1) very stable, and 2) almost always at or below 80 days. ACM’s DSOs historically were flat and below 80 days, then gradually increased for the last three years to almost 100 days. The business itself hasn’t changed, so focusing more on collections should allow ACM get back to 80 days.
2. Revenues are not about to fall off the cliff, they will likely be flattish for years to come.
Infrastructure E&Cs’ revenues are never as volatile as the market thinks. When the stimulus was introduced, infrastructure e&c stocks (JEC, Stantec, AECOM, TetraTech) almost doubled in a couple of months, then it turned out to be a non-event for revenues. Now investors think spending on public infrastructure is about to fall off the cliff because we haven’t had a Federal Highway Bill for the past couple of years (it was just renewed two weeks ago). Even with temporary short-term injections of cash every 3-6 months for the last three years, highway spending has remained broadly flattish. The passage of highway bill by Congress two weeks ago ensures that transportation revenues, the part of the business the market worries about most, will stay flat plus some inflation adjustment through late ’14 – better visibility than most cyclical businesses.
AECOM is quite diversified across geographies. Despite all the fear about impending revenue collapse, ACM has shown flat organic revenues year to date, which is not a terrible result. This happened despite a 4% drop in AECOM’s biggest market – the U.S., despite rapid exit from Iraq this year and abrupt end to AECOM’s substantial work in Libya and Abu Dhabi early last year. The reason revenues have stayed flat: there were several offsetting trends like significant growth in Asia-Pacific and flattish Canada. The point is that AECOM is so large that it would take a synchronized global recession to really hurt the revenues, and even then the decline is perhaps 2-5% a year, insignificant vs. the majority of other industrial companies, and this ignores the fact that governments around the world tend to counter-act recessions with new fiscal stimuli. Assuming a very conservative scenario of no growth in Asia, continuing collapse in Europe, acceleration of decline in the US, we still only get a couple of percentage points of revenue decline. The bottom line is that organically, this company should maintain its revenue stream roughly constant in most macro scenarios.
The composition of business and actual and likely future growth rates look as follows:
Geography Share 2012 YTD Organic growth Growth next couple of Yrs
Asia 10% 17% in Asia-Pac 0% in Asia-Pac
Canada 10% 1% 5%
Middle East/Africa Infrastructure 6% (7%) 10%
Europe 10% (9%) (10%)
US Gov’t Envir. & Facilities 19% (4%) all US (5%) all US
US Gov’t transportation 15%
US Private Envir. & Facilities 8%
US Gov’t military support 5% (7%) 7%
TOTAL 0% (1.7%)
3. Margins have been hurt by recent restructuring in Europe and the Middle East, right-sizing in the US and poor performance and structuring with the military in Iraq. Margins should recover to industry standard and ACM’s historical range.
The earnings delta between the bears’ expectations and ours comes from normalization of margins, not from revenue growth. The business in London and Libya disappeared fairly rapidly, so AECOM had to take charges in the last four quarters. In addition, it was a management issue – they expected US business to reaccelerate and carried too many people, but since it didn’t happen, AECOM just laid off 1,000 people in the U.S. This happened year-to-date, so we haven’t seen any positive effects from cost-cutting yet. Lastly, the ramp-down in Iraq before the ramp-up in Afghanistan combined with a bad acquisition and poor contracting (caps on SG&A billed to US DoD make it difficult to cover fixed costs even under cost-plus contracts when business is slow) drove ACM’s MSS segment into losses. These margin issues won’t disappear overnight, but over the next year the margin should normalize in the 10% EBITDA range, which is easily achievable as seen in both ACM’s own history and its peers’ current margins. For example, since ACM went through the restructuring of its London office – twice – it has now achieved profitability in its European business in the current quarter (vs. big losses in the last two quarters). Note that there’s very little price competition in ACM’s businesses – the government infrastructure business has standard salary multipliers, so most of competition is on technical qualifications.
ACM’s margins were in the 8% range in ’04-’06, gradually increased to nearly 12% in 2H’11 before collapsing to 8% in 1H12. We think margins will return to 10%-11% in Q3 and Q4 of this year due to cost cutting. ACM’s stated goal is 12% by 2015. We compared ACM’s EBITDA margins to peers over time. Margins of peers have generally been higher and very stable. TTEK always had margins in 10% to 12% range. Arcadis margins are more volatile, but average 12%, with occasional drops to 10%. Margins at Stantec are very stable in the 13% to 16% range. The point is that it shouldn’t be difficult for ACM to get back to 10% margins –below the level they have already been, below their stated goal and below all of their competitors’ stable margins.
4. Valuation looks OK even on blow-up results over the last six months and dirt cheap on normalized results we’ll see in a year.
The following discussion shows how value will be created by ACM as a result of massive FCF generation over the next two years.
ACM’s market cap is $1.8bn and it has net debt of $800mm for an EV of $2.6bn. On net service revenues of $5.2bn, with 10% normalized EBITDA margin (see point 3 above), ACM should earn $2.35/sh EPS and $270mm of FCF/sh before any working capital is released (note: mgt expects to generate $300m of FCF from operations annually going forward; we’ve chosen to be conservative).
The decline in DSO’s to 80 from 99 over two years should release $400mm of FCF. Therefore, over two years, FCF to equity should be over $900mm, 50% of the equity value and 35% of EV (note: mgt expects to generate $1B of FCF over the next two years; we’ve chosen to be conservative). Assuming buy-backs and dividends, that’s a 25% FCF yield a year for two years in a row.
Assuming the cash accumulates, the company will be debt-free in two years and trading at 7x P/E. 25% FCF yield for the next two years is by far the highest in the industry (double or more vs. peers). Even on blow-up earnings from the last 6 months including the charges on restructuring and seasonally weak revenues and margins, the stock is trading under 10x P/E. On normalized EPS of $2.35 and $520mm EBITDA, it’s at 7x P/E, and 5x EV/EBITDA respectively (about 6.5x blow-up EV/EBITDA).
All of this assumes zero organic growth at AECOM. It’s also predicated on the thesis that the era of the roll-up strategy has passed: management seems to recognize how much value was destroyed here (over $2bn money spent on deals since the beginning of ’07, more than the current market cap), the company has done no substantial deals in the last six quarters and the board has no plans to authorize any substantial deals.
There’s a range of outcomes as to what ACM can do with its cash flow. At the current price, the more stock the company repurchases, the higher the value of the stock. In the unlikely scenario they buy back $900mm of stock with organic free cash flow in the next couple of years (40% of the company), fair value would be $50/share in our opinion, more than triple the current price. On the other hand, just generating cash and letting it sit on the balance sheet still leaves us 100% upside.
1) $900mm stock buyback. Assuming $20/share average purchase price, the share count decreases by 45mm and assuming EBIT of $430mm, $50mm of interest and minority interest and 29% tax rate, FCF of $270mm gives us FCF/sh of $4.03. Assuming 12.5x multiple, we get a fair value of $50/share.
2) Assuming $600mm in M&A, $200mm buyback and $100mm debt pay down, and assuming more bad deals at 11x EBIT, sustainable EBIT for the company increases to $480mm, interest and minority interest drops to $45mm and FCF goes to ($430mm+$54mm-$45mm)* 71%=$311mm on the share count of 102mm, or FCF of $3.05/sh. At 12.5x, we get a fair value of $38/share for the stock.
3) Assuming all $900mm is used for more M&A if the management doesn’t change their strategy, and deals are done at 11x EV/EBIT, we add $81mm EBIT to the current EBIT of $430mm and using the current share count and interest, we get FCF of $2.92. At 12.5x FCF, the stock’s fair value is $36.50/share.
4) If they just generate the cash and don’t use it, net interest goes away, and we have FCF of $2.72/share. At 12.5x we get fair value of $34/share.
1. We do not consider this management team to be strong. They have destroyed a lot of value through their rollup strategy, driven by faulty compensation practices. They may not agree, even under significant pressure from large shareholders, to change this value-destroying strategy.
2. The board may be reluctant to make significant changes to the CEO’s and President’s compensation. They may also establish low targets for cash flow generation to allow management to easily achieve targets.
3. Synchronized collapse in government finances of developed economies around the world, especially in the US, Canada and Australia, could lead to substantial revenue declines at ACM, which would temporarily pressure margins again as the company restructures to the new size again.
1. Change in compensation, linking it closely with shareholder returns and cash flow – should be done at August ’12 board meeting. This is a result of ACM’s largest shareholders vetoing the existing compensation structure via Say-on-Pay vote.
2. Margin recovery as long-needed cost-cutting finally occurring across the company will drive margin improvement, further magnified by the charges in the last four quarters that make for easy comps.
3. Cash flow generation should improve as compensation is linked to it and as DSOs normalize closer to industry standard and ACM’s past standard of 80 days, releasing 400mm of working capital;
4. New capital allocations strategy: the company has recently made clear to investors that the board is not approving any large deals, so we think a new capital allocation strategy is likely with more buy-backs, more debt pay-down, and potentially a dividend.
5. Valuation itself in this case is a catalyst. The stock is trading at 6x-7x P/E, which implies E will be collapsing. We think this is highly unlikely due to margin recovery and stable revenues.
6. An activist shareholder could get involved. We are hopeful the company is changing its capital allocation strategy which alone should result in tremendous value creation (no more large deals, buying back stock and paying down debt). While large shareholders are currently pressing management for change, these shareholders remain passive. Given pressure on management and the board from existing shareholders, it’s likely an activist shareholder could garner a very large degree of support from the current shareholder base.
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