Description

EXECUTION SUMMARY

• We see potential for $100mm in EBITDA uplift from Arcosa’s highly-cyclical inland barge manufacturing business, as this business is on the cusp of a substantial, multi-year uptrend from trough earnings levels. This compares to a 2019 estimate for total company EBITDA of $238mm.
• We see at least ~300bps segment margin improvement potential in Arcosa’s Energy business, as cost initiatives take hold and Arcosa taps into latent pricing power in its Transmission business.
• Arcosa’s Transmission business is also a strategic asset for the two other market leaders: Valmont and Sabre. 
• No longer a captive supplier to Trinity, Arcosa also has the potential to significantly expand their customer base in its Railcar Components business at high incremental margins.
• In Construction Products, recent and future bolt-ons will bring immediate synergies with a focus on broadening the geographic footprint, adding complementary product lines, and reducing the overall cyclicality of the business, while remaining disciplined on price.
• As ValueAct selling of Arcosa shares abates and investors get to know the company, underappreciated fundamental business improvement afoot in a number of Arcosa’s operating segments will drive the stock higher. 
• Base case SOTP on ‘22 estimates, which considers deployment of excess balance sheet to do further tuck-ins, drives an ~$72 SOTP ’22 Target Price, or 37% IRR.

Background

Arcosa operates with three segments loosely-connected by the theme of Infrastructure:

• Transportation – Inland Barges, Railcar Components
• Energy Equipment – Wind Towers, Utility Structures, Storage Tanks
• Construction Products - Aggregates (primarily sand and gravel), Construction Safety products

We believe these disparate operating segments contribute to an unwarranted “conglomerate discount” on Arcosa’s shares.  

In late October 2018, the last thing market participants wanted amidst the unrelenting sell-off was another small-cap, cyclical industrial business, but that’s just what they got when railcar manufacturer Trinity Industries spun-off its infrastructure businesses as Arcosa. 

ValueAct supported the spin of Arcosa, owing in part to the severe cyclical earnings downturn in Arcosa’s Inland Barge business, which was serving to obfuscate the more predictable railcar leasing and management earnings streams of Trinity. One of ValueAct’s main angles is that its leasing business was under-levered relative to peer GATX, and with the cyclical businesses removed Trinity could pursue a more optimal capital structure and buyback shares with the proceeds. 

With this background and the relatively smaller market cap amongst their positions, we don’t find it overly surprising the ValueAct appears to be working towards an exit of their ACA position. But the presence of a large, known, and respected seller naturally puts pressure on the stock. This should abate with time as they sell down the position, and as new investors get to know Arcosa. 

We believe these underlying dynamics plus underappreciated fundamental business improvement afoot in a number of Arcosa’s operating segments create a very compelling time to build a position. Below we discuss the three primary drivers of upside to the story as we see them

1. Transportation segment

Arcosa’s Transportation segment, despite accounting for less than 25% of 2019 Segment EBITDA by our estimate, offers a disproportionate share of the multi-year upside optionality. Both of the opportunities require a longer time horizon:

• Railcar Components – Arcosa spun with the business that supplies axles, coupling devices, and forgings to Trinity’s railcar business. Post-spin, they are no longer a captive supplier to Trinity, and management believes they are in a position to significantly expand their customer base. The Company has won some trial orders, which probably will not be meaningful for another 12-24 months. We expect the wins to come with high incremental operating margins, as they leverage existing equipment and, to a lesser extent, labor resources.
• Inland barge cycle – Arcosa is the leading manufacturer of tank barges and hopper barges, which move chemicals, refined products, crude oil, and agricultural products through the U.S. inland waterway system. By virtue of the Jones Act, Arcosa does not have to concern itself with foreign competition. What it does have to concern itself with is massive cyclicality. Since the life of a barge is 30 years, operators can defer replacement and age their fleets in lean times (the current average age of 15 years is fairly neutral as a demand indicator). In addition, the gyrations of the oil market over the last 10 years contributed to a healthy barge cycle peak period from 2011-2015, but also to the precipitous drop from 2016-2018.

While it is no guarantee of a multi-year uptrend, Arcosa’s backlog in this business bottomed in 2018, and is up 76% year-over-year as of Q2 2019. We believe Arcosa is just starting to see the tank barge demand from many large petrochemical plants coming online in the U.S. Gulf. Further, many large players in refining and petrochemicals increasingly require newer tank barge equipment, as the liabilities of any potential accident or spill far outweigh the cost of fleet modernization. Additionally, U.S. crude oil production has recovered over 30% from the trough of three years ago, and WTI and Brent differentials remain at a level that encourage crude by Barge transportation.

One simplistic approach to thinking about cyclical upside is to compare the most recent peak inland barge EBITDA of $128mm in 2015 (or the average of 2011-2015 which is not too different at $120mm) to 2018 EBITDA of $12mm. We think there is potential for much more than a ~100mm uplift in EBITDA, given the fact that the only other competitor in the last cycle has exited the market (Jeffboat). We see monopolistic pricing, shipyard expansion, and better asset utilization (as Arcosa can dictate terms more), as a powerful set of earnings drivers that will develop through this upcycle.

2. Energy Turnaround

Arcosa’s Energy segment is a good example of standalone equity incentives creating newfound urgency for management to tackle structural cost and under-investment issues that were not prioritized at the former parent. It also shows how spinoffs can make certain business lines more meaningful as value-creating carve-outs that are digestible for potential industry consolidators. 

The Energy Equipment segment represented only ~12% of Trinity’s EBIT in 2017, but its margin story will matter significantly to the upside for Arcosa. Energy segment EBITDA margins have fallen from 14% in 2016 to ~11% today, but Arcosa management is addressing this via restructuring, lean manufacturing techniques, and growth capex. 

The company is implementing best practices (i.e., robotic technology) from its Wind into its Transmission business. There’s also up to ~$12mm of growth capex related to this project that will roll-off upon completion (out of total estimated capex of $75mm and relative to FCF of $160mm for consensus ’19E). A more robotic, automated production line will lower costs and increase throughput. Arcosa also intends to improve margins through optimizing the production footprint. 

The company’s Storage Tank business within Energy, with production down in Mexico, has undergone a recent restructuring. Demand for storage tanks in Mexico is growing as the industry responds to chronic fuel shortages. Storage EBITDA margins will likely turn from a segment drag to tailwind in the coming quarters. 

The attainable target to get its broader Energy segment back in the range of 14% would make its margins approximately even with competitor Valmont Industries (VMI). 

We believe an added layer of value may also exist in simply matching the pricing discipline of Valmont in the Transmission utility pole business, such that mid-teens EBITDA margins do not have to be the ceiling. Arcosa benefits from a favorable industry structure in its Transmission business, where the market is an oligopoly shared by Valmont (~40% share), Sabre-FWT (~35% share), and Arcosa (~20%). Our channel checks suggest that pricing discipline has been improving among these three players (going back to 2016 and improving since Arcosa spin). 

In addition, revenue visibility has also been improving industry-wide, as utilities have been leaning towards smaller, more frequent projects because they’re easier to get approved and execute. This shift to smaller and more frequent projects enhances revenue visibility for the major three providers, and allows for more efficient and regular use of capacity.  Arguably, VMI and Arcosa’s Transmission business deserve a re-rate thanks to the improving industry structure, its strengthening pricing power, and improving revenue visibility from more frequent customer order patterns. We give Arcosa's Energy Segment a current Valmont multiple in our sum-of-the-parts, but believe there is upside to that assumption. 

The last period of pricing promotion, industry disruption, and excess capacity occurred across 2015-16 after the large Texas-based CREZ project wound down. Since that time, industry capacity has come offline (with some as recently as Feb. ’19, when VMI closed one of its PA facilities). 

Beyond improving supply/demand balances, the “Big 3” enjoy healthy barriers-to-entry. Large utility Alliance programs are not easy to get on the approved vendor list. Transmission poles are an important, but often smaller part of multi-billion dollar projects. The risk of a pole vendor screwing up a massive project, or even worse a pole falling down from poor construction, makes utilities more conservative and less price-sensitive. 

For some history, the Transmission business came to Arcosa via a circuitous route. It was first Thomas Betts, which became part of ABB, and then part of Trinity, where it was not a needle-mover and therefore not a chief area of focus, before spinning as part of Arcosa. Further, according to one of our contacts, VMI has a comparable lack of focus stemming from its breadth of services, as it manages a much broader Utility Services (USS) business beyond just the tubular steel support. Sabre has grown over many years organically and inorganically as their larger competitors managed their competing business lines sub-optimally.

For these reasons, we see Sabre as a potential suitor of Arcosa’s Utility Structures business, as they would bring added focus and discipline to Arcosa, and further consolidate the industry into a duopoly. Valmont could also be a potential suitor, and particularly if they felt Sabre might move first, given a Sabre-Arcosa Transmission tie-up would cost Valmont its market leadership position. 

We do not believe there’d be anti-trust concerns with a deal by either of the other two players, because the market can be defined broadly enough to include other parts of the utility industry (like lattices), an area in which Arcosa does not participate. 

Once the operations of Arcosa’s Energy segment are optimized (which is currently ahead of schedule), we believe management will likely be open to exploring all options, and that a sale of the business to Valmont or Sabre would be a compelling way to simplify the overall Arcosa story, crystallize value at an EBITDA multiple above the overall company, and create further balance sheet flexibility for either share buybacks or accretive M&A in Aggregates.

3. ACG- a platform for accretive M&A

Arcosa also fits the spinoff pattern recognition in terms of value creation via control of its own strategic and capital investments, untethered from the competing and dominant priorities of the corporate parent. For Arcosa, this is epitomised in the ability to purchase strategic assets in the Construction Products segment, as they become available at the right price. Free from its parent, less than two weeks after Arcosa’s November 1, 2018 spin-off, for example, the Company announced the $315mm acquisition of ACG Materials, which added product and geographic diversification while growing Construction Products segment revenues by ~50%. 

On its recent Q219 earnings call, Arcosa announced ~$30mm worth of two further bolt-ons (to the larger ACG platform) in Aggregates (at a “mid-single digit EBITDA multiple”) and in Marine Components, as Arcosa produces a full line of deck hardware to the marine industry, including hatches, castings and winches for towboats and dock facilities (in its Transportation business). 

We expect additional bolt-on deals like these to create value over the life of our investment. The company noted on its last earnings call they “expect to complete one or more deals between now and the end of the year, taking advantage of the growth platform we can offer smaller producers of aggregates and specialty products” and also that “the [ACG] business brought along a pipeline of small acquisition candidates that could be bolted on at attractive pricing” (which we take to be MSD EBITDA multiples).

Both the recent and future bolt-ons will bring immediate synergies with a focus on broadening the geographic footprint, adding complementary product lines, and reducing the overall cyclicality of the business, while remaining disciplined on price. 

As a bit of background for those who may be familiar with the large public companies in Construction Materials (Martin Marietta and Vulcan Materials), there are similarities with Arcosa’s business, but we would not suggest that Arcosa enjoys the same returns or competitive moat. 

Arcosa’s business skews more towards sand and gravel (where natural deposits are more prevalent) and less toward crushed stone/granite/aggregates (where strategic ownership of long-lived quarries creates regional duopolies that price based on value/weight ratios and project-by-project transportation costs). Arcosa’s products typically are lightweight and/or specialty in nature, and can be shipped over longer distances, increasing the competitive radius and decreasing relative pricing power. Accordingly, we do not use VMC/MLM-type multiples in our SOTP. Still, we believe that Arcosa’s Construction Materials business is solid, and will get stronger over time with further regional consolidation.

Valuation and Risk/Reward

On consensus numbers for 2020, Arcosa trades at an undemanding valuation of 13.3x P/E (EPS of $2.62) and 6.4x EV/EBITDA. 

We model $3.75 in 2022 EPS, using our estimate of “mid-cycle” inland barge earnings and giving Arcosa credit for continued traction in the Energy initiatives. Our EPS estimate doesn’t consider use of free-cash-flow between now and then to buy back shares or make acquisitions. Applying 16x NTM P/E to this estimate yields a target price of $60. 

But looking at a base case SOTP on 2022 estimates (realized on 12/31/21), and considering deployment of excess balance sheet in our base case, we see the potential for Arcosa to execute ~$800mm of bolt-ons through ’21. If we assume they buy targets at ~7x and 5.5x post-synergy multiples (levering the balance sheet up to 1.5x), this amounts to an added $146mm of EBITDA (when capitalized at 9x Construction Multiple yields an ~$72 Target Price), or a 37% IRR from 9/13 closing price of $34.93. 

Our risk case SOTP assumes negative organic growth in Aggregates, the cost initiatives in Energy don’t deliver, the Barge cycle never recovers – and appropriate discounts to peer multiples to reflect all this. Further, we consider less bolt-ons for higher multiples pre and post-synergy of 9x and 8x. The risk case assumptions yield a $28 target price, or a neg. -9% IRR from Arcosa’s 9/13 closing price (rendering a better than 4:1 in our base-to-risk cases).

Risks 

Expiration of Production Tax Credit - Future wind tower orders are subject to uncertainty following a phase out of the Production Tax Credit. However, even with a much smaller production credit last year, there were significant orders. Also, this Tax Credit in the past has been extended, and this could happen again. But regardless, wind is a competitive source of energy on its own merit. The Wind business represented ~15% of 2018 Segment EBITDA. 

Construction Slowdown – A slowdown in infrastructure and construction-related projects would dampen demand for Arcosa’s Aggregates businesses. However, an offset is strong aggregates demand from the Texas Dept. of Transportation (DOT) spending for extensive highway projects, which Arcosa is well-positioned to capitalize on given the location of its Aggregates assets.

This report (this “Report”) on Arcosa Inc. (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold long positions tied to the securities of the Company described herein and stand to benefit from an increase in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their long exposure to the Company’s securities or establish short positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

Catalyst

• Continued rebound in Inland Barge cycle
• Evidence of cost initiatives taking hold in Energy Segment 
• Pricing Increases in Transmission business 
• Further accretive bolt-on M&A