Description

Background of our thesis: We recommended ACM at $16 on July 19, 2012.  Today, it is $30.  We believe ACM remains among the most attractive stocks in our portfolio and is going 30-50% higher over the next 12 months.  We are now presenting a new idea in ACM’s closest competitor, URS, where we think a base-case scenario allows 100% upside over 2-3 years.  We highlight ACM because we believe buying URS today is the equivalent from a price versus value perspective of buying ACM at $20.  The catalysts that occurred at ACM are now emerging at URS and we believe ACM is now the benchmark for URS.  A portion of this write-up will discuss the history of our investment in ACM because we believe it is the simplest way to present our thesis on URS.

Company Description: URS is a leading global provider of engineering, construction, program management, design, O&M, technical services and decommissioning services to public and private sector clients around the world.  It has recurring-revenue contracts with both private and public enterprises that helped earning prove resilient and grow through the Great Recession.  80-85% of their contracts are cost-plus, unlike the majority of the E&C industry which has higher exposure to fixed-price contracts.  At $12B in revenue, URS is now one of the largest most diverse E&C companies in the world.  By end market, 34% is federal, 29% is oil and gas, 15% is infrastructure, 13% is power and 9% is industrial.  Of the federal market, we estimate 20% is defense related, 6% is DOE and 8% is a mix of DHS, Justice Treasury, EPS, NASA, UPS and GSA.  While federal was 49% in 2011, it is 34% today as the Flint acquisition diversified the company further into the faster growing non-conventional O&G market.  This compares to ACM’s 2/3 government mix.

Why the stock is mispriced:  We described 4 reasons for ACM’s mispricing in our original write-up July 19, 2012.  Three of these are identical in URS’s case today: 1) Poor historic capital allocation, 2) Government exposure and 3) Recent poor FCF conversion.  We also believe URS is mispriced because the cyclical decline over the past few years in the power, commercial and industrial segments are being extrapolated.  We believe capital allocation is the majority of the reason the stock is mispriced and the emphasis of this write up will focus on that aspect alone since correcting it will generate more than a sufficient return by itself.  Regarding #2, like ACM, government exposure weighs on URS’s valuation.  Cost-plus contracts enable expense reduction in line with revenue declines.  We believe this limits the full effect of sequestration (10% federal cuts across the board), if enacted, to an earnings headwind of 22c.  We believe this risk is accounted for at the low end of the company’s 2013 GAAP EPS guidance of $4.25-$4.75.  Regarding #3, as was the case for ACM, we expect recently poor FCF conversion at URS to reverse this year as management focuses on reducing DSOs by ~3 days, releasing $100m+ of cash.  We believe there is an additional opportunity over the next 1-3 years to convert to cash an incremental $265m of receivables recently re-classified as other long term assets.  Finally, a cyclical recovery in commercial, industrial and power end markets are call options we do not count on in our investment thesis.

URS background: 

The best word to describe URS’s free cash flow is: prodigious.  Over the past 4 years, pro-forma for Flint, the company has generated cumulative FCF of $1,704m, or $426m/year on average, or $5.72 of FCF per share.  This is despite working capital going from 11% of sales in 2009 to 17% of sales in 2012.  For context, the difference between 11% and 17% on proforma 2012 revenue is $744m of cash. 

URS is an above-average business.  Aggregate returns on tangible capital have been ~17% for the past decade and ROE was maintained in the high teens-low 20s during the 90s but it has been declining ever since for a simple reason: management built an empire over-paying for increasingly larger acquisitions expanding their domain at the expense of shareholders.  URS now has the lowest valuation and ROE in the E&C industry as a result.

There has been a very consistent pattern to URS’s M&A history.  We count 11 deals since 1996 and have data on 8 of them.  These 8 deals have cost $6.3B with the majority paid in cash – compared to a current enterprise value of $5.4B.  We estimate the aggregate multiple of EBITDA paid is 11x, while the median multiple is 8x.  In contrast, URS currently trades at 6.2x EBITDA per our calculation, which excludes NCI and 5.4x per Wall Street’s calculation, which includes NCI.  $4.1B of goodwill and intangibles have accumulated ($826m of which was written off in 2011).  All of the big deals were public companies and some involved auctions, increased offers and very large premiums.  The company has levered up to 4x, 5x, 6x and even 7x to accomplish this.  The most recent acquisition was Flint Energy in early 2012, which occurred at a price of $1.25B, a 68% premium to Flint’s closing price and 25% above its all time high.  The deal brought gross leverage—defined as gross debt/EBITDA-NCI to just over 3x.  Current leverage of 2.5x is well below historic levels.  Shareholders have been crushed in the aftermath of almost every deal but in every instance, the ensuing 1-2 years of de-levering eventually transferred value back to the equity from the debt.  The stock has outperformed handsomely during these de-levering periods, largely as a result of the under-performance preceding them.  We think we’re in one off these periods currently. 

A question management has not asked until recently is what has their strategy produced for URS shareholders?  Including all of the capital management has presided over—the relevant yardstick by which to measure shareholder value creation, URS’s ROE is just 6% in aggregate over the past 6 years.  This compares to a 12% cost of equity per CAPM and our estimate in the mid-teens.  The magnitude of wealth destruction at URS looking backward actually makes ACM’s prior record look rather remarkable.  For this result, Chairman and CEO Martin Koffell has received a steady ~$7m per year from 2009-2011 with only a minority paid in stock.  We do not understand why shareholders have permitted a company with no majority owner and a de-classified board to under-earn its cost of equity by this degree for so long.  The good news is we think a buyer of the stock today is not paying for value destroyed in the past and will profit as the capital allocation pendulum shifts in a new direction. 

Why won’t the cash continue to be burned like chopped wood at the cabin as it has been for the past decade?  For the 8 years we have known this company, return of capital to shareholders has been considered blasphemy.  Signs this mentality is changing have emerged.  Given management’s historical adversity to shareholder-friendly actions, even a subtle change is meaningful.  The first indication of change occurred on URS’s most recent conference call in February.  In his closing remarks before Q&A, Chairman and CEO Martin Koffell said:

“…organic growth opportunities are now our primary focus.  And we will use excess cash to further de-lever our balance sheet and return value to investors.” 

Then in the Q&A section of the call, CFO Tom Hicks elaborated saying:

“Well, we have been generating somewhere between $400-$500m of what I would call discretionary cash flow that we could use for any number of things, including supporting working capital; doing acquisitions, to the extent we’ve done them; pay down debt and repurchase shares; and, now, of course pay dividends.  So priority-wise, we’ll pay the dividends, obviously.  We’ll support working capital.  And then we will balance the rest of our cash flow between repurchasing shares and paying down debt.  And we have some ranges of debt pay down that we’ve discussed with our credit providers and with the rating agencies, which we intend to stay within.  And then to the extent we are successful in generating cash beyond our nominal amounts, the rest will grow towards repurchasing shares.  We don’t plan to do any more major acquisitions this year.”

There’s also logic to returning capital to shareholders at this stage of the company’s journey.  By the company’s admission, they now love their portfolio and no longer see the need to expand their platform in another major vertical. 

As Martin also described during the last earnings call:

“We’ve built a business focused on five key market sectors.  Each has a distinct business cycle.  And it is shaped by unique trends and market fundamentals, many of which we have discussed and of course, on today’s call.  Our objective in building and managing the company is to deliver consistent and strong cash flow throughout the business and economic cycles, regardless of trends that may be affecting any one individual sector.” 

 He closed by saying:

“URS now has tremendous scale, skills, and resources.  We have leading positions in almost every sector of the E&C market…organic growth opportunities is now our primary focus.  And we will use excess cash to further de-lever our balance sheet and to return value to shareholders.”

The new song being sung continued in a Reuter’s interview Martin did on March 12:

Question:  “In the past you’ve grown through acquisitions and organically.  Do you expect to see more acquisitions going forward?” 

Answer:  “We don’t.  You have to remember, within the tenure of this management team, URS has grown from a company with $100m in revenue and 900 employees to $11.8-$12.2B in revenue this year and we are approaching 60k people.  So the company we set out to build largely has been achieved.  With the scale we have and the international reach, the organic opportunities are so terrific that the first use of our cash flow will be organic growth and with the acceptance that M&A isn’t a necessary part of our future, FCF after satisfying organic growth opportunities will go to enhancing stockholder value, to continue paying down debt, to continue our dividend program and to tactical buybacks of stock from time to time.  That position has been well received by the Street and I think we’re well aligned with our stock holders.”

The motivations, catalysts, causes and solutions for the mispricing of ACM and URS are identical.  In a ZIRP world, the ACM precedent is potent not only because it’s ongoing and working as intended but because as URS’s closest competitor, a public comparison is unavoidable.  Over the past 12 months, ACM’s capital allocation playbook was re-written, put into action and shared with the investment community.  As a result, ACM’s P/E has expanded 95% from its low last summer to today.  In contrast, over this period URS’s P/E has expanded only 35%.  We believe the 60% relative differential is explained almost solely by the dramatically positive change in capital allocation strategy.  We think the evolution of URS’s capital allocation strategy is where ACM’s was 18 months ago and expect URS’s valuation to converge with ACM’s over the next 1-2 years, starting from a lower base, while ACM’s continues increasing.  We think a base-case scenario for URS’s stock allows 100% upside over 2-3 years. 

ACM background:  After five years of low/negative returns generated by ACM’s acquisition strategy since emerging as a public company in 2007, shareholder frustration built to the point where change was demanded.  Change in capital allocation at ACM started in a subtle way during the fall of 2011 when the company announced a $200m stock repurchase authorization (10% of $2B market cap).  Upon completion, this was followed by another $300m authorization in 2012 (15% of market cap) and finally another $500m (+20% of market cap) in early 2013 for a total of $1B.  The increasing size of each successive buyback is a manifestation of a broader discussion the company has been having about shareholder preferences for capital allocation towards its highest and best use. 

Catalysts for change.  Say on Pay Advisory Vote on Executive Compensation, a provision of Dodd Frank mandated a couple years ago, is a tool formerly unavailable to otherwise passive institutional investors.  For the second consecutive year in 2012, ACM received less than a 60% SOP approval rating from shareholders and against-vote recommendations from both ISS and Glass Lewis.  Poor 1, 3 and 5-year TSR and ‘pay-for-performance disconnects’ formed the basis of ISS’s and Glass Lewis’s against-votes. 

Motivated to improve their SOP approval vote in 2012, management engaged top shareholders.  One outcome was a change in compensation metrics.  EBITA growth and ROI were replaced with EPS and FCF/share.  The key win for shareholders was the inclusion of the share count in the denominator as management was no longer incented against share repurchases.  The FCF substitution also incented management to manage DSOs for the first time. 

Just prior to their annual meeting in 2013, on March 5 the company amended their latest proxy stating that management is recommending to the BOD to 1) declassify itself and 2) include future goodwill impairments in LTIP compensation starting in 2014.  The goodwill provision incentivizes management to avoid overpaying for acquisitions.  Declassified BODs are more valuable to shareholders than classified ones.

Transparency of capital allocation improved.  External manifestations of ACM management’s newfound shareholder orientation first appeared on fiscal Q3’12 and Q4’12 conference calls in prepared remarks as stock buybacks started moving up the list of priorities and M&A discussion began to take a back seat.  This messaging continued at their December 2012 analyst day where stock buybacks were highlighted as their focus for 2013.  Management made explicit reference to the fact that shareholder deemed buybacks to be the highest and best use of their capital given the cheap prevailing price of the stock in relation to inherent earnings power.  Finally, upon reporting fiscal Q1’13 results, management made an explicit commitment to spend “at least 50%” of their FCF over the next two years buying back stock.  Chairman and CEO John Dionisio stated on their Q1’13 earnings call: “we believe one of the highest returning investments we can make is in our own company.  As a result, our Board has authorized an additional $500m in share repurchases which brings the total amount of capital committed to repurchases to $1B over the last 18 months.”  Further evidence of management’s commitment is the response to a question on the call about how much more than 50% of FCF could be directed towards share repurchases.  CFO Steve Kadenacy responded “if there are no other available options for us and our stock remains low, in theory, it would be significantly more than that.”  In the next sentence, he went on to say “there is no reason why we wouldn’t invest all of our capital in that, if it is the best opportunity.” 

We think ACM’s share count will have gone from 118m in 2011 to about 85m in 2014, down 28%.  So few companies find themselves in a position to do what ACM is doing, much less execute.  URS is now in such a position. 

Capital in the hands of good allocators is worth more than in other hands.  As Buffett articulated in his 1984 shareholder letter:

“The other benefit of repurchases is less subject to precise measurement but can be fully as important over time.  By making repurchases when a company’s market value is well below its intrinsic value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders rather than actions that expand management’s domain but do nothing for (or even harm) shareholders.  Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business.  This upward revision, in turn, produces market prices more in line with intrinsic business value.  These prices are entirely rational.  Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of self-interested manager marching to a different drummer.”

ACM is an empirical example of Buffett’s comments.  The vast majority of the 95% increase in ACM’s NTM P/E (and the 60% out-performance versus URS’s P/E) is explained by Mr. Market’s recognition of the phenomenon Buffett describes.

Financials, Valuation and Expected Return:  

URS is priced for a continuation of the value-destruction Mr. Market has become accustomed to.  One indication of this is reflected by an 8x multiple of cash EPS even before the benefit of excess working capital, NOLs and tax deductible goodwill.  Even if we are wrong that capital allocation is going to improve from here, the stock’s valuation allows a margin of safety against this risk.  We think a base-case scenario allows for 100% upside over 2-3 years as we will touch upon below.  We acknowledge a range of outcomes with the variability in our opinion largely determined by the size and timing of the buyback in addition to the valuation re-rating we expect.  Precision is not our intention and the scenarios we present are high level.

We believe the non-federal part of the business (2/3) is growing while in aggregate, the federal part (1/3) is still declining and will bottom next year.  In total, we project 2% top line growth and flat margins with upside potential from a cyclical recovery in commercial, industrial and power end markets.

We define FCF as: CFO – capex – capital lease outlays – net distributions to NCI (financial cash flow).  Over the past 4 years, pro-forma for Flint, the company has generated cumulative FCF of $1,704m, or $426m/year on average, or $5.72 of FCF per share.  This is despite working capital increasing from 11% of sales in 2009 to 17% of sales in 2012.  If working capital efficiency were to improve to 2009 levels, $744m of incremental cash could be released in theory.  Management is targeting a 3-day reduction in DSOs this year, which should generate $100m+ of cash.  We believe there is an additional opportunity over the next 1-3 years to convert to cash an incremental $265m of receivables recently re-classified as other long term assets. 

We define Cash EPS as NI + tax-affected amort.  Of note is $110m of intangible amortization running through URS’s P&L.  Untaxed, this is $1.48/share; taxed it is about $1.00/share.  Cash EPS is therefore $412m or $5.50 at the mid point of management’s 2013 guidance. 

The company also has ~$1B of various NOLs and tax-deductable goodwill so cash taxes are below GAAP taxes looking backward and forward.  We give no credit for this in our valuation on cash EPS but we do consider it in our estimate of FCF generated over the next three years and how this gets allocated.  The last factor to consider is that capx for legacy URS has been $60m on average historically versus $80m of depreciation.  We do not give them credit for this benefit going forward.

Summing this up, we estimate URS should generate $1.4B-$1.7B of FCF during the next three years (2013-2015).  This compares to a current market cap of $3.45B and enterprise value of $5.35B. 

How they allocate $1.55B of cash will be the largest determinant of shareholder value creation.  The highest and best use currently is stock repurchases given a double digit cost of equity versus a 1.7% pre-tax cost of debt on their term loan, which is the tranche they are paying down.

Base Case: $300m of debt reduction, $200m of dividends and $1,050 of stock repurchased at an average price of $55* (>20% higher than current stock price).  Gross leverage is reduced to 2.1x in 2013 and 1.8x by 2015.  $1,000m buys 19.1m shares at $55 but is offset by 3m shares of dilution for a net reduction of 16.1m shares.  The share count is reduced from 74.5m in 2012 to 58.4m in 2015.  GAAP Net income is $353m and cash net income is $429m.  2015 Cash EPS is $7.35.

Bull Case: A leveraged recap takes gross leverage from 2.5x to 5x today, in line with prior periods of leveraging.  An incremental 2.5x turns of gross leverage provides capacity for $2,062m of incremental debt.  We think URS can borrow this amount with new senior bonds at 6.5% while negotiating a new credit facility that raises the cost of their term loan from 1.7% today to ~4% (1.25% LIBOR floor + 275 bp spread).  In a vacuum, total interest expense increases $149m ($134m on the senior debt and $15m on the term loan), which reduces 2015 after tax net income by $102m.  Assuming $2B of stock is repurchased today at ~$55*, the share count is reduced 36m to 38m, or 41m in 2015 after dilution.  $1.35B of debt is paid down over the next three years bringing gross leverage down to 3x, reducing pretax interest expense by $88m and after tax interest expense by $61m.  GAAP net income is $314m and cash net income is $391m.  2015 cash EPS is $9.53.  *Given the status of the loan market currently, borrowing more at 4% (and less at 6.5%) may be possible, which would lower interest expense versus our assumption here.

Historical valuation:  Over the past decade, URS has traded at a median trailing P/E of 17x and a median forward P/E of about 14x.  For most of this period, it did not have the same degree of non-cash deal amortization running through its P&L, which renders GAAP EPS today materially below cash EPS relative to history.  Currently, URS trades at 8x cash EPS of $5.50, giving zero credit for ~$1B of NOLs and tax deductible goodwill and as well as excess working capital that should be converted to cash.  It currently trades at 10x GAAP EPS, also excluding these additional benefits.

In our base case, we are assuming a 12x multiple of cash EPS, upon a shift towards shareholder-oriented capital allocation.  Our base case price target in 2-3 years is $88 + $3 of dividends for a of 100%.

We think this same 12x multiple is reasonable for our bull case as leverage comes down. 

Our bull case price target in 2-3 years is $114 + $3 of dividends for a return of 160%.

We think URS’s multiple will also expand in our bear case as some shift in capital allocation occurs, but not as much as in our base and bull case. 

We assume 10x cash EPS for a bear case price target in 2-3 years of $64 + $3 in dividends for a return of 50%.

In terms of EV valuations, URS currently trades at 6.2x EV/EBITDA per our calculation, which excludes NCI and 5.7x per Wall Street’s calculation, which includes NCI.  After capx, URS trades at 7.7x our calculation of EV/EBITA.  We believe there is up to a .5x turn of EBITDA of excess working capital so one could also adjust the EV for this, making the above multiples 5.7x EV/EBITDA-NCI and 7.2x EV/EBITA-NCI.

Risks:

1. Sequestration could impair the 34% of URS’s business that serves federal agencies.  We estimate the full impact of sequestration, should it be implemented as written in current legislation, is 22c of EPS, 5% of GAAP EPS and 4% of cash EPS.  We think the full impact is incorporated at the low end of management’s 2013 GAAP EPS guidance of $4.25-$4.75 but believe the full impact is unlikely to occur.  While the federal government as a whole is URS’s largest end market, the combination of more than two dozen agencies and departments are not one customer because they manage separate budgets.  Procurement processes for federal agencies are not centralized.  While the loss of the entire Army or DOE, a scenario that we have a hard time envisioning under almost any circumstance, would have a material impact on URS’s cash flows, the loss of any single contract would not.

2. PricewaterhouseCoopers stated in URS’s 10K released in February that the company did not maintain, in all material respects, effective internal control over financial reporting as of December 28, 2012.  This is a change from prior years.  While a concern from an auditor is always noteworthy, it would seem even more so for a highly acquisitive working capital intensive services firm where DSOs have been trending up the past few years (97 days at the end of 2012).  Our understanding is the concern relates to a separation of reporting duties within the audit function that was partially caused by their Oracle ERP system.  Per the CFO, this occurrence was not unique to URS and several other companies also experienced the same issue this year—though we know of none.  Per the CFO, this concern is expected to be rectified during Q1 and updated in their next 10Q. 

3. Price risk—we are not concerned with this because we are longer term investors.  The beauty of the thesis is the intrinsic value per share increases in the long term if the stock price declines in the short term, given the outstanding authorization to repurchase shares.  This is likely true even if the stock declines due to an economic slowdown that actually impacts earnings, rather than the annual market swoons we have become accustomed to.  For example, a change in buyback assumption from $55 to $35 entirely offsets a hypothetical change in the top line forecast from 2% positive to 2% negative growth for a period.

Catalyst

1. The motivations, catalysts, causes and solutions for the mispricing of ACM and URS are identical.  The ACM precedent is potent not only because it’s ongoing and working as intended but because as URS’s closest competitor, we believe a public comparison is unavoidable.  There are a lot of interested parties that can connect the dots including management, shareholders or sell-side analysts.