AECOM Technology's Management Presents at Bank of America Merrill Lynch Global Industrials & EU Autos Conference 2013 (Transcript)

Mar.19.13 | About: AECOM Technology (ACM)

AECOM Technology Corporation (NYSE:ACM)

Bank of America Merrill Lynch Global Industrials & EU Autos Conference 2013

March 19, 2013 7:20 am ET


Stephen M. Kadenacy - Chief Financial Officer and Executive Vice President


Andrew Obin - BofA Merrill Lynch, Research Division

Andrew Obin - BofA Merrill Lynch, Research Division

First, [indiscernible] make some introductory remarks and we'll move ahead.

Unknown Analyst

I just wanted to -- this presentation is being webcast and I just wanted to draw your attention to our Safe Harbor language, which is on the second page of our deck. And you can also find additional information on our risks in our SEC filing, 10-K, and also in our most recent 10-Q, which can also be found in our website. Thank you.

Andrew Obin - BofA Merrill Lynch, Research Division

And we have Steve Kadenacy, company's Senior Vice President -- I'm sorry, Executive Vice President and CFO.

Stephen M. Kadenacy

One of these days, I'm going to get Andrew to pronounce my name right as well.

Andrew Obin - BofA Merrill Lynch, Research Division

What's wrong with it? I didn't do anything wrong.

Stephen M. Kadenacy

Kadenacy -- Steve Kadenacy. And thank you, all, for coming. I'll try and speed through the presentation and get to the Q&A as fast as possible so that we make sure that we cover all of your questions that you may have. I know that many of you are new to the story. So I hope we cover most of the points, but I want to make sure there's a chance for you to ask the things that you're most interested in.

As Andrew mentioned, we are the #1 design firm in the world. Well, I think there's a few things that differentiate AECOM from our competitors. The one -- the most significant is the design aspect. We don't do any self-performed construction, although we have diversified into construction management over time and I think most of you know that, that line is blurring a bit between engineering and design and construction firms. But AECOM has always stayed on the low-risk end of the spectrum in that regard. Although over time, we can see that line blurring and have dipped our toe into the construction management side, but we don't do any self-performed construction. We have approximately 45,000 employees globally in 140 different countries and $8.2 billion revenue through last year. The other most significant aspect of AECOM relative to our peers is we're one of the most diversified engineering firms in the world not just from a geography standpoint, but from the types of services that we perform and where and/or which -- what kind of clients and the funding sources that support those projects, and I'll take you through that in a little more detail. But between the pure design and the diversification, it's a significant impact on our risk profile that we're very proud of. As Andrew mentioned also, we perform a lot of iconic projects. We're working on at least 6 of the largest 20 large infrastructure projects in the world, many of which people are familiar with. Close to home here, we were the master planner for the London Olympics. We're -- we leveraged that expertise and are now the master planner for the Rio Olympics. We're working on some of the Crossrail work, the U.K. high-speed rail. We work on the Thames Water framework and other major projects of the kind. We're well positioned in markets. We try and diversify ourselves, where we see infrastructure spending will grow significantly over the next 5, 10, 50 years. And there is many macro indicators that would give us the insight into where those are and that guides our organic and our acquisitive investments to grow in those areas. The last point on this slide is our balanced capital allocation structure, which I'll emphasize for you and take you through in a little more detail later in this presentation. But our focus on addressing the growth areas from the macroeconomic indicators, where we think infrastructure spent will grow. We want to expose ourselves to that, but we weigh that against the organic versus acquisitive investments that will get us into those markets, as well as returning capital to shareholders. And I'll take you through that in much more detail.

Starting with just -- to get you familiar with the story, as I mentioned, we're in 140 different countries. We have 2 major segments, Professional Technical Services and Management Support Services, the majority of that is the PTS side and that encompasses our work in facilities, environment, which also includes our water business, transportation. And a smaller slice of the pie is power, energy and marketing. And on the Management Support Services side is our work for the U.S. federal government only, and that spans a host of different departments within the federal -- U.S. federal budget, from cybersecurity to overseas contingency support.

On the next page, it shows just a little bit more about the diversification. On a -- chevrons across the top are the services that we perform within those end markets that I mentioned. So again, no pure construction. But we range in services from the front end and the long-range planning and consulting side to the engineering, whether it's architecture or building, engineering designs, ultimately to the operations and maintenance of the facilities of the construction projects and then moving on into the construction management itself; on the MSS side, the last 2 chevrons being the cybersecurity support and the logistics overseas support within that business. The circle charts on the bottom of this page just further show the diversity from the end market standpoints that I've already mentioned, environmental facilities, MSS, power, energy and mining, and transportation slices of the pie, where the funding sources are coming from 41% of our business is private, the rest being from governmental agencies in the U.S. -- state and local U.S. and non-U.S. government. And in the geographies, you can see our split between Europe, Middle East, or our super geographies, Europe, Middle East, Asia Pacific in environmental. And these tides are changing over time, and I'll give you a little bit of insight into where we're trying to drive those changes.

Our long-range goals are, first and foremost, to focus on increasing shareholder value through our balanced capital allocation strategy. Everything that we do weighs organic, acquisitive and return of capital to shareholders against each other, determine what we think will drive the highest return on capital. But operating the business is what's going to drive that free cash flow is going to allow us to make those capital allocation decisions. So in order to maximize that free cash flow, we have to go where we think GDP will grow, where infrastructure spend will grow. And the way we're going to do that is through -- one is drive higher-margin services that will be attractive in those markets. So our investments now, organically and acquisitively, will always be in services where we think we can drive higher gross margins. We think that over the next -- the near term, our growth in general will come mostly from organic and niche strategic acquisitions in emerging markets and/or markets that will give us a higher exposure to rapidly growing end markets like oil and gas, particularly gas in the U.S. The other aspect, and this is mostly through organic investment, is our higher exposure in the private sector to minimize our exposure in the government markets, where we're seeing more funding issues. And we have significant effort in that regard, which I'll take you through in a little bit more detail in a couple of slides. And that initiative is -- the Point 5 here, is increasing our exposure into multinational corporations to provide them end-to-end services on a global basis. More and more, we're seeing multinationals looking for a service provider who can service them across the globe in their development activities, whether it's building data centers or factories and things like that. And we have an approach to attack that piece of the market. And lastly, but not least, is our exposure in emerging markets in Africa, China, India and others that are the listed here, where we see and have great visibility in the infrastructure spend investment that those geographies are going to be making over the near term.

This gives you some macroeconomic indicators on why we think that's true. One, and then probably the biggest where we benefit the most, is urbanization because of the infrastructure needs that come with it. Here, you can see, between now and 2050, estimates are that 3 billion people will move from suburban and rural environments into the cities, requiring buildings, facilities, water treatment, roads, subways and other infrastructure. Emerging markets, as a percentage of world GDP, will -- is forecasted to grow to 54% by 2016. We'll talk about our investments there to capitalize on that. And then you can see the demand for natural resources. We have -- that, obviously, is driven by the urbanization, but we also benefit significantly from the infrastructure needs to transport those raw materials to where they're needed. And lastly -- I mean, those are the emerging market side of it, but we have had the exposure in developed markets as well. Our biggest market is the U.S., heavy exposure in Canada, significant exposure in Western Europe, particularly here in the U.K. And the aging infrastructure is a major problem that will ultimately have to be addressed. There are significant funding issues. We spend a lot of time talking to investors about these funding issues in the short run. But over time, the -- and particularly, my most familiarity is in the U.S., where the infrastructure will have to be updated. At some point, it will become anticompetitive. And the estimates there, over $50 trillion are required to update the infrastructure in the developed markets. And we're there to take advantage of it. We're closing out on the macros here. Click on it.

The -- we tend to grow at a multiple of GDP depending on the markets that we're in. And this just shows you the GDP compounded annual growth rates in these various markets that were exposed and the annual expenditures on infrastructure themselves. So you can see the Americas at $1.1 trillion, EMEA at $1.3 trillion, and Asia Pacific at $2.1 trillion.

Those are the macros and what AECOM is all about. Let me just tell you a little bit about where we've come from and give you some insight into where we want to go from a financial discipline standpoint. From 2007 to 2012, our revenue grew at 16%. Our EBITDA margins improved 280 basis points. Earnings per share grew 21%, and our backlog grew 22%. That was a mixture of organic with some significant acquisitions in there. Remember that AECOM went public in 2007. The key changes between that trajectory and where we are now is that we're seeing more flattish organic growth than we had in the past. And the company significantly increased its focus on free cash flow, which then gave rise to the need for a very disciplined focus on what to do with that free cash flow. So the first and foremost focus for the company right now is generating that free cash flow. So firstly, we're doing that as the focus on margins to get to 12% EBITDA margin, and I'll walk you through how we're going to get there. We have a 5-year forecast of $1.3 billion to $1.8 billion in free cash flow. The low end of that range would indicate very little organic growth. The higher end would have some growth and some margin improvement, but you can -- so we have good visibility and confidence in being able to produce at least net income and free cash flow. And that would give rise to a number somewhere in that range. And from there, it's fairly simple to do some back of the envelope free cash flow yield analysis to understand the value of the company. And for the 2013 to 2014 period, we've committed to returning at least 50% of our free cash flow back to our shareholders in the form of share repurchases. We had our first share repurchase last year, a $200 million authorization which we executed on. We had a $300 million authorization to follow, which we executed, on all but $67 million, through the last quarter. And we also announced that we now have another $500 million authorization in our -- at our disposal that we plan to use opportunistically as we evaluate all of our capital allocation decision.

So first, let's talk about the operating levers to get us to margin. There's one way -- the easiest way to get -- well, not the easiest way, but probably the most simple to imagine getting to 12% EBITDA margin is just cutting $120 million of cost. That's effectively what we would need based on our 2012 results. That's a lot of cost-cutting, but it's not unachievable, over time. And we have various ways to get there. One is the efficiency of our workforce. We spend money in 4 major categories: People is by far, number one, with Professional Services business. Number two is real estate, leases, operating leases. Number three is travel, moving our people around the world to perform their services. And then number four is kind of everything else we use. We're intensely focused on cost savings, and we've driven a lot of costs out of the system over the last 5 years. But there's a lot more to come. We expect to reduce our real estate footprint by 20% over the next 3 years. We have very good visibility into that. That's over $35 million in savings. And then we have rigorous programs on travel, and we're putting in the latest procurement software systems to manage the rest of our expenses.

The second way to drive margins -- it worked -- the second way to drive margins is on project execution, again, leveraging the tools that are -- we have. We've moved our business from 5 years ago, roughly 20% to 25% on Oracle to almost 90% on Oracle today. This allows us to provide to our people -- and you see some -- you seep up here an iPad flash of a tool that a project manager might look at to manage his or her project, as well as provide project management training to make those projects more efficient, all of those designed to drive our project margins up through healthy management of the project.

The next way we drive margins is through effective use of our workforce. As you can see, since 2009, we've improved our utilization by 300 basis points. That means people are working more on projects by 300 basis points, spent on indirect time, idle time in between projects or other things. That's a significant cost or margin driver in our business.

So those are the levers. The question is, there is -- how quickly will that get you to 200-basis-point improvement in your margins, which is what we need to move from 10% EBITDA -- at 10% EBITDA margins to 12%? It's very difficult to say exactly which levers will get us there and by when. The biggest unknown is how quickly the top line growth returns, which is dependent on our ability to execute into the emerging markets, execute into the faster line -- growing line items, which our backlog portends will happen with about 8% increase in our backlog. We have record backlog, but we're still having flat organic revenue. Our current G&A structure can support more revenue. If that revenue growth comes, higher-margin business mix continues, which is the driver into private sector, oil and gas and construction management, between the top line growth, the cost containment, that operating leverage and efficiency will drive those 200-basis-point margins, if not more.

I mentioned cash flow. It's very strange. I clicked it. And sometimes it goes, and sometimes it doesn't. So the cash flow has been an inflection point. We had, in 2011, 71% -- which button do I advance, yes -- 71% of net income. In the 2008 recession, our DSOs ticked up 10 days. It was roughly a $200-million drag on cash flow over a 4-year period. In 2011, we refocused ourselves on regaining those DSOs and driving cash flow. And over the last 3 quarters, we've put up about $450 million of free cash flow. As you can see, the free cash flow yield in -- for FY '12 reached 142%. In the first quarter, it was 139%. We want to do at least 100% of net income every year, and that gets you to the $1.3 billion to $1.8 billion range that we mentioned. The -- several things brought this inflection point. One is having every one on the same system enables us to execute very well at the project level on collections and billings. Number two is we increased the compensation level for all of our chief -- our senior executives to 50% of their compensation, their incentive-based compensation. Both in short-term incentive base and long-term incentives are cash based, 50% for every single senior executive. And that's the right balance for us. At the end of the day, earnings are important. But cash earnings are as important.

And that gets to the balanced capital allocation priorities that I mentioned. And the choices -- that's going to go to it -- the choices that I mentioned in terms of what we're looking at is we have organic investments, training our people, hiring talent, expertise in key markets and things like that, that will drive long-term returns. And we're in a position now -- versus the acquisitions and versus the buyback. And we're in a position now where we have the ability to the allocate capital to each of those and may change quarter-to-quarter and where we're spending that. But we have the ability to execute on all of it. And we measure those investments against each other. The easiest one to measure is share buyback from an internal rate of return. We have the best visibility into our future. We know what the earnings of the company should be. Obviously, there is some uncertainty there. We know what free cash flow yield of the company should be. And we can quantify an internal rate of return. We measure our other investment options against that. So we can drive it to the buyback when appropriate, opportunistically. We can drive it through strategic acquisition when we need to. And we see the opportunity or we can buy back stock. Or if none of those investments look good at the appropriate time, we can deleverage.

So let's talk about some of the organic investments first. I mentioned the multinational clients. More and more, we are seeing -- well, one is the CapEx of multinationals is significant. And we expect it to increase by $1.5 trillion, and we think about $150 billion of that is addressable for AECOM. These are data centers. Globally, we're becoming more back in demand, factories. It's businesses that operate in multi-jurisdictions and want a partner where they're not trying to refigure out how to get things done in these very, very diverse markets, which is something that very few engineering design firms can do, AECOM can. So here's a couple of examples. In the green is an industrial client in 17 countries. So we're helping them, the oil and gas client on environmental impact side of the business that does business in 21 countries. And there's a mining client that is in 5 countries. And we're delivering work for that mining client in those 5 countries with expertise from 3 different continents.

The next area for potential capital allocation is strategic investments. Our last 3 niche acquisitions all totaled less than $80 million in purchase price. They were in emerging markets, South Africa, Southeast Asia, and bought -- we bought a construction management piece out of Bovis Lend Lease in Eastern Europe. These are our way getting boots to the ground in these emerging markets so that we can deliver work there at the pay scales and labor rates of those jurisdictions, as well as gain access to the geopolitical environment there that, if we were to invest in that organically, would take a significantly longer time.

And then lastly, I've mentioned several times here because it's been -- the single largest source of our capital allocation over the last year is our share repurchases. As you can see here, we've repurchased 20 million shares since August 2011, which is 17% of our outstanding. We have about $65 million left in the second authorization. We have another $500 million that was just authorized that we have in our toolbox. So it's something that we felt important. We didn't say we were going to spend the last $0.5 billion right away, but we wanted to have it in our capital allocation toolbox. And we have it there now. And as I mentioned also earlier, we have committed to returning over the next 2 years at least 50% of our free cash flow to the shareholders.

Getting close to wrapping up here is our outlook, our earnings per share range of $2.40 to $2.50. In the last quarter, we clarified that we had high confidence in the upper end of that range. And we still have confidence in free cash flow at least equaling net income. This is despite flat organic growth that we're experiencing right now. And if that growth returns, which our backlog would indicate -- as I mentioned, we have $17 billion of backlog, which is the highest backlog we've ever had as a company, would portend organic growth is going to return shortly. But to be prudent, we have not put that in guidance.

So just the key summaries. I think the way to look at AECOM other than the big picture, which is a diversified company with a low-risk model, is that there is organic growth opportunity out there that's not built into our current guidance. The financial discipline, both on generating cash and spending it, is important. And we're leading with managing the margins because in our world, managing the margins is an opportunity for more cash. More cash gets us to the upper end of that $1.3 billion to $1.8 billion, which has some organic growth and margin improvement in it. And the math would show you that the free cash flow yield at those levels is quite compelling for AECOM.

So I think that's the high-level -- that's the consistent message that we've been sending for a year now and delivering those results over the next few quarters and intend to do so in the future. With that, I'll open it up for questions.

Question-and-Answer Session

Andrew Obin - BofA Merrill Lynch, Research Division

Sure. I guess, we have a question in the back.

Unknown Analyst

This is sort of a high-level question. A couple of years ago, you were putting things on doing acquisitions, which you're very good at just small company with only platforms if you don't need the, well, x number of times. Can you give a big focus on -- like you said, you have a lot more visibility. So it seems -- I would kind of imagine some of those companies have been cheaper now than they were 5 years ago. Could you just maybe go over what time role has made, certainly [indiscernible] take down or -- it's a vague question. I'm not saying it's the wrong one. There's a lot of value being created. I'm just curious what's really the goal there.

Stephen M. Kadenacy

Yes, I think it's a good question. The real change, I think, was the valuation. You have to measure stock repurchase against an acquisition on what either can do from an IRS standpoint in a good capital allocation model. And when our stock is 15, knowing what we could do from a cash flow generation standpoint at those levels, our free cash flow yield was upwards of 15% when S&P was trading at 7. So it would be difficult -- first, the purchase prices for most companies in our space in a highly fragmented industry don't change much. Everyone is kind of looking for the 5 to 7 multiple in the engineering design space regardless of the market. And that may change if you've seen multiples that have been different in the space. So to meet an IRR on a stock repurchase when our stock was in the 15% up until -- to 30% range, and depending on where you are in the $1.3 billion to $1.8 billion range potentially still, the company would have to be growing. The acquisition target would have to be growing at high-double digits, which you don't see too often at 5 to 7 multiples. So we're not -- we haven't changed our focus away from M&A. We still think it's very critical for us to grow, again, in emerging markets. And getting exposure to key services that we can deliver to our current footprint is core to our strategy. We're still in a fragmented business. We just need to do that with great discipline. And the easiest way for us to kind of conceptualize and apply discipline to ourselves is benchmark it against the buyback because it's the easiest thing to...

Unknown Analyst

Steve, kind of just -- sorry, for a quick follow-on. Do you think that will change the valuation of your stock? Obviously, it goes up when you become an 8x or 9x multiple company. Does that slow down because it's obviously still from a visibility perspective? I think there will be shareholders that would want you to do more because they would say, "You were very cheap then. You're still very cheap now. We actually really like your strategy from a buyback perspective."

Stephen M. Kadenacy

Yes. I mean, I think that the buyback is compelling still depending on your free cash flow assumptions. But obviously, as your stock increases, the IRR on that purchase, on that buyback changes. So it does fluctuate and makes other investments more attractive.

Andrew Obin - BofA Merrill Lynch, Research Division

But just a follow-up on that question, given where the stock is right now, given a very healthy environment of the stock, do you feel the IRR is still compelling to buy your stock up here given alternative opportunities for cash deployment?

Stephen M. Kadenacy

Yes. I mean, I think that when you look at that range -- the way I would look at it, the way I'd visualize it without saying exactly what we're doing in the marketplace relative to the buyback is if you go to $1.8 billion of free cash flow, you can compute your free cash flow yield on our current market cap and draw your own conclusions. So it's still quite compelling.

Unknown Analyst

I was just wondering if you could talk a bit more about your experience in a couple of particular end markets, specifically the U.S. So I'm hearing that state funding is actually improving but where you have to have matched state and federal funding. And that's a headwind because of what is going on in federal. So if you could talk a bit more about that. And also in the Middle East, we appear to be seeing some cash flow issues, lengthy negotiations. There's a lot of excitement about that market, but it doesn't appear to be showing up in numbers.

Stephen M. Kadenacy

Sure. Starting with the U.S., the markets -- the U.S. federal is kind of a general headwind, although we haven't felt it specifically within the state system. Well, there's been no hit to it, but I would think there is general kind of liquidity issues and funding issues in general. But we perform -- more than half of our state and local infrastructure spend is in states where they have alternative funding sources, like New York, where tolls will pay for a portion of their infrastructure spend; or California, where they have an income tax that's solely added on and directed towards infrastructure spend; Pennsylvania, again tolls, user fees; and then Texas and Florida, which are making more use of alternative funding sources like public-private partnerships. If -- so I think that these funding issues will continue. The more alternative funding sources, P3-type strategies, will ultimately have to solve that infrastructure issue because the infrastructure in the states is so in need of upgrading. So right now, I'd say it's a bit flatline, particularly in transportation. But over time, we'll have to work that out. And we haven't seen significant issues of sequestration yet in our business, the $85-billion cut to spending increases really. We haven't seen any programs defunded or anything like that. But there is a macro problem in the states in that the deficit is unsustainable. In the Middle East, we're actually driving significant cash flow. We had a significant drag on our cash flow from the Dubai slowdown in 2009. But most of that has sorted out, and we're driving continued decrease in our DSOs in the Middle East and significant upticks in opportunities, bidding and wins. The drivers of that are infrastructure spend in the U.A.E., mostly Abu Dhabi, significant wins in the Midfield Airport terminal, the Abu Dhabi Metro; wins in Doha, where they're spending a lot of money; and Saudi Arabia, where we're working on several very, very large projects from the King Khalid medical facility, which is 1 million square foot medical city, to the Jeddah wastewater and flooding prevention development program they have going on there. So we're seeing a lot of opportunity in the Middle East and less -- it's very competitive on price. So we have to deliver that work very efficiently, but we're not seeing the long bid time slowing us down. We're -- if anything, we're seeing a ramp.

Andrew Obin - BofA Merrill Lynch, Research Division

Okay. Can I just ask a question of sequestration? Well, it actually has broader issue of, A, looking at all the companies in my coverage universe particularly on your side with the exposure to federal budget; B, weathered the storm on the past couple of years remarkably well. I mean, if you asked me 3 years ago, I would have never guessed that the revenue would hold up as well across the board as it had. And B, nobody seems to be particularly concerned about the sequestration. Can -- are these 2 related? And why are people not more concerned about sequestration? I'm not hearing about any company just sort of saying, "No. No it's a red flag." People just sort of seem to -- as people say, "It's market share. We will follow through that." From your perspective, what has been going on?

Stephen M. Kadenacy

We'll, I do see sequestration as a red flag. But sequestration to me is just -- it's a short-term bump in the road versus the U.S. federal larger issue of entitlement spending pushing out all discretionary spend over time. So sequestration, the $85 billion is a cut to future spending increases. It doesn't have an immediate effect on our programs. And that people always miss that point. It's that the sequestration is all about cuts to spending increases. The problem is that over time, unbridled entitlements will push out all spending. That has to be solved at some point. So it is a red flag on the horizon we're addressing in a couple of ways, one, diversify within our federal business away from line items that we think are going to shrink and into line items that we think are going to grow. If the U.S. federal government is going to reduce overseas contingency spend, then they better increase cybersecurity, homeland security intel, which is where we're focused on bidding on projects. So we're just bidding away from those. And the second is diversify outside of our MSS business into the private sector, which is why we have organic investments in the private sector; diversify our business into emerging markets away from U.S. federal spend, where we're going to see more infrastructure spend. That's our strategy. So I don't mean to minimize the fiscal problems of the United States government. It's a significant issue. But again, macroeconomic terms, the infrastructure itself, alternative funding will have to come in and figure out a way to upgrade it or the U.S. will, in the long run, become anticompetitive. You go to Hong Kong today and drive around, go to the tunnels, go to the bridges, ride a subway. Soon, you'll be able drive to Macau on a bridge that we're building. And then come back here into Western Europe or go to the United States, and you'll see people better get their infrastructure in gear or they're not going to be as competitive.

Andrew Obin - BofA Merrill Lynch, Research Division

You should just give 1/3 of the market here and in Europe and problem will be solved. Thank you very much. I think we're out of time. I appreciate it.

Stephen M. Kadenacy

Okay. Thank you.

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