Astec Industries (ASTE) is a key player in the design, engineering, manufacturing, and marketing of equipment and components for nonresidential construction: mainly road building, aggregate processing, oil and gas drilling, wood processing, and related construction activities worldwide. It operates in five groups: aggregate and mining, asphalt, mobile asphalt and paving, oil and gas, and other.
ASTE's growth is highly dependent on road and highway construction, and can be measured by increases in state and federal budgets and partially predicted by, for example, leading indicators such as federal highway obligations and contract awards. According to the Federal Highway Administration (FHA), as of the third quarter 2013, contract awards had increased approximately 5% YTD, reversing a 22-month downward trend. Given the additional investment catalysts described below and stock price trading at 2008 levels (only 48% appreciation from the $25 bottom), there appears to be a divergence between the expected future cash flows and present value of said cash flows reflected by the stock price. This can partially be explained by the investments risks and sluggish growth in nonresidential spending.
1. Favorable Regulatory Conditions
The company primarily benefits from increases and implementations of public transportation government funding. According to the most recent annual report, Federal Funding provides for approximately 25% of all highway, street, roadway, and parking construction in the US. In August 2005, President Bush signed into law the Safe, Accountable, Flexible and Efficient Transportation Equity Act - A Legacy for User ("SAFETEA-LU"), authorizing approximately 286.5 billion dollars in guaranteed federal funded projects for such projects. After its expiration at fiscal year-end 2009, President Obama enacted the Hiring Incentives to Restore Employment ("HIRE") Act, extending the SAFETEA-LU funding through December 2010. Additionally, for the year ending September 2011, Congress funded federal transportation budgets at $41.1 billion, with short-term funding through March 2012. Lastly, in July 2012, President Obama signed into law the Moving Ahead for Progress in the 21st Century Act ("Map-21"), which funded the highway and public transportation program through fiscal year 2014 at 105 billion dollars.
2. Lagging Indicator Creates Opportunity
Finding opportunities that are moving from a declining business cycle period to one of growth represents strong potential. ASTE will benefit from moderate growth and continued recovery in nonresidential construction in 2014 and beyond. To this point, domestic nonresidential construction spending has lagged residential spending since the financial crises. According to Commerce Department figures, from the first quarter of 2012 to the fourth quarter 2013, residential construction spending growth grew at quarterly rates of 10.6% to 20.1% YoY. During the same period, nonresidential spending was flat to negative at -2.2% to 4.4%. Nonresidential construction activity can be measured by the Architecture Billings Index (ABI), which, according to the Index's website, serves as a leading economic indicator that leads nonresidential construction activity by approximately 9-12 months.
Notes from the most recent report dated January 22, 2014 state:
"Following consistently increasing demand for design services throughout most of 2013, the Architecture Billings Index has posted its first consecutive months of contraction since May and June of 2012. As a leading economic indicator of construction activity, the ABI reflects the approximate nine to twelve month lead time between architecture billings and construction spending. The American Institute of Architects (AIA) reported the December ABI score was 48.5, down from a mark of 49.8 in November. This score reflects a decrease in design services (any score above 50 indicates an increase in billings). The new projects inquiry index was 59.2, up from the reading of 57.8 the previous month."
The stock dropped 10% in January, moving from $40 to $36, in part likely due to the negative sentiment in the index. The stock continues to trade around the $36 level presently, representing potential upside gain over the short term if the overall positive trend remains intact despite the short-term regression. These short-term fears can be offset by the fact that public nonresidential spending grew YoY in the fourth quarter of 2013 at a rate of 2.7%, the largest growth figure since the second quarter of 2009, with highway and street construction spending contributing the most, at 8.7% YoY.
3. Acquisitive Growth & Healthy CapEx
In company presentations and filings, management highlights the intent to grow future cash flows partly through acquisitions and capital expenditures. According to the most recent company presentation, over the last six years, the company has invested over $150M in new equipment and facilities. The company also boasts a current ratio of 3.6 and a Debt/Equity ratio of 0, so the company also has ample amounts of cash for investment and flexibility and ability to continue to pay a strong dividend or reinvest internally.
ASTE has announced five acquisitions over the last six years. Typically, a company heavily reliant on acquisitions poses a risk and is a large negative for me, however, in reviewing the balance sheet, Goodwill comprises only 2% of total assets and the company has taken on no debt to finance these activities. Presumably, net PP&E accounts for a large amount (~25%) of total assets, but depreciation benefits taxable income while the company is able to remain free cash flow positive despite its acquisitive nature.
ASTE, while FCF positive, does not generate abnormally large FCFs (i.e. greater than 5% of sales). Margins are relatively stable and can improve given the current gross margin expansion despite flat to negative sales in the most recent quarter (discussed in more detail in the most recent quarterly financial results). Additionally, ROA and ROE are near ten-year lows and have room for expansion if the company can capitalize on increased nonresidential construction sales and increase inventory turnover.
The company operates in a highly competitive industry, but one with high barriers to entry due to high CapEx requirements and investment in PP&E. Overall, I would not gauge ASTE to have significant competitive advantages, but its size and scale represent small indications of competitive moat.
1. Increases in Product Costs
Steel and oil are two important commodity costs related to ASTE's prices and margins. Steel is a major component in ASTE's products, and according to the most recent company filing, steel prices increased modestly leading into the fourth quarter of 2013 and management expects the supply and demand to be relatively balanced during 2014, leading to price stability in the near future. Firm revenues are also sensitive to oil prices as significant portions of revenues related to the sale of equipment involved in the production and use of asphalt mix, a by-product of oil.
While an increase in oil prices may have a negative impact on customers, ASTE's equipment benefits from the ability to use significant amounts of recycled asphalt pavement and sales of several of the company's products, specifically those relating to drilling for oil and natural gas, benefit from higher commodity prices as price increases lead to higher demand for drilling activity.
2. Federal Spending Decreases or Delays and Highway Transportation Fund Deterioration
While the company believes Map-21 will provide stability for federal highway program funding in the near term, additional long-term government spending will provide the most stability and positive impact for the company. The level of future funding is uncertain and could represent a material risk if expectations are not met or funding is delayed. Of important note, states must match federal fund for highway expenditures. These obligations are at the highest levels since 2011 with state budgets expanding by approximately 4% annually since 2010.
3. Tapered Growth in Nonresidential Construction Spending
The recent ABI read showed short-term contraction that could materialize in a long-term trend. If this is the case, a downturn in this index would negatively affect ASTE's business and stock price. However, given the year long general uptrend in the index, the short-term dip may have presented a strong long-term buying opportunity.
Most Recent Quarterly Update
For the third quarter 2013, ASTE reported a sales decrease of 2% and earnings from continuing operations decreased to $6.5 million from $6.6 million in the previous year's quarter. Sales for the first nine months of 2013 compared to those of 2012 increased slightly, from $708.6 million to $709.1 million with an EPS increase of 8% to $1.33 per diluted share from $1.24 per diluted share. During this time, domestic sales increased 3% and international sales increased 5%. The backlog increased approximately 1%, comprised of a ~20% increase in domestic backlog and a ~20% decrease in international backlog.
Despite the mixed results, during the call management was optimistic about the future growth opportunities, despite the fact that management noted that it expects the U.S. Economy to remain somewhat stagnant over the next couple of years. Of important note is the progress on the wood pellet plants in Georgia, which as of the third quarter was 80% complete. During the call, management stated that expected fourth quarter revenue from the plant is to be $20-22 million, with future expectations of $50-55 million.
Across segments for the first nine months of 2013 compared to 2012, the Asphalt group, which accounts for approximately 22% of consolidated sales, experienced gross margin expansion of 240 basis points. The Aggregate Mining (~37% of consolidated sales) group's gross margins declined 90bps, while Mobile Asphalt (~16%) increased 20bps and Underground (~13%) declined 510 bps, largely due to decreased sales and divestiture of Trencor products in November 2012.
Margin expansion is possible given the fact that the Asphalt and Mobile Asphalt groups, for example, grew margins by 540bps and 170bps, respectively, YoY in the third quarter of 2013 despite flat to negative sales growth in both segments YoY in the same quarter.
Despite its acquisitive nature, ASTE is able to consistently remain FCF positive, average ~2% FCF/Sales over the past 10 years. This is not an outstanding figure, but given the ample cash levels and zero debt balance sheet, I am confident in the company's ability to remain financially healthy and earn generous returns over the long term.
Using the DuPont ROE breakdown, the drop in 2009 ROE is primarily due to the large decrease in ROA. Since the company has no debt, financial leverage is essentially non-existent, and ASTE's ability to earn high returns on equity is dependent upon the company ability to increase net margins and asset turnover. Given the previous returns prior to the financial crises, doubling ROE fueled by previously mentioned margin expansion and increased sales is realistic.
ASTE boasts a current ratio of approximately 3.5 and quick ratio of 1.3, meaning considerable amount of short-term assets are tied up in inventory. This continues the trend of necessitated increases in sales that can be expected if nonresidential continues to turn from negative-to-stagnant growth to positive, which based on the underlying data, appears to be slowly materializing.
Clearly, ASTE operates in a cyclical environment given its intimacy with the overall macroeconomic cycle and spending trend habits dictated by expectations of future growth, interest rates, and commodity prices. Both revenues and earnings have been stagnant since 2009 and yet to reach consistent growth patterns. Furthermore, given the stable relationship between revenues and earnings, quality of earnings appears to be rather high.
The company receives an overall grade of C based on its current and historical data, as well as the relation from one to the other, across profitability, as measured by margins, financial health, growth, returns, and FCFs. Given the low FCF/Sales rate and relatively low margins, the overall score is somewhat average.
The valuation models are selectively weighted based on the nature of the industry, and hence, P/S for example, is given a considerably smaller weight than the EV-EBIT model due to the likely differing nature of the company's capital structure to its peer group. The models themselves yielding largely differing values, but a weighted average of approximately $45-48 is derived, with downside/worst case scenario of $34 based on technical patterns, producing an overall reward/risk ratio of approximately 5/1. The range is a bit higher than indicated by the models due to the heavy weighting on backward looking results and improved expectations of future expansion.
Given the cyclical nature of ASTE's operating environment, sluggish growth in nonresidential spending and recent earnings results, and uncertainty of future public spending, the stock is not without risks. It should not be surprising the stock received downgrades after its most recent earnings announcement, which to me, however, represents a contrarian opportunity if timed well. For those willing and able to take on risk with a long-term investment horizon, ASTE could represent an excellent opportunity. With a price target of $45-48 and a 33% margin of safety, a recommended entry price range of $34-36 is calculated.