With cyclical recovery in its key end market (DCS Americas) taking hold, low valuations (<10x P/E), excellent free cash flow generation ($600M-800M per year guidance implying 12.6%-16.8% yield) and good earnings growth prospects, AECOM (NYSE:ACM) is a good long candidate in this otherwise overvalued market. The stock was all set to breakout and made a 52-week high on 23rd June, when Brexit uncertainty dampened the bulls and the stock corrected ~10%. I believe this provides a good entry point for short-term as well as long-term investors.
Brexit is likely to be positive for the company
AECOM derives 11% of its revenues from the EU, with the UK being the major end market. So, it is understandable when the first reaction of investors was sell now, think later. However, if one takes a closer look at the company's key growth and profit driver in the UK, it has been design and consulting work on government projects which are set to benefit from post-Brexit stimulus measures by the government. For example, AECOM has substantial exposure to the UK's Northern Powerhouse initiative which featured in chancellor George Osborne five-point plan to galvanise the economy. According to Financial Times,
"Beside the tax cut, the chancellor said his five-point plan included focusing on a new push for investment from China, ensuring support for bank lending, redoubling efforts to invest in the Northern powerhouse and maintaining the UK's fiscal credibility."
It is not uncommon for governments to increase spending in infrastructure projects to stimulate the economy during uncertain times and AECOM's UK business (in particular DCS segment) is set to benefit from it. While there will be some pressure on the company's building construction business in the UK, it is a very small portion of its revenues and does not contribute meaningfully to the profits as it is mostly a pass through project with AECOM managing the construction but passing most of the work to subcontractors.
So if we look at net impact, given the company's exposure to right end markets in the UK and coupled with other government initiatives like tax cuts, I believe Brexit will be a tailwind for the company rather than headwind.
DCS Americas recovery
While most of the short-term investors are focusing on Brexit, the real alpha opportunity for medium- to long-term investors lies in the cyclical recovery of DCS America segment.
AECOM's design and consulting business in North America has been under pressure of quite some time. In the last two years alone, this business has seen over $500M decline in revenues ($220M in FY2015, $310M in FY2014, Source 10-K). This business has returned to organic growth last quarter. One of the big contributors for this recovery was passage of a $305B, 5-year highway funding bill which provided the funding visibility for long duration big ticket transport infra projects - ones which AECOM specializes in. The company's transportation backlog was up 10% last quarter, and as recovery in this market continues to take hold, revenue growth is likely to match backlog growth in this business.
The North American transportation sector accounts for ~26% of the company's DCS revenues with higher than average margins. Historically, the stock has shown good correlation to transport market spending trend. With growth in this market taking hold, one can expect meaningful improvement in EPS as well as multiple expansion. Last year, the company posted ~$8B in DCS segment revenues and North American transportation business accounted for ~$2B in revenues. If we look at 10% growth in this segment's backlog last quarter, and also consider the double-digit consensus revenue growth expectations for pure play transport infrastructure companies like Granite Construction (NYSE:GVA), it is likely that AECOM's North American business can grow at a similar double-digit run rate for next few years. Assuming low double-digit growth, this segment can increase revenue by ~$400-$500M over the next couple of years, and incremental gross margin in 20% range can contribute ~$100M in profitability.
Cash flow math which most of the investors/analysts are missing
AECOM has guided for $600-$800M in free cash flow for FY16 (ending September) which it reiterated in June 2016 investor presentation. This year the company has guided ~$200M in acquisition and integration expenses (the company has already spent $92M in the first half of this year). This is a non-recurring expense and is likely to reduce meaningfully in FY2017 and will be nil in FY2018 as integration URS gets completed. This means that even without any meaningful growth in business, the company's free cash flow can see meaningful improvement as acquisition and integration expenses wanes. The company plans to utilize this cash flow to cut debt from the URS acquisition by half over the next couple of years. This will lead to an interest expense reduction of over $100M by FY2018 which will further add to the company's free cash flow. So, over the next couple of years, we are likely to see AECOM having a FCF north of $800M per annum which implies a 17% yield at current valuation making it an attractive pick for value investors.
I believe the recent correction in stock is not justified and it will make a new 52-week high as long as investors realize that Brexit is likely to be a net positive for the stock. In the medium to long term, the stock can see meaningful upside with EPS growth and multiple expansion. The company can reduce its interest cost by at least ~$100M by FY2018 which after tax can contribute $70M or $0.45 per share to the company. Cyclical recovery in US transportation can add a similar amount to EPS. Add to that integration and acquisition cost savings as well as growth in Management Service business, we are talking about an EPS run-rate well higher than $4 per share by 2018. Cyclical recovery in DCS America along with meaningful reduction in leverage (from $4B to $2B) will help multiple expansion as well. A 15x multiple on $4 in EPS implies the stock can double over the next 2-3 years and reach $60.
Disclosure: I am/we are long ACM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.