Arcosa - Value Play In Unattractive Industry With High Barriers To Entry

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About: Arcosa, Inc. (ACA)
by: Vladimir Dimitrov, CFA
Summary

Pure play infrastructure business post the spin-off from Tinity Industries.

Arcosa could easily improve return on capital by leveraging its competitive advantages or simply moving towards industry average levels of debt.

Very conservative valuation, providing significant margin of safety.

Image result for arcosa logo

Source: Arcosa Investor Presentation

Business overview and the spin off transaction

Arcosa (ACA), a recent spin off company from Trinity Industries, is a pure infrastructure play. The company operates three main segments - Construction, Energy and Transportation. Although infrastructure spending is highly cyclical, Arcosa is well diversified across its product offering and industries being served.

Source: Arcosa 10-K and 10-Q SEC Filings

The Construction Products division, produces natural and lightweight aggregates for residential, commercial and industrial construction. As well as materials for bridge and road construction. The specialty materials part of the division has high barriers to entry, selling materials for roads, fracking infrastructure, drilling pads and various agriculture uses. Most of the specialty materials sold were acquired as part of the ACG Materials deal, which increased the business unit revenues by roughly 50%. Finally, the Construction Products division also produces trench shields used for a wide array of underground infrastructure.

Source: Arcosa Investor Presentation

The Energy Equipment division is operates under three sub-segments - wind towers, utility structures (transmission poles) and gas and liquids storage tanks. The wind towers business is heavily dependent on General Electric, which represents 19% of total consolidated revenues as of FY 2018. The business has also been impacted by the planned phase out of the production tax credits and is likely to see further uncertainty over the short-term. Meyer Utility Structures business, acquired in 2014 from ABB, serves municipalities and public and private utilities. The Energy division also serves residential, commercial and industrial markets through the storage tanks segment. Margins are heavily dependent on two factors - steel prices and capacity utilization.

Source: Arcosa Investor Presentation

Transportation Products unit is the country largest manufacturer of dry and liquid inland barges servicing energy, chemicals and agriculture markets. Arcosa operates four manufacturing sites, of which three are currently active and production is expected to ramp up over the next two quarters of 2019. The division also produces axles and couples for railcars, with the company's former parent - Trinity Industries being the largest customer making up around 11% of consolidated revenues as of FY 2018.

Spin-off

Trinity Industries, the former parent of Arcosa, has been on my radar since July 2016, when the activist investor ValueAct reported a nearly 7% stake in the company. The spin-off transaction was aiming to unlock shareholder value through the separation of the Trinity's legacy railcar business and the emerging opportunities in the infrastructure sector.

Although being labelled as the "growth" part of the former parent, Arcosa is trading near book value due to the company's low return on equity. I will cover that below, but Arcosa is well positioned to leverage on its competitive advantages and improve its future returns. The company is also well diversified across its product portfolio and industries it serves, but remains as a pure infrastructure play.

Return on Equity

Arcosa's Return on Equity has been declining since 2016, from as high as 9.2% to its lowest point in 2019 of 4.8%.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

Calculating a daily beta of 1.0 against the S&P 500 since ACA became publicly traded company in November 2018 in conjunction with 2.5% risk-free rate and equity risk premium of 6.00% we arrive at required return on equity of 8.5%, much higher than the company's current return on equity of 4.8%.

By using the low end of the FY 2019 EBITDA guidance of $215m and assuming D&A expense of $80m and effective tax rate of 25%, I calculate the FY 2019 Return on Equity of 5.4% for FY 2019. This explains ACA's current P/B ratio of x1.03.

Source: Arcosa Investor Presentation

There are a few reasons, however, why I believe that ACA will be able to leverage on its competitive advantages and increase its ROE over the next few years. Thus increasing both its book value of equity and its P/B ratio.

As we saw above the Energy division is by far the largest in terms of size (both on revenues and total assets). However the business unit significant headwinds and the slowdown of wind tower orders due to expected PTC phase out has significantly reduced the divisions' return on assets. Not only that, but even back in 2016 the Energy segment had the lowest ROA of all three divisions, primarily due to the high capital intensity of the sector.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

* based on operating income by division, excluding corporate level SG&A

As a result, ACA management has shifted its focus on acquisitions within the Construction Products segment and increased capital expenditure in Transportation Products. On top of the higher ROA, ACA also has sustainable competitive advantages within these two segments. Therefore, as the relative size of the Energy Equipment division falls, ACA's overall profitability and return on capital should improve.

Asset Turnover

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

Declining asset turnover has been one of the key factors behind ACA's falling return on equity.

Construction Products

The construction division saw a rapid decline in 2018, following the large acquisition of ACG Materials, which now makes roughly 1/3 of the division's revenues. Although having negative implications on the business unit return on capital, the ACG deal brought significant competitive advantages.

Firstly, the specialty materials division of ACG has significant barriers to entry. The clients are heavily dependent on the exact chemical and mechanical properties of the products, which makes it harder for competition to match the exact same properties of ACG's products. On top of that the R&D investments by ACG has allowed the company to mix its gypsum with additives and by-products from other mines and thus create products able to service various niche customers.

Secondly, ACG expanded the portfolio offering of ACA both geographically and on a product level. As seen on the map above, it brings significant geographical and end market diversification, away from ACA's legacy construction business in Dallas Fort Worth area. Cross selling and economies of scale as the integration continues should improve the overall asset turnover.

The management is committed to a smaller bolt-on acquisitions on lower multiples and seems to prioritize successful integration over size expansion, which is a positive sign for the division's future returns.

Transportation Products

The transportation division main competitive advantage lies within its size. The company is the largest barge manufacturer in the U.S. and this allows economies of scope. As seen above, when the company shut down one of its facilities in 2017, the asset turnover fell significantly.

Source: Arcosa Investor Presentation

As the backlog has increased significantly over the past 4 quarters, the increased throughput and higher capacity utilization should result in higher asset turnover for the division. On top of that the re-opened barge plant in Madisonville will start deliveries in Q3 of 2019, thus further improving turnover ratio. Should the management achieve its full year guidance of between 70% and 80% revenue growth in inland barges segment, while even assuming flat steel components sales, the division's asset turnover could easily reach 1.7 compared to 1.3 as of Q1 2019.

Source: Arcosa Investor Presentation

Operating Margins

ACA's operating margins have also seen significant downward pressure over the past few years. The largest division of the three, Energy Equipment, was by far the worst performer.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

Energy Equipment

The increasing steel prices and falling volumes formed a perfect storm for operating margins of the Energy Equipment division.

Recent problems at General Electric, the division's largest customer, and uncertainties around the phase out of renewable energy PTC have had a negative impact on capacity utilization and margins.

Source: Arcosa's 10-K SEC Filing

To counter the lower volumes and higher steel prices, Arcosa's management has been busy improving cost structure of the division. The company also divested its non-performing business in cryogenic tanks and oilfield equipment in order to improve profitability. The restructuring efforts are already showing some results, with Energy Equipment operating margin increasing from 8.9% in Q1 2018 to 12.1% in Q1 2019 (after adjusting for the $2.9m bad debt recovery over the quarter).

Whether or not the division would turn a corner is much harder to predict, as demand highly cyclical and dependent various political decisions. Nevertheless, ACA is executing well on improving the division's cost structure, while at the same time being a leader in wind tower and transmission poles.

Construction Products

Margins within the Construction Products division have also faced headwinds over the past few years. The reason being twofold:

Firstly, the historically high margins of ACA's business have come down as a result of increased competition. As the CEO Antonio Carrillo put it:

We're in great regions, and the margins are going to be very good. They will be just, let's say, not abnormally high. They will be more like our industry peers. So it's not something that is scaring us. Or we didn't want - we don't want to sound alarms about our margins. It's more - it's normal to have competition in high-growth areas, and we're good with that.

Secondly, ACG Materials has lower margins than the Arcosa's legacy construction business, but still higher than the overall business. As a result of these two factors, operating margin of the division fell from 17.7% in Q1 2018 to 10.7% in Q1 2019. On an annual basis, however, operating profitability of the division is within the Arcosa's peer average of 15%.

Source: Yahoo Finance

The two key factors, that I see playing a role in the segment's future margin improvement are:

  • the division's competitive advantage in the specialty products segment
  • management's focus on capacity utilization and expansion, both organically and through bolt-on acquisitions

Leverage

Arcosa's leverage or equity multiplier (Total Assets / Total Equity) has increased slightly over the past few years, but is still at very low levels due to the company's tiny debt amount.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

As of Q1 ACA's Debt to Equity stands at only 0.06 while net debt is negative. This presents a big opportunity for ACA, should the company find attractive opportunities to grow organically or pursue bolt-on acquisitions.

Comparing ACA's D/E ratio to that of its peers, clearly shows that ACA's current capital structure is not optimal.

Source: Yahoo Finance

The management's conservative approach to M&A deals seems encouraging as they are committed to purse much smaller bolt-on acquisitions than the ACG deal and seem to be prioritizing successful integration over the quick scaling up of the business. Nevertheless, the company's Return on Equity should improve gradually as ACA continues to pursue higher return on capital opportunities and improve its capital structure.

Cash Flow Generation

Despite the downturn in the Energy Equipment division, ACA has kept a relatively stable cash flow from operations.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

Abnormal levels of working capital were to blame for the large negative impact in FY 2018. According to the CFO, these were primarily related specific customer terms in few large contracts and ACA should return to more normal levels of working capital through the rest of the year.

This should have a positive effect on cash flow from operations, which even at these abnormal working capital levels has been consistently above the company's EBITDA.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

Capital Expenditures fell in 2018, due to the costs associated with ACG acquisition. This led to Capex falling below the current levels of depreciation, but as we can see this is already changing in Q1 2019 and the company is guiding for FY 2019 capes levels of between $70-80m, in line with the annual D&A spend.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

FCF Yield

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings

* based on low end EBITDA guidance of $215m, high end CAPEX guidance of $80m, 25% effective tax rate and $80m of D&A expense

As of the first quarter of 2019, ACA has a Free Cash Flow yield of 5.8%, which is in line with the company's historical figures. However, based on my recent calculations of S&P 500 FCF Yields, ACA is above the average of the index.

Source: Author's calculations based on Yahoo Finance Data

At current price levels, ACA would trade at 5.9% its free cash flow if the company achieves the lower end of its 2019 EBITDA guidance of $215m while spending on capital expenditure on its high end of the guidance of $80m (assuming 25% effective tax rate).

The free cash flow yield is very attractive at a time when the company is investing heavily into the business, while keeping leverage at very conservative levels.

Valuation

DCF Model

A DCF model using very conservative assumptions, shows that at current levels ACA has significant margin of safety. The model does not take into account any significant downturn in the U.S. economy as I find it quite speculative to try and time the market. That's why it's prudent to keep a significant proportion of an equity portfolio in cash & cash equivalents, in case the market corrects significantly due to recession, withdrawal of liquidity or whatever other external factors we might face.

The first very conservative assumption I am making in my DCF is that ACA would achieve the lower end of its 2019 EBITDA guidance. As we have seen in Q1 the business is turning around and there is significant order pickup in orders.

Based on that assumption, Q1 annualized D&A and Interest expense and 25% effective tax rate, I calculate target Return on Equity for 2019 of 5.4%.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings and Management's 2019 guidance

Based on the 5.4% and 5.8% ROE scenarios, I estimate FCF growth of 4.8% and 5.3% respectively for my explicit forecast period of 5 years. Again taking into my account my analysis of ACA return on equity above and the fact that they could increase that by simply leveraging the business, I consider these growth assumptions very conservative one.

The third conservative assumption I am making is perpetuity growth of 1.6%. This is based on IMF long-term forecasts for the U.S. economy. Even if the U.S. economy grows at such a low rate for the foreseeable future, the infrastructure spending is likely to be above that rate.

Based on these assumptions I arrive at the following FCF figures for the next 5-years under my Low and High end scenarios:

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings and Management's 2019 guidance

Discounting these into perpetuity at a rate of 8.5%, I calculate a target price of $36.6 in my low scenario and $39.8 in my high end scenario. These prices show a premium of Arcosa's current price at 3.0% and 12.2% respectively.

My point here is not try and put an exact target price of ACA, but rather to show that even using very conservative assumptions going forward ACA still looks undervalued from its current levels.

P/B Ratio

Due ACA's current suppressed ROE, the company now trades close to its book value. Even after adjusting for a full goodwill impairment of the underperforming Energy division, ACA would trade at x1.36 book value of equity.

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings and Yahoo Finance Data

Looking at ACA's peer group in materials and energy, the company trades at the lowest P/B ratio. Of course, if one believes that the company would be unable to increase its Return on Equity from its current levels, then P/B ratio is likely to stay at current levels in spite of the high anticipated growth. Even if that turns out to be true, ACA's stable profitability would allow the company to steadily increase its book value of equity, while simply increasing leverage to industry average levels at current rates of return would boost the return on equity.

Source: Yahoo Finance

EV/EBITDA

Source: Author's calculations based on Arcosa's 10-K and 10-Q SEC Filings and Yahoo Finance Data

ACA's EV/EBITDA multiple is actually expected to contract from the 2018 levels regardless if the company achieves its low or high end EBITDA guidance. This further highlights the attractive current price level of Arcosa's common stock.

Factor Exposure

ACA also has a very high exposure to the value factor (HML). A factor that most classic value investors, such as Warren Buffet, have a very high exposure to:

Source: Author's calculations based on Yahoo Finance and Fama and French Data

What I find interesting is that even though TRN, the old parent company of ACA, currently trades at a slightly higher P/B ratio of x1.26, the company has much lower HML exposure when compared to Arcosa.

Conclusion

Arcosa's simpler business structure post the spin off transaction would allow the company to better focus on improving its competitive advantages and increase its market share.

The company has faced significant headwinds in all of its three divisions - increased competition in Construction segment, lower orders coupled with higher steel prices in Energy Equipment and cyclical downturn in inland barges demand.

As a result, Arcosa's return on equity has fallen below 5% over the last year. However, management is taking the right steps to turn the business around and improve its efficiency. Moreover, ACA has significant competitive advantages which combined with the company's negative net debt are a recipe for higher future returns.

Finally, the company currently trades at book value and other valuation metrics also point to an overly conservative valuation. In a nutshell, Arcosa presents a classic value opportunity within the infrastructure industry.

Disclosure: I am/we are long ACA. 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.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.