Via SeekingAlpha.com

Source: arcosa.com

The Business Turnaround

It has been almost a year since I covered the recent spin-off from Tinity Industries (TRN) – Arcosa (ACA). Since then ACA management has been executing well on its turnaround plan which has been highly rewarding for existing shareholders.

Over this period the stock returned 16% (excluding the dividend), compared to a loss of 2% for the S&P 500.

Source: Yahoo!Finance

The outstanding performance came on the back of improving fundamentals in each of the company’s three divisions, while at the same time some industry tailwinds also started to surface.

At the time I last covered Arcosa, the company was forecasting an EBITDA range of $215m to $225m for fiscal year 2019. The company exceeded the high end of this range by a wide margin, realizing $241m of adjusted EBITDA for the period. Guidance for 2020 is now incorporating an even stronger business fundamentals and is indicative of the management’s strong conviction in the business.

Source: Arcosa investor presentation

As a result return on equity rebounded from its lowest level in 2018 to 6.5% in 2019, which however is still below the company’s cost of capital.

Source: author’s calculations based on data from Arcosa 10-K SEC filings

Having said that, if guidance for 2020 is achieved, Arcosa return on equity would increase further and reach between 7.7% and 8.8%.

Source: author’s calculations based on data from Arcosa 10-K SEC filings

Impressive as it is, that improvement on itself might not be enough for a highly cyclical company to trade significantly above its book value of equity.

There is one key reason why expected ROE gravitates around the company’s cost of capital might be enough for ACA to trade at a significant premium to book value of equity and this is leverage.

Going forward Arcosa’s management has the ability to significantly increase its leverage from its currently low levels of slightly above one. Such a move would act as a ROE multiplier.

Source: author’s calculations based on data from Arcosa 10-K SEC filings

For comparison, Arcosa’s direct competitors in the construction segment have nearly twice as high leverage, which suggests that ACA would most likely accommodate higher gearing in the future.

Source: author’s calculations based on data from Arcosa 10-K SEC filings

Increasing leverage to only x2.0, would increase current return on equity by around 50% which combined with the improving business fundamentals could give Arcosa a significant premium to book value.

Equally important is the company’s ability to generate free cash flow which I will review in more detail below.

Source: Arcosa investor presentation

Although the turnaround efforts might see a hiccup, caused by the economic slowdown in the U.S., the company’s competitive advantages would allow it to capitalize on higher infrastructure spending once things return to normal.

Improving Business Fundamentals

All three segments of Arcosa have made significant progress over the last year. Margins in the energy division improved considerably and are now in line with historical averages. Thus the business now makes around 50% of the company’s total operating profit.

ACA also continued with bolt-on acquisitions in the construction segment, which is experiencing softness in profitability due to pressures from the oil and gas sector.

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The transportation segment continued to ramp up production, thus increasing capacity utilization and asset turnover.

Energy Equipment Unit – Improving Margins

Product diversification in the energy equipment unit is key to offsetting short-term headwinds. Around a fourth of the segment revenue is coming from storage tanks while the rest is from wind and utility structures.

Although all three product segments are heavily dependent on steel prices, they serve very different areas of the energy segment – wind power generation, power grids and oil and gas. They also face different demand drivers throughout the business cycle which helps to smooth variations in operating profitability.

Source: author’s calculations based on data from Arcosa 10-K SEC filings

Improved operating margin in the Energy division in 2019 was due to:

Finally, within the Energy Equipment underline market fundamentals for utility structures remained robust. Driven by grid hardening and reliability initiatives and the demand for storage tanks in the U.S. and Mexico has remained steady.

The backlog for wind towers covers most of 2020 although pricing is lower than 2019. Now that the PTC has been extended, third-party forecasts for near-term wind installations have increased.

Source: Arcosa Q4 2019 Earnings Conference Call

Although the extension of wind production tax credit by the end of 2020 would likely improve demand this year, the industry will continue to expand its capacity over the long-term as wind is now a competitive energy source on its own.

Also demand for offshore wind towers would continue well beyond 2020.

Wood Mackenzie still forecasts 11 gigawatts of new wind installations in the U.S. in 2019, 15.2 gigawatts in 2020, and 12.5 gigawatts in 2021.

On the utility structure side, the need for increased infrastructure spend due to aging grids would continue to play a role in the foreseeable future. Utilities would likely continue increasing their spend on grid resiliency as risks associated with aging grids have increased considerably over the past decade.

Increased throughput in the energy division, coupled with lower steel prices and improved operating efficiencies, have resulted in improved operating profitability. The company’s contract-specific purchasing practices however would likely have a stronger effect on 2020 margins due to the recent fall in steel prices.

Source: author’s calculations based on data from Arcosa 10-K SEC filings

Our backlog to be delivered within the next 12 months is up 27% from year end 2018, which includes orders for both wind towers and utility structures. For the segment overall, we expect mid-single digit revenue growth in 2020 and we view our fourth quarter margin of 12% to 13% as an achievable target for 2020.

Source: Arcosa Q4 2019 Earnings Conference Call

Construction Products – Size Matters

ACA has been focused on expanding the size of its construction products unit, both organically and through bolt-on acquisitions. Although the size of the division has grown significantly from $252m in sales in 2016 to around $700m, post Cherry acquisition in January 2020, it is still relatively small compared to other peers.

Source: author’s calculations based on data from Arcosa 10-K SEC filings

Arcosa management is targeting economies of scale, synergies and geographical diversification that would allow it to improve its constitution margins over time and match the peer average.

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Source: author’s calculations based on data from 10-K SEC filings

The drop in operating margin in 2019 was also due to some transitional factors:

First, our aggregates plants serving oil and gas markets in Texas and Oklahoma continued to be weaker than expected and we achieve lower margins on those products.

Secondly, we had an unanticipated plant shutdown at one of our specialty products plants during the quarter. This plant is now fully up and running again.

Source: Arcosa Q4 2019 Earnings Conference Call

Lower drilling activity is affecting margins in the energy infrastructure end market of ACG which is around 20% of revenues of the acquired company.

Source: Arcosa investor presentation

if you follow drilling activity certainly it has been hit in the last year and we’ve had to make a lot of changes to right size that footprint to correspond to lower demand level. Revenues in that market held up decently well, but the margins have been really compressed so it’s really had an outsized impact on construction margins particularly in the third quarter and fourth quarter.

Source: Arcosa Q4 2019 Earnings Conference Call

Assuming flat revenues for ACG materials in 2019 vs. 2018, and 20% of its $152m revenue servicing the oil & gas market, this leaves us with $30m or roughly 7% of the division revenues coming from the sector. Although not a significant amount, it is enough to have a noticeable short-term impact on margins.

Acquisitions also had a negative impact on margins over the past few years. Although being necessary to scale up the business, lower EBITDA margins of acquired companies at higher than the Arcosa’s EV/EBITDA multiple are affecting the division’s return on capital. That’s why synergies realized and cross-selling would be important factors in assessing the M&A strategy.

Source: author’s calculations based on data from 10-K SEC filings and Yahoo!Finance

Transportation Products – increased throughout

In the transportation industry, ACA has witnessed an increased demand for barges which coincided with the reopening of the Madisonville, Louisiana facility in 2019. At the same time the company has increased hiring at its other two facilities in Tennessee and Missouri on the back of increased backlog.

Source: Arcosa investor presentation

With margins in the division relatively stable in 2019, asset turnover should continue to improve in 2020, provided that there are no material impact in barge production schedules due to Covid-19 closures.

Source: author’s calculations based on data from 10-K SEC filings

Closer look at Free Cash Flow

ACA free cash flow increased nearly four times during the 2019 on the back of improved margins and a significant working capital tailwind. A large proportion of the working capital improvement represents a $50 million of advanced payments from customers to reserve production capacity in the utility structures and barge businesses as well as receivables returning to normal after an elevated amount in 2018 due to ACG acquisition and amounts due from ACA’s former parent company.

Source: author’s calculations based on data from 10-K SEC filings

Even if the entire cash flow received from improvements in working capital is excluded, ACA’s free cash flow increased to $140m in 2019 or 89% when compared to prior period.

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As 2020 EBITDA guidance was lifted so was the expected capital spend to fuel additional organic growth projects.

Source: Arcosa investor presentation

Based on 2020 guidance as of end of February for EBITDA between $275-$300m, flat working capital and capital expenditures in the range of $95m to $105m we could expect FCF to be between $130m and $160m. Again provided there are not significant disruptions in production schedules for 2020 due to the Covid-19 pandemic.

Source: author’s calculations based on data from Arocsa 10-K SEC filings and Yahoo!Finance

At current prices and TTM free cash flow adjusted for net working capital, free cash flow yield is at 7.0% which is significantly higher than the large cap companies within the sector.

Source: siblisresearch.com

If Arcosa achieves the high end of the 2020 guidance and the company trades at its 2019 free cash flow yield of 6.5%, the share price should reach $50.6 which at current levels represent a 22% improvement. Of course this comes with another big IF – if the U.S. economy quickly recovers from the current recession and market valuations reach pre-Covid 19 levels.

Assuming a more conservative scenario and applying current FCF yield of 7.0% which is already pricing to a certain degree the 2020 recession and using the low end of the 2020 guidance I estimate a share price of $38.5 or a 7% decline from current levels.

Conclusion

Arcosa has had a great year since I first covered the stock back in May 2019. The company is firing on all cylinders with excellent execution in all three segments. Needless to say that this has been highly rewarding for existing shareholders.

The company is also very conservatively financed at that moment and an opportunity exists for improved return on equity if the company achieves industry average leverage.

Although short-term challenges for the U.S. economy have increased over the past few months, Arcosa is attractively priced on a free cash flow basis and has significant long-term competitive advantages.

Looking past the current uncertainty around the U.S. economy and the Covid-19 pandemic, Arcosa business remains on a strong footing over the long-term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.