I have always found myself drawn to interesting companies. But to me, the definition of interesting is probably different than it is for most people. I like companies that have unique business models, especially ones that might not seem all that exciting to most people. As an example, one business that I have a great deal of appreciation for is Advanced Drainage Systems (NYSE:WMS). For those who don’t know about the company, it provides innovative water management solutions to customers in the stormwater and on-site septic wastewater industries.
Back in August of 2023, I decided to see whether or not shares might make sense to buy into. At that point, the firm was experiencing some fundamental weakness, which led to it underperforming the broader market. Weaker demand in the US construction and housing markets seemed to be to blame. To make matters worse, management was forecasting continued weakness from a revenue perspective for the 2024 fiscal year. As a value-oriented investor, this made me think that there might be some short-term pain to deal with in exchange for long term gain. In short, I was hoping that the market might be overreacting. But when I saw just how pricey shares remained, I could not help but to rate the business a ‘hold’ to reflect my view that the stock would be unlikely to outperform the broader market.
Since then, shares have continued to disappoint. While the S&P 500 is up 12%, shares of Advanced Drainage Systems have seen upside of only 7.6%. The good news is that there is always an opportunity of the picture changing for the better. And the next time that management is expected to announce financial results that will give us some indication of the health of the firm will be February 8th, before the market opens. At present, analysts are forecasting a modest decline in revenue. But unlike what we have seen so far for the 2024 fiscal year, they believe that profits should rise slightly year over year. Although I still believe that the stock warrants a ‘hold’ rating, those who are bullish about the firm should keep a close eye to see if management can match or even exceed forecasts. Because if they can, it could imply some upside down the road.
A mixed picture
When I last wrote about Advanced Drainage Systems, we had data covering through the first quarter of the 2024 fiscal year. Today, that data now extends through the second quarter. During that time, revenue came in weak at only $780.2 million. That represents a decline of 11.8% compared to the $884.2 million generated the same time one year earlier. The largest chunk of that pain came from a reduction in domestic pipe sales of 14.1%. However, domestic allied products and other sales, as well as infiltrator sales, both came in materially weaker year over year as well. Management attributed all of this weakness to lower demand in the US construction and agriculture and markets. Internationally, there was also some weakness. But those sales dropped by only 5.5%.
I find this weakness to be a bit odd. Even though there was some pain in the residential space last year, overall construction spending was up. According to one source, for November of last year, construction spending was 11.3% higher than it was one year earlier. Regardless, the decline in sales brought with it a decline in profits as well. Net income fell from $152 million to $135.8 million. It is true that operating cash flow managed to rise from $187.2 million to $214.9 million. But if we adjust for changes in working capital, we get a decrease from $198 million to $181.2 million. Over the same window of time, EBITDA for the business dipped from $263.2 million to $246.3 million.
As you can see in the chart above, results for the first half of the 2024 fiscal year as a whole were very similar to what the second quarter on its own was. So this was not a one-time blip on the radar. And unfortunately, management does not have very high hopes for 2024 in its entirety. For 2023, revenue came in at $3.07 billion. For 2024, that number has been forecasted to be between $2.70 billion and $2.80 billion. That represents a year-over-year decline of 10.5%. The only profitability guidance that management gave involves EBITDA. And that calls for a reading of between $800 million and $850 million. Even in the best-case scenario, that’s down from the $904 million reported for the 2023 fiscal year. If we simply annualize the results seen so far for 2024, it would imply net profits of $462.7 million and adjusted operating cash flow of $615.5 million.
Using these figures, valuing the company as shown in the chart above was fairly straightforward. It’s worth noting that, for the 2024 estimates, Advanced Drainage Systems is slightly cheaper than when I last wrote about it in 2023. But that doesn’t necessarily mean that shares make sense to buy into at this time. In the table below, I decided to compare the enterprise to five similar firms. On a price to earnings basis, I found that four of the five businesses were cheaper than our prospect. This number dropped to three of the five when using the price to operating cash flow approach. And when using the EV to EBITDA scenario, only two of the five ended up being cheaper than Advanced Drainage Systems.
Company | Price / Earnings | Price / Operating Cash Flow | EV / EBITDA |
Advanced Drainage Systems | 22.0 | 16.5 | 13.5 |
Builders FirstSource (BLDR) | 14.9 | 9.0 | 8.9 |
Masco (MAS) | 18.8 | 12.6 | 14.0 |
Allegion (ALLE) | 20.2 | 19.6 | 15.2 |
Lennox International (LII) | 25.7 | 20.6 | 18.8 |
Owens Corning (OC) | 12.0 | 8.5 | 6.8 |
As I mentioned earlier in this article, however, the picture always does have an opportunity to change. And what better time than when management reports financial results for another quarter? At present, analysts believe that revenue for the company for the third quarter of the 2024 fiscal year will come in at around $632.4 million. That would represent a modest decline from the $655.2 million reported one year earlier. Profits per share, however, are forecasted to come in at around $1.04. That would be slightly better than the $0.99 per share reported for the third quarter of 2023. Assuming this comes to fruition, it would take net profits for the company up from $82 million last year to $82.5 million this year. Unfortunately, we don’t have any estimates when it comes to other profitability metrics. But in the table below, you can see what these were for the third quarter of the 2023 fiscal year. Although the revenue decline should technically take a toll on the bottom line, achieving analysts forecasts when it comes to earnings could mean that management is cutting costs enough to push cash flow figures higher year over year as well. But only time will tell what transpires on that front.
Takeaway
At present, I can understand why some investors might view Advanced Drainage Systems in a negative light. I’m not particularly bullish on the firm myself, though I do find the space that it works in to be intriguing. If the stock were cheaper, I would almost certainly be a buyer. But for now, the fundamentals just aren’t there. Of course, this could change. But if it does, it will likely be when management reports results in the coming days. And with analysts bullish on the bottom line, investors might just have something to look forward to. I don’t like to speculate all that much, so until I see something concrete, I will keep the business rated a ‘hold’.