Arcosa: A Good Business But Already Priced In (NYSE:ACA)

Thesis

Arcosa (NYSE:ACA) has experienced decent volume growth during the last quarter, which should continue further as the economy recovers. The strong backlog levels and increased prices should also act as key drivers for topline growth in the quarters ahead. The long term looks promising as well due to tailwinds primarily in the Barge business and wind tower business, which should drive growth in the coming years. Margin also improved Year on year, and should continue to improve with operational efficiencies across the business and volume leverage in the long term.

However, the valuation does not look reasonable to me as the company’s stock is currently trading at a premium to its historical average as well as sector median. Therefore, despite a promising outlook, I am giving this stock a HOLD rating for now.

Business Overview

Arcosa is an American company that provides products and services related to Infrastructure that serves in the construction, transportation, and engineered structures market across North America with its leading brands. The company mainly operates under three segments:

• Construction Products: This segment is involved in the production and sales of natural aggregates, specialty materials, recycled aggregates, and construction side equipment such as shoring products and trench shields.
• Engineered Structures: This segment involves manufacturing and sales of structures related to infrastructure, electricity transmission and distribution, wind towers, traffic, and telecommunication.
• Transportation Products: The third and the smallest segment in terms of revenue share in ACA’s overall revenue, manufactures and sells inland barges and fiberglass barge covers and has a leading position in these categories in the U.S. Other products include marine hardware, steel components for railcars, and other industrial equipment.

Last quarter performance

ACA successfully divested its Storage Tank business from the Engineered Structure segment. The impact of this transaction was visible in the last quarter, as the overall revenue experienced a decline of 2% to $591.7 million versus the prior-year quarter. However, excluding the divestiture transaction, the topline grew by approximately 10%, as the remaining two segments continued to deliver strong topline growth.

On segment-wise analysis, the Construction segment benefited from higher prices in aggregates and specialty materials, as well as volume recovery on the natural aggregates side driven by strong growth in the Gulf Coast and Texas region, which more than offset the modest declines in the company’s West and Ohio River valley regions. The margins, however, were almost flat with a 30 bps Y/Y improvement in adjusted EBITDA to 22.4%, as the impact from the lower margin on the specialty side largely offset benefits from pricing and reduced inflationary pressure.

The Transport Product segment reported robust topline expansion of 29.5% during the quarter, again due to improved pricing and volume growth in its Barge and steel business. Adj. EBITDA margin almost tripled to 17% from just 5.9% in Q2 2023, thanks to the significant operating leverage in the segment. The Engineered Structures segment on the other hand experienced margin contraction, even after excluding the divestiture part, due to additional expenses at several locations due to equipment downtime in the last quarter.

Outlook

While most industries in which Arcosa operates are subject to cyclicality, such businesses usually have to face significant headwinds during any periodic downturn in the economy. However, the economic conditions have started to improve, which has so far resulted in strong volume recovery across the ACA’s business.

I anticipate that the company’s topline should benefit from volume growth in 2024. Prices increased during the last quarter, primarily across the construction aggregates and specialty materials businesses of the Construction product segment, and also in the Barge and Steel components business of the Transportation segment. The price increase should further boost the company’s revenue in the quarters ahead. The company’s margins on the other hand should expand in the coming quarters with the help of improved pricing and volume leverage.

The Transportation Products segment of ACA delivered strong double-digit growth throughout 2023 with 29.5% Y/Y growth in the last quarter. The Barge order intake of this segment was modest in the recent quarters as some customers delayed their purchasing decision primarily due to historically low water levels on the Mississippi River system.

However, the inquiries continued to be healthy, and the total Barge backlog nearly doubled to $240 million in the last quarter. And, the good thing is, approximately 75% of this backlog is anticipated to be delivered during 2024, which should boost the segment’s revenue for FY24. Order activity remained strong in the Engineered Structure segment as well, as it ended Q3 2023 with a combined backlog of $1.5 billion for Utility and related structures. Overall, the backlog levels are strong and provide production visibility for FY24, which makes me optimistic for the topline growth of ACA in the coming quarters.

The company’s earning for Q4 is scheduled to come in late Feb. The company’s track record has been good in terms of beating the consensus estimates since 2021. For 2023, management stays confident in the outlook and maintains full-year 2023 guidance. I also anticipate the revenue should grow in the high single digits in the next quarter. And, while the margins also remain strong, the EPS should beat the normalized EPS estimates of $0.49 in the next quarter, maintaining its long-term streak.

What does the long-term hold?

Talking about the longer term, the potential need for new dry barges and increased capacity in the Wind tower industry should be key components of ACA’s long-term growth. While there is a near-term headwind in the Barge business, the long-term fundamentals remain favorable, as well below annual barrage deliveries have created the potential need for about 750 dry barrages through 2026, almost 3 times of the past 5 years’ average rate, to keep fleet age constant.

In addition to this, the long-term outlook for the wind power business also looks good as a 10-year PTC extension is anticipated to boost capacity for onshore wind installation in the U.S. To benefit from this, the company has strategically invested in its New Mexico facility with a similar potential for manufacturing like the other 3 capacities in Newton, Clinton, and Tulsa.

The new facility puts the company in a good position to support wind investments in the Southeast and is expected to start manufacturing in the latter half of 2024. The company has so far received wind tower orders over $1.1 billion due to investment under IRA (Inflation Reduction Act), which is to be delivered through 2028. In my opinion, these key growth drivers should fuel the company’s topline growth in the coming years, and I am optimistic about the company’s long-term growth prospects.

Bolt-on acquisitions

Along with these long-term opportunities, the company continues to focus on its strategic priority of business expansion through M&A. Recently the company closed three bolt-on acquisitions in construction products including two recycled aggregate producers and one stabilized sand producer, which is anticipated to enhance ACA’s presence in the fast-growing North Houston market in the coming years.

The company continues to have an attractive pipeline of additional bolt-on opportunities. In my opinion, the company holds a sound financial position with a net debt to EBITDA ratio well below the long-term target of 2x-2.5x, at 1.0x as of Q3’23, which should support the company in its future M&A, further benefiting the company’s revenue growth in the coming years.

Valuation

Before Covid, the stock of ACA used to trade in the EV/EBITDA range between 7.5x to 10x. However, post-COVID recovery, this metric has been trading above 10x due to a significant increase in the company’s total debt and reduced profitability. Since then, the stock is trading in the range of 10x and 13.5x. I am using the EV/EBITDA approach to value this stock, as it gives a more holistic view of the companies that are involved in M&As like ACA and also covers debt components of the capital structure.

The company’s stock is currently trading at a forward EV/EBITDA of 12.16 times, which is at a premium of about 14.5% to the 5-year average TTM EV/EBITDA of 10.16 times. Currently, the forward EV/EBITDA appears to be in the upper range of what it traded in the past 2–3 years as we can see in the chart above, which makes me more cautious about the probability of this stock price going up further.

Takeaway

The company’s margin has experienced a modest margin expansion in recent quarters. The company’s topline is anticipated to grow in 2024 which should benefit the margins as well. However, while the long-term prospects remain favorable, I am worried about the stock’s current valuation, which is already up by 40% in the past year and reached a level that doesn’t look reasonable to me at the moment. Therefore, despite a promising outlook, I would suggest a “HOLD” rating on this stock for now.