2023-11-09 16:06:23 ET
Summary
- WMS achieved 12.7% CAGR revenue growth over the past 9 years, driven by acquisitions and the past 2 years of high product prices. This led to growing ROE and gross profitability.
- The growth in revenue and profitability is not sustainable in my view, due to cyclical crude oil prices, a high Reinvestment rate and concerns about the company's financial strengths.
- A valuation assuming that the high price situation persists did not provide a margin of safety.
Investment Thesis
Advanced Drainage Systems, Inc. ( WMS ) achieved 12.7 % CAGR growth in revenue over the past 9 years. But this was due to a combination of acquisitions and the past 2 years of high product prices.
While the growth resulted in growing ROE and gross profitability, these are not sustainable. Firstly, crude oil prices which affected the product prices are cyclical. Next, growth was funded by a high Reinvestment rate as well as increasing debt. I also have concerns about its financial strengths.
Furthermore, a valuation assuming that the high price situation would persist did not provide a margin of safety, and so this is not an investment opportunity in my view.
Business background
WMS is the leading manufacturer of innovative water management solutions in the stormwater and onsite septic wastewater industries. The company designs, manufactures, and markets a complete line of high-performance thermoplastic corrugated pipe and related water management products.
Its end markets and applications include residential, non-residential, infrastructure and agriculture applications.
The company reports its performance under 4 business segments:
- Pipe. The segment products include single, double, and triple-wall corrugated polypropylene and polyethylene pipes.
- Infiltrator. The segment products include leach field chambers, and related accessories used in septic systems and decentralized commercial wastewater treatment systems.
- International. Apart from its manufacturing facilities in Canada, this segment has joint ventures to serve markets in Mexico, Central America, and South America.
- Allied Products & Other. The products here include storm retention/detention septic chambers, PVC drainage structures, fittings, water quality filters, and separators.
The company's IPO was in 2014 and as such I analyzed its performance from FYE 2015 to FYE 2023. Note that the company FYE is in March. As such unless stated otherwise, the year used in this article refers to the financial year instead of the calendar year.
Chart 1 shows the revenue trends over the past 9 years.
- For 2023, the Pipe segment accounted for 56 % of the total revenue.
- The US accounted for 92 % of the revenue for 2023.
- The company diversified into the Infiltrator segment with a USD 1.1 billion acquisition in 2020 of Infiltrator Water Technologies.
Chart 1: Revenue Profile (Author)
The construction sector accounted for 86% of the revenue in 2023. This can be broken down into 47 % non-residential, 33 % residential, and 6 % infrastructure.
Operating trends
I looked at 3 metrics to get an overview of the overall performance - revenue, PAT, and gross profitability (gross profits / total assets). Refer to Chart 2.
Chart 2: Performance Index (Author)
Note to Chart 2: To plot the various metrics on one chart, I have converted the various metrics into indices. The respective index was created by dividing the various annual values by the respective 2015 values .
From 2015 to 2023, its revenue grew at 12.7 % CAGR. This growth came from a combination of organic growth and acquisitions.
In comparison, from the calendar year ended March 2015 to the calendar year ended March 2023, the total US construction spending grew at 7.2 % CAGR. Refer to Chart 3.
Without the Infiltrator acquisition, WMS revenue growth was about the same as that for the total construction spending. To wash out the effect of the Infiltrator acquisition, I compared the growths for the following periods:
- Calendar year March 2015 to the calendar year March 2019. WMS achieved a 4.1 % CAGR compared to 5.0 % for the total construction spending.
- 2015 to 2023 excluding the Infiltrator segment. The total revenue for the other segments grew are 10.5 % CAGR. In contrast, the total construction spending grew at 7.2 % CAGR. As will be shown later, the higher growth rate by WMS was due to extraordinarily high prices in 2022/23. Excluding these, there was not much difference in the 2 growth rates.
Chart 3: Total construction spending (FRED)
PAT-wise, over the past 9 financial years, WMS incurred 2 years of losses - 2015 and 2022. Notwithstanding these, PAT showed an uptrend.
- The loss for 2015 was due to the adjustments for the fair value of the convertible preferred stock as well as forex losses.
- The loss in 2020 was due to a special dividend compensation for the Employee Stock Ownership Plan.
The other positive sign was the uptrend in gross profitability. This meant an improvement in the capital efficiency since 2015.
The improving PAT led to improving ROE from negative 1 % in 2015 to positive 61 % in 2023. Refer to Chart 4.
Chart 4: DuPont Analysis (Author)
A DuPont analysis shows that the improving ROE was due to improving net margin and increasing leverage. You should not be surprised by the jump in leverage in 2020 as the company took on debt to fund the Infiltrator acquisition.
From an operating efficiency perspective, the 2023 asset turnover was lower than that in 2015. This was in contrast to the improving gross profitability.
Why was there a discrepancy?
- This was because gross profits grew at 1.7 times the total assets growth rate.
- But revenue grew at 0.9 times the total assets growth rate.
Margins
I defined net margin as gross profit margin minus SGA margin and Depreciation & Amortization margin.
Over the past 9 years, the net margin improved from 3.4 % in 2015 to 23.6 % in 2023. As can be seen from Chart 5, this was due to improving gross profit margins and reducing SGA margins
Looking at Chart 5, you can see significant improvements in the margins in 2021. This would suggest that this came from the Infiltrator acquisition.
But why was there another jump in performance in 2023? This was the result of high prices.
High prices
The main raw materials for the company are HDPE and PP. The prices of both are linked to crude oil prices. The prices of HDPE and PP are determined by the cost of their raw materials:
- HDPE raw materials include ethylene and natural gas. Ethylene is derived from crude oil, and natural gas is used as a feedstock in the production of ethylene.
- PP raw materials include propylene and natural gas. Propylene is derived from crude oil, and natural gas is used as a feedstock in the production of propylene.
You can see the links in Chart 5 that showed similar price patterns. The average price of plastic water pipes in calendar years 2022/23 is 2.7 times higher than the average price in calendar years 2015/16.
The company in 2023 benefited from higher prices that offset lower volumes:
"Our Pipe segment experienced growth primarily through improved pricing/mix of products sold partially offset by volume decreases…Infiltrator segment… lower volume offset by improved pricing/mix… Growth in Allied Products & Other…mainly by improved price/mix of product offerings…partially offset by volume decreases."
Chart 6: Plastic prices vs crude oil prices (FRED)
Crude oil prices are not expected to remain high in the immediate future. The US Energy Information Administration expects the average Brent crude prices to be USD 61 per barrel in 2025 and USD 88 per barrel in 2035.
What are the key takeaways?
- The past 2 years' high performance should not be a good representation of future performance. A better representation is some weighted combination of the pre-2022 performance and the post-2021 performance.
- While crude oil prices are cyclical, WMS revenue does not seem to be cyclical. This is because it caters mainly to the construction market which experienced continuous growth over the past 9 years as shown in Chart 3.
1H FYE 2024
In the six months ended Sep 2023, net sales and PAT declined by 13 % and 9 % respectively compared to those for the same period ending Sep 2022.
However, the gross profit margin for the 6 months ended Sep 2023 was higher at 41% compared to the gross profit margin of 37 % for the six months ended Sep 2022.
The company attributed the changes in the gross profits to the decrease in volume and unfavorable fixed cost absorption, partially offset by favorable material costs.
Should you be worried? In the context of long-term performance, I consider quarterly results as "noisy". I pay less attention to them compared to the longer-term trends.
Growth
From 2015 to 2023, revenue grew at 12.7 % compounded annually. Part of this growth came from the Infiltrator acquisition. Excluding this, the growth from the other segments was much lower as summarized in Table 1.
Due to the extraordinarily high prices over the past 2 years, the 2015 to 2021 performances would give a more representative growth picture.
Over this period, the US total construction spending grew at 6.8 % CAGR. WMS growth rate based on a weighted average growth rate for the Pipe and AP & Others segment was about the same as the total construction spending.
Without the Infiltrator acquisition, WMS did not gain market share in the construction sector.
Table 1: Segment growth rate (Author)
The company did not provide a breakdown of the growth into organic growth and acquisition. But you can get a sense of this by looking at the amount spent on CAPEX and acquisitions.
From 2015 to 2023, the company spent USD 675 million on CAPEX compared to USD 1,235 million on acquisitions. I would say that acquisitions contributed a bigger portion of its growth.
The key takeaway is that excluding acquisition, this was not a high-growth company. The US construction sector is also not a high-growth sector. In estimating its intrinsic value, it would be more appropriate to use a single-stage growth model.
Reinvestments
Growth needs to be funded and one metric for this is the Reinvestment rate. This is defined as:
Reinvestment with acquisitions = CAPEX & Acquisitions - Depreciation & Amortization + Net Changes in Working Capital.
I then determined the Reinvestment rate = Reinvestment / after-tax EBIT.
Acquisitions are an integral growth driver for the company. As such I have included the annual acquisition expenditure as part of the CAPEX.
Over the past 9 years, the total Reinvestment amounted to USD 1,298 million. The after-tax EBIT for the same period came to USD 1,551 million. This resulted in a high Reinvestment rate of 84%.
This high rate is not sustainable as it would mean more borrowings to fund the acquisitions. I believe that the company would have to scale down the level of acquisition to a more sustainable rate.
What is a sustainable rate? This is from the fundamental growth equation of growth = Return X Reinvestment rate.
Financial position
I would rate its financial performance as average as there were both pros and cons when assessing its financial standing.
The positive side included the following:
- As of the end of June 2023, it had USD 470 million in cash and short-term investments. This was about 15 % of its total assets.
- Over the past 9 years, it generated positive cash flow from operations every year. This was despite incurring 2 years of net losses over this period.
- Over the past 9 years, it generated about USD 2.3 billion in cash flow from operations compared to PAT of USD 1.0 billion. This is a good cash conversion ratio.
The negative points included the following:
- It has a 52 % debt capital ratio as of the end of Jun 2023. This is high compared to the 22 % for the building materials sector. Source: Jan 2023 Damodaran's dataset.
- The is no clear picture of shareholders' value creation. Refer to the following section.
- It had to increase its debt to fund the acquisitions. Refer to the subsequent section. A better capital allocation plan would be to lower the debt ratio by reducing dividends.
Shareholders value
Did it manage to create shareholders' value? To create shareholders' value, the returns have to be greater than the cost of funds.
Over the past 9 years, the average return as measured by EBIT(1-t) / TCE was 10.2 %.
As can be seen from Table 2, this is about the same as the weighted average cost of capital. There is no evidence of shareholders' value creation.
Table 2: Estimating the Cost of Capital (Various)
Note: Based on the Google search for the term "WMS WACC"
Capital allocation
Over the past 9 years, it generated about USD 2.3 billion of funds from cash flow from operations. Refer to Table 3.
You can see that the cash flow from operations was about sufficient to fund the dividends & buybacks as well as CAPEX.
But there was not enough to fund acquisitions. The company had to borrow for this.
Table 3: Sources and Uses of Funds (Author)
Valuation
There were 2 challenges in valuing WMS.
- The company did not provide data on physical volume shipment. As such I had to find a way to separate the price impact from the volume impact.
- There were 2 different product price situations. There was a low-price situation as represented by the performance prior to 2022 and a high price situation as represented by the performance of the past 2 years.
To address the former, I derived a price factor based on a revenue per pound ratio using the raw material poundage. This was of course a rough measure.
To address the latter, I used a weighted average performance of the high-price and low-price situations.
The valuation model was built on the following assumptions:
- Using the average 2022 and 2023 revenue to represent the revenue for the high-price case.
- Factoring the average 2022 and 2023 revenue to represent the revenue for the low-price case.
- Using the average 2022 to 2023 margins for the high-price case and the average 2020 to 2021 margins for the low-price case
The expected scenario was based on an 80 % probability for the low-price case and a 20 % probability for the high-price case. This probability was guesstimated by looking at the price situation over the past 9 years.
The results are summarized in Table 4. You can see that there is no margin of safety even if you assume that the high-price scenario represents the future.
Table 4: Summary of valuation (Author)
Notes
a) Margins based on 2020 to 2021 average values.
b) Margins based on 2022 to 2023 average values.
c) Weighted average with 80% probability of low-price and 20 % probability of high-price.
d) Price factor based on respective period average relative to the 2022 to 2023 average.
The price factor was to wash out the high prices from the 2022 to 2023 average revenue. This will then reflect the low-price revenue case but based on the average 2022 to 2023 "size".
To determine the price factor, I first estimated the revenue per pound of raw materials.
- I used the average 2022 to 2023 revenue per pound ratio as the base of 1.0 for the high-price case.
- For the low-price case, I used the average 2020 to 2022 revenue per pound ratio.
Valuation model
My valuation is based on the single-stage Free Cash Flow to the Firm model as shown in Table 5.
Free Cash Flow to the Firm (FCFF) = EBIT(1-t) X (1- Reinvestment rate).
Value of Firm = FCFF X (1 + g) / (WACC - g).
g = growth rate. I assumed 4% based on the long-term GDP growth rate.
WACC = weighted average cost of capital as per Table 2.
Value of Equity = Value of Firm + Cash - Total Debt - Minority interests.
The key assumptions for Table 5 are as follows:
Item b. This included the 2020 to 2023 forex, restructuring charges, and other unusual items.
Item d. Tax. I used the average 2021 to 2023 rates as there was a loss in 2020.
Item g. TCE. This was derived based on the projected revenue multiplied by the 2022 to 2023 average TCE/Revenue ratio. I needed the TCE to derive the Return of item h.
Item i. The Reinvestment rate was based on the fundamental growth equation.
Risks and limitations
It would help if you considered the following when looking at my valuation:
- Valuation model.
- Price factor.
- WACC.
I have assumed that in the long run, the company would scale down its acquisitions so that its growth matched the long-term GDP growth rate. I have thus derived the Reinvestment rate based on the growth equation.
If you believe that the company will have some acquisitions shortly, you would model it based on a 2-stage growth model. You are likely to get a higher valuation based on this. As such you can consider my valuation as conservative.
Secondly, I created a price factor to determine the revenue for the low price situation. This reflected the current "size" but with low prices. The price factor was derived based on the raw material poundage.
The company did not provide the exact raw material poundage. For example, in its 2023 Annual Report, the company stated:
"We currently purchase in excess of 1.1 billion pounds of virgin and recycled resin annually."
You can imagine the imprecise nature of the price factor. One way to mitigate this was to have a higher margin of safety. In this analysis, this was academic since there was no margin of safety.
Finally, the WACC used is high because of the high debt. With the 4% growth rate, the company would have excess cash and this would probably be used to reduce the debt. The WACC would then be lower. This means that my valuation could be on the high side.
Conclusion
WMS serves mainly the construction sector which is not a high-growth one. But over the past 9 years, the company managed to achieve 12.7% CAGR in revenue. This high growth rate was due to the combination of acquisitions and the past 2 years' high product prices.
This growth led to improving ROE and gross profitability. But not all are rosy:
- The growth was from a high Reinvestment rate and funded by increasing debt. In the long run, I would expect the Reinvestment rate to be reduced to a more sustainable level.
- The past 2 years' growth was also driven by high crude oil prices which I do not believe to be sustainable.
- I also have concerns about the company's financial standing.
The company benefitted from the past 2 years of high crude oil prices that led to high product prices. For a more realistic valuation, I estimated the intrinsic value based on a weighted average of a low-price and a high-price situation.
On such a basis, there was no margin of safety. There was no margin of safety even if you assumed that high prices would persist. As such I would not consider WMS an investment opportunity.
I am a long-term value investor and my analysis and valuation are based on this perspective. This is not an analysis for those hoping to make money over the next quarter or so.
For further details see:
Advanced Drainage Systems: Likely Not A Sustainable Performance