AECOM Short Thesis: 33%-45% Downside by Spruce Point Capital Management
About Spruce Point Capital Management
Spruce Point Capital is an industry recognized research activist investment firm founded in 2009
Founded by Ben Axler, a former investment banker with 15 years experience on Wall Street
- Ranked the #1 Short-Seller in the world by SZ after a comprehensive study of 12,000 analyst recommendations dating back to 2008
- Five-star investment ranking from TipRanks and cracked the top 100 out of 4,759 investment professionals tracked in 2015
- Track record of significant changes at Company level post research activism publication:
- Two companies have been charged with fraud and delisted from the Nasdaq to the Pink Sheets
- Three other companies have been forced out of the public markets, privatized or acquired
- Eight CFOs and Eight CEOs have resigned or been replaced post Spruce Point research initiation
Executive Summary: AECOM – 33%-45% Downside
AECOM Levered Up At The Top of the Oil/Gas Market To Acquire URS Group
- AECOM (”ACM” or ”the Company”) is a global engineering and construction firm based in Los Angeles, and is an enormous roll-up that came public in 2007. Bowing to pressure from an activist to maximize shareholder value, URS Corp (URS) sold itself in October 2014 to AECOM (for approx. $5bn – a cash/stock deal which included the assumption of $1bn in URS debt). The URS deal is the largest in AECOM’s history. AECOM’s proforma leverage at closing of 4.4x was forecasted by the Company to decline to 2.ox by 2017 due to ”strong free cash flows” – a claim Spruce Point will put to rigorous scrutiny!
- The URS deal was touted as giving AECOM ”heft” in the oil and gas market, at exactly the wrong time! As shown by the investor presentation, URS also added exposure to the mining and industrial sectors – other areas that have shown persistent weakness since 2014
- The company predicted 25% accretion to ”Cash EPS” and noted $25om of synergies. Commenting on the deal, analyst Will Gabrielski of Stephens (ironically now AECOM’s VPI IR) said, “You couldn’t have had a better marriage of two companies that complement each other’s skill sets, scope and capabilities so well. They both have the federal government as a large customer; but there is very little overlap in what they do,” he said. ”It’s a great value for both companies.”
Substantial Accounting Issues Plague AECOM, Proceed with Caution
- Spruce Point has been following AECOM, and has generally viewed its post-deal financial results with skepticism. Our view was fortified when on Aug 10, 2016 after reporting Q3’16 results, AECOM filed an amended 10-KfA and noted the following:
“Our management has reassessed and concluded that our internal control over financial reporting was ineffective as of September 3oz 2015I due to the existence of a material weakness that existed at the end of fiscal year 2015 that is described further below. In our third quarter of fiscal year 2016, management discovered deficiencies associated with the acguisition of URS Corporation related to (02 the alignment of accounting policies specific to forward loss reserves and (bf income tax accounts.”
- Rampant Governance Concerns Raises Questions Why Anyone Would Own AECOM:
- Management Has Almost Zero Alignment with Shareholders: Since coming public in 2007, insider ownership has declined from 13.5% to a pathetic 1.1%. When thinking about the totality of our concerns, investors need to consider that management has virtually nothing at risk if AECOM doesn’t perform
- Excessive CEO Comp Tied to Inflated Adi. Free Cash Flow: AECOM’s CEO (also its Board Chairman) netted $18m in comp (inc. a $5m special performance for the URS deal (one we View as a disaster)). Management boldly tried to sell investors that it produced $4.59 of FCF/share in 2015, +52% over the prior year. In our view, this measure is grossly inflated, and fails to account for key adjustments to remove financed receivables, excess distributions from unconsolidated subsidiaries, and distributions to noncontrolling interests. With these adjustments, we find that AEOCM’s 2015 normalized FCFZshare was $2.36 and declined by 9% from 2014
- AECOM’s Knows How to Make News: In the past year, there’ve been rampant allegations of misconduct, open investigations, lawsuits and settlements on a global basis involving AECOM. To illustrate, it agreed to pay $20.2m to resolve a US investigation into an alleged fraudulent overbilling scheme, paid $201m to settle an Australia Toll-Road lawsuit (one of the largest settlements related to misleading and deceptive conduct in Australian history), faced a federal lawsuit related to systematically defrauding NASA, and is being investigated by the Dept. of Energy for its role in the Hanford Nuclear Reservation
- Given recent disclosures, Spruce Point felt it necessary to make our analysis public with the goal of allowing investors to assess how material AECOM’s accounting issues are. In our opinion, investors should be very concerned about the following issues:
- AECOM’s Adiusted EPS vs. GAAP Results Are Wildly Diverging: AECOM has changed its EPS definition three times since selling investors on the URS deal. Not surprisingly, each change makes the number more inflated. AECOM is now adding back “non-core operating losses” and “expected and actual asset sales” even though it told investors no divestitures were planned at deal inception. Even more alarming, in Q2’16 it booked pension curtailment gains to revenue and EPS to claim an earnings beat!
- AECOM Has lncessantly Changed the URS Purchase Price Allocation: Even though GAAP says that final intangible and goodwill allocation has to be completed within 12 months of closing, AECOM is still making changes 18 months later!
- AECOM Appears To Have Set-up a Cookie Jar Reserve: for “billings in excess of costs on uncompleted contracts” that include a margin fair value liability associated with long-term contracts acquired in connection with the acquisition of URS. AECOM has repeatedly changed its disclosure about the value of the margin liability accounted for at its inception, and continues to change its value 18 months later. The reversal of the margin liability has allowed AECOM to book free revenue with 100% margin! We estimate this reserve has been used to book $149m of revenues and $0.73 cents of earnings!
- Questionable Synergies: AECOM boosted its estimate of cost savings synergies from $25om to $325m shortly after its CFO was rotated out of his position to become President at the end of FY Sept 2015. According to our analysis of recent industry mega deals, AECOM has promised the largest synergy targets seen in the E&C industry by a wide margin
- Evidence of Poor Financial Planning or Worse: We are skeptical of AECOM’s synergy targets because AECOM grossly misestimated acquisition and integration costs (”A&l”), along with amortization of acquired intangibles. According to its own estimate, AECOM expected 2015 costs to be $29om and amortization of $25om, but actual results came in +37% and +44% above estimates, respectively. Total A&I costs are now estimated to reach a lofty $626m! This heightens our worry that AECOM could be running regular costs through its income statement, and trying to disguise them as deal costs
- Free Cash Flow Appears Overstated: AECOM has shown three different definitions of Free Cash Flow! In the proxy it showed URS’s free cash flow as adjusted for noncontrolling distributions, a definition we view as accurate. It currently does not remove distributions, and later changed to “capital expenditures net of asset sales.” In our view, this adjustment is very aggressive and not common. Lastly, we note that AECOM includes accounts receivable financing activities, as well as excess joint venture dividends above equity earnings, as part of operating cash flow. By adjusting for these items and distributions to noncontrolling interests, we believe free cash flow is overstated by approximately 90% in the LTM ending June 30th
- Plummeting Tax Rate: AECOM noted issues with its tax accounts w/out discussing specifics. We observe that its forecasted effective tax rate fell from 32% in Dec ’14 to 24% as of June ’16. In the last quarter, its estimated tax rate fell by 300bps!
- AECOM Capital Could Further Distort Earnings and Cash Flows: Management is trying to condition investors to expect that capital fund sales should be viewed as “core” earnings and operating cash flows. It has already booked $16m of gains in 2015, and is telling investors to expect more in the next 12 months. These irregular gains can hardly be considered “core”
- Rising Interest Expense Revision and Debt Covenant Step-Up: AECOM just raised its interest cost estimate by $15m, yet has reduced its total and floating rate exposure. It says its exposure to a 1% move in rates should add $16m of costs. We estimate rates have only moved 25bps; something doesn’t add up! AECOM’s credit agreement ties its interest cost to its leverage. Did AECOM just signal that its EBITDA will be falling (leverage rising)? Its stated 6/30/16 leverage is 4.3x and come Sept 30″, its leverage covenant drops to 4.75x – leaving AECOM very little cushion
- Trying to downplay this issue, AECOM stated further that: “These deficiencies did not have a material impact on the Company’s previously reported financial results for the year ended September 30, 2015, and the Company recorded in the third quarter of fiscal year 2016 an immaterial cumulative adjustment.”
- Trading Near 52 Week And All-Time Highs, Shares Are Fully Valued With A Terrible Risk/Reward Owning AECOM
- AECOM’s Looks ”Cheap” – Buyer Beware: Trading at 11x Price/16E EPS vs. peers at 14.ox, AECOM looks cheap, but in our view its Adj. EPS is fraught with overstatement. Based on our adjustments, it trades at close to 19x, a substantial premium. AECOM is Ievered 4.3x Debt / EBITDA leaving little room for error, but by adjusting its Debt to include its unfunded pension and sizeable operating leases and normalizing its EBITDA, true leverage is closer to 7.4x!
- Even Analysts Seem To Agree: The average price target is little more than $35/sh and analysts’ are more neutral than positive
- Meaningful Downside Potential: Given numerous accounting distortions to EPS, we believe the best way to value AECOM is on a multiple of LTM Free Cash Flow. Applying a range of 9x – 11x on $2.10 of LTM FCF per share, we get $19 – $23/sh (33-45% downside)
In Our View, True Free Cash Flow Estimated 90% Lower Than Presented By AECOM
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