AECOM Technology's (NYSE:ACM) stock has seen a good run up in the last year, significantly outperforming its peers as well as the S&P 500. Despite a roughly 50% increase in its stock price, AECOM is still trading at a significant discount relative to its peers,Tetra Tech (NASDAQ:TTEK) and Stantec (NYSE:STN). The company's fundamentals are encouraging, and AECOM's stock price is likely to continue its upward trajectory going forward.
AECOM is the largest engineering design and architecture firm in the world, serving a range of end markets. The company's clients include U.S. and non-U.S. governments, as well as private players.
The story so far
In the last few years, the U.S. government's poor fiscal health and the delayed recovery in commercial construction adversely affected AECOM's U.S. business. Australia was another weak geography for the company.
To increase shareholders' returns despite sluggish top-line growth, management decided to stop trying to boost sales by buying up other companies, and start returning cash to shareholders through buybacks instead. The new strategy also focused on improving free cash flow by reducing Days Sales Outstanding (DSO) and increasing the company's EBITDA margin to more than 12% (2015 target) by cutting costs, improving productivity, and trying to make its higher-margin construction business a bigger part of its overall sales.
AECOM has made decent progress in its plans. In the first three quarters of fiscal 2013, the company generated $212 million in free cash flow, which was significantly higher than its net income of $163 million. AECOM also purchased $312 million worth of shares in this period. In addition, the company took a restructuring charge of $14 million to right-size its Australian business and lay off 1,000 employees.
Going forward, the company is focusing on reducing costs by consolidating its real estate footprint, which will help it achieve $40 million per annum cost saving by 2015. In addition, it is improving its procurement process and rolling out a new centralized online purchasing tool that is expected to help it save $30 million in its indirect goods and services spend over the next three years. The remaining improvement in EBITDA is expected to come from productivity improvement and increasing contribution of higher-margin construction business to overall sales.
The company's top-line prospects also look good. One of the key problems that the company faced over the last few quarters was uncertainty over the U.S. budget sequestration. According to management, while sequestration was only expected to cut the federal budget by 8% to 10%, the uncertainty over which projects are affected created additional headwinds and resulted in many of AECOM's projects in the United States being delayed. The company is likely to see some pent-up demand as work starts on these projects.
The company's private sector business and state/local business in the United States also are poised for growth. Most of AECOM's private sector business in the United States comes from the commercial construction end market, which is showing strong signs of recovery. In addition, the finances of state and local governments are also improving, with state and local tax collections increasing 7.2% year over year. This bodes well for the company's U.S. business, which is almost 60% of its top line.
Internationally, Australia is likely to see continued revenue declines, albeit at a slower pace. Given that the company has right-sized its Australian operations, it is likely to see a year-over-year increase in earnings despite declining revenues. Asia and the Middle East are seeing strong trends that are likely to continue.
One thing that I find surprising is that AECOM is trading at just 12 times forward earnings, a discount to its immediate peers Tetra Tech and Stantec, despite the encouraging outlook.
Tetra Tech is a much smaller and less diversified engineering design and architecture company. Last quarter, the company disappointed its shareholders and posted a loss per share of $0.47, excluding good-will impairment.
Going forward, the company's fundamentals are likely to remain muted. The key issue with Tetra Tech is its heavy exposure to water and wastewater end markets, which will see a reduction in orders from the federal government as it cuts discretionary spending. On the other hand, AECOM will be affected to a lesser degree than Tetra Tech because much of its federal business comes from transportation end market that already has a secured funding of $105 billion for fiscal 2013 and 2014 under MAP-21 authorization.
Despite Tetra Tech's relatively poor business mix, it is trading at 15.81 times fiscal 2014 consensus EPS. If AECOM were to trade at a similar multiple, it would mean atleast a 31% upside in its stock price.
Canadian firm Stantec is another AECOM peer. The company is trading at 16.40 times fiscal 2014 consensus EPS. Stantec derives 58% of its gross revenues from Canada, where it is seeing strong growth. The company expects to grow its revenues by 3% to 4% in fiscal 2013.
Stantec's high P/E multiple implies that investors are rewarding the company for its strong organic growth, and deservedly so. Stantec has a long track record of consistent execution and a decent dividend yield of 1.2%. While Stantec is a good company, most of the upside is already priced in its stock. I also find Stantec's inorganic growth strategy risky because the recent run up in the stock market means acquisition targets are now more costly.
To sum up, AECOM's earnings have stagnated for the last three years amid a challenging macro environment. However, things are likely to improve for the company going forward, given its cost-cutting measures and improving top-line outlook. It is surprising that the company is trading at a discount to its peers despite solid fundamentals. The stock could have substantial upside, once investors start realizing AECOM's EPS growth potential.
Fool contributor Nidhi Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.