I recently ran a stock screener to find the large-cap stocks that hedge funds were buying in the third quarter, and three names grabbed my eye. 3D engineering and design software company Autodesk (ADSK 0.46%), data center real estate investment (REIT) Equinix (EQIX 0.58%), and sustainable water technology company Xylem (XYL 2.87%) all had more than 70 investment managers initiating new positions in the third quarter, but are they still buys now?
This company sells design and engineering software to architecture, engineering, and construction companies (60% of sales) and to manufacturing companies (30%), with the rest coming from media and entertainment.
The investment case for the stock rests on the idea that the company's transition toward selling its software on a subscription basis (as opposed to software licenses) will enable it to better convert non-paying users. It's a highly relevant point because the explosion in digitization (3D modeling, collaboration in the cloud, etc.) in engineering and design means customers using older products will miss out on new solutions from Autodesk.
As such, management continues to target 16% to 18% compound annual growth in revenue from fiscal 2020-2023, and aims to hit $2.4 billion in free cash flow (FCF) in 2023. Based on the current market cap of $63.5 billion, that would put Autodesk on 26 times its FCF in 2023 -- an inexpensive ratio for a company growing its earnings and FCF at a mid-teens growth rate. For example, a stock trading on 23 times FCF and with a 15% FCF growth rate will trade on just 11 times its FCF in five years time provided the price stays constant.
However, based on the numbers discussed on the last earnings call, it's clear there is no room for error. For example, Autodesk just reported its third quarter of 2021 earnings and forecasts FCF of $1.3 billion to $1.36 billion for the full-year 2021, with low- to mid-teens revenue growth and 20% FCF growth in 2022.
Playing with the numbers gives $1.56 billion to $1.63 billion in FCF for 2022, which implies a jump in FCF of $770 million to $840 million in 2023, or an increase of 47% to 53% in percentage terms. That seems like an aggressive target, and given that the company trades on 71 times its 2020 earnings estimate it appears that the market is already pricing these aggressive assumptions in.
As attractive a company as Autodesk is, the pressure is on the company to carry on out-delivering expectations. As such, it's probably one for the watch list, with a view to buying in if it reports a disappointing quarter or two down the line.
It's not hard to see the underlying investment case for this data center REIT and/or why investment managers have been piling into the stock. Simply put, the pandemic has accelerated the already strong trend toward increased demand for data and cloud storage. As such, investment managers have almost certainly been piling into the stock as a "COVID-19 play."
That said, the underlying forces that drive long-term data demand are getting stronger. For example, 5G networks will revolutionize how companies and individuals use data, while big data analytics, artificial intelligence, and the shift toward digital technologies and the internet of things (IoT) will lead to an explosion in demand too.
Equinix is a near-term beneficiary of stay-at-home measures and the associated growth of remote working and video conferencing. However, it would be a mistake to sell the stock off just because the news on coronavirus vaccines might lead some to think the company was headed toward some sort of near-term growth hiccup.
With management forecasting adjusted funds from operations (AFFO) per share of $23.48 to $24.61 for the full-year 2020, its dividend of $10.64 per share (yielding 1.53%) is easily covered by cash flow, and investors can expect growth in the future. All told, Equinix is worth picking up given the recent sentiment-led dip.
This sustainable water technology company generates around half of its revenue from water utilities (wastewater treatment and clean water delivery). Another 35% comes from the industrial sector (applied water treatment), and the rest comes from the commercial and residential (applied water) sector. As such, it reports out of two main segments, namely water infrastructure and applied water.
The third segment, measurement and control solutions, contains an exciting collection of smart technology businesses that use advanced analytics and web-enabled devices to help utilities monitor and deal with leakages and theft, and engage in smart metering. It's an interesting mix of solid end demand from the need to continually update water infrastructure, allied with the growth kicker from its advanced analytics solutions.
The stock is now up more than 40% since last looked at in April and trading on 37 times estimated 2021 earnings. It's hard to argue that Xylem is still a good value, particularly for a company that reported a 7% organic sales decline in the third quarter.
Stocks to buy?
All told, Autodesk is an attractive company, but on a risk/reward basis the stock looks fully valued. Xylem is a stock worth following closely, but it also looks overvalued. Meanwhile, the recent dip in Equinix's share price is creating a good entry point into a very good long-term story.