FA Alpha Daily

Still water runs deep, and it may bring even higher returns

The United States is in a supply chain supercycle, with infrastructure building benefiting companies like Advanced Drainage Systems (ADS). ADS provides water management solutions for commercial, residential, and infrastructure construction. The company’s strong relationship with government agencies has given it a competitive advantage. Despite these, the market has not fully recognized ADS’s value, leaving its stock significantly undervalued. In today’s FA Alpha Daily, we’ll discuss how the supply chain supercycle has impacted ADS and the market’s future expectations for the company.

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Thursday Uniform accounting analysis
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Infrastructure and supply chain have been underinvested in the U.S. since the Great Recession. Various problems came along with this, including supply chain disruptions, delays and higher prices. Additionally, the pandemic has exacerbated these problems.

Especially in the wake of the pandemic, the U.S. government and companies realized the importance of infrastructure and supply chain investment. Hence, Congress passed the Bipartisan Infrastructure Law, which has authorized $1.2 trillion in infrastructure investment.

The investment is being made gradually over the next eight years, it will help to improve the efficiency of the U.S. supply chain and make it more resilient to disruptions.

One company that is well-positioned to benefit from this investment is Advanced Drainage Systems. The company is an Ohio-based manufacturer of water management and other drainage products. The company’s products are used in a variety of infrastructure applications, including roads, bridges, and airports. 

The company is already on good terms with local agencies and the state departments of transportation. So, this investment is a major opportunity for the company. Advanced Drainage Systems seems confident that it will be able to capitalize on this opportunity and continue to grow its business in the years to come.

Moreover, Advanced Drainage Systems is also opportune to take advantage of the growing demand for sustainable infrastructure solutions. The company’s products are made from recycled materials and are designed to be energy-efficient.

While the market believes Advanced Drainage Systems will bring high returns, it is not entirely confident that the figures could exceed this year. 

We can see this through our Embedded Expectations Analysis (“EEA”) framework.

The EEA starts by looking at a company’s current stock price. From there, we can calculate what the market expects from the company’s future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well a company has to perform in the future to be worth what the market is paying for it today.

At the current stock price, the market expects that the company is not going to be able to sustain its profitability, and its Uniform return on assets (“ROA”) will fall below 30%.

Though the expected ROA levels are still high, the market seems to have concerns about the company. This may be understandable since all investments are heavily reliant on the changes in the overall economy. 

In addition to macro uncertainty, the water industry is highly regulated to protect water quality and public health. This may increase the cost of doing business and make it challenging to innovate. 

However, the positive outlook in the macro environment and the company’s strong relationships with state agencies serve as differentiating factors, offsetting concerns about the company.

Nonetheless, the market seems to underestimate the effect of the supply chain supercycle on Advanced Drainage Systems. As the United States is the company’s largest market, any further investments in the U.S. economy would have a significant impact on the company’s profitability. 

Considering this, the market does not seem optimistic enough about the future of the business. As Advanced Drainage Systems continues to execute as it is, there might be a great upside potential.

SUMMARY and Advanced Drainage Systems Inc. Tearsheet

As the Uniform Accounting tearsheet for Advanced Drainage Systems Inc. (WMS:USA) highlights, the Uniform P/E trades at 22.1x, which is above the corporate average of 18.4x and its historical P/E of 20.2x.

High P/Es require high EPS growth to sustain them. In the case of Advanced Drainage Systems, the company has recently shown a 55% growth in Uniform EPS.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Advanced Drainage Systems’ Wall Street analyst-driven forecast is a 20% EPS shrinkage in 2024 and a 14% EPS growth in 2025.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Advanced Drainage Systems’ $122.05 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to grow by 1% annually over the next three years. What Wall Street analysts expect for Advanced Drainage Systems’ earnings growth is below what the current stock market valuation requires in 2024, but above its requirement in 2025.

Furthermore, the company’s earning power is 5x its long-run corporate average. However, cash flows and cash on hand are below its total obligations—including debt maturities, capex maintenance, and dividends. 

All in all, this signals average credit risk.

Lastly, Advanced Drainage Systems’ Uniform earnings growth is below its peer averages but in line with its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

The Uniform Accounting insights in today’s issue are the same ones that power some of our best stock picks and macro research, which can be found in our FA Alpha Daily newsletters.

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