The Bull Case For Advanced Drainage Systems Inc.

With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in Advanced Drainage Systems Inc. WMS. Firms such as Citadel Advisors, Blackrock, and Alyeska Investment Group have all added to their WMS positions recently. Most notably, Citadel added a new 712,770 share position in Advanced Drainage Systems (as filed on 9/30) within the last quarter, worth $85.2 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Advanced Drainage Systems Inc.

Earlier this month, Advanced Drainage Systems Inc. reported second quarter earnings results for FY24. Financials looked mediocre during the quarter, however, management believes that demand is largely in line with expectations. The non-residential construction outlook remains uncertain due to high interest rates and tighter credit standards, which management believes hasn’t been fully digested by the market. On the other hand, infrastructure activity is picking up, mitigating the demand slack from a weak non-residential construction outlook. During the quarter, management slightly downgraded guidance, pinning FY24 net sales at $2,700 - $2,800 (in millions) and adjusted EBITDA at $800 - $850 (in millions), while increasing the adjusted EBITDA margin 20 - 100 basis points to 29.6% - 30.4%. With these earnings results in mind, we believe that Advanced Drainage Systems Inc. is a compelling investment opportunity trading at a fair valuation.

Advanced Drainage Systems Inc. WMS is the leading manufacturer of innovative water solutions in the onsite septic wastewater and stormwater industries, providing drainage solutions for use in the agriculture and construction marketplaces. The business’ innovative product line covers a broad range of end markets and applications, including non-residential, residential, agriculture, and infrastructure applications. The business has a leading position in many of these end markets by leveraging their national sales and distribution platform, industry-acclaimed engineering support, product breadth, market share model, and scale plus manufacturing excellence.

Advanced Drainage Systems Inc. operates within a highly fragmented industry, holding leading positions in multiple market sectors. In particular, the stormwater drainage industry is highly fragmented, with many smaller speciality and regional competitors providing a variety of product solutions and technologies. The business largely competes against concrete pipe, corrugated steel pipe, and PVC pipe producers on a national, regional, and local basis. Management believes that Advanced Drainage Systems is the only corrugated HDPE pipe producer with a national footprint, with their primary competitors operating on a regional and local basis.

Management believes that they hold a strong competitive advantage in multiple market sectors, with lighter, more cost effective, and more durable products that are easier to install than comparable alternatives made with traditional materials. For example, the business’ entrance into the non-residential construction market with the introduction of the N-12 corrugated HDPE pipe in the late 1980s has led to the displacing of traditional materials like corrugated steel, reinforced concrete, and PVC. Competitive factors for their leading market sectors include local selling coverage, product availability, breadth of product offerings, customer and supplier relationships, and pricing of products, among other things. Advanced Drainage Systems is competitive in all of these competitive factors, leading to their status as a leader in multiple market sectors.

Management is solid, and their capital allocation priorities are shareholder friendly, doing a good job of aligning shareholder and management interests. In February of 2022, the Board of Directors approved a $1 billion dollar share repurchase program of the business’ common stock. This program replaced a previously approved repurchase program that had no remaining capacity left. In FY23 alone, management repurchased a whopping 6.1 million common shares at a cost of $575 million dollars. As we can see, management likes to return value to shareholders via share repurchases, increasing shareholder value. In addition to share repurchases, Advanced Drainage Systems also offers a quarterly cash dividend, further increasing shareholder value. 

Looking at NEO compensation, we can see that Advanced Drainage Systems’ management is well incentivized, with an incentive structure that does a good job of aligning management and shareholder interests. The Long-Term Incentive Plan considers cash flow from operations and return on invested capital (ROIC) as performance measures to determine payouts to NEO’s. The target performance earns a 100% payout, whereas the threshold performance earns a 50% payout and the maximum performance earns a 200% payout, incentivizing management to meet and exceed their cash flow from operations and ROIC performance measures. The Long-Term incentive compensation is paid out in the form of equity, a great way of aligning shareholders and management. As management builds more equity in the business, the more incentivized they are to maximize financial performance and the performance of their shares in the business.

Advanced Drainage System Inc. is an efficient business. The business currently operates at a LTM ROE of 45.7% and a LTM ROIC of 27.1%. With a WACC of 10.8%, Advanced Drainage Systems operates at a ROIC to WACC ratio of around 2.5x, showcasing the business’ ability to generate returns on cash reinvested back into the business at rates of return far higher than the business’ weighted average cost of capital. Businesses that are able to efficiently reinvest cash back into the business at favorable rates of return are considered to be compounders, businesses that are able to rapidly compound intrinsic value over the long-term, handsomely rewarding shareholders. Looking further at efficiency metrics, we can see that ROIC has handsomely expanded within the last few years, possibly showing that Advanced Drainage Systems has a strengthening competitive advantage or moat in the water management industry. In 2014, Advanced Drainage Systems operated with a ROIC of 13.5%, compared to today where the business operates at a LTM ROIC of 27.1%.

Analyzing Advanced Drainage Systems’ Income Statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2014, Advanced Drainage System has grown revenue at a CAGR of 11.14%, with gross profit growing at a CAGR of 18.4% in that same time frame. This growth in gross profit can largely be attributed to expanding gross profit margins, which have expanded from 19.3% of revenue in 2014 to 36.4% of revenue today. In terms of earnings, Advanced Drainage Systems has grown EBITDA at a CAGR of 21.6% since 2014, with EPS growing at a CAGR of 40.7% from 2016 to today. This large growth in EPS can largely be attributed to share repurchases as of late. The business has diluted shares outstanding in the past, however, this has largely changed within the last year. From 2022 to today, Advanced Drainage Systems has repurchased over 5.4 million shares, or nearly 6.5% of shares outstanding from 2022.

Looking at Advanced Drainage Systems’ balance sheet, we can see that the business operates in good financial health. The business currently holds $470.4 million dollars worth of cash and equivalents on hand, paired with $1.26 billion dollars worth of long-term debt. While we like to see businesses with more cash on hand than debt, this is a manageable cash to long-term debt ratio to operate at. Adding credence to the point that the business operates in stable financial health, Advanced Drainage Systems’ currently operates at a current ratio of 2.7x, meaning that for every dollar of current liabilities, the business has $2.70 in current assets.

Analyzing Advanced Drainage Systems’ cash flow statement, we can see some stellar sustained growth in net income and free cash flow within the last decade, showcasing the business’ increased operational efficiency. Since 2014, the business has grown net income at a whopping CAGR of 60.8% (even despite the fact that net income went negative in 2015 and 2020), with free cash flow growing at a CAGR of 33.3% in that same time frame. This growth in free cash flow can largely be attributed to expanding free cash flow margins. In 2014, the business operated at a free cash flow margin of 2.9% of revenue, compared to today where the business operates at a free cash flow margin of 17.6% of revenue. As we can see, expanding free cash flow margins are acting as catalysts for growth in free cash flow generation. As free cash flow margins continue to expand, Advanced Drainage Systems will be able to generate more and more free cash flow from revenue, giving them excess cash to reinvest back into the business, repurchase shares, or offer / increase a dividend.

After conducting a reverse discounted cash flow analysis, we found that Advanced Drainage Systems is trading at share prices that imply a 5.39% growth rate (CAGR) in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10%. Advanced Drainage Systems is a quality business, and we believe this valuation is low, given expanding free cash flow margins acting as a catalyst for future free cash flow generation growth. While past performance is not indicative of future results, this implied growth rate seems low considering the fact that the business was able to grow free cash flow at a CAGR of 33.3% within the last decade. If free cash flow margins continue to expand and revenue continues to grow at a reasonable pace, it is very likely that the business will be able to grow free cash flow at a growth rate much higher than 5.39% in the next 10 years, making this a reasonable valuation in our eyes. However, this opinion is based on our models, and we encourage all investors to do their own due diligence when it comes to valuation.

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