The need to maintain and upgrade infrastructure isn’t going away any time soon, and the promise of an infrastructural bill adds a growth kicker to all three of these stock picks. Let’s take a look at why sustainable water company Xylem (NYSE:XYL), infrastructure consultancy AECOM (NYSE:ACM), and metal coating company AZZ (NYSE:AZZ) are worth buying to play the infrastructure spending theme.
The investment case for buying AZZ rests on the company’s efforts to refocus its core business, namely galvanizing metal. The metal coating segment generated $107 million in adjusted operating income in its fiscal year 2021, compared to just $15.7 million from the infrastructure solutions (enclosure systems, switchgear, electrical products, and lighting systems).
For reference, galvanizing is the process of zinc coating steel or iron to prevent it from rusting. As such, any infrastructure spending that leads to more spending on construction is good news for AZZ. The company operates out of 39 galvanizing locations in North America and is the largest player in the market.
Moreover, management plans to continue its acquisition strategy (eight bolt-on acquisitions made since 2017) to grow the metal coating business. That makes sense given that the metal coating segment has an operating profit margin in the range of 21% to 23%, compared to the infrastructure solutions segment margin in the low to mid-single digits. In fact, management is conducting a review of the infrastructure solutions business with a view to exiting some of the worst-performing businesses.
All told, AZZ is expanding in its high-margin core metal coating business and focusing on restructuring its low-margin infrastructure businesses. It’s a sensible strategy and positions the company well for a pickup in infrastructure spending.
The infrastructure consultancy is also in the throes of restructuring. Having divested many of its non-core businesses (including power construction, civil construction, and management services), consolidated its business regions, and simplified its business structure, AECOM is now well-positioned for an expansion in infrastructure spending.
Following the divestitures and restructuring, AECOM now focuses on its core competency in infrastructure. It currently generates 35% of its revenue from transportation, 34% from facilities, and 28% from environment/water. As such, the company will benefit from global spending on infrastructure, whether it’s from an infrastructure bill in the U.S. or from the need to increase development spending in emerging economies.
AECOM’s management targets a doubling of its adjusted earnings and free cash flow from 2020 to 2024, with operating margin expanding to 15% in 2024 from 13.1% at the end of the first quarter of 2021. In other words, management expects adjusted earnings per share (EPS) of $4.30 and free cash flow of at least $680 million by 2024.
Based on its current market cap, those figures would put the stock on 14 times its free cash flow and 15 times its earnings in 2024. An infrastructure bill in the U.S. could bring those targets forward — something for investors to keep an eye out for.
This sustainable water products company is an intriguing mix of solid end demand from water utilities and cyclical demand from industrial, commercial, and residential customers. Meanwhile, underlying it all, the company has a long-term growth opportunity from growth in its smart infrastructure solutions, known as advanced infrastructure analytics (AIA). Xylem’s AIA solutions include web-enabled smart meters and leak detection technology that helps utilities diagnose, monitor, and control issues such as leakage, theft, or inaccurate billing.
Around 55% of its revenue comes from water utilities (notoriously slow adopters of new technology), with a 50/50 split between wastewater and clean water treatment (pumps, filtration, valves, controls, etc.). Industrial customers (water treatment) contribute around 30% of revenue, with commercial (10%) and residential (5%) making up the rest.
Xylem’s long-term prospects will be driven by ongoing spending on water treatment by water utilities and how fast they (water utilities) adopt its AIA solutions. The continuing need for water drives the former, and the latter is a question of “when not if.”
Trading on 44 times estimated 2021 earnings, Xylem isn’t a value stock, and cautious investors may want to wait for a better entry point. On the other hand, its long-term growth prospects look excellent, and if the rate of adoption of AIA picks up, then earnings estimates are likely to be revised upwards.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.