Spruce Point Capital Issues Strong Sell Opinion on AECOM (NYSE: ACM): New Material Weakness Disclosure, Rising Leverage ...

Background: AECOM Levered Itself To Acquire URS In 2014, Gaining Significant Exposure To Oil/Gas/Mining Sectors At the Peak

• AECOM (ACM or "the Company") is a global engineering and construction firm based in Los Angeles, and is an enormous roll-up that came public in 2007. Bowing to pressure from an activist to maximize shareholder value, URS Corp. (NYSE: URS ) sold itself in October 2014 to AECOM (for approx. $5bn - a cash/stock deal which included the assumption of $1bn in URS debt. The URS deal is the largest in AECOM's history. AECOM's pro forma leverage at closing of 4.4x was forecasted by the Company to decline to 2.0x by 2017 due to "strong free cash flows" - a claim Spruce Point will put to the test of rigorous scrutiny!
• The URS deal was touted as giving AECOM "heft"  in the oil and gas market, at exactly the wrong time! As shown by the investor presentation, URS also added exposure to the mining and industrial sectors - other areas that have shown persistent weakness since 2014
• The company predicted 25% accretion to "Cash EPS" and noted $250m of synergies. Commenting on the deal, analyst Will Gabrielski of Stephens ( ironically now AECOM's VP, IR ) said,
• " You couldn't have had a better marriage of two companies that complement each other's skill sets, scope and capabilities so well. They both have the federal government as a large customer, but there is very little overlap in what they do," he said. "It's a great value for both companies. "
  

Source: URS/AECOM Deal Presentation

According to the deal proxy statement , AECOM significantly haircut URS  projections. Nonetheless, URS's 2015 revenues came in at $8.5 billion, well below the $10.1 billion discounted expectation." Since the acquisition date, URS contributed $8.5 billion in revenue and $219.0 million in income from operations during the twelve months ended September 30, 2015 " AECOM FY 2015 10-K . page 84

Spruce Point has been following AECOM, and has generally viewed its post-deal financial results with skepticism. Our view was fortified when on Aug 10, 2016, after reporting Q3'16 results, AECOM filed an amended 10-K/A   and noted the following:

" Our management has reassessed and concluded that our internal control over financial reporting was ineffective as of September 30, 2015, due to the existence of a material weakness that existed at the end of fiscal year 2015 that is described further below. In our third quarter of fiscal year 2016, management discovered deficiencies associated with the acquisition of URS Corporation related to (A)  the alignment of accounting policies specific to forward loss reserves and (B)  income tax account s."

Trying to downplay this issue, AECOM stated further that :

" These deficiencies did not have a material impact on the Company's previously reported financial results for the year ended September 30, 2015, and the Company recorded in the third quarter of fiscal year 2016 an immaterial cumulative adjustment ."

Given recent disclosures, Spruce Point felt it necessary to make our analysis public with the goal of allowing investors to assess how material AECOM's accounting issues are. In our opinion, investors should be very concerned about the following issues :

• AECOM's GAAP/NON-GAAP Results Wildly Diverging : AECOM has changed its EPS definition three times since selling investors on the URS deal. Not surprisingly, each change makes the number more inflated. AECOM is now adding back "non-core operating losses" and "expected and actual asset sales" even though it told investors no divestitures were planned at deal inception. Even more alarming, in Q2'16, it booked pension curtailment gains to revenue and EPS to claim an earnings beat!

• AECOM Has Incessantly Changed The URS Purchase Price Allocation : Even though GAAP says that final intangible and goodwill allocation has to be completed within 12 months of closing, AECOM is still making changes 18 months later!

PricewaterhouseCoopers Acquisition Accounting Guidance

" The fair values of identifiable net assets recognised in a business combination may be based on the provisional fair values available at the time of the acquisition. The fair value of these assets and liabilities and the resulting amount of any goodwill must be finalised no later than 12 months from the acquisition date. Goodwill, as the residual, is not finally determined until the fair value exercise is complete. A change to goodwill arising from the completion of the fair value exercise is not an impairment ."

Source: PWC guide , Business Combinations and Non-controlling interests, Application of the US GAAP and IFRS Standards, 2nd edition Feb 2016

Changes To URS' Account Valuation By AECOM  (changes shade in orange)

• AECOM Appears To Have Set-up A Cookie Jar Reserve : for "billings in excess of costs on uncompleted contracts" that include a margin fair value liability associated with long-term contracts acquired in connection with the acquisition of URS. AECOM has repeatedly changed its disclosure about the value of the margin liability accounted for at its inception, and continues to change its value 18 months later. The reversal of the margin liability has allowed AECOM to book free revenue with 100% margin! We estimate this reserve has been used to book $149m of revenues and $0.73 cents of earnings per share!

• Questionable Synergies : AECOM boosted its estimate of cost savings synergies from $250m to $325m shortly after its CFO was rotated out of his position to become President at the end of FY Sept 2015. According to our analysis of recent industry mega deals, AECOM has promised the largest synergy targets seen in the E&C industry by a wide margin

• Evidence Of Poor Planning Or Worse ?  We are skeptical of AECOM's synergy targets because AECOM grossly misestimated acquisition and integration costs ("A&I"), along with amortization of acquired intangibles. According to its own estimate, AECOM expected 2015 costs to be $290m and amortization of $250m, but actual results came in +37% and +44% above estimates, respectively. Total A&I costs are now estimated to reach a lofty $626m! This heightens our worry that AECOM could be running regular costs through its income statement, and trying to disguise them as deal costs
• " We expect to incur approximately $250 million of amortization of intangible assets expense and $290 million of acquisition and integration expense in the next 12 month " 10-K  (p. 56)

But in reality, for the year ended Sept 30, 2015, AECOM reported in its 10-K  (p. 35 & 84) $398.4m and $361.6m acquisition and integration expense and intangible amortization, respectively

• Free Cash Flow Appears Overstated:  AECOM has shown three different definitions of Free Cash Flow! In the proxy, it showed URS' as adjusted for noncontrolling distributions, a definition we view as accurate. It currently does not remove distributions, and later changed to "capital expenditures net of asset sales." In our view, this adjustment is very aggressive and not common. Lastly, we note that AECOM includes accounts receivable financing activities, as well as excess joint venture dividends above equity earnings, as part of operating cash flow. By adjusting for these items and distributions to noncontrolling interests, we believe free cash flow is overstated by approximately 90% in the LTM ending June 30th.
• It's important and appropriate to deduct the accounts receivables that were sold to financial institutions because this is a financial arrangement that results in the sale of a company asset (the asset being accounts receivable). The A/R financing arrangements can provide management tools to potentially overstate operating cash flow. To illustrate, ACM reported $108.9m of receivable sales in 2015. URS contributed $2,512m of receivables upon deal closing, while ACM's receivable balance was $2,655m at 9/30/14. Thus, while ACM's total receivables grew 94% due to the URS transaction, its financing receivable sales grew from $10.9m in 2014 to $108.9m in 2015, representing a ~900% increase!  At the very least, we believe ACM should present the financing receivables more clearly to investors in its press releases, rather than bury them in one sentence in the 10-Q. To illustrate this best practice, we point out that IBM  clearly separates financing receivables as part of its normalized operating cash flow Annual Report, p. 62.

• Plummeting Tax Rate:  AECOM noted issues with its tax accounts w/out providing specifics. We observe that its forecasted effective tax rate fell from 32% in Dec '14 to 24% as of June '16. In the last quarter, its estimated tax rate fell by a 300bps!

• AECOM Capital Could Further Distort Earnings And Cash Flows : Management is trying to condition investors to expect that capital fund sales should be viewed as "core" earnings and operating cash flows. It has already booked $16m of gains in 2015, and is telling investors to expect more in the next 12 months. These irregular gains can hardly be considered "core."
• Rising Interest Expense Revision and Debt Covenant Step-Up: AECOM just raised its interest cost estimate by $15m, yet has reduced its total and floating rate exposure. Its recent 10-Q  says its exposure to a 1% move in rates should add $16m of costs. We estimate, key rates such as LIBOR and Prime have only moved 25bps; something doesn't add up! AECOM's credit agreement  ties its interest cost to its leverage. Did AECOM just signal that its EBITDA will be falling (leverage rising)? Its stated 6/30/16 leverage is 4.3x and come Sept 30th, its leverage covenant drops to 4.75x - leaving AECOM very little cushion.

• Management Has Almost Zero Alignment With Shareholders : Since coming public in 2007, insider ownership has declined from 13.5% to a pathetic 1.1%. When thinking about the totality of our concerns, investors need to consider that management has virtually nothing at risk if AECOM doesn't perform.

• Excessive CEO Comp Tied To Inflated Adjusted Free Cash Flow : AECOM's CEO (also recently appointed  its Board Chairman) netted $18m in comp (inc. a $5m special performance for the URS deal (one we view as a disaster)). Management boldly tried to sell investors that it produced $4.59 of FCF/share in 2015, +52% over the prior year. In our view, this measure is grossly inflated, and fails to account for key adjustments to remove financed receivables, excess distributions from unconsolidated subsidiaries, and distributions to noncontrolling interests. With these adjustments, we find that AECOM's 2015 normalized FCF/share was $2.36 and declined by 9% in 2014

• AECOM Knows How To Make News : In the past year, there have been rampant allegations of misconduct, open investigations, lawsuits and settlements on a global basis involving AECOM. To illustrate, it agreed to pay $20.2m  to resolve a US investigation into an alleged fraudulent overbilling scheme, paid $201m to settle an Australia Toll-Road lawsuit (one of the largest settlements related to misleading and deceptive conduct in Australian history), faced a federal lawsuit  related to systematically defrauding NASA, and is being investigated by the Dept. of Energy  for its role in the Hanford Nuclear Reservation

Trading Near 52-Week And All-Time Highs, Shares Are Fully Valued With A Terrible Risk/Reward Owning AECOM

• AECOM Looks "Cheap" - Buyer Beware : Trading close to 11x Price/16E EPS vs. peers Jacobs Engineering (NYSE: JEC ), Fluor (NYSE: FLR ), Quanta (NYSE: PWR ), Amec Foster Wheeler (NYSE: AMFW ), Chicago Bridge & Iron (NYSE: CBI ), KBR Inc. (NYSE: KBR ) and SNC Lavalin ( OTCPK:SNCAF ) at 14.0x, AECOM looks cheap, but in our view, its Adj. EPS is fraught with overstatement. Based on our adjustments, it trades at close to 19x, a substantial premium. AECOM is levered 4.3x Debt/EBITDA leaving little room for error, but by adjusting its Debt to include its unfunded pension and sizeable operating leases and normalizing its EBITDA, true leverage is closer to 7.4x!

• Even The Analysts See Little Upside : The average price target is little more than $35/sh and analysts are more neutral than positive.

• Meaningful Downside Potential : Given numerous accounting distortions to EPS, we believe the best way to value AECOM is on a multiple of LTM Free Cash Flow. Applying a range of 9x-11x on $2.10 of LTM FCF per share, we get $19-$23/sh (33-45% downside).

T hank you for your interest in our work.

Disclaimer

This research presentation expresses our research opinions. You should assume that as of the publication date of any presentation, report or letter, Spruce Point Capital Management LLC (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our subscribers and clients has a short position in all stocks (and/or are long puts/short call options of the stock) covered herein, including without limitation AECOM ("ACM"), and therefore stand to realize significant gains in the event that the price of its stock declines. Following publication of any presentation, report or letter, we intend to continue transacting in the securities covered therein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. All expressions of opinion are subject to change without notice, and Spruce Point Capital Management does not undertake to update this report or any information contained herein. Spruce Point Capital Management, subscribers and/or consultants shall have no obligation to inform any investor or viewer of this report about their historical, current, and future trading activities.

This research presentation expresses our research opinions, which we have based upon interpretation of certain facts and observations, all of which are based upon publicly available information, and all of which are set out in this research presentation. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward looking statements, expectations, pro forma analyses, estimates, and projections. You should assume these types of statements, expectations, pro forma analyses, estimates, and projections may turn out to be incorrect for reasons beyond Spruce Point Capital Management LLC's control. This is not investment or accounting advice nor should it be construed as such. Use of Spruce Point Capital Management LLC's research is at your own risk. You should do your own research and due diligence, with assistance from professional financial, legal and tax experts, before making any investment decision with respect to securities covered herein. All figures assumed to be in US Dollars, unless specified otherwise.

To the best of our ability and belief, as of the date hereof, all information contained herein is accurate and reliable and does not omit to state material facts necessary to make the statements herein not misleading, and all information has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer, or to any other person or entity that was breached by the transmission of information to Spruce Point Capital Management LLC. However, Spruce Point Capital Management LLC recognizes that there may be non-public information in the possession of AECOM. Or other insiders of AECOM that has not been publicly disclosed by AECOM. Therefore, such information contained herein is presented "as is," without warranty of any kind - whether express or implied. Spruce Point Capital Management LLC makes no other representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use.

This report's estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This is not an offer to sell or a solicitation of an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction. Spruce Point Capital Management LLC is not registered as an investment advisor, broker/dealer, or accounting firm.

All rights reserved. This document may not be reproduced or disseminated in whole or in part without the prior written consent of Spruce Point Capital Management LLC.