According to analyst estimates as of May 2011, AZZ is expected to generate approximately $434 million in revenue in 2012 and $471 million in revenue in 2013. Recently, management re-affirmed their guidance for fiscal year end February 2012 with revenues of $450 million to $475 million and earnings between $2.90 to $3.10 per share. I generally prefer to maintain conservative revenue estimations within my model, so I projected that 2012 revenues would amount to approximately $405.8 million and 2013 revenues amount to approximately $436.7 million, well below management and analyst expectations. Below is an example of my DCF projections which exclude the net effect of debt on operations (i.e. interest).
In the above model, revenue trends upward at a high single digit pace until 2015, whereby I project that revenues will grow at approximately 13% representing stimulus spending in infrastructure (utility upgrades / electrical infrastructure), which then scales downward to a long-term growth rate of 3% by the terminal period beyond 2021. I projected that Cost of Goods Sold (COGS) will remain flat at the 3 year historical rate of approximately 71% during the projection period and beyond. Overtime COGS may fluctuate significantly due to variations in raw material costs and volatility in commodities markets, particularly markets for Zinc, a critical input for steel galvanizing. Sales, General, and Administrative Expenses (SG&A) were projected at their 3 year historical average of 11.6%. It is anticipated that SG&A expenses will converge at historical values once synergies are realized from the acquisition of North American Galvanizing. The historical low for SG&A expenses was 10.5% in 2009, which lends itself to the additional value creation that can be generated by effective cost controls within the organization. The remaining operating income was then burdened with a US effective tax rate of 39.3%, which is in line with the firm specific tax rate of 38.5% as of August 31, 2011. After calculating the After-tax Operating Income, additional adjustments were made for Depreciation & Amortization (D&A), Changes in Working Capital, and Capital Expenditures. D&A expenses were projected at the 3 year historical rate 3.8% during the discrete projection period. CAPEX was projected at the 3 year historical rate of 4.2% and then reduced to a 3.8% by the terminal period to alleviate any long term value depletion that is associated with the variations in the CAPEX to D&A relationship. Given the unpredictability of historical Working Capital (excluding cash), 3.0% was applied through the entire projection period, thus creating an additional burden to conservative cash flows. Overall, FCF to the business as a percentage of sales was 7.1% for the projection years, 2012 to 2018. From 2019 to the terminal period, FCF increased to 7.4% of sales. For the most part, I believe that my estimations are relatively conservative and do not represent any potential windfall profits that be achieved through conservative management of the business. Additional research is need to gain a better understanding of potential commodity volatility, reasonable CAPEX spend and associated D&A, and Working Capital.
After completing the cash flow calculations, I modeled out a reasonable discount rate using the CAPM for Cost of Equity. My estimation included the following variables: Cost of Debt, Risk Free Rate, Market Risk Premium, Size Premium, Beta, and Debt to Capital Ratios. Below is the build up of my WACC.
For my WACC build up I applied the following variables: Bloomberg average investment grade Cost of Debt (Kd) of 6%, 4.5% 20 year treasury rate, 5.5% market risk premium, beta of 1.2 (AZZ beta), effective tax rate of 39.3% for the US, and a conservative capital estimation of 70% equity to 30% debt. After compiling my variables I calculated the Cost of Equity (Ke) using the Capital Asset Pricing Model (CAPM). According to the CAPM, the following Ke should be applied to AZZ Incorporated:
Ke= Rf + B * MRP + Sp + a
11.1% = 4.5% + 1.2 * 5.5%
Using a 11.1% Ke, 6.0% Kd, and 30 / 70 debt to equity ratio, I derived a discount rate for AZZ of 10%. Additional analysis is required to develop an actual market capitalization ratio, market cost of debt, market beta, and size premium.
Upon calculating my discount rate I calculated the residual value of the firm using a 3.0% long term growth rate. For the most part, this value is somewhat subjective; however, 3.0% should be in line with long term inflationary expectations. It is assumed that over an infinite time period, the performance of all firms converges at the expected long term growth rate for the economy as a whole. Depending on the nature of the business, this may be slightly higher or lower than the total output of the US economy. I have yet to see an empirical evidence to support unmanageable inflationary levels above 3.0% so I will continue to use 3.0% as a proxy until I believe otherwise. In general, my long term growth expectations range between 2.5% and 3.5%. Below I have included my calculation for the residual value of AZZ.
Additionally, I have calculated present value of my projected cash flows to derive a total value of Equity for AZZ.
Based on the assumptions listed above and the calculated diluted shares outstanding for AZZ I derived an intrinsic value per share of $47.65. This estimation is below the analyst consensus estimation of $52; however, I have already adjusted my expectations for the future to better align with what I believe are reasonable expectations for the business. Additionally, I have created a sensitivity model, whereby variations in the WACC is plotted against variations in the long term growth rate to gain a better understanding of the potential implications that may occur to an investment in AZZ. Below I have provided an example of my sensitivity model.
The overall valuation of AZZ, given conservative estimations, falls somewhere between $42 and $52 a share, barring any significant changes to the business, management expectations, or major value depletion. Given the current market price of $38.04 (10/03/2011), AZZ offers a fairly substantial value at its current price level, implied MOS of between 12.8% and 37.9%. Management has indicated that they currently do not foresee any major obstacles in their business and they continue to establish and build upon their backlog of business. I intend in future entries to provide additional measures of value including the details to my Cost Method analysis, in addition to providing additional details pertaining to the strength and weaknesses of management and the future value accretive opportunities for the business. For now however, I will provide the current details pertaining to my valuation summary for those who are interested.
Please feel free to provide any commentary or feedback that may assist in my analytical methods for valuing companies. I am always open to new ideas or considerations. Additionally, this entry is in no way a recommendation to buy or sell a stock.
Disclosure: I currently hold a position in AZZ.
Additional Resources:
AZZ Homepage
Stock Ideas
Lifts Guidance
Dividend Stock
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