Impactive Capital sees a structural shift creating upside for this wastewater company

Activist hedge fund Impactive Capital has taken a position in Advanced Drainage Systems (WMS), a market leader in stormwater and wastewater solutions, asserting the company is undervalued despite its strong fundamentals. Impactive's thesis counters investor concerns regarding construction cyclicality and margin compression, arguing WMS's revenue is resilient due to market share gains, increased exposure to repair/remodel markets, and infrastructure demand. They also believe WMS's margins are structurally expanding through product mix shifts and unique input cost management, projecting mid-teens EPS growth and significant three-year total returns of 69% (base case) to 146% (upside case).

Analysis

Advanced Drainage Systems (WMS), a market leader in stormwater and wastewater solutions, has attracted an activist position from Impactive Capital, announced on October 21st. Impactive's bullish thesis contends that WMS is undervalued despite its impressive 28% EPS CAGR and ROIC consistently above 20%, following recent share price underperformance and a re-rating to a low-to-mid 20s P/E multiple. This underperformance is attributed to investor concerns regarding construction cyclicality and potential margin compression.

Impactive Capital argues WMS's revenue streams are more resilient than perceived, countering fears of construction cyclicality. The company benefits from plastic pipes gaining significant market share, now exceeding 40% of the market compared to 20% in 2010. Strategic acquisitions have increased exposure to the stable residential repair and remodel market, while increased billion-dollar storm events drive demand for complex stormwater infrastructure.

Regarding margin concerns, Impactive asserts WMS's margin expansion is structural. The company has diversified towards higher-margin Allied Products and Infiltrator offerings, which boast adjusted operating margins in the mid-50s, significantly higher than the pipe segment's 30%. WMS also uniquely mitigates input costs by toggling between recycled and virgin resins based on oil prices, allowing for margin protection even when construction spending is weak.

As a result, Impactive projects WMS to return to mid-teens EPS growth, forecasting a base case three-year total return of 69% with a 19% IRR, and an upside case of 146% total return with a 34% IRR. These projections suggest a significant undervaluation not currently reflected in forward consensus estimates, particularly concerning the potential 100 bps gross margin expansion over the next 12-24 months.

Key Decisions for Investors

• Investors should critically evaluate Impactive Capital's thesis regarding WMS's structural growth drivers and margin resilience, particularly given the company's historical underperformance despite strong fundamentals.
• It may be prudent to monitor WMS's execution on market share gains in plastic pipe, diversification into repair/remodel markets, and its unique input cost management strategy.
• Assess whether forward consensus estimates begin to incorporate Impactive's projected gross margin expansion and mid-teens EPS growth, which could signal a re-rating opportunity.