Description

AF GRUPPEN (AFG NO Equity)

(All figures in NOK).

Summary

AFG is the most profitable listed contractor in the Nordic region, and has been one of the top performing stocks since its listing on the OSE in 1997, with a CAGR of 22% including dividends. As of year-end 2020, that was almost double the average CAGR of competing nordic contractors Veidekke, Skanska, NCC and Peab. AFG has a stellar track record of shareholder value creation, a strong balance sheet and a large order backlog (38 Bn NOK) reducing near term earnings risk. The company has ambitious but realistic growth and margin targets for the next several years that I believe they will at least partly achieve, in particular a 40 bn revenue target and a goal of 7% EBIT margin at the end of the period. My AFG thesis is admittedly not very exciting. It is not an interesting special situation or an investment case with a hard catalyst that will unlock value. It’s just a good, somewhat boring company that I believe will continue to do well, available at a reasonable price. 

Brief company history

AF Gruppen was founded in 1985 as Arbeidsfelleskapet (AF). Throughout the 90s, the company secured larger contracts and was able to enter the construction and property markets through a series of acquisitions. It was listed on the Oslo Stock Exchange in 1997 and in the 2000s made several acquisitions enabling the company to enter the demolition and groundworks markets. Demolition also helped the company to enter energy and offshore as new business areas. In the decade that followed, AFG continued to grow through acquisitions in Norway as well as Sweden, including the purchase of Betonmast.

Divisions

• Civil engineering: roads, railways, ports, airports, tunnels, foundations, power & energy

• Construction: planning, building and renovation for both the private and public markets

• Betonmast: one of Norway’s largest building contractors, major player in public projects

• Property: development, design and building of residential and commercial projects

• Energy and environment: clean-up, demolition, recycling

• Sweden: civil engineering, construction, property development and demolition in Sweden

• Offshore: variety of maritime services including offshore installation demo & recycling

Company values and strategy

The core values of AFG include focusing on creating a uniform corporate culture (important for a company that has and continues to rely on M&A as a major growth driver) as well as allowing employees to participate in the shareholder value creation through encouraging employee ownership. Over 1400 out of the company’s 4500 shareholders are company employees.  Furthermore, AFG has a decentralized operating model emphasizing that decision making authority and responsibility should lie where the value is created. 80% of managers in AFG are internally recruited, including the CEO Amund Toftum and CFO Sverre Hærem. The chairman of the board Pål Egil Rønn was CEO from 2007 to 2015. Finally, AFG emphasizes the development and implementation of extensive risk management processes used in any tender process, and believes this contributes to the company’s continued success.

Long term financial goals

• Superior margins and ROIC compared to peers

• ROIC > 20%

• Operating margin > 5%

• Semi-annual dividend payments and minimum 50% payout ratio (in practice AFG pays out virtually everything it takes in)

• Equity ratio > 20%

Short term financials goals presented in 2020 for the period ending in 2024:

• Revenues > 40 Bn NOK

• 7% EBIT margin by the end of the period

• > 20% return on invested capital

Are these goals realistic?

To evaluate the realism of these goals, it is useful to see if the last strategic goal set in 2017 was achieved. The ambition was to reach NOK 20 Bn in revenues by 2020 with an EBIT margin of at least 5%, and increase its market share in Norway and Sweden. The company did this and more, reaching 27 Bn NOK in revenues (23% CAGR) and achieving an operating margin of 5.5% in 2020. The split between organic and M&A driven growth in this period was around 40-60. Key organic growth drivers were major road contracts for AF Anlegg with Nye Veier, construction in Bergen and Greater Oslo, Betonmast and the Swedish civil engineering business. On the M&A front, the most important acquisitions were Kanonaden Entreprenad (construction), Helgesen Tekniske Bygg (construction services), HMB (Swedish construction business in Stockholm) and Betonmast construction, Norway and Sweden). Furthermore, we can consult the historical margin figures for longer periods to establish a long term base rate for comparison. Over the last seven years the average EBIT margin was 5.8%, so reaching 7% would imply an operating margin profile quite a bit above the historical norm, however from 2012 to 2016, when the strategic goal of the company was to improve margins, the operating margin was lifted from 3.3% to 8.1% at the end of the period. So they have done something similar before.

Valuation

Assuming this target is achieved in full, the company would produce 2.8 Bn in EBIT in 2024. That may be too optimistic however. So let’s say they get three quarters of the way there for a top line of 36.7 Bn and an EBIT margin of 6.6% as a base case scenario. I’m further assuming a 6% sales growth in 2021, followed by 9% in 2022-24, falling to 5% in 2025. The EBIT margin is assumed to stabilize at 6.6% in 2024. 

My DCF produces a fair value of 289 NOK/share. This assumes a WACC of 6%, the inputs to which are a 6.7% cost of equity (the inverse of the long term average P/E multiple of the company) and a 5% pre-tax cost of debt. This is my base case valuation. 

In a bear case scenario where revenues are unchanged until 2024 and the EBIT margin falls to 5%, and applying a 10x multiple to that EBIT, the stock is only worth 127 NOK/share. This seems reasonably unlikely to me, but I’m giving it a 25% chance of occurring nonetheless.

My p-weighted fair value estimate for AFG is 248. Let’s assume it takes the market 2 years to come to the same conclusion.

The implied CAGR would then be 15.8%.

Risks and negatives

• Input cost inflation may not be passed successfully on to customers. Commodity price inflation is currently pretty high and there is no guarantee it will subside in the near or medium term.

• Project risk - this is always a risk. AFG has been very good in terms of risk management in the past, but as they say, past results are no guarantee for future results.

• FX risk

• Rising interest rates increasing financing costs and putting pressure on residential and commercial real estate markets, increasing current project risk and reducing the attractiveness of future projects

• M&A has historically been an important growth driver for AFG, there is always risk of doing a bad acquisition. As the company is now much bigger than in the past, I see the risk as larger than before as the company becomes harder to manage when it consists of over 100 smaller companies. The risk of crappy, “transformative” larger acquisitions also increases with size.

Historical revenue growth 1997-2020

Historical ROE and ROIC 1997-2020

Catalyst

Time