Description

Disclaimer: This writeup represents my personal opinions only and is solely for VIC members. Do not distribute. Do you own due diligence to verify or discredit my work

I am recommending a long position in SNC-Lavalin Group Inc for VIC members. As usual, I suggest the reader gain a basic understanding of the company through its website, filings (go to www.sedar.com) and sell-side research.

Investment Thesis Summary:

I believe SNC represents an opportunity to invest in a great business at a cheap price –  primarily due to headline risk and inferred association with: 1) corruption in SNC’s business in Libya (a $35 mln payment that is improperly accounted for) and 2) a criminal investigtion against a former executive responsible for its North Africa business. Despite SNC’s decline in share price YTD, its shares do not appear cheap due to: 1) the non-recourse debt booked on its balance sheet, and 2) the 15x consensus forward P/E SNC is still trading at.

By looking at SNC from a sum-of-parts perspective, I believe downside to the current share price is limited and supported by SNC’s net cash position and its infrastructure investments. Hence, an investor is getting SNC’s core engineering and construction (E&C) business, beyond the current booked backlog, almost for free.

To be explained in further detail, I see SNC as a great business because:

1. Public Private Partnerships (P3) provide a tangible value proposition for government infrastructure projects, with government cost savings in the 15-30% range when they involve the private sector. This should enable private participants to generate > 15% ROCE sustainably
2. SNC’s competitive advantage includes technical expertise, experience, scale and access to partners with deep pockets (Canada Pension Plan, BC Investments Management Corp, etc.).
3. The consortium bidding structure prevents too much competition (3 to 4 bidder groups) as some competitors team up, while smaller players hope for subcontracts instead of competing
4. Using history as a guide, SNC grew their dividend every year since 1994 from $0.01 per share per qtr to $0.22 per share currently ($0.88 annual rate). http://www.snclavalin.com/investors_dividend.php?lang=en
5. SNC’s shareholder friendliness and capital allocation skills are also apparent in its willingness to engage in share buybacks, that started since 1995. http://www.snclavalin.com/investors_buyback.php?lang=en
6. SNC has consistently generated ROCE’s in the 10-15% range. Removing the non-recourse debt, ROCE’s are more like in the high teens.

It is impossible to precisely handicap the risk associated with SNC’s potentially corrupt practices, but I would point to:

1. the latest independent review has suggested the questionable $35 mln payment is an isolated incident,
2. ethically challenged behavior may really be part of this business and not unique to SNC,
3. many E&C companies have mitigated/maneuvered around these issues historically, including SNC, and
4. SNC since the “scandal” has won another close to $2 bln in new projects (a testament that their reputation is intact).

• http://www.snclavalin.com/news.php?lang=en&id=1746&action=latest_news_details (Altalink is a related party though)
• http://www.snclavalin.com/news.php?lang=en&id=1704&action=press_release_details&paging=1&start=6
• http://www.snclavalin.com/news.php?lang=en&id=1686&action=press_release_details&paging=1&start=11
• http://www.snclavalin.com/news.php?lang=en&id=1689&action=press_release_details&paging=1&start=11
• They are also preferred bidder for a $1 bln hospital project in Montreal,Canada.

Here is how I would handicap SNC's valuation:

Draconian Bear Case: $29 per share. $17.50 for SNC’s infrastructure investments (ICI), $6 net cash and $5 per share for current booked E&C backlog of ~ $12 bln. No more E&C business ever.

Base Case: $54 per share. $17.50 ICI + $6 cash + $30 E&C (continuing business but lose 20% assuming no SNC work in Middle-East and Africa).

Bull Case: $70+ per share. Not really unreasonable, just that business continues as usual and they continue to reap benefits from P3, mining/energy and international growth.

At the current price it is probably about $8 downside, $20-$25 upside.

Description and History: 

SNC has been around since 1911 (101 years). Overtime, SNC expanded both geographically and got involved in not only engineering but construction, operations and maintenance of infrastructure projects (O&M), as well as directly investing in some infrastructure projects. SNC breaks down its operating segments into: 1) Infrastructure & Environment, 2) Chemicals & Petroleum, 3) Power, 4) Mining & Metallurgy, 5) Other, and 6) O&M. In essence, SNC benefited and continues to benefit from 2 themes:

1. The secular growth in P3 projects i nCanada and elsewhere as governments essentially outsource infrastructure projects to save on costs and manage risk
2. The growth in global demand for resources and the need to increase supply as a result (i.e. mining and oil & gas projects).

Please read these to gain an understanding on P3s (called PFI in the UK):

• http://www.bankofcanada.ca/wp-content/uploads/2012/01/fsr-0606-woodman.pdf
• http://www.parliament.uk/documents/commons/lib/research/rp2001/rp01-117.pdf

Unique Insight in SNC’s Sustainable Competitive Advantage:

My discussion here focuses on P3s, as I don’t have unique insight into the mining/energy cycle (wish I did!), other than miners are experiencing shortages of labour and E&C help - hence capex inflation for many projects are 20-50% recently.

Through involvement/scuttle/industry contacts, I have some understanding of the process of the Canadian/Provincial government(s) had in setting up infrastructure projects under a P3 structure a decade ago, publishing request for proposals (“RFP”), to get bids from the private sector), and evaluating bids.

Before I go further, I will explain what exactly a P3 structure is in simple terms – as I think the sell-side doesn’t really understand the structure. First, the idea of P3’s came from the UK where they called it PFI, Project Finance Initiative (P3 is more of a misnomer as the government and private sector aren’t really equity partners but that’s another story). Essentially the PFI structure was created because of 2 reasons:

1. The government wasn’t efficient in building infrastructure projects itself (delays, cost overruns, etc.),
2. however, the public was generally against private company "ownership" of infrastructure projects

So instead of giving the private sector ownership of a project (like a toll road), a P3 structure gave the private sector a “concession” which is just a contract that they will be paid for their services over a period of time, at the end of which, the government retains ownership and control. The scope and length of the concession depends on what needs to be done. The narrowest scope being DB (stands for design and build), where the private sector just designs and builds the project, whereas the widest scope is DBFOM (stands for design, build, finance, operate and maintain, so the government is free to choose the scope of the P3: DB, DBO, DBFO or any combination etc etc)). The wider the scope the more opportunity there is for cost savings and risk transfer to the private sector. For instance, if the government wanted to build a new highway, it could set up a DBFOM RFP stating the specifications the government requires. Various private sector players (E&C companies, institutional investors, O&M players etc) would form different consortia to bid on the RFP (i.e. price it). The RFP could be set up so the private group (consortium) gets paid during the construction period only when certain milestones are met and penalties for delays. In the meantime, the winning consortium designs the highway to keep costs low, raises financing to proceed with construction, etc. Given the financial incentives (and disincentives), the consortium is typically incredibly efficient at this, relative to the government. Upon completion, the consortium gets its final construction payment and opens the highway for public use. Even if the highway is not tolled, the government can set up “shadow tolls”, meaning they would measure the amount of traffic and pay the consortium a base payment + payment based on traffic volume and perhaps deduct payments if there are excessive accidents/safety/quality issues. Again, the private sector is incentivized to operate the highway efficiently, and in fact, give the government feedback as to whether the project is “useful” to begin with – i.e. is there enough expected traffic to justify this highway?

The pushback to P3s is that in theory the government can do the projects cheaper, since the private sector incorporates an element of profit (10-20%) when they bid, while the government can work for breakeven. Second, the government would have a better cost of capital to finance the project vs. the private sector. However, the studies have shown despite these concerns, government projects were actually 15-20% cheaper than if the public sector did it themselves, and that is after the private sector would have priced the project for a profit to begin with. In essence, theoretically, the private sector can generate a minimum of 10% return on these projects (all savings (the extra 15-20%) accrue to public sector), to a maximum of 30% (10% return, plus all 20% savings the government would have had). This is an important point, because P3 players like SNC can in theory generate 10-30% project returns (and hopefully ROCE’s) sustainably over time.

Now when the P3 structure was first brought to Canada, the government was quite green and needed help. Through observation/scuttle/others opinions, here are my personal observations (and personal opinion of course):

1. the public sector is incredibly inefficient in Canada, the savings were probably well north of 20% for many projects
2. because of this inefficiency, the government had no idea what to expect from RFP bids (i.e. how the private sector would price their bids, and what type of payments make sense (lump sums vs annuity payments etc). E&C companies were hired to perform “shadow bids” – i.e. pretend to bid on a project and lay out the private sector economics, so one would know what to expect from “real” RFP bids.
3. I understand SNC at the time provided “shadow bidding” help, which was great given their reputational and expertise.  It doesn’t appear to be a smart move at the time as it blocked them from submitting real bids for those projects, and they were “blacked out” for a period of time.
4. In hindsight this was genius (my opinion only), they knew exactly what the government was looking for, and in theory the maximum profit they can extract given the assumptions the government might use (labour, materials, etc etc). This insight and relationship building is probably key to SNC owning the box in P3s in Canada and beating the international giants who try to enter the market (Siemens, Bilfinger Berger, Fluor, Ferrovial etc)

 This brings up my key argument that SNC’s competitive advantage and good ROCE generation is sustainable:

1. They have an advantage in terms of insight and knowledge of infrastructure projects up for bidding
2. They avoid competition with smaller players by subcontracting their work to them. (i.e. see Bird Construction http://www.bird.ca/)
3. Given SNC’s first mover advantage and expertise, some international players are bidding with SNC instead of against them. (http://www.ferrovial.com/en/Business-Lines/Toll-Roads-Announcements/Ferrovial-consortium-selected-East-Extension-Highway-407-Canada). I would say the trend is private bidders are becoming more like an oligopoly than a perfectly competitive market (hence higher and sustainable ROCEs)
4. They have on their side pension funds with deep pockets and a cost of capital advantage such as the Canadian Pension Plan (>$150 bln in assets),  the British Columbia Investment Management Corp. (> $90 bln in assets), and Caise de Depot Quebec (> $150 bln in assets). These funds also operate tax free (hence can provide financing on more aggressive terms). For instance, see the consortium for the Canada Line built in Vancouver,Canada.
5. From an industry macro perspective, P3s are a growth market. Over 160 more projects slated in Canada (maybe value of $80 bln+ assuming $500 mln per project. This is a rough guess and depends on each project and its scope)
6. P3s will likely gain momentum in the US (> $100 bln in transportation P3 projects potentially) and in emerging markets. There are no explicit studies on the “P3’ability” of the US. But if Canada is 1/10^th of the size of the US, then perhaps it is an $800 bln P3 market (again, we are not counting on any of this in my thesis)

Reputational Risk, the Libya Situation and Unaccounted for Agency Payments:

There was a recent $35 mln payment that is unaccounted for. The inference is that SNC directly or indirectly used it as a facilitation payment to win deals in Libya. The independent review found accounting weaknesses but that the issue was limited and not wide-spread, although they don’t know exactly where the payment went. This led to the resignation of the CEO and some other executives. And one of the executives has since been arrested on corruption allegations in Switzerland (the total unaccounted for payments now reach $56 mln I believe, along with $22 mln that never left Libya when Ghaddafi was ousted).

Latest Annual report note on this:

The Company has identified material weaknesses in its internal control over financial reporting as at December 31, 2011 relating to management override, non-compliance with and ineffective controls over compliance with the Company's policy on commercial agents and its code of ethics. As a result, the Company has concluded that its disclosure controls and procedures and its internal control over financial reporting were not effective as at December 31, 2011. These material weaknesses and proposed remedial measures are fully described in the Company's annual Management's Discussion and Analysis.

On top of this, SNC was also temporarily restricted from bidding on world bank projects. Allegations are confidential, the inference again is corruption but it represents only 1% of SNC’s revenues.

http://www.snclavalin.com/news.php?lang=en&id=1718&action=press_release_details&paging=1&start=6

This is the most difficult part of my analysis as it is incredibly difficult to figure out the impact of potential reputational damage and whether it is severe enough that SNC will fail to win new projects as a result (i.e. business continuity). To triangulate a view on this, I will examine:

1. SNC’s own history of scandals
2. Other similar companies’ scandals
3. How to financially handicap this risk – sum of parts

SNC History of Scandals

• http://en.wikipedia.org/wiki/SNC_Lavalin_scandal
• http://en.wikipedia.org/wiki/Bre-X

As you can read for yourself, SNC has navigated through previous scandals in the 1990’s and escaped more or less unscathed. The more concerning one is the Bre-X case, a $6 bln fraud case where Bre-X salted its samples (faked gold) – and SNC (its subsidiary technically) supposedly provided the independent resource estimate for them. You will note that SNC stock back then was cut in half as a result of the Bre-X fraud (and took ~5 years to recover) but I would note SNC used to be a tenth of the size it is now so its exposure to Bre-X was incredibly significant (relative to a $6 bln fraud). That and they didn’t have infrastructure investments and cash that accounted for 60%+ of their market cap.

Even so, in 2001, the claims against SNC were largely dismissed

• http://www.leagle.com/xmlResult.aspx?page=47&xmldoc=2001819197FSupp2d622_1766.xml&docbase=CsLwAr2-1986-2006&SizeDisp=7

• P.T. Kilborn's motion to dismiss is GRANTED in part and DENIED in part (Dkt. No. 446);

• Kilborn Engineering's motion to dismiss is GRANTED in part and DENIED in part (Dkt. No. 444);

• SNC-Lavalin's motion to dismiss is GRANTED (Dkt. No. 442);

My point is that given the current size of SNC, the Middle-East and Africa region only represents about 1/5 of its business. And even then, SNC has navigated through equally challenging scandals historically to see another day. In fact, as described earlier, they’re still winning ~ $2 bln in projects since this scandal and their backlog is at an all time high.

Other recent examples of corruption allegations in the E&C space: 

• http://www.reuters.com/article/2011/06/10/siemens-kuwait-idUSWEA543820110610
• http://www.reuters.com/article/2011/12/13/us-siemens-argentina-idUSTRE7BC18J20111213
• http://www.bloomberg.com/news/2012-02-22/alstom-units-barred-from-world-bank-contracts-on-misconduct-1-.html

I’m not here to be the morality police and hence some might find these comments offensive. Please skip this part if you wish.

So again this is just my opinion on the matter, and purely from a financial perspective: The point is from what I understand, SNC is no more ethically challenged than many of its competitors and corruption allegations and criminal investigations are more common than one might think. Finally, one can probably make a “negotiation resolution agreement”, pay a fine and carry on (see Alstom case). Certainly, I would like to see SNC and the industry clean up its practices but I don’t think these scandals/allegations are typically sufficient for the market to price these companies as non-going concerns.

How to Handicap SNC’s risk; Sum of Parts Analysis

I’m going to break down SNC’s intrinsic value into 3 parts: 1) net cash, 2) ICI (infrastructure investments), and 3) core E&C (and O&M) business, especially in light of its backlog.

Before I proceed, I calculate SNC’s net cash excluding its $1.6 bln in non-recourse debt. The reason being the debt is put onto its ICI stuff. (that’s like me saying if I own 10% of a company with $100 mln net debt, I don’t effectively put $10 mln of net debt on my own balance sheet).

In each of the cases I use:

1. Net Cash = $6 per share
2. ICI = $15 to $20. Using deal values, book values, market values as appropriate. Lets use the mid point $17.50. I don’t have particular diverging insight into these asset valuations that is different than the Street, perhaps other than some of their mining assets are probably worth more than book value.

So we are at $23.50 per share excluding SNC’s E&C core business. 

Draconian Case for SNC’s E&C business. I have a proforma backlog of around $12 bln (SNC states $10.5 bln, which I think at least excludes the $1 bln Montreal hospital preferred bidder project + 407 East). Assuming a 10% EBITDA margin (see historical financials probably 8-12% is reasonable), less $100 mln interest, $60 mln capex, then 30% tax gives you just over $700 mln FCF, or $5 per share. If you really want you can discount the time value of it a bit but your guess is as good as mine.

So Bear Case = $29 per share. (should be higher than $29 as capex should be barebones if you’re winding the business down)

Bear Case. Same as above but assume 3 years of life left in business of $7 bln in revenues each (so stretching backlog by $8 bln). Same logic, I get to $8 per share.

Conservative Case, non-continuing E&C business = $32 per share

Base Case. Similar logic but SNC E&C business a going concern. Assuming limited growth in revenues. I get $350 mln FCF per year, 15x FCF = $5.3 bln or $37 per share. Take a 20% discount to $37 per share to account for an elimination of work in the Middle East andAfrica(pretty conservative I would still say). $30 for E&C

In total sum of parts at $54 per share

Bull Case. There are bull cases given my thought on the secular growth in P3 structures withinCanadaand new countries beginning to adopt this model that provides a clear value proposition. We don’t need to get into this and the sum of parts would look very high and we’re not banking on this. (valuation would be > $70 per share).

Risks

• Reputational risk – major projects excluding SNC for consideration as bidders.
• Margin compression + Admin/Investigative Costs – significant G&A costs associated with dealing with scandal, implementing conduct guidelines, $250 mln outstanding class action lawsuit, fines etc.
• Holdco Discount – the market beginning to apply a holdco discount on its cash and ICI, as if it is a close-ended fund. (although the market’s demand for yield and infrastructure assets may mitigate this a bit)
• Significant downturn in metals/energy
• Government Austerity leading to freezing of projects, even if its a P3 structure.

Catalyst

1. More project wins – we are already seeing this. At some point, the backlog is so significant that the market cannot ignore it anymore
2. Announcement of a reputable full time CEO
3. Market recognizing valuation beyond P/E multiples, i.e. the underlying cash, ICI and E&C business
4. Major Canadian sell-side brokerages not keeping hold ratings to manage their own reputational risk (peculiar some analysts have a Hold on SNC and 15-19% upside to their targets, at > 20% it has to be a Buy according to their guidelines usually).
5. More aggressive share buybacks to augment their recent dividend increase
6. Clearing up SNC’s alleged ethically challenged behavior even if it means fines/penalties etc.