|Shares Out. (in M):||152||P/E||0.0x||0.0x|
|Market Cap (in $M):||5,656||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-818||EBIT||0||0|
|TEV (in $M):||4,837||TEV/EBIT||0.0x||0.0x|
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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:
It is impossible to precisely handicap the risk associated with SNC’s potentially corrupt practices, but I would point to:
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:
Please read these to gain an understanding on P3s (called PFI in the UK):
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:
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):
This brings up my key argument that SNC’s competitive advantage and good ROCE generation is sustainable:
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.
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:
SNC History of Scandals
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
• 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:
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:
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).
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