Description
SNC-Lavalin Group Inc. (SNC CN) – Long, $70/share ~12 month target
Market Cap: $9.1b (Last Sale: $54.90)
TEV: $9.0b ($213mm Net Cash)
3-month Avg Daily Volume: 532k shares/day ($29mm)
Investment Type: Value w/ catalysts
Investment Horizon: ~12 months
Summary
SNC-Lavalin (SNC) is a well-regarded E&C business that is trading at an attractive valuation. Importantly, I believe SNC’s pending purchase of WS Atkins (ATK) is a sound strategic move by management that will prove highly accretive to earnings and free cash flow in the medium term. Moreover, assuming a continued pick up in end market demand and successful cost cutting initiatives, I believe there is upside to consensuses estimates. On the whole, I believe SNC is quite cheap – on a sum of the parts basis their core E&C business is trading at ~5x EV/EBITDA which is well below where peers are trading.
Valuation
Base Case: $70/share (+28%) – my base sotp valuation, which assumes the core E&C business trades at ~10x FY18 EBIT
Down Case: $49/sh (-10%) – my down case sotp valuation, which assumes the core E&C business trades at ~8x a down cast FY18 EBIT
Bull Case: $76/share (+39%) – my up case sotp valuation, which assumes the core E&C business trades at ~10x up case FY18 EBIT
Thesis
My long case for SNC is based on:
- Key end markets are picking up, notably:
o The backdrop for Canadian infrastructure is promising as the current federal government intends to boost infrastructure investments materially over the medium term. The 2016 federal budget calls for an additional $60b of infrastructure spending over the next decade. Most recently, in its Fall Economic Update, the federal government increased its infrastructure budget to $187 billion over the next 12 years, and is largely focused on projects related to public transit and social infrastructure.
o Going through this earnings season, I think it’s becoming evident highly cyclical commodity-based end markets like oil & gas and mining have stabilized in recent months, providing some comfort that demand levels have bottomed. That being said, commodity prices will obviously dictate what happens from here. Nonetheless, SNC is ~50% exposed to commodity linked end markets.
o Nuclear is a key area of growth for SNC, especially with the pending close of their acquisition of ATK. The firm is well positioned
- The purchase of ATK is a very good strategic move by management for several reasons:
o The deal diversifies SNC both geographically and by end market. For instance, ~20% of pro forma revenue will be derived in Europe (vs ~5% for SNC standalone).
o Per SNC, the deal is expected to be immediately accretive to SNC’s consolidated EPS before any revenue or cost synergies.
o Cost synergies are expected to run ~$120mm by the end of 2018. Overall, I expect a major uplift to 2018 earnings estimates once the deal closes (expected 9/30/17).
- Cost cutting initiatives have improved profitability considerably, as SNC E&C EBITDA margins came in at 4.6% in 2016, +240bps from the 2.2% realized in 2013. I believe further margin improvements are on the horizon, especially in light of a targeted $100mm saving in SG&A in 2017. By 2018, I believe E&C EBITDA margins can approach the 7% mark.
- Litigation remains an overhang though there are some signs of light. Please see the ‘Risks’ section below for further discussion of the litigation overhang.
- Frankly, I find SNC to be quite cheap under most non-disaster case scenarios.
Catalysts / Event Path
The key events for the stock over the next 12 months are:
- Closing of the ATK deal (expected 9/30/17)
- Earnings releases, as I believe end market demand will pick up in coming quarters
- Contract wins
- Any conclusion to external investigations and/or quantifiable fines may act as a positive catalyst
- Any announcement of a strategic action surrounding the 407 International concession (i.e. Spinoff, sale, etc.)
Business Description
SNC is one of the leading E&C companies in the world and a major player in the ownership of infrastructure. With offices in more than 50 countries and ~35k employees, SNC provides engineering, procurement construction, completions, and commissioning services, together with a range of sustaining capital services to clients in four industry sectors: oil and gas, mining and metallurgy, infrastructure, and power.
SNC’s E&C segment comprises five primary businesses. Following its acquisition of Kentz in 2014, Oil & Gas (O&G) has been the largest division for SNC and accounted for 44% of E&C revenues last year. Despite lower activity levels for some of SNC’s services (i.e., mining, electricity transmission & distribution, Canadian infrastructure, operations & maintenance), EBIT margins continued to push higher and reached 3.7% in 2016 (includes unallocated corporate costs).
SNC also owns a 16.77% stake in 407 International, the owner of the 407 ETR (Express Toll Route), a freeway in Ontario that provides an alternative route through the Greater Toronto Area. 407 ETR is the world’s first all-electronic, barrier-free toll highway, stretching 108 km from Burlington to Pickering. Along with SNC, 407 International is owned by Canada Pension Plan Investment Board (40%), and Cintra Global (43.23%). 407 International operates Highway 407 under a 99-year lease agreement that matures in 2098. SNC has sold down its ownership in the asset since acquiring its 26.92% stake in 1999, however, current management indicates further sales are unlikely in the medium term.
Outside of its stake in 407 International, SNC owns a portfolio of 15 investments across the power, transportation, and infrastructure sectors.
SNC’s standalone revenues (2016) breakdown as follows:
- 44% Oil & Gas
- 19% Power
- 19% Infrastructure & Construction
- 11% Operations & Maintenance
- 4% Mining & Metallurgy
- 3% Capital
Risks
The main risks to SNC are:
- Decline in key end markets, notably oil & gas given SNC’s large exposure to this maket.
- Cost overruns, like all other E&C firms, are a concern for SNC.
- Risk that the ATK deal doesn’t close on time.
- F/x
- Litigation risk – for the last 6 years SNC has been dealing with a number of legal issues, which continue to be an overhang for the stock. Summary of these issues per BMO listed below:
o The RCMP’s corruption charges on Libya-related contracts are set for preliminary hearings in September 2018, which the company recently noted could be moved forward to late 2017. Without any changes to the federal legislative framework, SNC would go to trial and, if found guilty, could be debarred from federally-financed contracts for a period of 5-10 years and be subject to material fines. An alternative SNC has been pushing for is the federal adoption of Deferred Prosecution Agreements (DPAs). Under this scenario, SNC would self-disclose its violations, pay a significant penalty but still be able to bid on federal contracts. It is our understanding that the federal government is still evaluating and has not provided a timeline for potential adoption.
o SNC self-disclosed violations on certain provincial and municipal contracts in Quebec between 1996 to 2016 through the province’s Voluntary Reimbursement Program. This process is ongoing, with an expected winding up of the program in 2017.
o Following an investigation related to a project in Bangladesh, the World Bank debarred about half of SNC’s legal entities in 2013 for a period of 10 years, or 8 years if SNC meets certain conditions. The debarment is aimed mostly at SNC’s construction-related entities, representing insignificant revenues, according to management.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.
Catalyst
- Closing of the ATK deal (expected 9/30/17)
- Earnings releases, as I believe end market demand will pick up in coming quarters
- Contract wins
- Any conclusion to external investigations and/or quantifiable fines may act as a positive catalyst
- Any announcement of a strategic action surrounding the 407 International concession (i.e. Spinoff, sale, etc.)