Description

We believe SNC Lavalin (SNC CN) is a compelling, uncorrelated special situation that has the chance to meaningfully re-rate over the next several months.

SNC is a story of a complex, controversial business that has been through the ringer over the last few years. The main issues have either been entirely resolved or are in the process of full resolution, and what is left behind are two very high quality assets: a minority position in a toll road and an industry-leading engineering and design firm.

At $29/share, today’s price, SNC is deeply discounted on an absolute and relative basis and we believe the stock has an intrinsic value of $50 even in a conservative case.

Recent History

The SNC-Lavalin saga is long. If we flash back to just 5 years ago this was a well-regarded E&C business with both a consulting-like engineering and design business as well as a fixed price construction business with a large position in oil and gas projects.

Then, things got choppy. A few elements the company has dealt with since:

• 1)     Their fixed price E&C business blew up. Billion dollar charges, massive cost overruns, and an unreliable and cyclical set of end-markets made for a painful trip for shareholders

• 2)     The “SNC-Lavalin Affair” emerged in 2019 and was on front pages in Canada for a year. Essentially, SNC had been accused of bribing government officials in Libya between 2001-2010. They were eventually offered a deferred prosecution agreement, but it came out that Justin Trudeau had influenced this decision. You can read the Wikipedia entry. Regardless, old bribery allegations were resurfaced and the business was viewed as essentially untouchable because of their connection to the scandal. I’ve checked – no one involved has worked at SNC for years.

• 3)     Covid hit, hurting their toll road business but also creating cost overruns at their remaining fixed price contracts and generally causing chaos even in their most stable assets.

The core thesis here is that all of these issue are near total structural resolution. The SNC-Lavalin affair is gone from the headlines and charges entirely resolved. COVID is (mostly) gone, and they have shut down their fixed price and oil and gas E&C businesses.

This isn’t a situation where they’ve resolved “problem projects” but have an ongoing business that could make these mistakes again – they are permanently out of the fixed price business and will never suffer these issues in the future.

They have also replaced their CEO with Ian Edwards, who we believe has done almost everything right since he took over. He’s been honest with shareholders, taken drastic but necessary steps, and is focused on growing their core business. He’s also super boring to listen to.

What remains at SNC is compelling. They have the final death throes of the fixed cost business, which takes 99% of analyst focus today, and a wonderful engineering and design business. They also still have their stake in the 407 toll road in Canada. Let’s dive into it:

The Remaining Fixed Cost Projects (12% of revenue):

The first thing to get out of the way is the biggest issue – the remaining projects from the fixed cost business. This is the final overhang that needs to be cleared, and the reason we think the stock isn’t $50 today. Fortunately, after last quarter we are in a great place to see a re-rating occur with some specific and relatively near-dated catalyst here.

Two problem projects still on the books:

Eglington - $150m of backlog remains, 90% complete. Will be completed by YE 2022. Ontario infrastructure/train station project.

Trillium - $275m of backlog remains, 70% complete, will be substantially completed by YE2022 and entirely completed early 2023. Ottawa rail and train project.

These projects were responsible for the lion-share of recent charges, culminating in the kitchen sink charge in Q4 2021 of $231m, well above expectations. SO what is going on here? Essentially, because of a combination of omicron and input costs for these projects spiking, the company made some very conservative assumptions and took a big charge. Their assumptions:

•         Continued high absenteeism from Omicron through March

•         Continued supply disruption/lead time issues

•         Inflation stays, but doesn’t substantially increase

•         Zero available cost recovery from the customer

They also provided an even worse scenario which would yield another $300m in charges:

•          Absenteeism above Omicron levels throughout remainder of both projects

•         Productivity also does not improve – essentially that Omicron continues

•          Lead times for key equipment get worse

•         Cost inflation rates continue to rise until project completion

•          Zero available cost recovery from the customer

After a lot of diligence here, we believe the “base case” charge they took is accurate and maybe a bit conservative, and the worst-case charge is deeply pessimistic and it is likely the company is already performing better.

They have set this up nicely, as in each quarter they will be able to “revise down” the $300m worst case number as they get closer to project completion.

Finally – and most importantly – after having spoken with executives in the industry, in Canada, and lawyers who have worked on these types of arbitrations, there is a significant chance that SNC will be able to recover a majority, if not ALL of the costs associated with COVID and Omicron issues in arbitration with customers. The pandemic is a clear “MAC” in the contracts and, if they win, could result in over $300m of reversed charges and cash collection by SNC. They have won these types of arbitrations before – in fact its relatively common in the closing process.

So on these projects, we think we see a nice catalyst path of reduced backlog, reduced “worst case” charges, and conversations about the potential for arbitration as these projects permanently conclude by the end of this year. To say these project remain an overhang on the stock would be a significant understatement.

The third remaining project:

Reseau Express Metropolitan (REM): $600m backlog, 60% complete, will be finalized in 2024.

This project is a different animal for one key reason – the customer is also SNC’s largest shareholder and most instrumental political supporter – the province of Quebec.

What we’ve universally heard about this project is that – while SNC isn’t going to make a lot of money here – they also have and will continue to have a highly collaborative relationship with the customer that is very unlikely to result in a significant loss. And although they haven’t been specific, it is our understanding that REM is not responsible for significant charges to date, and they don’t expect significant charges going forward given ongoing conversations with their customer.

So, once we reach the end of 2022, the entire fixed cost project dynamic should be gone, and we are left with the rest of the business, which is pretty great.

The New SNC Lavalin

So what is left? The short answer is a high quality project management and engineering business focused on infrastructure, renewable/nuclear energy, transportation and water. The company has a non-cyclical backlog of long-term strategic projects that they have a great history of winning and monetizing. Their specific segments:

Engineering, Design and Project Management: 52% of Revenue - A non-fixed price professional services business that manages large projects for governments, corporations, non-profits. An end-to end engineering consultancy. Projects are completely non-cyclical, roads, bridges, government buildings, defense, airports, etc. A lot of the profit actually comes from the design side. Recurring, high quality business where SNC has great relationships that even its past issues couldn’t damage, and continues to produce.

Infrastructure Services: 18% of Revenue - This is SNC’s remaining business that is most similar to high quality Engineering and Construction. Mostly power infrastructure and grid construction, lots of renewable energy projects (they build offshore wind for Orsted). Non-cyclical, huge ESG tailwinds, etc. Majority of projects already contracted through 2034. Not fixed price.

Nuclear - 13% of revenue - SNC’s best business. Probably the best global nuclear engineering firm. They have business in new builds, operations support, life extension, and decommissioning and waste management. One of only few providers globally who can do the entire nuclear life cycle. Lot of old nuclear plants out there that need increasing amounts of work, which is a secular growth trend for this segment, and with the power challenges in Europe and the re-evaluation of nuclear, a great growth opportunity globally. They also own the CANDU reactor design - the only approved design in Canada and used worldwide – so all maintenance or work on these must involve SNC Lavalin. And if we think nuclear catches another wind for climate reasons, huge upside here. A wonderful business that standalone would be 18x+ EBITDA we think. 95% of business on 7-15 year contracts.

Capital: A collection of toll roads anchored by the 407, where they own just south of 7%. While these assets obviously took a hit from COVID due to a massive reduction in miles driven in Canada, they have bounced back well and should continue to thrive. They also have great pricing power that is inflation protected. Not a hard sell here. I have valued using a DCF with a WACC of 5.5% in the base case. 

Speaking of selling they are pretty easy to value as SNC recently sold a chunk (10% holding) of their stake in the 407 to the Canadian Pension Plan Investment Board, which ties into my DCF value. 

Valuation

The way we value SNC:

·         The Project Management & Design business

·         The toll roads

·         Burden with “worst case” additional cash loss of $300m

Even with what we believe is a low multiple for the quality of the business, there is still 27% upside in a low case. My base case is $50.

The last question is – why are these multiples reasonable?

Fundamentally: As of 2023 the engineering and design business for SNC will be a non-capital intensive, non-cyclical infrastructure business with extremely long-duration customer relationships and contracts that should grow mid single digits top line and high single digits in free cash flow, with great free cash flow conversion. This business includes a world-class nuclear business with secular growth drivers and an advantaged position across its businesses to win new infrastructure projects. This business is worth more than 8x EBITDA.

Peers: There are two good peer companies in Canada – WSP Global and Stantec. WSP is highly similar to SNC, without the nuclear business. And Stantec is a bit more focused on design but still a good peer, if sub-scale. WSP trades at 13x 2023 EBITDA despite similar growth and margins to SNC, and Stantec trades at 12x. SNC should trade in line with these peers once all the dust has settled.

Other Risks:

•         Sales of share by Quebec – doubtful but could happen

•         New emergence of long-dated bribery scandals. Likely to not be material but always possible

•         Cost at remaining fixed price exceeding worst case scenario – this would damage credibility and we think the window for this to happen is very narrow, but also becoming hard to move the needle. Many are worried about this, obviously.

Disclaimer

This document is for informational purposes only. All content in this report represents the author's opinion. The author obtained all information herein from sources believed to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind — whether express or implied. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any information contained herein. This report is not a recommendation to purchase the shares of any company. The information included in this document reflects prevailing conditions and the author’s views as of the date submitted, all of which are accordingly subject to change. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity. Any or all forward-looking statements, assumptions, expectations, projections, intentions or beliefs about future events included in this document may turn out to be incorrect. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment prior to making any investment decision.

Catalyst

• Reduction of backlog and "worst case" charges each quarter in 2022
• Finalization of remaining problem projects in year end 2022