SNC-Lavalin: Exposure To Oil And Canada With Less Risks

| About: SNC Lavalin (SNCAF)

Summary

The current revenue backlog is at a record high.

The intrinsic value of the company suggest upside of more than 50%.

The company will benefit from the oil's recovery and the Canadian economy more broadly.

Note: All figures are in CAD unless otherwise stated. SNC-Lavalin trades primarily on the TSX as SNC.

SNC-Lavalin (OTCPK:SNCAF) has been in the news for the good reasons in the last few months. Of course its status as a pariah is a thing of the past.

The company is part of a consortium building the new Champlain Bridge, which is very big here in Montreal. The project is already ahead of schedule.

Click to enlarge

The new Champlain Bridge just before NYE. Source: SSL.

Furthermore, the company recently won a refurbishing contract for one of Ontario's nuclear power plants.

This article will provide investors with an in-depth look into SNC-Lavalin. This company is an engineering and construction (E&C) company with multiple infrastructure concession investments (ICI) on its books. The company is headquartered in Montreal.

This article will focus on the revenue backlog, the safety of the dividend, the intrinsic value of the company and the identification of downside risk and upside catalysts for this stock.

Current order backlog

The current order backlog stands at $12.5B: a record high. The recent backlog low was of $11.5B in March 2015. In my opinion, this is a statement that the company can still win major contracts in Canada and abroad despite the bad press of the last years. It seems that its reputation to deliver is still enviable. Let's look at the backlog in details.

  • Power: $2.6B
  • Mining & Metallurgy (M&M): $0.3B
  • Oil & Gas (O&G): $3.9B
  • Infrastructure & Construction (I&C): $3.9B
  • Operations & Maintenance (O&M): $1.9B

So far, the only bad news is of course in the mining sector: the revenue backlog of $0.3B is small. To put that in perspective, the company had $1B of revenues attributed to M&M in 2014. The company won't be able to keep the pace in that sector. The pain in M&M is there to stay for the time being.

Revenue backlog for I&C should increase if the Canadian government invest in major infrastructure projects as expected.

The management team is confident to maintain its backlog in O&G despite the current environment in the oil market. Indeed, the company's biggest client in the Middle East, Saudi Aramco, is still investing in its oil facilities despite the fall of oil.

In conclusion, the revenue backlog should continue to grow overall, albeit more slowly because of the Canadian economy and the drag in the M&M and O&G sectors.

Dividend safety

The dividend is currently yielding a little under 2.6% which isn't a lottery ticket but still is nice given the current environment in stock markets all over the world.

It is also safe when considering operating cash flows from ICI and E&C. On the other hand however, the payout in terms of cash flow has been increasing steadily if you considered only the core E&C operations of the company.

Source: SNC-Lavalin and my own work.

As we can see, the dividend was 75% of 2014 FCF. Given that the company doesn't plan to sell all of its ICI, I wouldn't bother with this figure as the combined cash flow is more than enough to pay the dividend. Indeed, cash flow from operations from ICI was of over $600M in 2014.

In conclusion, the dividend, even though the yield is small, is safe.

Sum of the parts and stock performance

Let's take a look at what is the fair value of the company by assigning a value per share for both the ICI and the E&C operations of the company. What will I take into account:

  • Cash: $1,455M
  • Total debt: $965M
  • ICI at book value: $500M
  • ICI at fair market value: $3,000M
  • 2016 FY EPS: $2.50/share
  • Number of shares: 150M

Note that I used the total debt carried by the company: this includes $516M of non-recourse long-term debt attributed to ICI. The fair market value of ICI is provided by the company. Finally, the 2016 FY EPS is the consensus EPS amongst all analysts following the company.

Source: SNC-Lavalin and my own work.

As we can see, the stock is undervalued compared to its fair value of over $65 per share. The stock had momentum coming in 2014 as it approached the $60 mark and its intrinsic value. However, because of the oil's downturn and the drag it created in the Canadian economy, the stock went down and has been trading around the $40 mark since.

Furthermore, the acquisition of Kentz just before the collapse of oil is another drag for the stock: investors might have seen this is a poorly timed investment by the management team.

Downside and upside catalysts

As you can see, this is a great company and a great stock: the revenue backlog is growing, the dividend is safe and the stock's intrinsic value suggest an upside of more than 50%. Then what is wrong with SNC-Lavalin?

  • The company is accused of fraud and corruption by the RCMP (federal police) in relation to operations in Libya from 2001 to 2011
  • The company gets the majority of its revenues from Canada and a third of its revenues from the oil and gas sector worldwide

Therefore, the company is tied to oil and the Canadian economy, which isn't a good place to be right now. The accusation of fraud and corruption by the RCMP is also very serious. Note that the company is already barred for 10 years from bidding in projects related to the World Bank because of corruption.

One could argue that settling the accusations out of court could be a catalyst for this stock and I also agree. However, there is no news related to this currently: SNC-Lavalin didn't have any contact with the federal government concerning this. Therefore the company is still expected in court for now.

With all of that in mind, what could drive the stock higher?

  • An offer to buy the company
  • Appreciating margins
  • Recovery of the oil market
  • Infrastructure spending by the Canadian government

SNC-Lavalin could be bought by a foreign company: the low value of the loonie and the low share price could draw attention.

Also note that investors would more than benefit from a takeover offer for SNC-Lavalin. Just as we are reminded today with the takeover of Rona, it will always get political when Quebec companies are being bought. You could see a bidding war à la Osisko, when the Quebec government tried to keep the company in its jurisdiction. One could also think of Videotron a decade ago, which has been very good for Videotron shareholders while questionable for the taxpayers.

I prefer SNC-Lavalin's too big to be bought over Bombardier's too big to fail. It's better for us shareholders.

Investors could also look at appreciating margins that will grow the bottom line, as this is one of the main focus of the CEO.

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Source: SNC-Lavalin and my own work. Average includes Aecon, Stantec, WSP, Aecom, Jacobs, Fluor and WorleyParsons.

The management team is targeting 7% as its new operating margin in 2017. We can therefore anticipate substantial progress in making the core E&C operation of the company profitable and valuable.

The company will also grow its backlog in the I&C sector when the Canadian government starts to spend heavily in infrastructures. However, it is important to know that most federal work, such as the new Champlain Bridge, have very low margins and won't contribute as much to the bottom line.

What should help increase the operating margins and the bottom line is the work done in the O&G sector.

Indeed, the recovery of the oil market will be a very big plus for the company's revenue and earning. The company will finally profit at the fullest from its acquisition of Kentz in mid-2014.

Finally, I see an investment in SNC-Lavalin first as a way to bet on the recovery of the oil market without a lot of the exposure and the risks related to the sector, second as a bet on the recovery of the Canadian economy and third as a bet on the expertise of the management team to bring back the core E&C business on track to above-average operating margins.

Furthermore, you are buying a company trading at 60% of its intrinsic value. This gives you a lot of margin of safety. Plus you can collect a safe dividend for the time being.

Disclosure: I am/we are long SNCAF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.