Aecon Group - Not Fully Valued Yet

Includes: AEGXF
by: Peter Jung


Aecon's record backlog in 1Q 2016 will continue to expand throughout 2016 and beyond largely attributed to the government's $60 billion infrastructure plan.

Aecon also did not include a significant number of contracts and arrangements in the 2016 total backlog as they were unable to quantify the accurate estimation of work.

Aecon, with its solid fundamentals and optimistic outlook, would be an attractive value proposition for investors who wish to circumvent the choppiness ahead in global financial markets.

Aecon Group Inc. ("Aecon")(OTCPK:AEGXF), a Canadian based construction and infrastructure development company, has been roaring over the last five months erasing a sharp 17% decline in its stock price experienced in early 2016. In fact, it is not strange at all to see such a robust recovery as the company recently announced a record backlog of $4.6 billion in 1Q 2016 surpassing a sizable backlog of $3.4 billion reported only three months prior to the announcement. Also the adjusted net losses reported in the first quarter of 2016 were better than the net losses reported a year before displaying confidence and momentum in its operation despite a challenging economy. As largely anticipated by many, Aecon has a big forthcoming tailwind as the Canadian government, especially supported by the Prime Minister and his liberal party, has been publicizing a $60 billion multi-year infrastructure program across the nation. Aecon, with its expertise and capability to complete such diverse projects, is standing in the forefront of the program to bid on and deliver in various cities and municipalities. As such, it is natural to observe a rapid increase in its stock price in such a short period of time corresponding to this optimistic outlook, and I believe that this stock can grow further to reflect its intrinsic value as I will demonstrate.

The timing of the $60 billion government infrastructure program

According to the Aecon's MD&A 1Q 2016, Aecon expects that substantial infrastructure spending in Canada will begin in late 2016, from smaller municipal and provincial projects to complicated projects in areas including public transit, roads and bridges, and green infrastructures. Aecon, after winning the available projects, will likely begin the construction process in 2017 and beyond. This means that in addition to the total $4.6 billion outstanding backlog (though, $1.4 billion of backlog will be completed in 2016), Aecon is expected to record another sizable backlog number into their book (particularly in its infrastructure segment) in the foreseeable future as the company is deemed to be one of the most suitable enterprises in Canada to perform multi-scale, complex structural projects. Recently, Aecon's revenue in infrastructure reached $154 million in 1Q 2016 (jumped 32% compared to the same quarter in 2015) attributed to heavy civil operations (+$23 million) and transportation operations (+$19 million) confirming its position as a top developer in the domestic infrastructure market.

Undisclosed internal backlog

In anticipation of a flurry of infrastructure projects launched by the government of Canada, Aecon also mentioned on its MD&A 1Q 2016 that a significant number of contracts and arrangements in which the accurate amount of work is unquantifiable or a minimum number of units in the contract specified price per unit is not guaranteed, was disregarded and not being included in the total backlog in 1Q 2016. As such, Aecon's 'real' backlog could be materially higher than what has been reported and this will eventually be cascaded to the income statement as 'additional' revenue.

Aecon is a defensive stock

As investors and speculators have recently baked in their concerns in the equity market and projected some volatility ahead in light of the upcoming British referendum and the FED's rate hike decision, it may be prudent to contemplate reshuffling your portfolio allocation in a defensive manner. Some people largely remain in cash to mitigate upcoming headwinds or some may seek opportunities in defensive stocks or safe haven currency. Aecon, which I would consider as both a defensive and a value stock, would be an attractive value proposition for any investors who wish to circumvent the choppiness ahead in global financial markets while banking on growth at a reasonable price. Remember, of Aecon's short-term and long-term projects and contracts, only 32% of backlog is scheduled to be completed within the next twelve month from now, and the total planned projects are expected to rise at a sustainable pace as long as the government infrastructure program remains on the line. Also note that as the Canadian economy woes continue, particularly in the western part of the country due to the plunge in commodity price and a lackluster growth in economy as a whole, this multi-year infrastructure initiative, along with other prospective sectors, will become the lifeblood to revive the economy over an extensive period of time.

Aecon's solid fundamentals and cash generating power

Based on my analysis, Aecon has the total package. First of all, Aecon's margins, from gross margin to pretax margin, are noticeably improving, not to mention that revenue and operating income in 1Q 2016 increased by 37% and 4.2%, respectively. Also, Aecon made an effort to pay down its long term debt by $12.6 million in the first quarter, and the finance costs dropped from $7.7 million to $5 million improving the bottom part of the income statement. Looking at the cash flow statement, although a large number of change in net working capital lately has dragged down the cash change in operating activities, in accordance with the Aecon's historical cash flow trend, cash flow operating activities have been consistently positive over the last five years attributed to the strong net income and non-cash expense items. Plus, most importantly, declining year-over-year in needs of capital expenditure and capital procurement is a positive signal which allows investors to expect a positive free cash flow and net changes in cash in the future. Last but not least, the following pertinent ratios of Aecon's profitability, growth, credit, and liquidity are definitely noteworthy to investors showcasing Aecon as a well-balanced, sustainable profit generating business.

In conclusion, my target price for Aecon is $18.5 (target price for the Canadian ticker listed on TSX) based on my DCF valuation model (cost of capital 7.3%, terminal growth rate 2.5%, EBITDA exit multiple 6.4x, etc.) and some added predictions, although this target can be adjusted depending on the company's future added backlog, completion of backlog, or the company's financial management. Some of the caveats that investors should be aware of regarding Aecon's operation and financial status before investing in are a) margins in the income statement are razor thin due to the nature of business and associated industry b) Aecon's convertible bond can be exercised at $20 and 8.625 million common shares can be issued upon conversion representing 15% of the total common shares outstanding, and c) the mining segment, which has the widest margin in gross profit and operating margin amongst four business segments, has been softening lately and management has forecasted that stable, recurring revenue work will be continued in 2016.

Disclosure: I am/we are long ARE CN.

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.

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