For Vinci, Strong Concessions Can Backstop A Contracting Recovery

| About: Vinci SA (VCISY)
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Increased public spending by the French government could bode well for Vinci's contracting business, though a full recovery likely needs stronger capex spending in oil/gas and industrial sectors.

Vinci's concession business is a high-margin operation with low operating risks; organic growth is likely to be unspectacular, but there are still many acquisition opportunities.

The company could have some vulnerability to rising rates, but the shares look undervalued and offer a solid dividend as well.

France's Vinci (OTCPK:VCISY) (SGEF.PA) is a bit of an odd company in a few respects. Its contracting business is overwhelmingly large in terms of its revenue contribution, but it generates less than a third of the company's income, and the shares of this contractor and concession operator often seem to behave more like a bond than equity. It's also very much a France-centric company in terms of its revenue and earnings base, but most of its growth potential lies outside France and outside Europe.

Those quirks aside, I think this is an interesting name to look at right now. Close to 70% of the company's operating income is in high-margin, low-risk concession businesses that should continue to grow and that are supported by long-term contracts. What's more, the other 30% should see improving operating conditions as the French government moves forward with significant building projects and as industrial and energy markets recover around the world. With a double-digit annual total return potential and a roughly 3% dividend, I think Vinci merits further due diligence.

One Of The Largest E&C Players In Europe

Vinci is among the largest engineering and construction (E&C) contractors in Europe, and the largest in France with high-single-digit market share. This business generates around 85% of the company's revenue, with around 60% of that generated from within France. That said, it's a cyclical and low-margin business; the French construction sector had been in a nearly decade-long downturn prior to last year, and this segment generates less than a third of Vinci's overall operating income. If there's a positive spin to that, it's that even modest improvements in margins can lead to meaningful growth in earnings and cash flow from the E&C business and business does appear to be looking up.

Vinci's contracting business is divided into Energies, Eurovia, and Construction. Energies generates a little more than a quarter of segment revenue and is involved in the design, implementation, maintenance, and operation of a wide range of "electrical" operations. These efforts include public power generation and transmission, lighting, industrial/commercial electrical and HVAC for process industries, building-scale electrical and automation, and IT/telecom services like network and data center integration.

The Eurovia business, which contributes close to 20% of revenue, is more straightforward in its focus on road-building/maintenance and road material production. Vinci Construction makes up the rest (close to 50% of revenue), with diverse operations in civil works, commercial, and housing construction.

Concessions Are A Lucrative Opportunity

Although small in revenue terms (about 15% of overall revenue), Vinci's concession operations are exceptionally lucrative for the company, generating almost 70% of operating income with a great deal more stability and consistency than the E&C business.

Toll roads make up the bulk of Vinci's concession business today; it acquires the rights (or companies that own those rights) to operate toll roads for specified periods of time, with the company taking responsibility for maintaining them and being paid though tolls. Vinci operates over half of France's tolled motorways, and about three-quarters of the French highway system is run by private operators (including Vinci, Eiffage (OTCPK:EFGSY), and Abertis (OTCPK:ABRTY)). While there have been disputes in the past over toll increases, Vinci's contracts include inflation-linked minimum increases as well as incentives to reward reinvestment (but also profit-sharing clawbacks if profits exceed certain targets).

While Vinci's French toll roads are the core of this business, the company has expanded into other countries, including Germany, the UK, Russia, and Greece and made acquisitions last year to expand into Peru and Colombia.

All told, I believe this is a good, long-term growth opportunity. While drivers hate tolls, I think you can argue that tolls are fairer in many respects than tax-based road funding, as tolls correlate with actual usage and also require foreigners to pay. What's more, the requirements on the companies to maintain and improve the roads mean that government officials aren't tempted to reallocate tax revenues or "kick the can down the road" on spending on maintenance. The end result is the France's tolled highways are in pretty good shape compared to a lot of tax-funded highways around the world.

Vinci also has a growing business in operating airports. This business has been anchored by a long-term concession to operate Portugal's main airports, but Vinci also has significant stakes in Cambodia's airports, the Dominican Republic, multiple regional French airports (including a 30% stake in Lyon's airport), and 40% stakes in the airport in Santiago, Chile and the Kansai and Osaka airports in Japan. The basic model here is broadly similar - operators like Vinci are paid through mechanisms like gate/landing fees, usage fees, rents, and so on, and are responsible for maintaining and reinvesting in the airport itself.

Roads and airports are the large majority of Vinci's concession assets, but the company does have some interests in other assets like rail lines, stadiums, and so on. Given recent M&A and deal activities, I think it's fair to say that management is very focused on growing the road and airport businesses.

Opportunities To Grow

France is starting to come out of a multiyear downturn in building activity, spurred by stimulus activity and the "Grand Paris" project. With that, there are billions of euros of projects coming available for roads and other transport projects, and a slowly improving French economy should also support increasing demand for private sector commercial construction. Although growth outside of France is likely to be more tied to recoveries in the oil/gas space, the company does have projects like the Denmark-Germany Fehmarn Belt tunnel to look forward to.

I'd also note that the company has more than a token presence in Africa. While Africa generates only about 5% of its revenue, the company is present in numerous countries (including countries outside of Francophone West Africa) and has the capability of participating in a wide range of public works projects including transportation, electricity, water, and civil construction (schools, etc.). Betting on Africa as a growth driver has never really worked out well, but this could be seen as a very long-term low-cost growth call option.

In addition to a better outlook for the contracting business, I think Vinci has opportunities to grow its concession business. Organic traffic growth is likely going to slow in 2017, after 3% growth in the motorways over the last two years and double-digit growth at the airports. That said, stronger industrial production in France will be bullish for heavy vehicle traffic (which pays higher tolls) and stronger overall economic growth and disposable income should be positive for both light vehicle traffic and airport traffic. Outside of organic growth, Vinci has a lot of opportunities to acquire more concession assets. Companies like Brookfield Infrastructure (NYSE:BIP) will be there to compete on opportunities like toll roads in Latin America, but there are also opportunities in Asia and Eastern Europe for the company to explore (where, of course, there will also be competition from the likes of Abertis, Atlantia (OTCPK:ATASY), and so on).

The Outlook

The biggest risk I see to Vinci right now is that interest rates rise ahead of inflation. Interest costs are a meaningful factor in Vinci's income statement, and while inflation and interest rates typically move together, there's a risk that interest rates outpace the inflation metrics that drive the company's tolls. While higher overall operating costs for its concession assets would also be a risk factor, Vinci has done a very good job over time of meeting its reinvestment and maintenance obligations very efficiently.

As for the contracting business, another turn into recession or just a prolonged period of "meh" economic conditions would be a threat. The good news, though, is that France's government does seem committed to moving forward with numerous large-scale projects, and Vinci's size all but guarantees a seat at the table.

I'm looking for low-single-digit revenue growth from Vinci over the long term. The contracting business could drive that higher on a short-term basis, but I think the overall trends in concession use and infrastructure spending will approximate developed country GDP growth (i.e., low single digits). On the plus side, though, the company has the capacity and willingness to continue acquiring new concessions and that can drive growth above and beyond what's in my model; it's also at least plausible that ongoing expansion into faster-growing emerging economies could perk up the underlying potential growth rate over time. On the margin side, I expect steady-as-she-goes performance; Vinci is already a very efficient operator of its concession assets, and while I think there is a little bit of upside from an improving contracting business, I don't think the free cash flow picture will improve dramatically.

The Bottom Line

Discounted back, 3% to 4% FCF growth can support a fair value about 5% to 10% above today's price. Add in a solid dividend and there looks to be a worthwhile opportunity here. I am a little worried about perception/sentiment, though, as Vinci can often trade more like a bond than a stock, and investors may see rising interest rates as a net negative for the shares. Still, if the contracting business can deliver improving orders and the concession business can keep performing as it has, I think there's a worthwhile opportunity here.

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