All in all, 2013 wasn’t such a bad year for SNC-Lavalin shareholders, as the stock gained 21 per cent, easily outpacing the broader S&P/TSX Composite. Many of the company’s peers in the engineering and construction business, however, saw their shares gain 30 per cent to 80 per cent as the global outlook for infrastructure spending improved markedly.
SNC’s lagging status owes much to concerns over its regulatory difficulties, with former executives charged under various federal and provincial corruption and fraud statutes. Perhaps even less helpful are a number of unprofitable projects the company must complete, dragging down earnings.
Yet recent advances in the company’s shares – much of 2013’s advance came in the final weeks of the year – suggest investors may be seeing 2014 as SNC’s turnaround year.
The company’s new management team has reorganized SNC with a focus on cost-cutting and efficiency, and they say there are plenty of new, profitable projects to bid on. Investors are also focused on the company’s efforts to raise cash and are increasingly excited about a potential bidding war over AltaLink, the Alberta energy-transmission subsidiary that SNC has put on the block.
Still, even a number of SNC bulls acknowledge that the coming quarters may produce erratic results, giving shareholders a rocky ride.
Investors with a longer term horizon, however, may find that SNC is poised to engineer a significant gain.
It’s a pleasant change of pace for things to be looking up at SNC. In March, 2012, the company acknowledged it found $56-million of “payments” which were “documented to construction projects to which they did not appear to relate.” SNC’s current disclosures say the RCMP is investigating SNC-Lavalin’s actions in Bangladesh, and two former employees have been charged under Canada’s Corruption of Foreign Public Officials Act. Also, the province of Quebec has charged the company’s former CEO and another executive “with various fraud offences allegedly in connection with a company project” in the province.
Company spokeswoman Lilly Nguyen says, “SNC-Lavalin is committed to doing whatever it takes to reach an agreement that is all-encompassing, final and fair and that would allow us to move on.”
Investors, however, may already be poised to move on. The consensus view as to what SNC might eventually pay to settle various regulatory charges against it seems to be from $100-million to $400-million.
Maxim Sytchev of Dundee Securities says a recent settlement by a joint venture co-owned by Alcoa Inc. confirms that in high-profile corruption instances, the alleged bribery-to-penalty ratio remains roughly in the 1-to-1 or 1-to-2 range. The venture, Alcoa World Alumina, recently paid a $223-million (U.S.) criminal fine and $161-million civil fine to U.S. federal authorities to resolve a matter dating back to 2004 in Bahrain. The U.S. Securities and Exchange Commission alleged Alcoa World Alumina made $110-million in illegal payments to Bahraini officials.
Applying this concept to SNC-Lavalin, Mr. Sytchev says the “worst case” 1-to-3.5 ratio would yield $196-million (Canadian) in penalties, which is about 40 per cent of the company’s net cash at the end of the third quarter. “Our own unofficial polling … suggests that any amount less than $300-million … would be viewed positively by investors.”
It is unclear when this settlement may occur. What seems to be occurring, however, is that investors are becoming more comfortable with the idea that there’s less headline risk at the company.
And that turns the question to just what kind of 2014 SNC-Lavalin will have.
CIBC’s Paul Lechem says SNC’s management blames recent underwhelming profit performance on “prior poor bidding practices and insufficient project controls.”
“SNC has previously been run in a decentralized fashion, with little co-ordination between divisions, and little centralized management, systems and control,” Mr. Lechem says. “This has led not only to operating inefficiencies, but also to the corruption and project control issues that the company now faces.”
Mr. Lechem, who has a “sector outperformer” rating and $48 target price (which SNC has since zipped past), says management is now reducing the number of operating units and centralizing project functions like bidding, contracting and project management “to better standardize, manage and control the business.”
That will help in the future. In the meantime, notes Anthony Zicha of Scotia Capital Inc., the company has $1-billion of backlog – unrecognized revenue from ongoing contracts – that is “challenging,” or merely breaking even on an operating basis, thanks to cost overruns. (For perspective, the company’s backlog totals $9-billion, and it recorded $8.2-billion in revenue in the prior 12 months.)
Yuri Lynk of Canaccord Genuity says that if SNC’s current estimates of its cost problems “turn out to be insufficient, subsequent quarters’ [earnings] could surprise to the downside.”
Mr. Lynk still has a “buy” rating and $59 target price, more than 20-per-cent above current levels. That’s because he is one of the most optimistic on the potential value of AltaLink, which the company plans either to spin off in an initial public offering or sell outright.
Mr. Lynk believes the asset could fetch as much as $20 per SNC share. “AltaLink provides 85 per cent of the Alberta population with electricity and is in the midst of a significant growth phase: Its rate base has doubled since 2011 and is expected to double again by 2019,” he says. “We understand interest in AltaLink is exceptionally high from strategic as well as financial buyers alike.”
Putting a $20-per-share price tag on AltaLink leads Mr. Lynk to value SNC’s entire portfolio of infrastructure investments, which also includes Ontario’s 407 tollway, at $38 per SNC share. And that would mean the company’s core engineering and construction business is trading around $10, or 6.7 times his 2014 earnings forecast for the business. Peers trade at an average P/E of about 15, he says.
Certainly, skepticism about SNC remains. Michael Yerashotis of Veritas Investment Research says he “continues to view SNC as a ‘show me’ story,” with the company’s need to borrow for growth and its regulatory risks outweighing possible earnings improvement in 2014.
Fair enough. But in all “show me” cases, the shares will gain on every positive development that demonstrates the company is completing its comeback. The biggest gains will come to investors who buy before all the evidence is in.