Are low expectations making SNC-Lavalin a bargain?

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For SNC-Lavalin Group Inc., there are signs of promise, which investors don't seem ready to acknowledge.

Despite reaching a two-and-a-half-year high, the current share price suggests the market practically assumes the worst on all fronts for a company still stained by corruption allegations.

SNC's valuation seems to price in a value-destructive acquisition, a failure to reignite the engineering and construction (E&C) business, and an undervaluation of the company's stake in the Highway 407 toll road, Dundee Securities analyst Maxim Sytchev said in a recent note. "These are some low expectations."

SNC recently announced an offer by Berkshire Hathaway Energy to buy its stake in Alberta electricity transmission company AltaLink for $3.2-billion, which was well above the value analysts afforded the asset.

The sale generated much discontent. CIBC downgraded the stock based on the risk that SNC won't find a way to use the proceeds to profitable effect.

Spinning a $3.2-billion windfall as a negative might be a little unfair, even to SNC, which has been plagued by problems in recent years. After all, what to do with all that cash seems like a good problem to have.

"You've got that cash and you've got the 407, which is probably undervalued the way AltaLink was," said Jeff Young, chief investment officer at NexGen Financial, which owns shares of SNC. "You have to have faith in management's ability to deploy those assets."

Granted, faith is not the overriding sentiment SNC might inspire among investors. Corruption and bribery allegations at home and abroad tainted the Montreal-based giant and lopped more than $2-billion off its market value in February, 2012. None of the allegations has been proven in court.

A management change and more than two years later, the company is trying to convince the market of its turnaround, with the goal of doubling revenues over the next five years.

Although many still consider the company undervalued, the stock has come off its trough to rise by 35 per cent over the past nine months and the share price is close to its pre-scandal level.

But the AltaLink sale, which was around $6 per SNC share higher than analyst expectations, barely registered on the market. That ambivalence is a product of SNC's low valuation.

The core E&C business, which is working its way through a big backlog of low-margin projects, trades at an enterprise value of about 4.5 times estimated 2015 EBITDA (earnings before interest, taxes, depreciation and amortization), RBC Dominion Securities analyst Sara O'Brien said in a recent note.

Acquisitions in the E&C space typically command multiples of twice that. That makes it "mathematically not possible to carry out an accretive transaction," said Mr. Sytchev, who rates the stock a "buy" at a target price of $67.

Acquisitions are accretive when the boost to earnings is greater than the purchase price. This is generally possible when the target company is valued more cheaply than the acquiring company.

Closing the valuation gap would be possible through a special dividend or share buyback, or through a resurgence in SNC's E&C business. Investors are assigning very little probability to either occurring.

Mr. Sytchev said he's "shocked" that the AltaLink price tag has not forced a reconsideration of the value of the Highway 407 investment. The market is missing $3.50 per SNC share in value from its 17-per-cent stake in the 407, Mr. Sytchev estimates.

Hard assets and cash on the balance sheet add up to $47.50 per share, he said. This means that – at Thursday's closing price of $53.75 – investors are paying only a little more than $6 a share for SNC's E&C business, which historically has accounted for $30 to $35 per share of SNC's valuation.

"You've got a cheap option on them turning the E&C business around," Mr. Young of NexGen said. "It might not happen. But you're not paying a ton."

Investors also apparently see little added value in SNC's relationship with Berkshire Hathaway Energy, which is majority owned by Warren Buffett's Berkshire Hathaway Inc., even though it could lead to future E&C work.

"Investors see [the AltaLink sale] as the end of the story," said Michael Bowman, portfolio manager at Wickham Investment Counsel. "But it's not the end of the story. It's the continuing work with that division of Berkshire to develop more opportunities."