Aecon Stock Report

Aecon Group Inc. (ARE, Toronto)

RESEARCH SUMMARY

Report Author(s):

InvestorsFriend Inc. Analyst(s)

Author(s)’ disclosure of share ownership:

 The Author(s) hold no shares

Based on financials from:

December ’18 Y.E. +Q1 ’19

Last updated:

April 27, 2019

Share Price At Date of Last Update:

 $                             18.76

Currency:

$ Canadian

Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual):

Speculative (lower) Buy at $18.86

Has Wonderful Economics?

No

Has Excellent and Trustworthy Management?

Good operationally

Likely to grow earnings per share at an attractive rate over the next decade?

Probably

Valuation?

Neutral in attractiveness

SUMMARY AND RATING:  The graph of revenues per share (red line) shows  quite flat revenues per share over the past eight years. The adjusted earnings per share have been quite volatile (although always positive for the year) with no upward trend. The Value ratios, based on recent past earnings  would indicate a rating of (lower) Buy. Management quality appears strong operationally but the track record of return on equity is not very good. The insider trading signal is moderately negative.  Executive compensation may be somewhat high for the results achieved. The outlook seems very positive for revenue growth in 2019 but management does not seem to be projecting a very large gain in earnings. The economics of the business do not seem attractive given the relatively low ROEs of recent years and the risks. It likely has some competitive advantages in terms of know how and established operations but nevertheless pricing in the industry appears to be very competitive which has limited profitability. Overall we would rate this as a Speculative (lower) Buy on the expectation of better profits in 2019 and significantly higher revenues. Overall, it does not seem to be a good choice for a long-term holding but may be worth consideration based on the expected gains in 2019.

LONG TERM VALUE CREATION: The long term value creation appears to be only fair to good. Retained earnings are smaller than the invested amount (indicating the value has not yet doubled). The book value per share has compounded up at a somewhat modest average annual rate of 5.2% over the past ten years. The price to book ratio is low at 1.33 indicating that the market does not value the company at very much more than book value. On the other hand the dividend has been fairly large as a percentage of earnings (currently 47%) and paying that out limits the growth in retained earnings and book value per share.

DESCRIPTION OF BUSINESS: Aecon Group Inc. is a large Canadian construction company that builds, repairs and upgrades large infrastructure and industrial projects and in some cases finances and operates infrastructure. Infrastructure projects includes roads and bridges, transit rail, hydro electric projects, tunnels, airports and much more. Industrial projects include SAGD oil sands, LNG plants, plant maintenance turnarounds, Nuclear reactor repairs and upgrades electricity transmission and distribution lines, water and sewer construction and much more. The finance and operate segment called “Concessions” includes notably a large contract to upgrade and the Bermuda International Airport and to operate it for 30 years. It also includes “P3” projects, several LRT systems  and the Gordie Howe International Bridge. In many cases including in Concessions, Aecon participates as a joint venture partner. Concession operations involve recurring revenues. In most cases the construction involves fixed price or maximum price bidding. In 2018, revenue was $3.3 billion dollars and the net profit was $59 million. In 2018, revenue was 93.2% from Canada 6.5% from Bermuda and just 0.3% from the U.S. The company made a large investment in intangible assets in Bermuda in order to secure the 30 year Concession on the Airport. In 2018 revenue was 58% from the industrial segment, 35% from infrastructure and 7% from Concessions. Operating profit was 43% industrial, 29% Concessions and 28% Infrastructure

ECONOMICS OF THE BUSINESS: (Based on 2018 annual figures) With a recent net profit of just 1.8% of revenues, the economics look rather weak. Sales are larger than assets so the return on assets is a bit higher at 2.0%. Given debt and other leverage, the equity is only 28% as large as assets which leverages the ROE up to 7.6%.  It is possible that earnings are somewhat under-stated due to the nature of amortization expense and due to the ability to defer part of the income taxes. But overall the  economics appear to be fairly weak.

RISKS: Cost overruns and execution problems on projects are probably the biggest risks. The annual report has an unusually clear description of the various risks. This is definitely a risky business.

INSIDER TRADING / INSIDER HOLDING: Checking from September 1, 2018 to April 22, 2019: The long-time CEO who recently stepped back to the Executive Chair position sold 146,000 shares in September at prices from $16.51 to $17.64. He then acquired 46,000 shares “under a purchase plan” in December at $18.38 but then sold a similar amount of shares in March at a similar price. Another insider acquired 2740 shares in November at $18.99 and immediately sold 769 shares at a similar price. He then acquired 1573 shares in December (in reality these shares may have been effectively bought earlier in the year) under a plan but sold even more, 2741 the same day at $19.00. The new CEO bought 5500 shares in December at $17.75. He was likely required to own shares. Overall the insider trading signal is moderately negative. Several Board members own substantial shares which is a positive indicator.

WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (fail due to its industrial nature, volatile history and risks), has favorable long-term economics due to cost advantages or superior brand power (fail based on achieved past earnings although this may be improving), apparently able and trustworthy management (marginal pass given past results and a new CEO), a sensible price – below its intrinsic value (marginal pass at best), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (fail) little chance of permanent loss of the investors capital (marginal pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass for existing operations excluding expansion)

MOST RECENT EARNINGS AND SALES TREND: The first quarter of 2019 saw a revenue per share gain of 15% while adjusted earnings per share improved but remained negative. The last two quarters of 2018 saw a share increase of about 34% in revenues per share. Adjusted earnings per share were also up substantially in the last two quarters of 2018. The latest trend is positive but the long term trend has been volatile and relatively flat.

COMPARABLE STORE SALES  OR INDUSTRY SPECIFIC STATISTICS

Earnings Growth Scenario and Justifiable P/E

VALUE RATIOS: Analysed at $18.76. The price to book value ratios is ostensibly not unattractive at 1.51 but reflects the low ROE and the risky nature of the business. The trailing 12 month ROE is approaching an acceptable level at 8.9%. The 2018 ROE was unattractively low at 7.6% and the average over the past 10 year has been only 7.3% with a range of 3% to 15%. Revenues per share have compounded up at an average of 3.2% over the past ten years. The trailing P/E ratio is neutral in attractiveness at best  (especially given the low historic ROE and growth) at 17.5. Analysts expect a sharp rise in earnings in 2019 such that the forward P/E is 15.1 which is moderately attractive. In the past five years, average annual revenue per share “growth” has been negative 1% per year as modest revenue growth was offset by a higher share count. The historic earnings per share growth has been quite poor but earnings per share did rise quite sharply in 2018. With volatile earnings , it is difficult to place any reliance on an intrinsic value based on growth but we calculate $12.63 if there is no growth for five years and the P/E declines to 12 W9which is quite pessimistic). And, $21.60 if earnings grow at 10% annually and the P/E declines modestly to 15 (which is not aggressive considering analysts apparently expect earnings to grow about 14% in the next 12 months). Overall, the value ratios would support a rating of (lower) Buy.

SUPPORTING RESEARCH AND ANALYSIS

Symbol and Exchange:

Aecon Group Inc.

Currency:

$ Canadian

Contact:

aborgatti@aecon.com  

Web-site:

www.aecon.com

INCOME AND PRICE / EARNINGS RATIO ANALYSIS

Latest four quarters annual sales $ millions:

$3,373.3

Latest four quarters annual earnings $ millions:

$68.5

P/E ratio based on latest four quarters earnings:

17.4

Latest four quarters annual earnings, adjusted, $ millions:

$68.0

BASIS OR SOURCE OF ADJUSTED EARNINGS: Used management’s adjusted earnings for 2011 through 2013. For subsequent years adjusted for gains on sale (including the sale of a division in 2015) and unrealized foreign exchange gain or loss. (Was not able to adjust for the FX in the quarterly figures)

Quality of Earnings Measurement and Persistence:

P/E ratio based on latest four quarters earnings, adjusted

17.5

Latest fiscal year annual earnings:

$59.0

P/E ratio based on latest fiscal year earnings:

20.2

Fiscal earnings adjusted:

$59.4

P/E ratio for fiscal earnings adjusted:

20.0

Latest four quarters profit as percent of sales

2.0%

Dividend Yield:

3.1%

Price / Sales Ratio

0.35

BALANCE SHEET ITEMS

Price to (diluted) book value ratio:

                                        1.51

Balance Sheet: The following describes the consolidated balance sheet. For complicated reasons this can be misleading but is the only view of the balance sheet we have available. Assets are comprised as follows: 22% cash plus another 7% in restricted cash (cash was usually high at the end of 2018 partly due to selling some operations of the business), 24% is accounts receivable and a further 20% is unbilled revenue 15% is intangible assets (most of which was paid to acquire “concession rights” to revenues from P3 type investments including the Bermuda Airport), 95 is property and equipment and the remaining 3% includes inventories, prepaid expenses and an equity-method investment. These assets are funded on the other side of the balance sheet as follows: 24% by accounts payable, 11% by deferred (pre-collected) revenue 22% by debt, 28% by equity and 4% by deferred income taxes and 1% by provisions. Overall this appears to be a strong balance sheet. It features a large investment in working capital which is about triple the investment in property, plant, and equipment.

Quality of Net Assets (Book Equity Value) Measurement: It appears that the book value per share is reliable and invested assets of real value. Particularly, considering that the total cash is larger than the total equity.

Number of Diluted common shares in millions:

                                 63.9

Controlling Shareholder:

Market Equity Capitalization (Value) $ millions:

$1,199.0

Percentage of assets supported by common equity: (remainder is debt or other liabilities)

27.8%

Interest-bearing debt as a percentage of common equity

90%

Current assets / current liabilities:

1.7

Liquidity and capital structure: The balance sheet appears to be relatively strong with debt that is 81% as large as the equity level. It appears that its credit rating is in the lower end of investment grade or may be somewhat below investment grade.

RETURN ON EQUITY AND ON MARKET VALUE

Latest four quarters adjusted (if applicable) net income return on average equity:

8.9%

Latest fiscal year adjusted (if applicable) net income return on average equity:

7.6%

Adjusted (if applicable) latest four quarters return on market capitalization:

5.7%

GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE

5 years compounded growth in sales/share

-0.9%

Volatility of sales growth per share:

 Stable

5 Years compounded growth in earnings/share

5.4%

5 years compounded growth in adjusted earnings per share

2.1%

Volatility of earnings growth:

 Volatile

Projected current year earnings $millions:

not available

Management projected price to earnings ratio:

not available

Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share?

No

Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained:

3.5%

More conservative estimate of compounded growth in earnings per share over the forecast period:

2.0%

More optimistic estimate of compounded growth in earnings per share over the forecast period:

10.0%

OUTLOOK FOR BUSINESS: Aecon’s backlog was up 61% at the end of 2018 versus the prior year. As of Q1, 2019, the backlog is up 46% versus the prior year. And, its revenues and earnings were up very sharply in the last two quarters of 2018 and 15% in Q1, 2019. Analysts appear to be projecting a 25% increase in earnings per share in 2019 (which is 14% higher than the Q1 trailing earnings) . Aecon’s “Concessions” segment (see description of the company above) is providing a layer of more stable earnings that is increasing with growth in that segment. Overall, Aecon’s outlook appears to be for strong growth. However, partly due to the sale of their former contract mining division, management does not appear to be projecting a very large increase for 2019. A possible headwind is that they have booked a receivable of about a $1.00 per share (after tax) that the customer K & S Potash disputes and instead has countersued for what would amount to over $2.00 per share after tax. This illustrates the risks that Aecon takes on.

LONG TERM PREDICTABILITY: Aecon can be predicted to remain in business and to grow. But its earnings per share have been volatile and have not trended up in the past ten years. Given its historic relatively weak ROE levels, it is not clear that Aecon can move to a higher ROE and sustain it although a higher ROE in 2019 appears quite likely.

Estimated present value per share: This calculation is not very applicable do the  difficulty of estimating an earnings increase rate. Earnings are expected to increase 25% in 2019 but given the volatile history it is hard to guess where the earnings would go after that. Nevertheless, we calculate  $12.63 if adjusted earnings per share grow for 5 years at the more (perhaps very) conservative rate of 2% and the shares can then be sold at a P/E of 12 and $21.60 if adjusted earnings per share grow at the more optimistic rate of 10% (which may be conservative considering the expected jump in 2019) for 5 years and the shares can then be sold at a P/E of 15. Both estimates use a 7.0% required rate of return.

ADDITIONAL COMMENTS

INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (pass, barriers include scale and knowledge and financing). No issues with powerful suppliers (marginal pass at best, as unionized workers constitute a powerful supplier who can usurp much of the profits). No issues with dependence on powerful customers (marginal pass at best since various governments and large companies constitute key customers), No potential for substitute products (pass) No tendency to compete ruinously on price (fail). Overall this industry appears to be relatively unattractive even for a large established competitor.

COMPETITIVE ADVANTAGE: Aecon has deep industry knowledge and capabilities.

COMPETITIVE POSITION: We do not have information on this.

RECENT EVENTS: On September 4, 2019, Aecon appointed a new CEO, Jean-Louis Servranckx. The retiring CEO John Beck had been CEO for over 50 years except from June 2014 to November 2016 when he had been Executive Chair but not CEO. On November 23, 2018, Aecon completed the sale of its contract mining business for $199.1 million. There was no gain or loss on the sale. In 2018 the division generated an operating loss. In 2017 it generated a very small operating profit. In 2017 Aecon had agreed to be sold to a Chinese publicly traded company for $20.37 per share but the Canadian government disallowed the sale.

ACCOUNTING AND DISCLOSURE ISSUES: There are complexities in the accounting due to numerous joint venture projects some of which are accounted for via the equity method and some where they consolidate their proportionate share.  To date we have not identified andy concerns about the accounting.

COMMON SHARE STRUCTURE USED: Normal, one vote per share.

MANAGEMENT QUALITY: A new CEO Jean-Louis Servranckx was appointed on September 4th 2018. He apparently hails from France and previously was CEO of large civil works / infrastructure company that operated in Europe, Africa and Canada.  The retiring CEO, age 76 had been CEO for over 50 years except fora 29 month period ending in November 2016 when he became Executive chair. Overall, given the lowish ROE history of Aecon it appears that management was good operationally but perhaps not as good at generating profits.

Capital Allocation Skills: At the present time, the company’s capital allocation skills cannot be described as very good or excellent. It’s return on capital has not been attractive. It’s more recent decision to increase the dividends payout ratio seems prudent given the lack luster returns in this industry.

EXECUTIVE COMPENSATION: The latest figures available are for 2017 and show that the CEO is compensated at over $3 million per year, The CFO at almost $2 million and the other 3 named officers are under one million. Given the profit levels the compensation for the top two is arguably somewhat excessive.

BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. Aecon has nine Board members. Several members have extensive construction industry experience. One member is a lawyer and was involved in securities regulation. Several board members are from the investment industry. They did have substantial investments in the company although most of that was likely acquired as Board member compensation. Overall, it appears to be a strong Board.

Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, achieved earnings per share growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.

DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.

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