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. +Q3 ’19

Last updated:

December 3, 2019

Share Price At Date of Last Update:

 $                             17.92

Currency:

$ Canadian

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

(lower) Buy at $17.92

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

Positive near-term earnings outlook?

modest growth

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 weak (very few trades) but  moderately negative.  Executive compensation may be somewhat high for the results achieved. The outlook seems moderately positive for the near-term although analysts are projecting only about 6% growth in earnings based on forward P/E. 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. SNC Lavalin is exiting the fixed-price bid market which is positive for Aecon. Overall we would rate this as a  (lower) Buy based on the moderately attractive valuation ratios but tempered by the  seemingly unattractive and risky nature of the business. Overall, it does not seem to be a good choice for a long-term holding but may be worth consideration based on its value ratios.

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 1.37 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, pipelines, 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 Q3 2019 trailing year figures) With a recent net profit of just 2.3% of revenues, the economics look rather weak. Sales are larger than assets so the return on assets is a bit higher at 2.5%. Given debt and other leverage (including substantial deferred revenue which cash collected in advance of performing the work) , the equity is only 27% as large as assets which leverages the return on ending  equity up to 9.4% which is not bad but certainly not great.  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 relatively weak.

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

INSIDER TRADING / INSIDER HOLDING: Checking from March 1, 2019 to December 2, 2019: The long-time CEO who recently stepped back to the Executive Chair position sold 46,000 shares in March at about $18.30 to hold none directly (He retains substantial deferred share units and 54,000 shares indirectly). The only other transaction was a director buying 76 shares “under a plan”. Overall the insider trading signal is weak but 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: In the past four quarters beginning with the most recent (Q3 2019) adjusted earnings per share (and the adjustments were very minor) declined 2%, rose 133%, was not meaningful, and rose 38%. Revenues per share in the same four quarters were flat, rose 14%, rose 18% and rose 36%. The latest trend is generally 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 $18.04. The price to book value ratios is potentially attractive at 1.37 but reflects the generally low ROE and the risky nature of the business. The dividend yield is reasonably attractive at 3.2%. The trailing 12 month ROE is arguably acceptable at 9.8%. 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 only 3.5% over the past ten years. The trailing P/E ratio is neutral in attractiveness  (given the low historic ROE and growth) at 14.6. Analysts expect a modest rise in earnings such that the forward P/E is 13.8 which is moderately attractive. In the past five calendar years (through 2018), 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 and have risen again in 2019. With volatile earnings , it is difficult to place any reliance on an intrinsic value based on growth but we calculate $14.21 if there is no growth for five years and the P/E declines to 12 which is quite pessimistic). And, $24.48 if earnings grow at 10% annually and the P/E remains at about 15 (which may be an aggressive growth assumption). 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:

$3,491.5

Latest four quarters annual earnings $ millions:

$80.6

P/E ratio based on latest four quarters earnings:

14.2

Latest four quarters annual earnings, adjusted, $ millions:

$79.0

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: Lower quality due to volatility and risks.

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

14.5

Latest fiscal year annual earnings:

$59.0

P/E ratio based on latest fiscal year earnings:

19.4

Fiscal earnings adjusted:

$59.4

P/E ratio for fiscal earnings adjusted:

19.2

Latest four quarters profit as percent of sales

2.3%

Dividend Yield:

3.2%

Price / Sales Ratio

0.33

BALANCE SHEET ITEMS

Price to (diluted) book value ratio:

1.37

Balance Sheet: The following describes the consolidated balance sheet (2018). For complicated reasons (involving joint ventures and some non-recourse debt at the subsidiary level) 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 was larger than the total equity at the end of 2018.

Number of Diluted common shares in millions:

                                 64.0

Controlling Shareholder: There is no controlling shareholder.

Market Equity Capitalization (Value) $ millions:

$1,146.9

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

26.6%

Interest-bearing debt as a percentage of common equity

76%

Current assets / current liabilities:

1.6

Liquidity and capital structure: The balance sheet appears to be relatively strong with debt that is 76% 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:

9.8%

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

7.6%

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

6.9%

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:

4.0%

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 Q3, 2019, the backlog is down 6% versus the strong level of Q3 2018. Its revenues and earnings were up very sharply in the twelve months ended Q2 2019 but then flat in Q3. Analysts appear to be projecting only about a 6% increase in earnings per share in 2020. 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. The outlook for government infrastructure projects including light rapid transit appears to be strong. Overall, Aecon’s near-term outlook appears to be moderately positive. 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. It seems likely that SNC Lavalin’s decision to exit the fixed-price construction services market will be beneficial.

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 its ROE did improve in 2019 (through Q3).

Estimated present value per share: This calculation is not very applicable do the  difficulty of estimating an earnings increase rate. Nevertheless, we calculate  $14.21 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 $24.48 if adjusted earnings per share grow at the more optimistic rate of 10% (which may be aggressive) 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 given competitive bid nature of the work). 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: SNC Lavalin has excited the market for fixed-price construction services and this should benefit Aecon. On September 4, 2018, 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 any concerns about the accounting. However, the disclosure does not appear to give much or any detail on any cost-overruns on individual projects.

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. Its return on capital has not been attractive. Its more recent decision to increase the dividend payout ratio seems prudent given the lack luster returns in this industry.

EXECUTIVE COMPENSATION: For 2018: The executives were compensated from $1.5 million to $2.7 million. These figures do not seem excessive. (But the new CEO was in place for only a few months and we can expect his compensation to rise).  However, the former CEO who is no is now executive chairman seems over-compensated at $4.9 million including additional incentive compensations so he would net leave (seriously!).

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. This includes a long-time former Stantec CEO. One member is a lawyer and was involved in securities regulation. Two 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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