Aecon valuationFirst of all, thank you Gabriel for highlighting ARE. As it is a similar play to SNC and many of you have already moved some capital over to ARE.
Aecon has 4 fixed price legacy JV projects (i'll call them L4) that have generated 270MM of losses in the last 10 quarters, with a substantial portion of that in the last 3 quarters. Three of these four projects are expected to be substantially complete between late 2023 and mid 2024. The fourth is expected to reach completion in 2025.
Given the lack of clarity on the extent of further cost re-forecasts on L4, and the fact that around half of the backlog is fixed price, shares have priced in a worse case scenario going forward.
Future of the Business
Similar to SNC, certain fixed price contracts suffered from inflation, labour force issues etc...resulting from the pandemic. SNC as we all know, and Stantec in 2018, chose to focus on the consultancy side of the business and exit these types of projects. Thats one way to deal with the situation, and the sector is one of the few bright spots in the market, with high demand for engineering services and improving margins despite inflaiton. This is not an option for Aecon. What they can do, is take advantage of having less competition and build in more contractual protections and risk sharing in future projects. In a sense, the pandemic will have the effect of improving the quality and profitability of the future backlog.
Valuation
From 2015 to 2019, EBITDA margins were in the 5% to 6% range. Due to the losses with L4, margins were 4.6% in 2022 and 1.8% in the first half of 2023. However, the L4 have masked what has been a steady improvement in margins for the remainder of the business. Excluding L4, 2021 consolidated EBITDA margin was 6.9% (I excluded the postive impact of CEWS payments here). 2022 was 8.6% and on the Q2 call, management noted that ex L4, Q2/23 EBITDA margin was a massive 9.7%.
ARE has traded at an average EV/EBITDA multiple of 5.7x over the last decade. Currently, it trades at 4.0x NTM EV/EBITDA, and 3.5x consensus 2025 EV/EBITDA. I'm focusing on 2025 when only one of the L4 projects remain and is substantially complete. Consensus has revenue at 5,002MM and 294MM of EBITDA (5.9% margin). I believe margins will be well north of 7%. Using a 7% margin, thats 362MM of EBITDA. If you think thats too optimistic, you should note that excluding L4, EBITDA in the last 12 months was 375MM as mentioned by Gabriel and confrimed by management on the call as well as my own calculations. If I apply a conservative 5.0x mutiple, Construction operations have an enterprise value of 1.510B.
I will further be conservative and assume H2 23 and 2024 free cash flow (which I expect to turn positive) will simply cover further losses on L4, leaving us with similar net debt as we have now:
Bank debt 18MM (after proceeds from Bermuda airport minority disposition)
Finance Leases 118MM
Equipment & other loans 28MM
Convertible debentures 184MM
Less: Core Cash of 13MM
Net debt = 335MM
Equity Value of Construction operations = 1.175B or $19.04 per share.
For Concessions, I value the remaining 50.1% interest in the Bermuda International Airport concessionaire at $178MM after-tax as per the recent transaction. The remaining concessions I conservatively value at a book value of 108MM. Total concessions = 286MM or $4.64 per share.
Applying a 10% time value discount to the 2025 NAV per share of $23.68, I get a conservative target of $21.31
EV/EBITDA multiples are obviously correlated to EBITDA margins, so I could easily see a multiple re-rate to 6.0x to 7.0x (instead of the 5.0x I used) which yields a price closer to $30.
We should also keep in mind that like SNC, Aecon expects to recover a significant portion of the losses they've taken on L4.
Path Forward
Whatever assumptions you use, it is quite likely we are dealing with a $20+ stock, giving us a margin of safety. I have no idea how the next year will play out in terms of cost re-forecasts on the L4. On the Q2 call, analysts were trying hard to get management to give them an estimate of that number, but they insisted that their forecast is zero, but anything can happen. When SNC gave a maximum further loss on LSTK of $300MM on the Q4/21 call, it was a positive catalyst. The stock traded down below $26 on the open and ended the day above $28. It doesn't appear that ARE management are willing or able to do that yet.
Do we see tax loss selling before year-end? 2022 saw huge tax loss selling in a lot of stocks, my gut tells me we could see more this year.
I'm also very bearish on equities going into year-end, so that will also influence my buy levels, but everyone has a different opinion.
Aecon has a $184MM convertible debenture maturing in December with a $24 conversion price. They could redeem it using their credit facility or got to market and issue another debenture. I really hope they don't issue another convert in order to lower the coupon. It would probably have a conversion price of $16 to $17 and that would not be good in terms of future dilution. I assume they wouldn't do so given the current depressed price.
On the dividend, its a hefty 6.5% and management doesn't see any reason to cut it at the moment. With free-cash flow likely to turn positive in 2024, the current payout ratio is only a temporary issue and the dividend should be well covered next year. I don't really care about dividends in distressed scenarios like this, but keeping it is a vote of confidence from management.