Thoughts on SNC Lavalin

The purpose of this post is to provide my current thinking on SNC Lavalin. As usual do not take this as investment advice. I have no financial or working relationship with either SNC or STN.

Before I get too far I would like to point out that I am NOT a current shareholder of SNC and based on what I see I do NOT intend to buy the common shares in the near future (weeks). If I change my mind I will let you know.

A long time ago I decided I would make a significant investment in an engineering company. The idea was simple. I had a background in engineering and markets and I would lever this idea to get good returns from an industry that I understand. At the time my choice, as I saw it, was limited to 2 companies. These were Stantec (STN) and SNC Lavalin (SNC). I decided to invest in STN due to a number of reasons - better management, transparent operations and probably most important better valuation. SNC, it seems, was always too highly valued in my opinion. It would appear I made the correct choice.

I should point out a key difference between SNC and STN. SNC is a much larger company than STN. SNC is around $8 billion in sales while STN is about $1.8 billion revenue. In capitalism larger is quite often "better". Larger companies command a powerful market presence and often have pricing power. That being said larger companies require more effort and skill to manage. Finally, there might be a market distortion at work here. Larger funds such as CPP or OTPP that want some engineering exposure in Canada have little choice but to invest in SNC. This fact, of course, is hard to prove.

In my investing philosphy I mention that I stay away from situations with storm clouds. Over roughly the last 2 years SNC has endured a massive hurricane of bad news. It never seems to end. The CEO has been arrested and numerous charges/allegations have been made over many incidents. It includes domestic and international operations. They have a systemic problem. This has not been an isolated problem such as the Walmart problems in Mexico a couple of years ago. I will not dwell on the specific issues - you can easily Google all the problems.

Here is a recent chart of SNC:

Over the last 2 years the stock has declined from the high $50's to about $41 today. Ouch.

Looking over the recent company information the following points are significant to me:

1. Top line revenue has actually increased from 2010 (6.3B) to 2012 (8.1B). This is good news but was factored into the backlog. Large projects have long time-lines and they are just working off the backlog. Note that a large part of SNC's revenue comes from concessions such as Altalink (Alberta electrical transmission) and the 407 highway just outside of Toronto. These provide a steady income to SNC and I would think they are nice asset to have right now.
2. The net income figures have declined dramatically since 2010. I have $2.89 in 2010 and $2.05 in 2012 (per annum figures ending in Dec). Profits are down as they sort out this mess. The company did take 2 significant project charges against earnings. $32M for a local infrastructure project and $17M against a Latin America mining project. SNC has indicated that they will try to recoup this money. The EPS figures are from Globe Investor Gold. SNC figures are slightly higher.
3. The forward guidance for annual sales is around $10B. This is a flat projection. Steady customers will likely stay around with SNC while new orders will likely be impacted negatively. The impact is unknown in my opinion.
4. The company is looking to sell some assets (or partner up) according to their Q1 2013 report. I am not sure why they are doing this. When I listened to the conference call this specific question was asked and I still don't get a clear picture. SNC talked in somewhat vague terms - maybe they want to keep their options open.
5. Last Wednesday the company got a credit downgrade from Standard and Poor's. In my opinion the market has already discounted this news. The rating remains investment grade.
6. The company has responded to all the problems by coming forward with a comprehensive program for reform. Ethics, compliance and governance are all very nice but bad things have been done by bad people. The market needs, above all other considerations, that the bad people are gone and the problems are also gone for good.
7. Analyst EPS forecasts for SNC into 2014 are at the $2.30 level. Lately the EPS estimates have been coming down. I always think EPS forecasts have a positive bias anyways. The forecasted 2014 P/E is approximately 18. This is  a depressed number since earnings are down. I generally like to see a multiple at the market level or below. I also like to see EPS estimates increasing. In other words I would like to see the company exceeding expectations. For me this is close to the holy grail of investing.
8. So far the dividend remain intact. Needless to say this is good news.
9. A big question that remains is the extent of their total liability from all the negative events over the last 2 years.

This stock is not for me at this time. It is too speculative for me. If the stock was trading materially lower I might change my mind. The company on an intrinsic basis remains a strong enterprise with many good people. The brand has been seriously damaged and management must rebuild that brand. This will take 3-5 years in my opinion.