Description

LONG: Aecon Group Inc. (TSE: ARE)

Elevator Pitch

Aecon has suffered from three years of project write-downs, primarily caused by covid-related delays and cost inflation, which has masked the underlying earnings power of the business. With the impacted projects approaching completion, we expect Aecon’s earnings to increase materially in 2024, revealing the true profitability of the business. Combined with a de-risked balance sheet and a potential for a doubling in backlog near term, Aecon is conservatively worth $35.00 per share, representing 150% upside.

Description

Aecon Group Inc. (“Aecon” or “the Company”) is a leading Canadian construction and infrastructure development firm providing services ranging from design, procurement, and construction to operations and facility management. Aecon has two segments, Construction and Concessions. The Construction segment includes all aspects of the construction of both public and private infrastructure, primarily in Canada, with a focus on civil infrastructure, industrial infrastructure, utility infrastructure, nuclear power infrastructure, and urban transport solutions.

The Concessions segment includes the development, financing, building and operation of construction projects. For example, the segment will build an airport or rail system and then operate that project for a term of around 30 years. Going forward, after the sale of 49.9% of the Bermuda business, the Concessions segment will be accounted for through the equity method.

Investment Setup

Aecon is currently suffering from several multi-year projects comprising over $3B in revenue that have gone awry. These projects are the Coastal GasLink Pipeline, the Finch West Light Rail Transit, the Gordie Howe International Bridge, and the Eglinton Crosstown Light Rail Transit. A perfect storm of Covid-related construction delays and significant cost inflation combined with the fixed-price nature of these contracts has rendered these projects unprofitable. As a result, Aecon has written-down these projects by a combined $361M, wiping out all expected profits from these projects and then some.

These write-downs have caused Aecon to miss EBITDA estimates in five of the last 8 quarters.

With the company taking project losses every quarter and repeatedly missing on earnings, investors have lost faith and Aecon’s shares have plummeted over 35% since the write-downs began in late 2021. The analysts covering the stock are in “wait and see” mode, preferring to sit on the sidelines until the company reports a clean quarter without project losses:

"Recent challenges in ring-fencing losses from legacy fixed-price projects are keeping us on the sidelines" – Raymond James

“We maintain our HOLD rating, as we continue to have near-term concerns around the potential risks associated with Aecon's four large fixed-price legacy projects, and we believe that upside in ARE will be limited until evidence of improved financial performance on these projects is observed." – TD Cowen

Differentiated View

We have been actively tracking Aecon and these projects since the pandemic, monitoring the business through this write-down cycle, and now believe the Company is at an inflection point.  As these projects approach completion, the write-down cycle is coming to an end: the Coastal Gas Link, Eglinton LRT, and Finch West LRT projects are all either already completed or in the final stages of construction. The Gordie Howe International Bridge, now expected to be finished in September 2025, is more than 2/3 completed with the most difficult part of the project, the 722-foot towers, fully in the rearview.

Meanwhile, the underlying business remains robust. Due to the outsized project losses, reported EBITDA margins are at 2.9%, which is less than half of Aecon’s long-term average.  However, excluding these problem projects, Aecon’s core underlying business has achieved an all-time high EBITDA, with LTM margins of 9.0%.

We expect these higher margins to be sustainable for multiple reasons: Aecon sold its low margin roadbuilding business in early 2023; Aecon’s new progressive design-build bidding model reduces exposure to future cost overruns; and the recent challenging operating environment has caused peers to exit certain markets, lowering competition. Additionally, Aecon has a healthy backlog of over $6.2B which does not even include an additional $7-8B of work that will be added to the backlog once two projects, the Go Expansion and Scarborough Subway Expansion, progress into the build phase of their progressive-design build contracts. Yet despite this, the sell-side does not have margins recovering beyond 5%.

We believe these expectations are far too low and that sustained underlying margin performance combined with an end to the write-down cycle will unleash Aecon’s true earnings potential.

Valuation

At its current share price, Aecon trades at 2.3x its underlying EBITDA, a steep discount to peers (many of whom are JV partners on the problem projects), which trade at 6-14x.

At 2.3x EBITDA, the market is ascribing a valuation to Aecon that is far too low, particularly considering Oaktree just made an investment into its utility business at a 9.0x valuation and Aecon sold its low-margin road building business for 8-9x. Moreover, Aecon’s low valuation fails to reflect significant working capital tied up in these projects which will be released as cash upon project completion, which alone will be more than $100M, or 10% of Aecon’s market capitalization (this can be estimated by looking at the trends in unbilled revenue vs deferred revenue). No matter which way you look at the valuation, you will come to the same conclusion: this stock is ridiculously cheap.

Alternatively, if you take today’s pro forma backlog and assume Aecon earns its 9% EBITDA margin on that revenue, you get a higher EBITDA than the current pro forma EV.

In other words, Aecon trades at a fraction of the profits to be generated from its backlog, as though the business will no longer be a going concern beyond that.

If you take the current valuation and back out the implied value of the Utilities business, which we know from the Oaktree deal, and the remainder of the Bermuda business, of which 49.9% was recently sold, you get an implied equity value of only $357.4M for the rest of the business. Excluding the remaining $283M of net cash, the implied enterprise value of the rest of the business, which we estimate will earn ~$245M of EBITDA in 2024, is worth only ~$75M.

If you value the core business at 5x instead of 0.5x, which would still be a large discount to peers, and assume they get $100M in NWC release from these projects, you get a share price of around $35.00.

Lastly, although we expect the valuation to improve after Aecon reports a quarter or two without write-downs, Aecon’s current dividend offers an attractive 5% yield in the meantime.

Utilities Upside

In October 2023, Oaktree acquired a 27.5% ownership stake in Aecon Utilities at a 9.0x EBITDA multiple. Oaktree (AUM of $179B USD) is owned by Brookfield (AUM of $865B USD), who Aecon has worked with on past infrastructure projects. Through this partnership, Aecon’s Utilities business will have access to its own credit facilities and the backing of the premier strategic partner in the industry. The goal of the partnership is to grow the Utilities platform, organically and through M&A, into a standalone business that can eventually be spun-off. Peer companies in the industry trade at a higher multiple than what Oaktree paid for their stake in the Utilities business.

From 2019-2022, the Utilities business has grown revenue at a compound annual growth rate of 19%, with most of that growth occurring in Canada. Oaktree will help to open the American market to Aecon and allow them to expand into a larger and more attractive market. If the Utilities business can maintain its rate of high double digits growth and make a few strategic acquisitions, it is not unreasonable to expect the EBITDA to double by around 2027, and with $180M in EBITDA the business could be worth $2-3B, significantly more than all of Aecon is worth today. At a $2B valuation, Aecon’s stake in the Utilities business could be worth $20.00 per share.

Price Target

Our price target for Aecon is $35.00, 150% upside.

Catalyst

Catalysts

• Reporting a clean quarter without write-downs
• Winning the second stage of the two large progressive design build contracts and adding $7.0-8.0B to backlog
• Analyst upgrades. The stock is currently 6 Buys / 6 Holds with an average PT of $14.10
• Aecon Utilities progress

Risks

• Additional project write-downs