Canada`s Engineering Firms Designing Impressive Shareholder Returns
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Transcript of Canada`s Engineering Firms Designing Impressive Shareholder Returns
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Infrastructure & ConstructionCanadas Engineering Firms: Designing Impressive
Shareholder Returns
Jamil Murji, CFA (Associate)
604.659.8261
Theoni Pilarinos, CFA (Assoc
theoni.pilarinos@raymondjames
604.659.8234
Greg Jackson (Associate)
604.659.8262
Frederic Bastien, CFA
604.659.8232
Ben Cherniavsky
604.659.8244
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RAYMOND JAMES
Canada ResearchPublished by Raymond James Ltd
Please read domestic and foreign disclosure/risk information beginning on page 44 and Analyst Certification on page 45.Raymond James Ltd. | 2200 925 West Georgia Street | Vancouver BC Canada V6C 3L2
Industrial May 3, 2
Industry RepFrederic BastienCFA | 604.659.8232 | [email protected]
Ben Cherniavsky| 604.659.8244 | [email protected]
Jamil MurjiCFA (Associate) | 604.659.8261 | [email protected]
Theoni PilarinosCFA (Associate) | 605.659.8234 | [email protected] Jackson(Associate) | 604.659.8262 | [email protected]
Infrastructure & Construction
Canada`s Engineering Firms: Designing Impressive Shareholder Returns
In this report, we explore the fundamentals of the engineering and design industry and explain why the Canadian firms serv
itGenivar, IBI Group and Stantechave been great stocks to own over time. We also include SNC-Lavalin in our anal
because of the influential position its engineering practice now commands globally, and the similarly impressive returns
100-year old firm has achieved for its shareholders. What we will highlight in the following pages is our thesis that the de
businessor what is often referred to as the professional technical services industryboasts compelling investment attrib
and will continue to be positively influenced by powerful secular trends. We will also demonstrate the four firms comprising
engineering sub-segment of our Infrastructure & Construction (I&C) coverage are best-in-class and suitable for a broad ranginvestors.
A Business Blessed With Attractive (and Enduring) Investment Attributes.Genivar, IBI Group and Stantec boast a numbe
characteristics that differentiate them from the other three I&C groups we cover (contractors, equipment dealers
engineered products). They focus on a fee-for-service consulting model and typically shy away from construction risk (th
where SNC-Lavalins model differs). Design firms also generate healthy margins that reflect their high value-add and tend
have low capex requirements, enabling them to generate strong cash flows from operations. Finally, the nature of their serv
and their positioning in all phases of a project life cycle facilitate the generation of stable and diversified revenue streams.
Strong Fundamentals Underpin this Sector.First there is a growing secular demand for public infrastructure. This was a
premise behind our Nov-28-07 Nation Building reports investment thesis and one that continues to weigh in positively tod
Then there is the highly-fragmented U.S. market, which represents fertile acquisition grounds for the three design firms un
our coverage (especially in light of the strong Canadian currency). Lastly, there is a trend toward larger and more comp
projects, and the impact of tighter environmental regulations, both of which are boosting demand for design services.High-Quality Companies; Near-term Headwinds.We believe the four Outperform-rated companies included herein boast s
management teams, industry-leading positions and very sound business strategies. That said, we remain mindful of certain r
and challenges each firm faces in the short term. Specifically, we expect: (i) the softer market conditions in the U.S. to conti
weighing down on both IBI Group and Stantec; (ii) the government of Trinidad and Tobagos quest to reform procurem
legislation to slow Genivars organic growth for one or two more quarters; and (iii) more headline risk to potentially emerge
SNC-Lavalin in the Middle East and Northern Africa. These headwinds, combined with the lack of any very compelling valua
discount on these stocks, explain why a Strong Buy rating is conspicuously absent from our recommendations for the group.
To Each His Own. None of this, however, should detract from our main message that Canada four engineering firms
designed to deliver impressive shareholder returns over time. Moreover, each boasts unique traits that make it attractive fo
broad range of investors. Genivar, which we selected earlier this year as one Raymond James Best Picks for 2011, stands ou
the stock that offers the best combination of growth and income. What draws us to IBI Group are its proven partnership m
and industry-leading yield. We favour Stantec for its leadership position in P3s and latent leverage to a recovery in U.S. e
market demand, and see SNC-Lavalin as the obvious choice for investors seeking exposure to global infrastructure markets.
Company Ticker Ticker Current Rating Target Price Total Re
Primary Secondary Price (6-12 months) To T
Engineering
Genivar Inc. GNV-TSX C$30.10 2 C$33.00
IBI Group Inc. IBG-TSX C$14.79 2 C$16.50
SNC-Lavalin SNC-TSX C$56.53 2 C$63.00
Stantec Inc STN-TSX STN-NYSE C$29.62 2 C$33.75
Raymond James Ltd.
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Canada Research | Page 2 of 52 Infrastructure & Construc
Raymond James Ltd. | 2200 925 West Georgia Street | Vancouver BC Canada V6
Table of Contents
Overview............................................................................................................................................. 3
Professional Technical Services 101 ................................................................................................... 6The ABCs of Design Firms........................................................................................................ 7How Projects are Administered...............................................................................................8 Defining Features of Design Firms...........................................................................................9
Key Industry Trends ............................................................................................................................12
1. Horizontal Integration: Many Innings Left..........................................................................122. Vertical Integration: More are Embracing the Integrated Approach..................................153. Projects are Growing Larger and More Complex ................................................................16
4. The Environment: A Good Business for Engineers .............................................................16End Market Outlook ...........................................................................................................................17
Buildings.................................................................................................................................. 18Urban and Muncipal Infrastructure ........................................................................................20Transportation......................................................................................................................... 20
Industrial and Power ............................................................................................................... 21
Environmental .........................................................................................................................21
Analyzing the Returns.........................................................................................................................23Return on Invested Capital (ROIC)........................................................................................... 23EBITDA Margin ........................................................................................................................25EBITDA Growth........................................................................................................................ 26Revenue and EBITDA per Employee........................................................................................ 27Working Capital Management (Day Sales Receivable)............................................................ 28
Company Profiles................................................................................................................................30Risks ....................................................................................................................................................41
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Infrastructure & Construction Canada Research | Page 3 o
Overview
This report profiles the engineering and design sub-segment of our Infrastructure &
Construction (I&C) coverage universe in Canada. Namely, the list of public companies
that participate in this market include Genivar, IBI Group, and Stantec. Recognizing
some important distinctions in its fully-integrated business model, we have also
elected to include SNC-Lavalin in this report because of its close parallels to the pure
design firms mentioned above.Our comprehensive analysis begins with a broad, high-level overview of what the
engineering and design business is all aboutor what we label Professional Technical
Services 101. We then identify and discuss what we believe to be the most important
industry trends currently underway before turning to a review of the key end markets
that the sector serves. Next, we introduce a peer group benchmarking exercise that
evaluates the historical performance of select financial ratios for the companies noted
above. We then provide a detailed review of our respective investment theses for
Genivar, IBI Group, SNC-Lavalin and Stantec, and close with a brief overview of some of
the largest independent players domiciled in Canada.
If asked to encapsulate all of the facts and opinions expressed in this comprehensive
report, we would reference Exhibit 1. Therein, it is strikingly evident that investing in
Canadas publicly-traded engineering and design firms has been a very lucrativeexperience over the long-run. For example, since its IPO in 2006 Genivar has generated
a total return (dividends and share price appreciation) of 244%; IBI Groups five-year
return has been 87%; SNC-Lavalins has been 82%; and Stantecs has been 37%. Over a
ten-year period, the total return for the latter two companies has been 819% and 579%
respectively (10-year data are not available for Genivar or IBI Group).
Investing in the engineering an
design sector has been a very l
exercise
Exhibit 1: Five-Year Total Returns for Canadas Engineering and Design Stocks
-50%
0%
50%
100%
150%
200%
250%
300%
Apr-06
Aug-0
6
Dec-0
6
Apr-07
Aug-0
7
Dec-0
7
Apr-08
Aug-0
8
Dec-0
8
Apr-09
Aug-0
9
Dec-0
9
Apr-10
Aug-1
0
Dec-1
0
Apr-11
SNC STN IBG GNV
Source: Capital IQ, Raymond James Ltd.
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Although the past tells us only very little about the future, our broad recommendation
to stay invested in this sector is significantly influenced by such impressive historical
results. Indeed, we believe it is more than mere coincidence that all four of our
engineering and design stocks have outperformed the index over such a challenging
period of time for the economy. Rather, we view this as indicative of the very strong
fundamentals that underpin this sector. At the macro level these include: (i) a growing
secular demand for public infrastructure; (ii) an increase in the outsourcing of
engineering practices from general industry to specialized firms; (iii) a tightening of
environment regulations and permitting processes; (iv) on-going horizontal and vertical
consolidation; and (v) a trend towards the construction of larger, more complex
projects.
Similarly, we believe that the microeconomics of this business are blessed with some
very attractive (and enduring) investment attributes including: (i) high gross margins
that reflect the value-added intellectual component of engineering and design
services; (ii) limited capital investment requirements that lead to strong free cash
generation; (iii) ample opportunity to cross-sell services and diversify revenue streams
into multiple end-markets and complete life-cycle solutions; (iv) disciplined
competitive dynamics; and (v) a general strategy (with some important exceptions, most
notably for SNC-Lavalin) of focusing on a fee-for-service model that limits exposure to
construction risks.
Favourable secular trends and
business fundamentals
The positive influence that all the variables noted above have had on our universe of
engineering and design companies is visible not only in the long-term shareholder
returns, but also in the financial benchmarking analysis that we have included in this
report (see the section Analyzing the Returns). For example, Genivar, Stantec and SNC-
Lavalin have each consistently averaged an ROIC in the range of 10-13% over many
years, well over their respective cost of capital. Similarly, respectable EBITDA margins
have been maintained in the range of 13-20% for the pure design firms in Canada and
8-9% for SNC-Lavalin going back to 2006 and beyond. Meanwhile, the most recent full
cycle EBITDA growth (i.e. over a trough to peak period in the economy) compounded at
a rate ranging from 23% (Stantec) to 55% (Genivar) for the group.
To the extent that all of the aforementioned macro and micro forces are expected to
remain intact (and in some cases accelerate), we believe that our coverage universe ofengineering and design firms can continue to generate impressive financial results for
the foreseeable future. That is largely why we currently rate all four of these stocks
Outperform. At the same time, we remain mindful of the numerous risks and challenges
that continue to weigh on this industry. As expounded upon in this report, these
include: (i) the governments increasing fiscal restraint; (ii) the depressed state of
private non-industrial construction markets; and (iii) the lofty valuations of independent
target firms that have made acquisitions more expensive. These headwinds, combined
with the lack of any very compelling EV/EBITDA discount on the stocks we cover, have
taken some of the sizzle away from our sector call and investment thesis at this point
in time. As a result, a Strong Buy rating is conspicuously absent from our current
recommendations for the group.
should positively influence
Genivar, IBI Group, Stantec andSNC-Lavalin for years to come
None of this, however, should detract from our main message that the engineering anddesign firms in Canada represent an attractive buy and hold opportunity for investors
seeking healthy long-term returns with relatively low-risk. Accordingly, we expect all
four firms in our coverage universe to perform well over the next 12 months and
beyond, with Genivar standing out as the one stock that was selected for Raymond
James Ltd.s 2011 Best Picks list in the Dec-7-10 report.
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Raymond James Ltd. | 2200 925 West Georgia Street | Vancouver BC Canada V6C 3L2
Our investment thesis for each of these companies can be summarized as follows:
Genivar.In the short five years it has operated as a publicly-traded entity, Genivarhas completed 51 acquisitions, grown its employee base from 1,150 to over 4,500,
and generated a total return of 244% for its shareholders. Much of this growth was
facilitated by the firms entrepreneurial and decentralized approach, which
empowers partners to focus on what they do bestwin business and drive revenue
synergies. There is reason to expect more of the same as the firm shifts its focus to
global diversification and aims to add new fields of expertise, including architecturaldesign, energy and mining. At the same, we expect the firms outsized position in
Canada to help drive organic growth at an annual rate of 5-10% for many years to
come (notwithstanding some recent short-term headwinds from the Trinidad &
Tobago operations). This, combined with Genivars healthy dividend, leads us to
believe the stock offers one of the Canadian I&C sectors most enticing combination
of growth and income.
IBI Group.Income-oriented investors will be well-served buying shares of IBI Group,in our opinion. We feel the firm is well positioned to capitalize on: (i) an impending
recovery in private sector spending; (ii) the continued growth in private financing
initiatives; and (iii) an increasing concentration of ownership and management of
real estate portfolios. But what draws us to IBI Group is its proven partnership
model; today the firms leadership team comprises approximately 80 Directors andAssociate Directors who collectively own 46% of the firms common shares. We
believe this is one of the most powerful ways to align the interests of all IBI
stakeholders. Other considerations supporting our constructive stance on the stock
include the firms world-class architectural practice and its strengthened position in
social infrastructure.
SNC-Lavalin. We find it difficult to poke holes in SNC-Lavalins integrated businessmodel. The Montreal-based firm has over the past ten years developed into a global
engineering and construction (E&C) juggernaut as well as an active participant in
the ownership, operation and maintenance of infrastructure assets. Simply put, no
other firm comes even close to matching the breadth and scope of SNC-Lavalins
operations in Canada, where the company is developing massive power and civil
construction projects a mari usque ad mare. Globally, the company is a go-to namefor mining and metallurgy projectsas recent services contract wins from Vale, Rio
Tinto and BHP Billiton can attestand also boasts one of the leading foreign E&C
presences in emerging countries. Recent events in Libya show that investing in SNC-
Lavalin is not without risks, but we know from experience (and the firms 10-year
average ROE of 19%) that management will adapt, innovate and continue to drive
shareholder value higher.
Stantec. Over the past decade, Stantec has evolved from a small, regional playerinto one of North Americas largest design firms. Its ability to generate this type of
self-funded growth (mainly through acquisitions) while maintaining healthy levels of
profitability, respectable ROIC, and conservative financial leverage has earned
management a laudable reputation among investors. Stantecs growing scale has
also provided it with an increasingly diversified revenue stream, lucrative cross-selling opportunities, and an expanding expertise in the P3 market. The depressed
state of the U.S. construction markets, the related depreciation of the U.S. dollar, a
deceleration of acquisition activity, and simply the law of large numbers have all
conspired to slow the companys growth rate more recently. Nevertheless, we
remain positive on the stock because of its reasonable valuation along with the
firms formidable position in the more robust Canadian market (especially in the
West), its strong economic fundamentals, its opportunity to continue consolidating
the market, and its latent leverage to an eventual recovery in end market demand.
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Professional Technical Services 101
Genivar, IBI Group and Stantec compete in the broadly defined professional technical
services field. Participants in this industry offer comprehensive consulting services
(which range from conceptual planning and design to engineering and project
management) to customers in the infrastructure and facilities market. Because these
entities have traditionally centered their activities on the front-end of projects, they are
commonly referred to as design firms. That description isnt stopping a growing numberof companies from adopting a holistic, long-term view to meeting client needs by
rounding out their offering with services such and maintenance and decommissioning
(see Exhibit 2).
Exhibit 2: Project Lifecycle
Project Lifecycle Phase Role of Professional Technical Services Firms
- Explore project concept
- Decide type of project (fixed price, cost plus)
- Determine delivery method (design-bid-build, design-build, PPP, etc.)- Feasibility study
- Schematic design and specifications
- Draft contract
- Project management
- Surveying
- Resident engineering services
- Facilities and infrastructure management
- Facilities operations
- Performance engineering
- Solutions and recommendations for taking facilities out of active serviceDecommissioning
Maintenance
Design
Pre-project Planning
Construction
Source: Stantec Inc., Raymond James Ltd.
Within the design industry, there is considerable diversity among companies. Some
choose to specialize in one or two specific disciplines while others (generally the larger
ones) strive to offer complete life-cycle solutions. The one common thread is that all
design firms focus on a fee-for-service consulting model and typically shy away from
construction risk. This low-risk strategy used by Genivar, IBI Group and Stantec differsfrom the integrated approach SNC-Lavalin has employed successfully for years and that
many global construction firms are moving towards. There are pros and cons to each
business approach, all of which will be expounded upon below. But first we wish to
delineate the professions that this report includes in its definition of design firms.
Professional technical services
focus on a fee-based model an
typically shy away from constr
risk
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The ABCs of Design Firms
We have structured this report to include the following practices: architecture, design,
urban planning, engineering and surveying. Architecture can be loosely defined as the
art and science of designing buildings and other physical structures. The discipline
employs licensed professionals who spend hours blending functional, technical, social
and aesthetic considerations into their drawings. On many projects, architects are also
called upon to prepare detailed bid documents, hire the engineers and general
contractors, and administer the construction contract on behalf of the project owner. In
contrast, designers are non-designated (no pun intended), less technical and generally
handle only a subset of an architects responsibilities.
Architects blend functional, soc
aesthetic considerations into th
drawings
Interior designers, for example, apply their skills to achieve built environments that are
functional and aesthetically attractive, support user safety and enhance the quality of
life of the occupants. Urban planning extends beyond the architectural practice (and
physical buildings) to include activities supporting the continued welfare of people
land use management, the design of transportation and communication networks, and
the protection and enhancement of the natural environment. To the extent
architectural, planning and design activities often overlap, it is common to see
companies offer these related services under one roof. IBI Group and Stantec are two
such firms.
While architects, designers and planners are generally viewed as the artists responsible
for the functionality, look and ambience of a building, engineers use math and science
to make it all work. Civil engineers ensure buildings are strong and stable enough to
resist all appropriate structural loads; mechanical engineers handle the ever so critical
HVAC and plumbing systems; and electrical engineers are responsible for all
communications, lighting, wiring, power and control systems. It is worth highlighting,
however, that these building engineers represent only a portion of all practicing
engineers today. Countless others specialize in other fields of the infrastructure and
construction sector (such as transportation, power and utilities, water treatment and
distribution, mining and energy) and in unrelated industries.
while engineers use math an
science to make it all work
We have opted to include geophysical surveying and mapping in this report for obvious
reasons. Because the profession focuses on locating and measuring the extent ofsubsurface resources, it exerts significant influence on sectors that are of strategic
importance to SNC-Lavalin, Genivar and Stantecoil, gas, mining and metallurgy
especially at this point in the cycle. However, for the sake of keeping the scope of this
report manageable, we exclude any other technical services professions from our
discussion.
Combined, these five consulting industries form a vital and growing part of the Canadian
economy, accounting for roughly two percent of GDP. According to Statistics Canadas
most recent survey, design firm operating revenues rose at an impressive compound
annual growth rate (CAGR) of 11.7% to $27 billion between 2004 and 2009, with
engineers making up the lions share of this market (see Exhibit 3). We attribute much of
the industry growth in Canada to three secular trends. Firstly, competitive and cost
pressures have compelled entities ranging from large oil and gas companies to realestate developers and crown corporations to focus operations on their core
competencies. As a result, such organizations began outsourcing their engineering
needs, the implementation of their capital expenditure programs and other non-core
projects to consulting firms. Secondly, all levels of government took decisive steps in the
mid 2000s to bridge the countrys infrastructure gap by significantly boosting
investments. This was the fundamental premise behind our Nov-28-07 Nation Building
reports investment thesis and one that continues to weigh in positively on the I&C
sector and all design firms (even despite our governments recent belt-tightening).
Lastly, professional technical services firms are seeing increased business from
With annual revenues of $27 b
design firms form a vital part o
Canadian economy
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environmental compliance and permitting as regulations continue to dictate the
progression of an infrastructure project be it a greenfield job or a brownfield
redevelopment.
Exhibit 3: Canadian Design Firm Operating Revenues
75%
12%
13%
2004 Market Size = $16 billion
80%
8%
12%
2009 Market Size = $27 billion
Engineering Architecture, design and landscaping Surveying and mapping
Source: Statistics Canada, Raymond James Ltd.
In the United States, the economy may be softer, but the demand for design services is
still outpacing overall GDP growth. Over the five-year period ending 2009, we estimate
that the industry expanded at a CAGR of 8.0% to US$252 billion, compared to an
average of 2.9% for the U.S. economy. We believe the decentralization of government
engineering arms and stricter environmental regulations have similarly influenced the
sectors growth, as have technological advances and the increased complexity of
projects undertaken nowadays. To the extent the American Society of Civil Engineers
gives Americas infrastructure a grade of D and estimates a five-year investment need
of $2.2 trillion, there is the potential for many more years of above-GDP growth rates
for design firms south of the border (www.infrastructurereportcard.org). However, we
believe this will depend largely on the countrys willingness to adopt innovative ways to
finance infrastructure projects (including public-private partnerships, or P3s) as well as
its ability to raise taxes as a means of tackling the federal and state deficits that loom
over the economy.
The U.S. design industry witnes
CAGR of 8.0% between 2004 an
versus 11.7% for the Canadian
How Projects are Administered
On a typical Design-Bid-Build project, which many in the construction industry refer to
as conventional delivery, the architect and its design team are the owners agents (and
represent its interests). While this relationship still holds true for much public and
private sector work performed today, the advent of the P3 and design-build (DB) models
over the past decade has altered the traditional pecking order for large-scale
infrastructure projects. Under these alternative delivery methods, the owner awards the
design-build mandate to a general contractor or a construction joint venture, which in
turn hires consulting firms to carry out the design and engineering. Because P3s are
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structured over terms that generally last between 25 and 30 years, they also force said
firms to place greater consideration on the assets operation and maintenance phases.
Although DB projects are diminishing the influence design firms have traditionally held
on the tendering process, they often bring additional opportunities for such firms. Thats
because a public owner sometimes chooses to engage a team of professionals, often
referred to as the owners engineer, to advise and represent its interest over the length
of the DB contract.
Defining Features of Design Firms
Professional technical services firms sell knowledge and solutions. As such, their most
valuable assets are the employees on their payroll. To attract and keep these
individuals, design firms must develop a healthy corporate culture that fosters a strong
entrepreneurial, can-do spirit, and offer opportunities to work on challenging projects
with some of the most talented people in the industry. They must also take the
necessary steps to groom the next generation of professionals through various training
and leadership programs, and incentivize all employees to row in the same direction. To
this end, all three design firms under our research coverage require their senior
management to own an equity position in their firm and offer up-and-comers long-term
stock-based compensation. These incentives, we believe, go a long way in building asignificant accumulated knowledge base, continuity in the firms relationships with their
clients and business stability.
Human capital is the largest an
important asset of a design firm
Design firms boast a number of characteristics that differentiate them from the other
three I&C groups we cover (see Exhibit 4). Broadly speaking, they tend to boast
relatively healthy margins that not only reflect their high value-add, but also their
critical role in the industry value chain. They are well-diversified and have low capex
requirements, but generally lack scalability. Equipment distributors similarly have
limited fixed capital investments, but do operate with considerable working capital
requirements. This group is exposed to attractive parts and service opportunities and
tends to perform best during the later stages of the cycle. Engineered product
manufacturers have comparatively high fixed capital requirements, which in turn
provide significant operating leverage. The defining characteristics of the contractorsegment are lower margins and a rather high degree of cyclicality (and scalability). The
amount of fixed capital investments for these companies depends on the degree to
which they chose to 'self-perform' construction activities.
Relative to other I&C segments
firms generate higher margins
have lower capex requirement
generally lack scalability
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Exhibit 4: Infrastructure and Construction Value Chain
DesignSurveying and mapping
Preliminary plans
Detailed engineering
Value engineering
Process engineering
Equipment selection
Equipment design
Programming
Construction
Site preparation
Site construction
Site supervision
Site inspection
Procurement
Scheduling
Quality control
Cost control
PlanningMaster plans
Feasibility studies
Strategic planning
Project development
Financial analysis
Functional programming
Technical programming
Operation &
MaintenanceCommissioning
Training
Start-up
Maintenance programs
Materials and
Engineered Products
ADF Group, Canam Group,
Armtec Infrastructure
GLV, ZCL Composites
Russel Metals
Equipment
Finning
Cervus Equipment
Rocky Mountain
Ritchie Brothers
Strongco, Toromont
Wajax
Engineering
Genivar
IBI Group
Stantec
SNC-Lavalin
Contractors
Aecon Group
Bird Construction
Churchill Corp.
North American Energy Partners
SNC-Lavalin
Source: Raymond James Ltd.
If we focus our analysis on the technical consulting firms specifically, we find that the
nature of their services facilitates the generation of stable and diversified revenue
streams. This level of diversification stems from their positioning in all phases of theinfrastructure and facilities project life cycle, and can be often enhanced further through
geographical expansion and/or the pursuit of complementary practice areas. To drive
this point home, we note that the seven engineering consulting firms included in our
I&C comparable valuations table were able to grow EBITDA at an average annual rate of
12% over the two-year period ending Dec-31-10, compared to respective declines of 6%
and 15% for two groups comprised of global integrated firms and North American
contractors (we provide more detail in theAnalyzing the Returns section). Additionally,
while we track and document the large jobs our engineering and architectural names
secure, this analysis merely captures the tip of the iceberg; the bread and butter for
these firms actually comes from a myriad of projects each performs for its clients every
single working day, and which are typically small in both size and scope (e.g., feasibility
studies, conceptual drawings and environmental impact assessments). For proof
consider that IBI Group, Genivar and Stantec handled roughly 10,000, 15,000 and 25,000active projects, respectively, in 2010 with none deriving more than 3% of their top-line
from any single project. This steady flow of work, in our view, also helps explain the
relative resilience of design firms in recessionary timeswhen clients prefer to plan
projects in anticipation of better times ahead.
Professional services firms wor
large number of small projects
various sectors, which helps extheir resilience in recessionary
Architects and engineers, like other consultants and professionals, charge a fee for their
service. The fees are structured depending on the type of project undertaken, the scope
of work to be performed, and whether the contract was competitively tendered or sole-
sourced (read: negotiated). In situations when the scope of services and schedule can be
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clearly defined, a lump-sum or fixed-fee arrangement is generally favoured. Examples of
this are an architectural firm executing a contract for a percentage of a buildings
construction cost, or a municipality hiring a civil engineering firm to perform a
transportation study for a set amount. However, in instances when either the scope or
the schedule of services cannot be reasonably defined, as is often the case on industrial
projects, a time-and-materials or hourly agreement is recommended.
Design firms agree to fixed-fee arrangements based on an estimate of the costs a
specific project will entail. They will tend to favour such contracts over those based onhourly rates to the extent they generally result in higher-margin, more profitable jobs.
But every so often some unforeseen difficulties can force staff to work additional hours
on a particular assignment, rendering it less profitable than anticipated. It is worth
stressing, however, that these cost overruns are usually immaterial to the consultants
bottom-line (especially when considering the multitude of projects over which they are
spread), and pale in comparison to the losses contractors and even integrated firms can
suffer on large hard-bid jobs. This latter point was most clearly driven home two months
ago when Aecon Group warned about a $55 million loss suffered on Suncors Firebag 3
Central Plant Facilities (CPF) project. Even best-in-class SNC-Lavalin was inadvertently
caught by surprise in 2007 when the bankruptcy of a key supplier derailed its Goreway
thermal power project for several quarters. From these examples, it is clear one key
advantage to the design firms fee-based strategy is that it limits their liability; the
flipside is that it prevents them from offering fully packaged, in-house solutions.
Cost overruns are rare and usu
immaterial to a design firms bline
...but can wreck a contractors
fortunes
Each consulting firm employs a unique mix of professional, technical and administrative
support staff with differing levels of experience, expertise and responsibility. As a rule of
thumb, when preparing their budgets, most firms typically commit 70-80% of available
staff time to billable projects, with the remaining 20-30% made available for business
development efforts, R&D projects, training and professional development. Also, since
there is a limit to how much revenue they can extract from the average professional,
design firms are best served to expand headcount when reporting over nine months
worth of backlog (conversely they should downsize when the backlog falls below six
months). To provide the basis for continued organic growth, and to offset the lack of
scalability inherent in their fee-for-service business model, Genviar, IBI Group and
Stantec have all been active acquirers; in the section that follows we explain why we
expect they will remain so.
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Key Industry Trends
Demand for the services design firms offer is innately linked to the business cycle. It
rises during economic upswings as the ability of private and public sector clients to
make investments improves, and typically declines when the outlook for corporate
profits becomes less certain. The degree to which fee volumes soften will invariably
depend on the governments ability to continue funding infrastructure projects or,
failing this, their willingness to embrace Keynesian economics. Recent history shows thefederal and provincial governments in Canada did just that following the 2008 credit
crisis, whereas their U.S. counterparts were largely ineffective with their pump priming
efforts. We believe this helps explain in part why Canadian-centric Genivar has been
able to expand its business while other technical consulting firms with U.S. exposure
struggled to grow organically (though there were also other factors at play behind
Genivars healthy performance). But over and beyond these macro forces, we see four
underlying themes combining to drive continued growth for the professional technical
services firms under our coverage. These include:
1. Horizontal Integration: Many Innings Left
The consolidation of engineering and design firms is much like the consolidation that
occurred in the accounting industry. In the 1950s most public accountants operatedlocally as sole-proprietorships or single-office partnerships. But as travel and
telecommunication improvements in the 1960s and 1970s made it easier to expand
business beyond local confines, accounting firms started following their clients abroad.
Many established satellite offices from the ground up, but soon found it simpler and
more efficient to partner with established companies sharing complementary client lists
and similar values of service quality and professionalism. From this emerged a multitude
of national firms and ultimately, through cross-border consolidation, the Big 4 (Deloitte,
PricewaterhouseCoopers, Ernst & Young and KPMG). Today these accounting firms: (i)
audit 98% of the more than 1,500 largest U.S. public companies on recordaccording
to United States Government Accountability Office; (ii) boast an expanded offering of
management consulting, corporate finance, risk and tax services, and (iii) are major
developers of talent within the financial services industry. While the Big 4 dominate theaudit market and are orders of magnitude larger than their next largest competitors,
they still leave some room for smaller entrepreneurial firms to thrive in specific niches
or regions.
Although no other profession has experienced to date a structural evolution emulating
that of the accounting industry, we believe design firms appear to be following a similar
path. In 2010, Stantec continued to march toward its goal of becoming a top 10 global
design firm with ten acquisitions, Genivar outlined plans to double in size over three
years, IBI Group snapped up the United Kingdoms largest architectural practice
specializing in social infrastructure (Nightingale Associates) and SNC-Lavalin added
Colombias biggest oil and gas engineering firm to its services offering. Notably, all of
this was unfolding as industry giants Aecom Technology Corp. and Tetra Tech were
gobbling up medium-sized firms across Canada including EBA, RSW and BPR.With all this consolidation activity, investors may be justified in asking: How long can
this possibly last?For quite some time, we believe. The ten largest U.S. design firms
generated combined revenues of US$34 billion in 2010, giving them a mere 13% share
of the professional technical services market (see Exhibit 5). Of these participants even
the largest, Aecom, had just 2% market share. This leaves the U.S. industry with nearly
400 firms generating annual fees ranging from US$25-500 million, and thousands of
smaller ones focusing on specialized sectors (see Exhibit 6). The design and consulting
world may not be as fragmented as it used to, but we believe there are many innings
left in the consolidation theme.
The ten biggest U.S. design firm
up only 13% of the market
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Exhibit 5: Top U.S. Design Firms in 2010
Ranking Company Type of Firm 2010 Revenue (million) Market Share
1 Aecom Technology Corp. Engineer-Architect $5,920 2.3%
2 URS Corp Engineer, Architect, Contractor $5,039 2.0%
3 Jacobs Engineer, Architect, Contractor $4,748 1.9%
4 CH2M Hill Engineer-Contractor $3,603 1.4%
5 Flour Corp. Engineer-Contractor $3,128 1.2%
6 Amec Engineer-Contractor $2,456 1.0%
7 Tetra Tech Inc. Engineer $2,456 1.0%
8 Bechtel Engineer $2,210 0.9%9 KBR Engineer-Contractor $2,170 0.9%
10 Parsons Brinckerhoff Inc. Engineer-Contractor $2,010 0.8%
$33,740 13.4%
25 Stantec Inc. Engineer, Architect, Planner $578 0.2%
Source: ENR Sourcebook, Raymond James Ltd.
Exhibit 6: Top U.S. Design Firms, 2002 & 2010
..but the total number
of firms in the industry is
very large.
0
50
100
150
200
250
300
350
More than $1
billion
$500 million to
$1 billion
$250 million to
$500 million
$100 million to
$250 million
$50 million to
$100 million
$25 million to
$50 million
Less than $25
million
2002 2010
In 2002, there were just 17 U.S.
Design firms with revenue greater
than US$500 million. in 2010 there
were 27.
..but the total number of
firms in the industry is very
large.
1000's
Source: ENR Sourcebook, Raymond James Ltd.
Genivar, IBI Group, Stantec and SNC-Lavalin consider acquisitions to be an integral part
of their long-term strategy. There are several reasons for this. Acquisitions provide
design firms with an increasingly comprehensive range of engineering services to
promote and cross-sell. They help address the scalability issues engineers and
consultants face when targeting new opportunities and can unlock significant revenue
synergies (as the customer lists of the design practices are combined). Moreover, if
done right, they allow employees to enjoy greater career opportunitieseffecting a
powerful and attractive virtuous circle for these firms (see Exhibit 7).
Acquisitions offer engineering f
an increasingly comprehensive
of engineering services to prom
and cross-sell
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Exhibit 7: Engineering Services Virtual Circle at Work
The firm adds capabilities across all three
parameters of the enterprise geography,
discipline and end marketmost predominantly
through acquisition
Satisfied clients in turn outsource more and more
engineering services to the firm, increasing demand
for new types of services
The firm gains a new client base to which it
can cross-sell services
The firm provides a full range of
professional consulting services to its
private and public sector clients
Potential
Partners
and
Targets
Private
and
Public
Clients
ProfessionalTechnical
Services
Firms
1
3
4
2
Source: Raymond James Ltd.
No matter how attractive an avenue for growth it represents, it is our view that a firms
roll-up strategy will ultimately be influenced by its cash flow generating capacity as well
as its ability to tap external funds. Specifically, we estimatebased on the industrys
historical operating profit margin of 10%that design firms can afford to grow
strategically at an annual rate of 5-10%. Beyond this range, growth can only be
reasonably achieved with sufficient access to capital (either from the public markets or
through strategic partners). This puts private firms at a significant disadvantage to the
extent their internal funds are typically paid out to employees-owners or retained to
buy-out retiring shareholders. The silver lining for the smaller firms it that the industrys
ongoing consolidation is giving them a practical alternative to succession. As the old
adage goes, if you cant beat them, join them.
Another driving force behind the growth-through-acquisition model is that it can be a
highly accretive exercise. Private companies, depending on their size and focus, have
historically been acquired for multiples ranging from 3.0x to 7.0x trailing EBITDA. For the
larger design firms, this compares very favourably to the average EV/EBITDA multiple of
8.5x they have commanded from the Street over the past 15 years (see Exhibit 8).
and can be highly accretive
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Exhibit 8: Engineering Services Historical EV/EBITDA Valuation
2x
3x
4x
5x
6x
7x
8x
9x
10x
11x
12x
1Q
96
1Q
97
1Q
98
1Q
99
1Q
00
1Q
01
1Q
02
1Q
03
1Q
04
1Q
05
1Q
06
1Q
07
1Q
08
1Q
09
1Q
10
1Q
11
TTM EV/EBITDA Average
Average: 8.5x
11.7x
5.1x
The engineering services industry has traded at an average
EV/EBITDA multiple of 8.5x over the past 15 years
1 standard
deviation
Private companies in the industry are
typically acquired for 3-7x EV/EBITDA
Source: Capital IQ, Raymond James Ltd.
2. Vertical Integration: More are Embracing the Integrated Approach
SNC-Lavalin was one of the very first engineering firms to package the professional
services that Genivar, IBI Group and Stantec deliver efficiently today with full-blown
construction services. In the late 1990s the company went a few steps further by
layering on investment financing and operations and maintenance (O&M) capabilities to
its engineering and construction offering. This was in keeping with the objective of
major infrastructure owners to integrate all key phases of the value chain to drive
efficiencies and reduce costs. To wit, SNC-Lavalins one-stop approach can take pressure
off the design, engineering and procurement activities, cut the risks of supply chain
conflicts and avoid the inefficiencies of managing too many supplier interfaces. It also
allows for more flexibility, as construction projects can be handled with varying risk
profiles and better coordinated with the work of designers. The integrated approach has
certainly pushed SNC-Lavalin to assume more risk, but it also has rewarded the firm with
a first-mover advantage over its industry peers and a significantly larger share of client
budgets.
There are advantages to integr
all key phases of the I&C value
chain
and large contractors have ca
on to these
Big construction firms have caught on to the benefits of the integrated model, and are
now positioning themselves earlier in the project life-cycle. This is precisely what U.K.-
based Balfour Beatty did in 2009 when it acquired U.S. engineering stalwart Parsons
Brinckerhoff (PB) for US$626 million. The deal combined PBs well-established globaldesign practice with Balfour Beatty's large construction and investment businesses to
create a group with significantly enhanced capabilities. Based on this example, we
would be remiss to ignore some of the appeal IBI Groups global architectural practice
may have for players situated further down the I&C supply chain.
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3. Projects are Growing Larger and More Complex
On a recent magazine cover, ReNew Canada coined the expression Infranormous to
describe the 100 largest infrastructure projects currently underway in Canada. We felt
this was appropriate since the average project on the list had ballooned in size from
$680 million in 2010 to $960 million in 2011. Due to their sheer size and the increased
complexity that tougher regulations and stricter standards have placed on owners, the
planning of such projects has been taken to a whole new level. Nowhere is this more
obvious than in the oil sands where a host of recently sanctioned projects are slowlyprogressing through the planning and engineering phases. Producers reason its better
to spend more time planning things right in the very early stages of development, than
to cut corners and end up paying for it dearly at the end. These delays may drive the
contractors we follow up the wall, but they are music to the ears of engineers.
The trend toward larger and m
complex projects
Many Canadian public owners have embraced the use of the P3 model to undertake
large-scale infrastructure projects. But we note that the resulting growth has had mixed
implications on the design industry. For one, high barriers to entry effectively render the
P3 market impenetrable to smaller firms. They also require the designer to work for a
reduced fee early in the proposal and qualification stages of a project, with the promise
of much improved economics if the bid proves successful. Accordingly, firms must
efficiently manage staff utilization and carefully asses the proponents they team up with
to ensure the rewards for chasing P3 work more than justify all efforts put in and risksassumed. There is obviously more upside for firms that maintain high securement ratios,
to the extent they can spread their costs across a greater number of successful bids. IBI
Group and Stantec appear to be doing a good job of it, judging from their recent
successes. Notably, the former company is lead architect on SNC-Lavalins Glen Campus
project in Montreal as well as the Womens College Hospital in Toronto; the latter is
handling all design services for two Carillion-led projects in Ontario, the new Forensic
Services and Coroner Complex and the Centre for Addiction and Mental Health.
has had mixed implications o
engineering and design industr
We invite readers interested in learning more about P3s to refer to our comprehensive
Jun-11-08 report titled Under the Microscope; How P3s Change Industry Dynamics and
our Sep-30-10 update The P3 Model: An Enduring Feature of Canadas I&C Marketfor
more detail.
4. The Environment: A Good Business for Engineers
Long gone are the days when environmental matters were plainly ignored in the
execution phases of a project. Increased regulation and public awareness have,
together, propelled environmental considerations and permitting to the forefront of a
projects planning phase. In turn, demand for related consulting services and expert
advice has balloonedarguably making environmental engineering the hottest
subsector of the design and consulting industry. Since all new projects under
consideration now invariably have a greenangle to them, most engineering firms see
the benefits of developing or acquiring expertise in this field. Stantec significantly
bolstered its expertise in the field in early 2009 when 1,700-employee strong Jacques
Whitford, an internationally recognized leader in environmental and earth sciences
solutions, joined the company. Largely as a result of this deal and the many tuck-ins it
has performed since, the firm today ranks as a top-tier firm in the North American water
sector.
but the impact of tighter
environmental regulations has
universally favourable
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End Market Outlook
Before turning our focus to the key market segments that professional technical services
firms target, we believe a brief analysis of the industrys macro drivers is warranted.
There are stark differences in t
fiscal state of Canadas ten
provinces, which biases our
research towards companies wstrong foothold in the west
Activity in the design industry is dictated at least partially by the economic cycle. This
certainly rings true for private sector spending, which relies heavily on corporate profits,
the labour market, property vacancy rates and commodity prices. When private sector
activity dried up at the onset of the global credit crisis, the Canadian governments keptthe lights on in the construction sector by not only committing $21 billion in stimulus
money, but also accelerating the roll-out of large-scale projects earmarked under the
$33 billion Building Canada Plan. However, as mounting fiscal realities force certain
provinces to scale back their funding, we believe that a sustained economic recovery is
necessary to propel the I&C sector higher. We maintain the western Canadian provinces
will provide more ample and lucrative business opportunities than their counterparts to
the east and the south, ceteris paribus, thanks to their healthier fiscal position (see
Exhibit 9) and wealth of natural resources.
Exhibit 9: Projected Provincial Debt-to GDP Ratios (F2011)
17%
-6%
7%
26%
36%
48%
34%
40%
35% 35%
-10%
0%
10%
20%
30%
40%
50%
B.C. Alba Sask Man Ont Que NB NS PEI NFLD
Source: Conference Board of Canada, Globe and Mail
Canadian design firms serve a smorgasbord of industries (see Exhibit 10). This makes an
analysis of numerous end markets an important part of any outlook for the sector, and
we follow a wide range of macro indicators accordingly. In some cases, such as mining
and oil and gas, where our firm has established respected sector research, we largely
defer to our internal sources of expertise for our analysis. In other areas, such as
buildings, transportation or municipal infrastructure, we have established our own
practice of evaluating trends and monitoring key demand drivers. Either way, a
thorough review of all the end markets that the design and consulting universe serves
could constitute a separate report on its own. Therefore, in order to maintain a
manageable scope, we limit ourselves to providing a summary of the current demand
conditions in and future outlook for the five markets that are most relevant to design
and consulting firms we cover.
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Exhibit 10: Sector Exposure of Canadian Designers and Engineers
BuidingsUrban and Municipal
InfrastructureTransportation Industrial and Power Enivironmental
Dessau < 5%
exp Global 5-20%
Genivar 20-50%
Golder 50-75%
Hatch 75% +
IBI
Stantec
SNC-Lavalin
Source: ENR, Company Reports, Raymond James Ltd.
Buildings
Projects in this segment are carried out for both public and private sector clients and
run the gamut from courthouses, hospitals and universities to condos, office towers andentertainment complexes. To gauge the prospects of the related components of this
industry in North Americaresidential, commercial, institutional and industrialwe
continuously monitor the monthly buildings permits data made available by both
Statistics Canada and the U.S. Census Bureau, the American Institute of Architects (AIA)
and the websites of all major P3 agencies.
Most large-scale social infrastructure projects north of the border have recently been
tendered under various P3 forms, and we expect this to continue for some time. In
healthcare alone, the list of projects includes the Oakville Hospital and the third phase
of the London Health Sciences Centre in Ontario, the Interior Heart and Surgical Centre
Project in British Columbia, and the Montreal University Hospital Centre (CHUM) in
Quebec. In Alberta, the government is expected to stick to the traditional procurement
approach to fund health facility projects in several medium-sized cities and rurallocations, including a massive hospital for Grande Prairie. However, if we look at the
general trend for institutional buildings intentions (see Exhibit 11), the data suggests a
drop in activity over the coming months and quarters, which is consistent with the more
cautious outlook we communicated in our Jan-14-10 report dubbed Life After Stimulus.
The outlook for privately-funded construction activity in Canada has brightened
considerably from 18-24 months ago, especially in the industrial sector, where key
commodity prices generally remain above investment threshold levels (despite the
recent volatility). According to many industry sources, the commercial building segment
in western Canada is also rebounding from trough levels as the surplus in office and
retail space is being worked off, but the last few months of data suggest the recovery
may be lumpy.
The outlook for privately-funde
construction activity has bright
considerably in Canada...
Also key to the publicly-traded design firms we cover are the construction intentions for
multi-residential buildings and the related influence these have on urban land
development. We would be remiss to ignore their impact on IBI Group, in particular, to
the extent the firm has been instrumental in the planning and design of Toronto and
Vancouvers waterfronts. In this regard, the outlook for private condo developments
also appears to be on the mend.
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Exhibit 11: Canadian Non-Residential and Residential Building Permits
Canadian Non-Residential Building Permits
0.0
0.5
1.0
1.5
2.0
Fe
b-0
6
May-0
6
Aug-0
6
Nov-0
6
Fe
b-0
7
May-0
7
Aug-0
7
Nov-0
7
Fe
b-0
8
May-0
8
Aug-0
8
Nov-0
8
Fe
b-0
9
May-0
9
Aug-0
9
Nov-0
9
Fe
b-1
0
May-1
0
Aug-1
0
Nov-1
0
Fe
b-1
1
PermitVa
lues(
$bil
lion
)
Industrial Commercial Institutional
Canadian Building Permits
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Fe
b-0
2
Jun-0
2
Oct-02
Fe
b-0
3
Jun-0
3
Oct-03
Fe
b-0
4
Jun-0
4
Oct-04
Fe
b-0
5
Jun-0
5
Oct-05
Fe
b-0
6
Jun-0
6
Oct-06
Fe
b-0
7
Jun-0
7
Oct-07
Fe
b-0
8
Jun-0
8
Oct-08
Fe
b-0
9
Jun-0
9
Oct-09
Fe
b-1
0
Jun-1
0
Oct-10
PermitVa
lues
($bil
lion
)
Non-Residential Residential
Source: Statistics Canada, Raymond James Ltd.
Any concerns about the fiscal condition of certain Canadian provinces pale in
comparison to the problems that the U.S. federal government and many U.S. statescurrently face. Simply put, we feel public-sector building work south of the 49th parallel
will continue to languish until the current debate in Congress over the deficit and the
budget gets resolved. The outlook for private construction activity is more favourable,
though we believe the restricted lending practices of the banks, excess housing supply
and a general lack of confidence in the economy will continue to present the industry
with near-term headwinds. All of these issues are evident in certain key industry metrics
that we track such as the building permits or the Architectural Billings Index. The latter
reflects a 9-12 month lag time between architecture billings and construction spending,
with any score above 50 indicating an increase in demand for design services (see
Exhibit 12). The corollary to this suboptimal environment, when combined with a strong
Canadian currency, is that the U.S. market should remain fertile acquisition grounds for
the Canadian-based designers for some time to come.
but economic conditions in th
remain suboptimal
This may prove fortuitous for t
companies highlighted herein
Exhibit 12: U.S. Non-Residential and Residential Building Permits, Architectural Billings Index (ABI)
150
200
250
300
350
400
450
500
550
600
650
700
750
Feb-02
Aug-02
Feb-03
Aug-03
Feb-04
Aug-04
Feb-05
Aug-05
Feb-06
Aug-06
Feb-07
Aug-07
Feb-08
Aug-08
Feb-09
Aug-09
Feb-10
Aug-10
Feb-11
(SAAR,US$
billion)
R es id en ti al N on -r es id en ta l
30.0
35.0
40.0
45.0
50.0
55.0
60.0
65.0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Architect's Bi llings Index (ABI)
12M Moving Average
Source: U.S. Census, The American Institute of Architects, Raymond James Ltd.
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Urban and Municipal Infrastructure
Professional services provided in this area focus on a citys below- and above-ground
infrastructure. This results in a broadly-defined market that encompasses water
distribution and treatment, wastewater collection and treatment, land planning,
landscape architecture and transportation accessibility. New investments in this field
are generally driven by the cyclical housing market, population growth and urbanization;
in contrast the maintenance, operations and repair of existing infrastructure is generally
managed (unfortunately) on an as-needed basis. This chronic underinvestment has todo with the fact that much of the funding commitment falls in the hands of local
municipalities, which have limited financial flexibility.
A more stable residential sector and fiscally stronger jurisdictions provide for a much
healthier outlook in Canada than in the U.S. Moreover, we view the nations aging water
infrastructure as the next logical candidate for the P3 model, and surmise that a pipeline
of related projects will build over the medium term. Globally, Frost & Sullivan pegs the
water market for design, consulting and construction at $126 billion. We highlight the
global water treatment and re-use segment for its explosive potential, as drinking water
shortages now affect roughly one-third of the worlds population.
Transportation
This segment includes planning, surveying, design and project management services fora variety of transportation projectsincluding highways, bridges, ports, airports, mass
transit facilities and traffic systems. Most clients represent public authorities, weighting
the sectors outlook heavily on spending budgets. However, as we have highlighted in
previous industry reports, larger-scale transportation projects are ideally suited for the
P3 model because: (i) the capital asset provision and the availability payments can be
tied to performance, and (ii) they necessitate significant operation and maintenance
requirements (see Exhibit 13). It is no wonder P3s are being contemplated for many big
ticket projects across Canada including the eastern extension of Torontos Highway 407,
the final leg of the Edmonton Ring Road and the reconstruction of Montreals crumbling
Turcot Interchange and Champlain Bridge.
Exhibit 13: Suitability of P3 Model for Various Infrastructure Project Types
Urban Government Major Water / Government Health Schools Post Facility
Highway owned service Rural Wastewater owned public Facilities Secondary Upgrades
delivery facility Highway buildings Institutions (brownfield
Higher Lower
Suitability Suitability
Proven model Defined and Defined Defined and Specialized Building L imited Partial GoA Latent
Well defined stable funct. performance stable program and complexity economies of funding defects
requirements requirements criteria operating and functional Premature scale Technology Unforeseen
Stable long Defined and Stable long performance requirements obsolescence Premature change risks
term O&M stable program term O&M criteria One-off Technology obsolescence Specialized Limited deal
Innovation & requirements Low financial Utility type buildings change Size/bundling technology flow
economies of Stable long risk function Architectural / Jurisdictional Program Building
scale term O&M Government Jurisdictional design issues inconsistency complexity
Low financial Government payment issues competition Need GoA Jurisdictional Jurisdictional
risk payment stream (municipal) Long term payment issues issues
Government stream Expansion Need GoA performance guarantee Need GoA Need GoA
payment Lessons requirements payment criteria change Severance of payment payment
stream learned Limited guarantee Technology O&M guarantee guarantee
Deal flow innovation & Asset change Limited deal Severance of Limited deal
economies of ownership Severance of flow O&M flow
scale O&M Asset Limited deal Asset
Limited deal ownership flow ownership
flow Asset
ownership
Source: Alberta Infrastructure and Transportation, Raymond James Ltd.
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South of the border, decreasing tax revenues and continued uncertainty about long-
term funding has stifled some planned transportation projects. A case in point is the
recent proposal from the House Budget Committee to reduce the mandatory budget
authority for all federal transportation programs by 30% to $41 billion for F2012. There
might be a silver lining to this, as the shortage of funding and the construction downturn
have many public agencies rethinking their approach to capital asset allocation and
evaluating alternative financing and procurement methods. But before we can count on
P3s to drive the U.S. transportation sector into recovery, lots of political hurdles need to
be cleared.
Industrial and Power
This segment encompasses various sectors including mining and metallurgy, oil and gas,
power generation and transmission, and manufacturing to name a few. The service
offering spans the entire project life-cycle, from planning, functional programming and
engineering to project management, construction support and decommissioning.
The industrial segment of the Canadian economy continues to demonstrate marked
resilience and growth. This is largely a function of strong commodity prices that support
elevated levels of related activity. The prevailing levels of capex in mining and energy
are particularly robust and, notwithstanding some recent volatility, are expected to
remain strong over the foreseeable future. Longer term our Raymond James Ltd. and
Raymond James & Associates energy and mining teams project oil, gold and copper
prices to settle at $125.00/bbl, US$1,100/oz and US$2.50/lb. We note that these
estimates, assuming they materialize, remain well above investment threshold levels
and should create favourable operating dynamics for the engineering firms that support
exploration and production (E&P) activities.
The industrial segment of the
Canadian economy continues t
show marked resilience and gr
In a sure sign that power demand is on the rise, various hydro-electrical power projects
were recently sanctioned across Canada. These include two SNC-led developmentsthe
Lower Churchill Project in Newfoundland and B.C.s Waneta Expansionas well as the
Lower Mattagami Complex in Northern Ontario. Although no material power gen
projects are slated for Alberta in the immediate term, the province is bulking up its
transmission infrastructure with investments totaling $14.5 billion over the next decade
(also a potential boon for SNC-Lavalins AltaLink). And while the demand outlook for
new nuclear reactors looks grim in the wake of the Fukushima Daiichi power plant crisis,
we believe more money will flow toward the refurbishment of older plants. Add to this
burgeoning wind and solar power industries and you have the recipe for many years of
growth for the engineering firms serving the power market, in our view.
while investments in power
generation and transmission as
have been accelerating
Environmental
As discussed in the Key Industry Trends section, a regulatory push from pollution
cleanup to prevention has taken hold amid growing public awareness. This has left
engineering firms to handle ever increasing volumes of work ranging from impact
studies, permitting and compliance audits to hazardous waste remediation and air
pollution monitoring. Engineers are also spending more time on existing assets, as thefear of retroactive environmental liability escalates among infrastructure owners. The
two high-profile industrial disasters in recent historyBPs Deepwater Horizon oils spill
and Fukushimas nuclear reactor leakmay also turn clients focus from solely
complying with regulations to more proactively managing the integrity of their assets.
Based on these, and to the extent environmental matters will increasingly dictate the
development and ongoing operation of infrastructure and facilities projects, it is easy for
us to envision a favourable outlook for the environmental engineering profession.
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Exhibit 14: Sector Summary Table
Market Key Drivers Outlook
- Overall economic activity
- Building permits
- Municipal budgets
- Environmental regulations
- Drinking water shortages
- Overall economic activity
- Government financing for public works
- Global economic activity
- Commodity prices
- Corporate profits
Environmental - Regulation and public awareness Neutral to Positive
Buildings Neutral to Positive
Neutral
PositiveIndustrial and Power
Transportation
Municipal Infrastructure Neutral
Source: Raymond James Ltd.
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Analyzing the Returns
In this section of the report, we present a comparative analysis of certain financial
metrics we consider key to the design industry. The intent is to provide investors with
some insightful data about how each company we cover stacks up against other
industry bellwethers (Aecom Technology, AMEC, Arcadis and Tetra Tech), along with a
cursory overview of how professional technical services firms compare to other
subsectors of the I&C industry, most notably the integrated firms (please refer toAppendix A for the list of companies comprising this group).
This analysis obviously involves some subjectivity in selecting what to measure and how
to measure it. It is also an imperfect exercise in that some of the companies we examine
have unique reporting segmentssuch as SNC-Lavalins Infrastructure Concession
Investments (ICI) divisionor operated under different capital structures until recently.
Here we specifically refer to Genivar and IBI Group, both of which converted from an
income fund structure to a corporate structure at the beginning of 2011. Our ability to
look back at and compare the historical performance of design firms is further limited by
the length of time they have operated as public entities. This is not a problem for
companies like Stantec and SNC-Lavalin, which have been public for many years. But for
IBI Group and Genivar, which first tapped equity markets in 2004 and 2006, respectively,
it is a consideration that cannot be overlooked.
Notwithstanding these complications, we believe a comparative analysis can still be
useful and telling. In particular, we like to look at it in the context of valuation. That is to
say, perhaps the companies with the best and most consistent financial performance
should command a premium multiple in the market, while those that have
underperformed deserve a discount. But this too becomes a subjective call because the
past can obviously tell us only so much about the future; we also, for reasons noted
above, have to be careful with how we interpret relative performance. With all of these
considerations in mind, we will briefly discuss each of the metrics that we have selected
for this analysis, why we selected them, how we define them, and what the numbers
tell us about the companies thatwe cover.Return on Invested Capital (ROIC)
We believe that ROIC is a useful measure of a companys overall financial performance
and of a management teams ability to create shareholder value. This measure,
however, is open to various definitions and interpretations. For our purposes, we prefer
to measure ROIC using net operating income less adjusted taxes (NOPLAT) divided by
total invested capital. We also like to adjust the capital base for any goodwill
writedowns and ignore the related charge to EBIT. Specifically, in our methodology, we
define ROIC as follows:
We view ROIC as one of the be
measures of a management te
ability to create shareholder va
EBIT less Adjusted Taxes + Changes in Deferred Taxes
Net Debt + Equity Capital
We have tax effected the operating profits of the two former incomes trusts using a
statutory rate of 34.5% over the 2005-2010 period, which helps to adjust for a more
accurate comparison with their corporate peers. We also elected to omit the addition of
changes in deferred taxes as we assume the tax rate adjustment accounts for GAAP and
income tax reporting mismatches. Ultimately, we will leave it up to the investor to
decide how to interpret these distortions and what to make of the whole income trust
debate (i.e. did it starve companies of capital for future growth?). But from our
perspective we offer the following observations about the data presented in Exhibit 15:
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Generally speaking, all of the companies in this benchmarking analysis havegenerated respectable ROIC metrics over both five and ten year periods. This
consistent ability to exceed the cost of capital reflects the attractive economics of
the engineering and design business and underscores our view that all four of the
firms that we profile in this report represent attractive buy-and-hold investment
opportunities.
Stantec has not only averaged the industrys highest ROIC over the medium andlong term, but also shown tremendous consistency over the years. This comes to usas no surprise in light of the firms consistent profitability (to be illustrated next)
and assiduousness in funding growth mainly through internally generated funds.
Having said this, we would be remiss not to acknowledge that its ROIC (after
adjusting for asset write-downs) has tracked lower in recent years (2009 and
especially 2010). This, we believe, is a function of changes in project mix, intensified
competitive pressures, and the timing and pace of acquisitions.
Stantec has generated the indu
highest ROIC over the mediumlong term
Genivars double-digit ROIC performance suggests to us that management has donea good job deploying the $200 million of additional equity it has raised since the
IPO. We also attribute the solid results, in part, to the firms concentrated exposure
to the Canadian I&C markets, which have proven more resilient than many other
jurisdictions in the past three years.
IBI Group, on the other hand, has exhibited the lowest returns among the group.We believe much of this has to do with the fact that as an architecture-heavy firm,
its past performance closely reflected the overall state of the commercial and multi-
residential (read: condominium) markets. Recent acquisitions in the civil and social
infrastructure markets should go a long way in alleviating some of the cyclicality
inherent in these private sector markets, and provide smother returns over time.
There has been a step change in SNC-Lavalins ROIC over the past few yearsanimpressive feat considering the improvement was achieved amid recessionary
times. We link this performance to a number of factorsincluding a maturing
staple of concession investments, the favourable allocation of resources toward
growth producing regions and strengthening project execution.
Exhibit 15: Peer Group Analysis of ROIC for Design Firms
ROIC 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 5-yr AVG 10-yr AV
ENGINEERS
Genivar n.a. n.a. n.a. n.a. n.a. n.a. 8.5% 11.3% 10.0% 8.6% 9.6% 9.6%
IBI Group n.a. n.a. n.a. n.a. 5.2% 9.0% 8.3% 6.4% 4.5% 5.6% 6.8% 6.5%
Stantec 11.5% 13.5% 15.8% 14.0% 17.0% 14.9% 13.6% 14.1% 13.6% 11.5% 13.5% 13.9%
Aecom Technologies n.a. n.a. n.a. n.a. n.a. n.a. 18.6% 6.9% 7.2% 10.0% 10.7% 10.7%
AMEC 8.8% 2.6% 13.2% 6.4% 5.7% 12.5% 5.1% 15.7% 5.4% 18.7% 11.5% 9.4%
ARCADIS NV 11.6% 15.7% 12.1% 10.5% 17.1% 14.7% 12.9% 14.9% 12.9% 10.8% 13.2% 13.3%
Tetra Tech 8.0% 12.0% 12.2% 3.5% 4.1% 8.8% 7.8% 8.3% 15.6% 11.2% 10.3% 9.2%
Engineers - Average 10.0% 10.9% 13.3% 8.6% 9.8% 12.0% 10.7% 11.1% 9.9% 10.9% 10.8% 10.4%
SNC-Lavalin 5.5% 6.9% 7.2% 8.1% 8.6% 7.6% 4.1% 10.9% 13.9% 12.8% 9.9% 8.5%
Integrated Firms - Average 2.9% 12.3% 17.2% 11.1% 12.9% 10.3% 10.9% 10.3% 14.8% 11.2% 11.5% 11.0%
Source: Capital IQ, Company Documents, Raymond James Ltd.
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EBITDA Margin
One notable disadvantage to using ROIC, in our view, is that it fails to reflect the
different policies design firms use for their purchase price allocations and to amortize
intangible assets. In other words, it does not provide a clear account of a firms cash
generating capabilities. For this reason, we feel it is important to look at the EBITDA
margin performance of the professional technical services firms under review (see
Exhibit 16). An analysis of EBITDA margins also provides us with a good read of firm
profitability. Our conclusions are as follows:
The Canadian companies we cover have sustained generally higher margins thanother