Keep your eyes on the highway 407 toll route, SNC-Lavalin investors

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Any investors pouncing on the beaten-up shares of SNC-Lavalin Group Inc. in the hope that the Montreal-based engineering and construction company is going to be acquired at a nice premium should focus on what its stake in the 407 Express Toll Route might be worth.

A rough estimate: It represents about $28.50 per share, according to analysts. That’s 76 per cent of SNC’s current share price, implying that the rest of SNC could be had for a song.

The 407 ETR is an Ontario highway stretching 108 kilometres from Burlington to Pickering, giving toll-paying motorists a way to bypass Greater Toronto’s more congested arteries.

The latest numbers underscore its success: The highway generated revenue of $382.7-million in the third quarter, ended Sept. 30, 2018, up 9.8 per cent year over year. Net income was $157-million, representing a fat profit margin of 41 per cent.

The 407’s stakeholders – SNC owns a 16.77-per-cent slice, alongside Cintra Global Holding Ltd. (a subsidiary of Spain’s Ferrovial SA) and Canada Pension Plan Investment Board – must be pleased.

SNC, though, has been floating the idea of selling part of its stake for some time. In August, the company suggested it would reduce its stake to about 10 per cent, driven by its belief that a partial sale could boost the value of the toll road, enriching stakeholders.

No sale has been announced. Nonetheless, the value of SNC’s stake in the 407 is going to be receiving greater scrutiny now that SNC has run into operational difficulties that have hammered its share price and raised questions about the company’s future.

On Monday, SNC announced a $1.24-billion writedown to its oil and gas division, after tax. The division has been struggling because of the deteriorating diplomatic relationship between Canada and Saudi Arabia, where SNC generated about 11 per cent of its $9.3-billion in annual sales in fiscal 2017. Volatile oil prices haven’t helped either.

The company’s shares fell 28 per cent on Monday, carving $2.8-billion from its market value.

Analysts who once saw a promising rebound in SNC, which has been struggling to resolve weak cash flow and the legal fallout from a bribery scandal in Libya in 2012, are now losing patience.

Desjardins Securities cut its target on the stock – or where it sees the shares trading over the next 12 months – to $47 from $72 previously. The brokerage also changed its recommendation on the stock to “hold” from “buy.” Raymond James, Laurentian Bank Securities and BMO Nesbitt Burns also downgraded the stock.

Nonetheless, SNC’s share price rebounded to $37.30 on Tuesday, for a gain of 6.5 per cent, suggesting that some investors see value here. The argument in favour of the stock: If you subtract SNC’s stake in the 407 toll route (and other concessions) from the share price, then the core engineering and construction business (E&C) is being valued at just $700-million, according to Maxim Sytchev, an analyst at National Bank Financial.

“With [the earnings] trajectory taking a step back, investors will be putting the name in the penalty box; that being said, taking away 30 per cent of the market cap [on Monday] is too harsh given the implied stub core E&C valuation,” Mr. Sytchev said in a note.

But there’s a problem standing in the way of SNC becoming an acquisition target: There is a lot of uncertainty in its core business. Profits are falling and SNC is burning cash. BMO estimates that the E&C business’s already-skinny profit margins, based on adjusted earnings before interest and taxes, will decline to just 4.2 per cent in 2018 from 6.1 per cent in 2017.

“Though valuation appears undemanding, we believe the lack of visibility into earnings performance and elevated financial leverage could keep a lid on the stock in the coming quarters,” Devin Dodge, an analyst at BMO Nesbitt Burns said in a note.

What’s more, SNC’s plans for selling part of its stake in the 407, which some analysts thought would ignite the share price, may be on hold now: Since SNC looks like a motivated seller, it may not be able to get the price it wants.

“As a result, we believe there is a risk that the perceived need to solidify [SNC’s] balance sheet could impact the value of bids,” Mr. Dodge said.