Maxim Sytchev, managing director at National Bank Financial.Christopher Katsarov/(Christopher Katsarov/The Globe
The S&P/TSX Composite Index has been grinding out gains, closing at a record high last week. Industrial stocks have been the third-best performing sector year-to-date.
Given the stock market’s run and global economic uncertainty, which industrial stocks can provide investors with some degree of downside protection if the positive market momentum reverses course?
To answer this question, we turned to Maxim Sytchev, a top-ranked analyst at National Bank Financial. Last month, he was named the Brendan Wood TopGun industrial products analyst for the fourth consecutive year.
In a phone interview, The Globe and Mail recently asked Mr. Sytchev for his top stock recommendations for 2020.
Before we highlight your top stock selections, can you provide us with your outlook on the sector you cover?
Because we do cover a relatively diverse group of companies, you have different cycles that permeate throughout the entire coverage universe. One of the things we have to be mindful of is the commodity cycle has been generally negative given what has happened with oil and gas and mining. The second bucket of concern is really around the duration of the business cycle. Right now, we are in the 11th year of expansion in the U.S. Obviously, as the U.S. goes so will Canada so we will have to be mindful in terms of that dynamic. At least we are not seeing inflation.
We do try to high-grade the best ideas in our coverage universe, companies that have [earnings] predictability, best management teams, strong balance sheets and also when/if there is a recession, these are the companies that investors will want to own.
Unfortunately, by virtue of our coverage, the industrial companies are more sensitive to macro economic activity. We are cautious on the commodity verticals, in general, that is why we prefer either companies that have precious metals exposure and companies that have a strong positioning on the public sector side.
Right now, the U.S., the U.K., Canada and Australia, which are the most active geographies for the companies in our coverage; there is strong public support for incremental infrastructure investment. That remains a positive driver for our coverage universe.
You have three stock recommendations. Let’s run through each of them, starting with WSP Global Inc. (WSP). Last month, you raised your target price to $92. Tell us about the company and your investment thesis.
WSP is a pure consulting company with a strong management team. Relative to some of its U.S. and Swedish peers, WSP is trading at a pretty significant discount, which we think is unjustifiable. Given the size and tier 1 positioning of the company on a global basis, only 17 per cent of the company’s top line comes from the Canada, it is much more of a global play on infrastructure without the construction risk.
They have grown significantly since they went public. The company right now has 48,000 employees, and by the end of this year, they are going to be close to 50,000 and their plan is to get to 65,000 employees by the end of 2021, implying fairly significant M&A [merger and acquisition] growth. Really they have a tier 1 practice in horizontal infrastructure - in transit and transportation - and a very strong, what we believe is tier 1 global practice, in vertical infrastructure - buildings. If you strongly believe in further urbanization globally, WSP is the way to play it.
Another interesting thing that I think differentiates WSP relative to other peers in the space is the shareholder structure. Canada Pension Plan Investment Board and Caisse de dépôt et placement du Québec own just under 20 per cent and approximately 19 per cent, respectively, of the shares. So we believe if there is a macro-economic downturn, WSP is one of the few companies that will be able to deploy its already strong balance sheet and also, with the backers from the pension side, the company will be able to do some potential transformative acquisitions. So you have that downside protection, which does not really exist for other peers in the space. We do expect a fairly accretive transaction between now and 2021.
We do feel very comfortable in terms of their deployment of capital for M&A given their track record, strong organic growth, and margin improvements that have been telegraphed. From an execution perspective and capital allocation, we feel particularly comfortable with this one.
Let’s turn to your second stock pick, Toromont Industries Ltd. (TIH). You have a target price of $79.
Toromont is the second-largest Caterpillar distributor globally in terms of revenue, and 95 per cent of what they do is in Canada.
The distribution of a tier 1 brand, Caterpillar, has historically been a very fruitful endeavour. Caterpillar has been around for around 100 years and I don’t think there is one instance where a CAT dealer went bankrupt in its history so it’s a very resilient business model.
It’s basically a horizontal infrastructure play on Eastern Canada. If you look at the spending patterns within Ontario and Quebec, the two largest geographies for Toromont, it’s really driven by subways, LRTs, roads, bridges and so forth, which are very equipment heavy.
Out of the public CAT dealers, Toromont ranks at the very top in terms of the margin profile; ROE generation, with an ROE north of 20 per cent; leverage is less than one times net debt-to-EBITDA despite the fact that they did a transformational deal in 2017; and it has an extremely savvy management team that has a track record of intelligently deploying capital into transactions.
Toromont has grown its footprint significantly with the acquisition of a private CAT dealer in Quebec – they made the acquisition of Hewitt Group in 2017 for $1.1-billion. Hewitt was generating a lower margin profile relative to legacy Toromont. The margin profile on a consolidated basis is actually higher now versus prior to the acquisition. Quebec is roughly 32 per cent to 35 per cent of the company’s top line, we don’t have the exact numbers,and Quebec is firing on all cylinders right now on a relative basis in Canada.So the acquisition really was on the cusp before the spending really started to take off in that geography so you get that positive revenue generation for the combined entity because of that Quebec exposure.
For us, this is another go to name in the good times and also in the bad times. An interesting dynamic in the dealership model is that when the [business] cycle comes off dealers have a tendency to liquidate the inventory so it’s actually very free cash flow generative during the down cycle as well.
What are your thoughts on the stock’s valuation?
The shares right now are roughly trading at 17.5 times P/E on 2020. That compares with the S&P/TSX Composite Index with a P/E multiple of around 16 times on a forward basis. But the average ROE for the S&P/TSX is around 14 to 15 per cent, while Toromont’s average and projected ROE is north of 20 per cent. So we believe that paying a slight premium for ultimately a much better balance sheet, [superior] asset position and a much higher ROE is certainly fair.
Is management still focused on integration benefits and achieving synergies from the Hewitt acquisition?
Yes, we are not anticipating some M&A in the foreseeable future as far as our forecasts go. Right now, it’s about capturing market share, especially on the rentals, so it’s higher revenue generation in the legacy Quebec or legacy Hewitt geographies that I think is going to be a bigger incremental driver relative to just looking at normalizing the margin profile.
Let’s move on to your final recommendation, Stantec Inc. (STN), which has been in a penalty box by investors. I guess you believe we are at or near an inflection point? You have a target price of $36.
Stantec’s business model is quite similar to what WSP does, so a pure consulting [company] with more exposure towards water and environmental services, which is roughly 40 per cent of the company’s top line.
Yes, it has been in the penalty box since 2017. One of the issues is that the company deployed $1.4-billion into M&A since 2012 without necessarily commensurate returns from those transactions.
Now, you have relatively new management - the CEO started on Jan. 1 2018. More importantly, the compensation structure for management has been changed. Before, it was driven by a three-year earnings per share [EPS] compound annual growth rate [CAGR] and ROE metrics, whereas right now it’s based on relative performance versus peers and ROE.
Given the fact that the stock has lagged so much relative to its peers, we are arguing for a potential catch-up dynamic.
We upgraded the shares after Q3 [the third-quarter earnings release], which was stronger than expected. The organic growth rate was 7.4 per cent, which was almost double versus the prior quarter. Stantec, with 60 per cent-plus of its revenue is driven by the U.S., if you strongly believe in improving U.S growth from an infrastructure perspective, this stock does provide that kick. We do believe the margin profile has stabilized and will have the ability to grow.
But for us, the biggest catalyst is the potential improvement on a capital allocation perspective. Based on our math, if they can do 2- to 3-per-cent organic growth next year, the free cash flow yield right now is close to 9 per cent, and they do have a pretty decent balance sheet, so if they start doing more share buybacks they can accelerate the EPS growth.
All in, you can model between 12 and 14 per cent compounding EPS momentum so that gets us back into an interesting situation where the stock can be up over 50 per cent over a two- to three-year time frame.
ESG (environmental, social and governance) investing has become an increasingly important consideration for investors when analyzing stocks. How do these companies we’ve discussed stack up?
If you look at the ESG parameters, all three companies rank very highly. We think this is another overlay that more and more investors are utilizing to screen for high-quality companies.This is something that we think is going to become even more prevalent on a go forward basis. All three companies screen very well and given their environmental exposure they are really at the forefront of the ESG dynamic, which we think will benefit from a fund flow on a go forward basis.
On Dec. 3, the company will be releasing its three-year strategic plan. What key items will you be watching for?
The overall growth rate. Historically, the company was highlighting 15 per cent CAGR through the cycle for the top line. We think that will be dialed down a little bit because it’s a much bigger entity. Then, discussions around M&A, in terms of the verticals and geographies. The third important bucket is capital allocation including dividends and share buybacks.
What about Brexit risk?
It’s still there. Their biggest exposure to the U.K. is on the water side. Around 6 per cent of their revenue is from the U.K. There is risk if Jeremy Corbyn comes to power, which doesn’t seem likely right now. He is talking about nationalizing the utilities so that can create uncertainty from a spending perspective but we do feel that this is probably a remote possibility right now. But from a spending perspective on water right now, the U.K. is actually spending more on a year-over-year basis.
Jennifer Dowty