STN - Stantec: Not A Buy After Recent Run-Up

Summary

• Stantec's revenue should benefit from healthy end-market demand, infrastructure investments, and strong backlog levels.
• Margins should benefit from good execution, higher margin project selection, and operating leverage.
• However, valuations are expensive compared to its historical levels and peers.

Investment Thesis

Stantec Inc. ( STN ) is poised to benefit from its strong backlog of C$5.9 billion exiting the fourth quarter of 2022, as well as major project wins and healthy end-market demand driven by increased infrastructure investments such as the Infrastructure Investment and Job Act (IIJA), CHIPS and Science Act, and Inflation Reduction Act (IRA). The company is already seeing the benefits of these investments and expects a robust pipeline of opportunities in the future, which should support revenue growth.

The company's margins are also expected to improve due to better execution, higher-margin project selection, and operating leverage. However, while the growth prospects are positive, the current valuation of the stock already reflects these expectations, and the stock is trading at a premium compared to its historical levels as well as its peers like Aecom ( ACM ), Jacobs ( J ), and KBR ( KBR ). Therefore, despite a positive growth outlook, I have a neutral rating on the stock.

Q4'22 Earnings

Stantec stock delivered strong top-line and bottom-line growth in the fourth quarter of 2022. Net revenue for the quarter was C$1.1 billion, representing a 23.4% YoY increase, and adjusted EPS was $0.82, up 43.6% from the year-ago quarter. While the company's project margin decreased 40 basis points to 54.9%, the adjusted EBITDA margin grew 150 bps YoY to 17%. The revenue growth was driven by strong demand across all end markets and regions, as well as successful backlog execution. The decline in project margin was due to unfavorable project mix shifts. Meanwhile, the increase in adjusted EBITDA margin and adjusted EPS was mainly attributed to operating leverage and lower general and administrative expenses as a percentage of revenue.

Revenue Analysis and Outlook

Following pandemic-related slowdowns in FY2020 and FY2021, Stantec's revenue growth rebounded in FY2022 thanks to the economic reopening and various government infrastructure investment initiatives.

The company's revenue growth momentum continued in the fourth quarter of 2022, driven by healthy end-market demand, successful backlog execution, and support from infrastructure funding. As a result, revenue growth increased by 23.4% YoY to C$1.1 billion. The increase in revenue growth was mainly due to a 9.8% benefit from acquisitions and a 3% benefit from foreign currency. Excluding FX and acquisitions, organic sales increased by 10.6% YoY.

Looking ahead, STN should continue to deliver revenue growth in 2023, driven by strong backlog levels, government infrastructure stimulus, and robust end-market demand.

STN's backlog remained healthy at C$5.9 billion (up 14.9% YoY and organic growth of 10.4% YoY) as of the end of fourth quarter of 2022. This robust backlog, combined with the company's improving backlog execution, is expected to support STN's revenue growth prospects for the upcoming year.

The strong backlog level reflects healthy end-market demand for the company, driven by investments in aging infrastructure, reshoring of domestic production, and increasing focus on climate change. Government infrastructure investments, including the Infrastructure Investment and Job Act (IIJA), CHIPS and Science Act, and Inflation Reduction Act (IRA), are providing a pipeline of opportunities for STN. Management expects benefits from the IIJA funding to accelerate as the year progresses, providing a positive outlook for the bidding opportunities.

In the fourth quarter, the company won several major project bids in Canada, including a streetscape design project in Alberta, a multi-disciplinary transit project in Quebec, and a soil and groundwater remediation project in Ontario. In the U.S., the company won the IRA-supported Qcell project, a $2.5 billion investment in solar power energy transition. The project aims to address the growing need for renewable energy and reshoring of domestic production to mitigate supply chain risk. STN also secured its first major design and build infrastructure project for Transport Scotland and a civil design project for the Belfast Wastewater Treatment Work in Northern Ireland. These project wins are expected to support the company's revenue growth moving forward.

STN's inorganic growth initiatives are also supporting its revenue growth. The acquisition of Cardno in December 2021 expanded the company's exposure in its key end markets, and two small tuck-in acquisitions in 2022 provided a 12.3% benefit to full-year revenue growth. STN's healthy balance sheet with a net leverage ratio of 1.6x is in a good position to support its strategic acquisitions, and the company plans to remain active in the M&A market.

Last year, there were some concerns due to the tight labour market and whether the company will be able to hire at a fast enough pace to ensure timely conversion of its backlog. This situation is also improving now as the labour market continues to ease and STN's voluntary attrition rates have started to stabilize. Additionally, STN is collaborating closely with its innovation groups to leverage digital products and enhance revenue per employee. So, I believe this headwind should also fade in the coming quarters.

I am optimistic about the company's revenue growth in the upcoming year, and I believe that management's guidance of mid to high single-digit organic sales growth in 2023 is attainable.

Margin Analysis and Outlook

Stantec has seen improved margins since the pandemic due to better project selection and execution. However, in the fourth quarter of 2022, the company's project margins (gross margin) were impacted by an unfavorable project mix in the global segment, partially offset by good execution in the U.S. segment. As a result, project margin declined by 40 bps YoY to 54.9%. Despite this, the adjusted EBITDA margin increased by 150 bps YoY to 17%, mainly due to lower general and administrative costs as a percentage of revenue.

Looking ahead, I am optimistic that STN will be able to achieve margin expansion in the coming years, helped by the company's efforts to improve project execution and focus on winning higher-margin projects. Additionally, the company reduced its real estate footprint by 28% in 2022, and management aims to decrease it by 30% in 2023, leading to cost savings that should also support margin growth. Lastly, operating leverage from an increase in revenue should further bolster margins. So, I am optimistic about the company's margin improvement prospects.

Valuation and Conclusion

Stantec is currently trading at a forward P/E ratio of 22.75x and 20.42x for FY23 and FY24, respectively. This is a premium to its historical 5-year average forward P/E of 20.10x. The following table compares STN's valuation and EPS growth (based on consensus estimates) with other E&C companies like Aecom, KBR, and Jacobs which are expected to benefit from government spending over the next few years.

While STN is expected to post higher EPS growth in the current year, the growth rates of other companies are higher in FY24. On FY24 consensus estimates, STN P/E is the highest among these companies. I like the company's good growth prospects but believe they are already getting priced in at the current valuation. Therefore, I have a neutral rating on the stock due to its high valuation.

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