CA - Stantec: Remaining On The Sidelines

2023-11-23 08:28:43 ET

Summary

• Stantec Inc. has good growth prospects driven by renewable energy demand, aging infrastructure, and federal infrastructure funding.
• The margin outlook is also good with easing labor market and improved productivity.
• Valuation is expensive.

Investment Thesis

Stantec Inc. ( STN ) has good growth prospects as the company is poised to benefit from healthy end market demand driven by global shifts towards renewable energy sources and increasing environmental concerns, secular trends such as aging infrastructure, water management, climate resilience, and the reshoring of manufacturing in the U.S. The company should also benefit from multiyear tailwinds stemming from federal infrastructure funding, ensuring sustained healthy demand. Moreover, strategic M&A activities, including the recent acquisition of Environmental System Design (ESD) in the U.S. and Zetco Engineering in Europe, should also help STN expand its footprint and contribute to growth. On the margin side, the company should experience benefits from improved productivity, operating leverage, and moderating wage inflation.

However, with the stock trading at a premium to its historical averages as well as its U.S. peer AECOM ( ACM ) which has some similar growth drivers, I believe the positive outlook is already getting reflected in the stock, and the anticipated growth is already priced in. Hence, I opt to stay on the sidelines as the elevated valuation does not present an attractive entry point and my rating for the stock remains neutral.

Revenue Analysis And Outlook

In my previous article , I discussed Stantec’s good growth prospects ahead as a result of a healthy backlog level, multiyear tailwinds from federal infrastructure investments, good end market demand, and M&As. Since then, the company has reported its third-quarter 2023 earnings which reflected these dynamics.

In the third quarter of 2023, the company saw good revenue growth due to higher-than-expected demand in Canada and the U.S. segment driven by strong Water, Building, and Environmental Services end markets. In addition, the company also benefited from good backlog execution and the acquisition of Environmental Systems Design, Inc. (ESD). This resulted in a 13.5% year-over-year rise in net revenue, totaling C$1.3 billion. After excluding a 2.2 percentage point benefit from foreign exchange and a 2.3 percentage point benefit from acquisitions, sales increased 9% year-over-year organically.

Looking forward, I believe the company should continue delivering good revenue growth benefiting from a healthy backlog, good end-market demand, government infrastructure investments, and M&A.

Backlog, a good indicator for future revenue growth, is at a healthy level for the company. At the end of the third quarter, the company had a backlog of C$6.35 billion, and compared to the previous year, it increased by 2.3% with growth across all three segments due to strong demand in the end markets. However, when compared to the second quarter of 2023, the total backlog decreased by 3.4% sequentially. During the Q3 FY23 earnings call , management stated that this decrease was a result of improving backlog execution rather than any slowdown in the market, and bidding activity remains healthy. I expect the backlog to remain at healthy levels in the coming quarters given the strong end-market demand.

Speaking of demand, the outlook for end-market demand is healthy, driven by growing interest in renewable energy sources and global environmental protection efforts. Additionally, the need for modern and sustainable solutions is on the rise due to aging infrastructure and environmental considerations, across the globe. Moreover, recent challenges in the supply chain have highlighted the significance of bringing manufacturing back to the U.S. further contributing to the demand for the company’s services.

The good end market demand is further being supported by various government infrastructure investments like the Infrastructure Investment and Jobs Act (IIJA), the Inflation Reduction Act (IRA), and the CHIPS and Science Act. The company is seeing the flow of funds from some of these government stimulus programs and anticipates further acceleration. In the Q3 FY23 earning call, while answering a question, management commented ,

... on the timing, we are seeing that some funding starting to flow. It's always -- we've been talking about this IIJA now for a couple of years, and it's always -- we've been optimistic as an industry that it's this quarter, the next quarter, this half, the next half. But we are seeing that those -- about 23% of the IIJA funds have been dispersed. We're getting ready for the '24 allocations now. So that's starting to hit the street now. So I think that's only going to continue to strengthen. The interesting thing is that when you look at our strong performance year-to-date, that's been without really any of the funding from IIJA or some of those other things. So that's I think just going to further strengthen as we move into '24 and the years beyond.”

So, I expect the healthy end market demand coupled with the government infrastructure stimulus accelerating should act as a multi-year tailwind for the company’s revenue growth.

While the company is well positioned to grow organically in the coming years, it should also grow inorganically thanks to the company’s strategic M&As. In the second quarter, the company acquired Environmental Systems Design, Inc. (ESD), a building engineering-related service firm, with a focus on critical facilities and data centers. ESD helped the U.S. segment to post a 20.2% YoY growth in the third quarter with an inorganic growth contribution of 4.5% YoY.

If we look at the balance sheet health, the company’s net-debt to EBITDA ratio was ~1.5x exiting the third quarter, which is well within its target leverage range of 1 to 2x. This positions the company well to expand its footprint and grow inorganically moving forward with the help of its strategic M&As. Continuing with its strategic M&As, Stantec recently announced a deal to purchase Zetco Engineering, a prominent German infrastructure company. Zetco specializes in bridge certification and assessment, project and construction management for tunnels, roads, and rail infrastructure, along with building condition assessments, enhancements, and certifications. This move should support STN in broadening its worldwide footprint and achieving inorganic growth in the upcoming year.

Overall, I remain optimistic about the company’s revenue growth prospects.

Margin Analysis And Outlook

In the third quarter of 2023, Stantec’s project margins (gross margin) benefited from improving productivity. In addition, higher-margin project wins, and operating leverage also contributed to margin growth. This resulted in a 70 bps YoY increase in project margin to 54.8%, while the adjusted EBITDA margin increased by 160 bps YoY to 18.3%. In the quarter STN also faced expenses related to the company’s long-term incentive plan (LTIP), primarily due to STN’s strong share price appreciation in the quarter. Excluding this expense, the adjusted EBITDA margin was 18.9%.

Looking forward, I believe the company should continue to expand its margins. Over the last couple of years, rising employee turnover and strong wage inflation have had an adverse impact on the company’s margins and its ability to convert revenue to backlog. However, the labour market is now easing and the employee retention rate has increased with voluntary turnover down to pre-pandemic levels in North America. This should reduce costs associated with hiring and training moving forward and improve productivity, benefiting the company’s margin growth.

Moreover, the company has also started to see salary pressure softening. As, compared to the previous year, salary increases have reduced from 4% to 4.5% down to 3% to 3.5%, indicating moderation in wage inflation. This should also help the company’s margin growth as we move into 2024. In addition, the company’s margins should also benefit from operating leverage as revenue continues to increase. Hence, I am optimistic that the company should be able to deliver margin expansion in the coming year as well.

Valuation And Conclusion

STN is currently trading at a 22.16x FY24 consensus EPS estimate of $3.12 which is higher than its 5-year average forward P/E of 21.04x. The company’s valuation is also higher than its U.S. peer AECOM (trading at 19.39x FY24 consensus EPS estimates) which is exposed to some of the similar end-market and growth drivers like government stimulus.

While the company has good growth prospects driven by a robust backlog, good end-market demand, strategic M&A activities, and good execution, my concern remains centered on its valuation. In my view, the anticipated growth is already factored into the company's elevated valuation. While I am optimistic about the company's growth prospects in the upcoming year, the current valuation does not present an attractive entry point. Hence, I maintain a neutral rating on the stock.

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