Aecon Group 2.0

Following Up on Positive, Recent Developments

Updated Thought as of September 2024

Despite a nice move up since publishing on Aecon in late March, we actually think the risk-reward today in Aecon stock is more asymmetric and attractive than its been in years, including when we first got involved with the business in early 2024.

We've compiled a few tidbits below that we believe in aggregate sum to meaningful, near-term catalysts for the stock. We believe the removal of ARE's largest overhang is imminent; the market's fear that perpetual losses from the Toronto-based Eglinton & Finch LRT projects will remain ongoing. ARE’s final legacy project, the Windsor-Detroit Gordie Howe Bridge, has been running smoothly towards completion, further substantiated by JV-partner Fluor reaffirming ARE's guidance of a Q3/25 competition date during our recent conversation with them.

Here's what's happened with Aecon in the last few months:

• March 11th: ARE appoints, new CFO; Jerome Julier, a career investment banker with a long tenure as Aecon's banker, having helped broker Aecon's recent divestment of its commoditized, low ROIC road construction business for ~9x EBITDA in May 2023 while also being hired by Aecon to represent the business during Oaktree's strategic investment in Aecon's Utilities franchise in October 2023. We found Julier's decision to leave capital markets for Aecon after 20 years as an investment banker rather intriguing given a reputation and resume such as Julier's would have had numerous opportunities over the years to leave his seat. This combined with his long-standing relationship with Aecon and our view that the business is imminently poised for an inflection point further peaked our interest. We spoke to several former colleagues of Julier who had positive things to say

• Legacy Projects Are at the Finnish Line:

• June 28th: Aecon announces $110m in additional losses related to its 3 remaining legacy projects (Gordie Howe Bridge, Eglinton & Finch LRT and a $127m non-cash, non-recurring charge related to Coastal Gaslink; this project is now 100% complete taking Aecon from 4 troubled legacy projects to 3. Recall that financial accounting for E&C projects is highly complex and percentage of completion amongst other factors does require a reasonable degree of subjectivity. Given this dynamic, followed by additional disclosure on ARE's Q2/24 a month later along with several, large share purchases by Aecon insiders post Q2, we believe that with hindsight this update will have most likely amounted to a "kitchen sink" type clearing event for the stock.

• July 4th: following a conversation with the company and additional scuttlebutt we posted the following on Value Investors Club:

  • Spoke to the company earlier this week. Naturally it's a complex and fluid situation but do not see the revised legacy project charges as an Aecon performance issue. My current view is that the probability adjusted IRR I initially underwrote has come down modestly but as FC87 mentioned, the normalized earnings power and cash generation are unaffected. We think it's reasonable that CGL completion has put a 2H24 or Q1/25 NCIB on the table. (UPDATE: ARE announced 1st NCIB since 2020 on its Q2/24 conference call on July 24th)

  • We also don't believe an independent third party will view Aecon at fault for ongoing cost overrides and do believe it's reasonable to expect a cash recovery payment at some point in the future, similar to Gordie Howe in 2H23 and what was previously done for the Eglington project- https://www.ontarioconstructionnews.com/io-adjusts-contracts-after-settling-legal-claims-with-builders-for-covid-19-expenses/ we believe this lawsuit from the Eglinton consortium remains ongoing- https://www.cbc.ca/news/canada/toronto/eglinton-crosstown-crosslinx-sue-ttc-delays-1.6844693 as Metrolinx does not have a current contract with TTC drivers to operate the new assets unless that was included as part of the recently resolved TTC union strike.

  • We will get a more detailed breakdown of the $110 on the Q2 call in 3 weeks. The vast majority of it stems from the two LRT (Eglinton & Finch projects) the client for both projects is Metrolinx. Recall that backlogged revenue for these projects was just over $100m as of Q1. So why the big charge? Aecon's work on these projects is all but done but fixed costs remain ongoing until the project is officially complete, creating a revenue/expense mismatch. This view has been similarly stated by a variety of Canadian newspapers dating as far back as early 2023 which have highlighted project delays primarily related to software and employee training. Metrolinx provided their most recent update on Finch in May: https://www.metrolinx.com/en/news/major-vehicle-testing-milestone-on-finch-west-lrt and Eglinton last week: https://globalnews.ca/news/10585293/metrolinx-eglinton-crosstown-lrt-update-verster/ which again reference software and training as the primary bottlenecks for the project. We've done a lot of attempted scuttlebutt with those closer to the situation that has aligned with Aecon's views on the projects.

  • As far as timelines, my sense is the $110 covers any potential losses until year end. Further project delays likely mean additional losses from there on and given Metrolinx's incompetency this tail risk has to be acknowledged.

  • Metrolinx had previously stated that both projects would be completed by YE24 but have not provided an update in some time. Two weeks ago, TTC's (TTC operates the LRT assets on behalf of Metrolinx) outgoing CEO made the following comments : "we have a great announcement about increasing service at the beginning of September that I look forward to participating in!" the media and public assumed this was related to Eg and Finch but was quickly walked back by TTC PR, make of it what you will.

  • Despite these setbacks Aecon's business mix continues to derisk as these legacy projects wrap up, and new projects shift towards cost+. Aecon Utilities is accretively acquiring assets, and Aecon Nuclear is winning international contracts. The go-forward business has substantially reduced its invested capital against margins that are well above historical levels and sell side consensuses. Lastly, Aecon continues to trade at ~3x normalized EBITDA and a HSD cash flow multiple.

• July 24th: Aecon reports Q2 results, most notably management quantifies the assumptions behind the previous announced $110m charge while providing additional disclosure for the first time ever that Aecon believes the maximum, additional losses related to completing the 3 remaining legacy projects is $125m with all 3 projects to be complete by year end 2025. This is the first time Aecon has quantified its maximum remaining losses, we have seen this disclosure serve as a catalyst for SNC-Lavalin (fka AtkinsRealis) which quantified their remaining losses related to its fixed-cost legacy project portfolio on its Q4/22 earnings call in March 2023, shares have appreciated 83% since.

  • Additional updates on the call included Aecon launching its first NCIB for up to 5% or 3.1m shares. Outside of $23m in share repos in 2H19/Q1/20, Aecon has not re-purchased stock since 2013. Further, normalized margins continue to track in the HSD range, in-line with our initial thesis and well above the market's consensus expectations and we have not made meaningful changes in our 2025 EBITDA estimates, meaning Aecon is still trading at ~4x our estimate. 

• August 1st: Numerous Aecon insiders (3 board members, 3 members of senior management) begin purchasing shares, most notably ARE's new CFO Jerome Julier has purchased over $300,000 worth of shares across several transactions. To recap; in Aecon’s first full quarter with Julier as CFO; he takes a legacy projects writedown and quantifies his expectations for the maximum remaining losses related to these projects. With the stock temporarily retreating following these two announcements, Julier and 5 other insiders begin a rapid series of insider share purchases in early August.

• August 7th: ARE hires Tim Murphy as Chief Strategic Affairs Officer. We found this notable given Murphy's stacked resume in infrastructure finance and government affairs. Murphy's CV includes serving as Chief of Staff under former Canadian Prime Minister Paul Martin. In our view this helps validate our belief that Aecon is one of the most strategically important companies in Canada, participating in a government-sponsored oligopoly with numerous tailwinds despite current valuations that suggest Aecon's status as a going concern is not a guarantee. 

• August 8/15th: Aecon announces 2 new project wins totaling $650m (~10% of backlog). Recall that ARE's Go Expansion and Scarborough Subway Expansion contracts, are Progressive Design Build contracts opposed to fixed-price and will soon add an additional ~$4-5B to Aecon's backlog within the next 2-3 quarters. Once added this will dilute fixed price contracts from 47% of ARE's current backlog to ~25% when officially added.

• September 6th: Aecon initiates its previously announced NCIB with shares accumulated in the range of $18.25-$18.50

• September 9th: Aecon announces a new services contract with GE Hitachi Nuclear Energy in the UK. This is Aecon’s second recent international contract with GE Hitachi following a similar announcement in June for a fleet of nuclear reactors in Poland. Additionally, Aecon’s Nuclear business has announced recent contract wins in Virginia and Ontario. Prior to these 4 announcements, ARE’s Nuclear Business represented just under 20% of ARE’s Construction Segment’s trailing 12 month revenue or roughly $800m in revenue at accretive margins to the rest of the segment.

We continue to conduct ongoing scuttlebutt related to Aecon's Finch & Eglinton LRT projects. This includes several first hand accounts of both sites along with ongoing discussions with people close to both projects. While counter-party Metrolinx remains incredibly tightlipped, the most recent key development we have heard from several sources is that driver training has ramped significantly in recent weeks for both projects, a key remaining milestone before both projects can announce technical completion. This can be confirmed by simply driving alongside the Eglinton or Finch routes in which you will see a large number of trams running ongoing testing and training. Training is expected to take 4-8 weeks to complete which aligns with a late September, early October timeframe.

We believe a go-live announcement from Metrolinx for both projects remains probable by year end, ahead of both projects being fully complete by Q1/25 should an announcement come sometime in Q4/24. We expect an immediate positive reaction for Aecon's stock, cause it to gap up significantly.

With the winddown of these legacy projects we expect the normalized earnings power of the business to become indisputable within a few quarters. Aecon’s business absent legacy project related charges continues to showcase a high single digit EBITDA margin profile, one of the key points in our original thesis and one that continues to be largely ignored by the market.

Today Aecon remains a collection of oligopoly government services with numerous tailwinds and a step change in underlying business quality, trading at ~4x our estimate of next years EBITDA.