Latest Thoughts On Two Ideas

Updates on ARE and STKL

Given several recent developments in a couple of portfolio names, I want to quickly share my thoughts. I think that the recent developments at ARE are worth a more extensive update, whereas the update on STKL is relatively minor.

Aecon Group (ARE-TO) — initial post here

For those unfamiliar with the investment thesis, ARE is a construction and infrastructure development firm whose profitability since 2021 has been negatively impacted by losses on four legacy projects due to COVID-related construction delays and significant cost inflation, coupled with the fixed-price nature of these projects. However, with the legacy projects finally approaching completion, the company appears to be on the brink of a substantial profitability inflection. On a normalized EBITDA estimate, the company trades at a 3x multiple, a substantial discount to peer valuations of 6x-14x EBITDA.

Last week, ARE provided an update on its four legacy projects:

• The company announced an arbitration settlement on the Coastal GasLink (CGL) Pipeline project. The settlement is expected to have no cash impact on ARE, while the company will record a C$127m non-recurring charge, which will be reflected in Q2’24 results.

• ARE also expects to record a write-down of c. C$110m related to the remaining three legacy projects in Q2’24.

Let’s start with the CGL Pipeline arbitration settlement. As a brief background, ARE and its JV partners previously put forth a legal claim to receive compensation for the increased costs related to the construction of the CGL Pipeline. While ARE also submitted claims for compensation related to the other three legacy projects, none of these claims have been in litigation or arbitration (as opposed to the CGL Pipeline project).

While the terms of the settlement have not been disclosed, the announced figures (i.e., the expected no cash impact and C$127m non-recurring charge) point to a slightly disappointing litigation outcome. ARE’s management has previously hinted that any write-downs related to the litigation would reflect any difference between the litigation/arbitration outcome and the litigation claims raised by ARE and its JV partners - see the quote from the Mar’24 conference call below. So the write-down seems to indicate that the settlement terms were worse than those pursued by ARE and its JV partners.

Yes. I mean when it comes to our positions on the legacy jobs, we essentially -- we take a position on our claims with our partners and based on legal entitlement and the values. And essentially, if there's an outcome that differs from that, we could either have a write-up or a write-down. But our positions are based on the best information that we have based on legal experts. And so any difference would arise from an outcome that's different from what the JV partners have on the 4 legacy projects.

However, despite this, I think this development is a positive for the investment thesis. The key point here is that the company is finally behind one of the four legacy projects, meaning that there will be no write-downs related to the CGL Pipeline project.

Moving on to the remaining three legacy projects.

The expected write-down of C$110m in Q2’24 related to the three projects is admittedly large, given that total legacy project write-downs stood at C$81m, C$91m, and C$40m during Q2’24, Q3’24 and Q4’23, with no write-downs recorded in Q1’24.

However, it seems that the large write-down might be the last major charge related to the legacy projects, potentially indicating the end of the write-down cycle. Several arguments suggest that this might be the case:

• The large non-recurring charge related to the CGL Pipeline gives ARE’s management a nice opportunity to also record write-downs related to the three remaining legacy projects (i.e., ‘kitchen-sink’) in the same quarter. This will most likely position the company to report financials without the impact of legacy project write-downs in the coming quarters.

• A look at ARE’s legacy projects suggests that the construction of two of the legacy projects, Finch West Light Rail Transit and Eglinton Crosstown Light Rail Transit, has been nearly completed, implying minimal additional charges. The remaining project, Gordie Howe International Bridge, is expected to be substantially completed in Sep’25 (74% completed as of May currently according to ARE’s JV partner FLR). However, it is worth noting that in Feb’24 FLR announced a $69m settlement on its claims related to the project.

• The C$127m to-be-booked charge is very significant compared to the $330m remaining backlog on the three legacy projects as of Mar’24. Given the pace of backlog reduction over the recent quarters (backlog stood at C$528m as of Sep’23 and C$420m as of Dec’23), the backlog seems likely to be fully worked off over the coming year.

If my read of the situation is correct, this is a positive for the investment thesis, indicating that after Q2’24 results, the company will be in a position to finally generate EBITDA that is much closer to its normalized profitability. This should catalyze a significant stock price re-rating. Given ARE’s current undemanding valuation of 3x normalized 2024E EBITDA, even a tiny 1-turn multiple uptick would imply a share price target of C$22+ or over 30% upside. Considering the valuations of ARE’s peers (6-14x) and where the company fully/partially sold several of its business segments over recent years (8-9x), this multiple is likely too conservative, and investors could expect a more significant multiple expansion here.

I will be awaiting Q2’24 results, scheduled for July 24, to refresh the normalized EBITDA estimate and the company’s valuation. In the meantime, with the investment thesis intact, I continue to like ARE.

SunOpta (STKL) — initial post here, last update here

A quick update on the STKL ‘short’ idea: last week, the company announced the completion of a $26m expansion of its Modesto, California plant. The expansion was related to the facility’s oat extraction production line.

While the expansion has been previously announced and the completion timeline is in line with management’s previous guidance, this is yet another indication of additional capacity entering the plant-based milk market. STKL expects that the expansion will allow it to “increase the amount of oat milk produced annually by more than 60%.” While the company does not provide a breakdown of plant-based milk sales, management has hinted that oat milk is one of STKL’s key plant-based milk product subcategories, suggesting that the expansion is likely to noticeably increase plant-based milk supply in the US.

One noteworthy risk here is that, unlike other plant-based milk subcategories, oat milk has seen sales growth over the recent years/quarters (e.g., see several quotes from STKL’s Feb’24 conference call below). So it is possible that the incremental oat milk supply will get absorbed by growing demand, leading to stable or even increasing oat milk pricing. However, given the expected size of the projected oat milk production capacity expansion, I think the impact on pricing is more likely to be negative.

Now let me offer some additional color on the Q4 results. In the beverage and broth product group, revenues increased 19% to $147 million. The growth was over 100% attributable to volume and mix, reflecting share gains with existing customers, the addition of new customers and TAM expansion. This product group represented 81% of our Q4 revenue. Growth in oat milk was incredibly robust and remains a key driver as it has been for over 3 years.

[…]

We definitely saw oat driving growth in the category, foodservice as well as our co-man business and private label business. So we saw oat as a driver. Remember, we also anticipated that and our oat extraction line in Modesto is in place. It's coming online in the first quarter, and we expect it to be positively impacting profits in the second quarter. So we foresaw the oat expansion.

Another risk is that even if oat milk prices move lower, the expansion will allow STKL to increase volumes, implying that the company might still be able to display solid growth. This is admittedly a risk; however, given the potential impact on margins, the company’s profitability could face pressure, which might catalyze a downward stock price re-rating.

As it stands, I think this announcement is a small positive/neutral development for the investment thesis, and I have maintained my short position in STKL.