Updates on Two Positions

Latest at 6736-T and ARE-TO

As noted in yesterday’s post, I am sharing quick updates on a couple of portfolio names, 6736-T and ARE-TO.

Sun Corporation (6736-T) — Initial post here, last update here

For those unfamiliar with the investment thesis, Sun Corporation is a Japanese-listed company trading at a large 50%+ discount to its NAV, comprised primarily of a 47% stake in the US-listed software company Cellebrite (CLBT). Below is an excerpt from my initial post summarizing why this situation is attractive:

There are admittedly a number of other Japanese 'discount to SOTP value' stories with comparable or even larger discounts, with the main uncertainty being if the underlying value can ever be realized. However, the key aspect of this setup is that there are two activists on Sun’s shareholder register who might help close the valuation discount. One of the activists, Leopard Activist Management, has already publicly pressured management to distribute the company’s stake in CLBT to equity holders. Another firm, the prominent Asia-focused activist hedge fund Oasis Management, owns 19% and holds one board seat. The presence of these two activists suggests that the underlying value might eventually be realized.

While there have been a couple of updates since the initial publication (as discussed in this post), the most notable development was in early June when True Wind Capital entered the field, launching a tender offer to acquire up to 19% of Sun Corporation’s outstanding shares at ¥4,400/share.

Since then, there have been several developments worth highlighting:

• This week, True Wind announced an extension of the tender offer expiration date from July 22 to August 5. As part of the extension, the PE firm adjusted the terms, raising the price to ¥4,750/share and lowering the minimum participation condition from 17% to 15% of outstanding shares.

• In response, Sun’s management has stated that it maintains a neutral stance on participation in the tender offer. As per the company's earlier comment, management will "leave it to shareholders of the company to decide whether or not they wish to tender their shares in the tender offer.”

Despite the improved terms, I continue to think that the tender offer is highly unlikely to go through. The offer still comes at a wide 52% discount to NAV, making it unlikely that the minimum participation condition will be fulfilled. The market holds a similar view, with Sun Corporation currently trading slightly above the offer levels.

Nonetheless, I think that this development is positive. Recall that True Wind is a reputable investment firm with c. $2bn in AUM and is led by two ex-KKR professionals who co-founded KKR’s Global Technology Group. Moreover, True Wind is highly familiar with Sun’s key holding CLBT, as the PE firm was a sponsor of CLBT’s SPAC and still maintains a stake in the company. Given the buyer’s background and familiarity with CLBT, I think the improved tender offer price underlines True Wind’s view of 1) the undervaluation of CLBT at the current stock price levels and 2) the chances of being able to successfully close the discount to NAV at Sun Corporation.

Given the ongoing tender offer and the involvement of other activists, I think Sun Corporation’s management might eventually yield to activist pressure and pursue a shareholder value realization path. While the exact outcome is far from clear, I believe that at the current stock price levels, the downside is well protected by the discount to NAV, which, despite recent developments, continues to hover closer to the higher end of the historical discount range seen over the last couple of years (0-70%).

Considering these investment setup dynamics, I continue to hold a hedged position (shorting CLBT at a hedge ratio of 4.3x) and will eagerly await to see how this situation unfolds.

Aecon Group (ARE-TO) — initial post here, last update here

Shifting gears to another portfolio name, Aecon Group, a construction and infrastructure development firm whose profitability is expected to inflect once the company completes legacy projects that have hindered its operational performance since 2021.

This week, ARE reported Q2’24 results. Below are my takeaways from the earnings release:

• Company’s operational performance, including revenue, margins and backlog, has generally been stable during the quarter, with management highlighting a positive outlook for the business.

• The company hinted that there might be significant additional write-downs related to the three remaining legacy projects until their completion.

Let’s unpack these in a bit more detail.

Starting with the operational performance. As expected, ARE reported weak Q2’24 numbers across the board due to the previously announced significant write-downs (C$237m recorded in Q2’24) related to the four legacy projects - see the slide below. However, adjusting for the impact of the legacy projects, revenues were flat while EBITDA was down 16%.

On the margin front, while ARE’s EBITDA margins (excluding the legacy projects) were down slightly in the quarter (8% vs 9.5% in Q2’23, explained primarily by certain projects benefitting Q2’23), margins remained stable on a TTM basis at 9%. But perhaps more importantly, during the conference call ARE’s management reiterated that TTM margins are a pretty good indicator of expected normalized levels. See the exchange from the conference call below:

You might recall from my initial post on ARE that one of my concerns was the sustainability of ARE’s ex-legacy project business margins. Prior to COVID, the company used to generate 4-6% EBITDA margins compared to 8-10% over the recent quarters (when excluding legacy projects).

So the fact that management remains confident on margin sustainability gives some reassurance that the actions taken over the recent years, including the divestiture of the lower-margin road building business in 2023 and an increasing focus on the design-build model projects (whereby ARE is exposed to capped cost overruns), will help the company maintain margins at significantly higher levels vs pre-COVID.

In the earnings release/call, ARE’s management maintained a positive outlook, noting that the demand for construction services in Canada remains strong. The backlog during the quarter was stable compared to Q1’24 and Q4’23, at C$6.2bn, and remains significant compared to ARE’s revenues (C$3.8bn on TTM basis). Note that the reported backlog does not reflect C$7bn+ of expected backlog from the company’s design-build projects that are expected to move into the construction phase next year.

The company also highlighted the growth opportunities for the Aecon Utilities business (c. 20% of ARE’s revenues) in the US, given the recent acquisition of Xtreme Powerline, a Michigan-based utility contractor. Given the Utilities segment’s significant growth over the recent years primarily in Canada (13% revenue CAGR during 2019-2023) and last year’s partnership with/investment from Oaktree, the segment might continue growing in the US through further M&A.

Moving on to the less positive news.

My previous contention that the legacy project costs were kitchen sunk with the previous write-down might prove not to be entirely accurate. In the earnings release, ARE announced that it might incur up to C$125m in additional write-downs related to the three remaining legacy projects by the end of 2025 when the projects are expected to be completed. The potential write-down would offset any “additional cost creep on the construction and development” of the remaining legacy projects.

This move is admittedly quite strange as it comes after ARE announced a $110m write-down on these legacy projects just a month ago. The previous write-down seemed to have already incorporated the expected completion delays in two of the projects (Eglinton Crosstown and Finch West LRT projects) and additional costs incurred in the Gordie Howe project.

Potential additional write-offs would likely prolong the timeline of the investment thesis, with the company potentially not reporting its clean financials, representing normalized earnings power, until after 2025.

However, while this is a slightly disappointing update, I do not think it is a thesis-breaking development. Firstly, at this point, it is not yet clear if the incremental write-downs will actually be incurred. ARE’s management has highlighted that its current estimate of total legacy project write-downs stands at C$110m, which was already recorded in Q2’24 financials (see the exchange from the conference call below).

Another aspect is that, even if the C$125m write-down is incurred in full, the likelihood of any further impairments appears to be low given the status of the three legacy projects. Eglinton Crosstown and Finch West LRT projects are near substantial completion (expected by the end of 2024 and early 2025), while the Gordie Howe International Bridge project has recently seen the completion of the bridge deck connection and is expected to be completed by the end of Q3’25. For reference, the backlog of the three legacy projects stood at C$269m as of Jun’24 vs. C$420m as of Dec’23 and C$330m as of Mar’24. So, I am inclined to interpret this as a neutral/slightly negative development, likely marking the beginning of the end of the write-down cycle.

Let’s now turn to valuation, as it is important to reassess what ARE’s profitability could look like when the legacy projects are completed. Below is the refreshed estimate of ARE’s normalized EBITDA on a TTM basis:

• -C$19m in TTM reported EBITDA.

• Plus C$368m in TTM legacy project write-downs. This is comprised of Q2’24 write-downs related to CGL (C$127m) and the remaining three projects (C$110m), as well as C$131m in write-downs recorded during Q3’23-Q1’24.

• Less C$6m in TTM EBITDA generated by ARE’s divested road-building business and the disposed 49.9% stake in Bermuda International Airport concession.

This would yield a TTM normalized EBITDA estimate of C$344m, implying a 3.6x multiple. This is substantially below ARE’s comps GVA, FLR, SNCAF, ACS-MC, and BDT-TO, which trade at 10x-20x TTM EBITDA multiples. Also note that ARE divested its lower-margin road-building business in 2023 for approximately 8-9x EBITDA, while the stake in the Utilities business was sold to Oaktree at a 9.3x TTM EBITDA valuation. As the legacy projects are completed and ARE’s profitability reaches estimated normalized levels, I expect the stock to re-rate closer to peer and divestiture multiples. Even a relatively minor 1-turn multiple uptick would imply a price target of c. C$20/share, implying a 30%+ upside.

ARE’s management seems to agree that at the current price levels, the company is cheap. Along with the earnings release, the company authorized a buyback (NCIB) for 5% of outstanding shares, subject to the approval of the TSX. I’d expect stock buybacks, once launched, to be a tiny positive, creating upward pressure for the stock.

Given the substantial potential upside, I continue to think that ARE presents a compelling and asymmetric investment opportunity, and I have maintained my position.