New Portfolio Idea — ARE.TO
Construction and infrastructure development firm on the cusp of substantial profitability inflection
In this newsletter, I share summaries of attractive investment ideas sourced from the Value Investors Club and incorporated into my personal portfolio. These summaries will be complemented by regular updates on key developments impacting investment theses. My aim with Idea Hive is to document my own portfolio management process while also enabling readers to quickly grasp and follow attractive investment opportunities.
Today, I am back with a new portfolio idea, Aecon Group (ARE.TO). ARE was pitched on VIC in late February. You can read the full write-up here. I think ARE presents one of the more intriguing investment setups I have come across recently.
Just a quick note before diving into the idea: I have already identified several other interesting starting positions for the Idea Hive portfolio, so you can expect frequent posts over the coming weeks.
Without further ado, let’s explore the investment idea.
Aecon Group (ARE.TO)
Elevator Pitch: Construction and infrastructure development firm on the cusp of substantial profitability inflection.
Current Price: C$17.03
Target Price: C$35+
Aecon Group is a C$1.1bn market cap construction and infrastructure development firm providing services including design, procurement, and construction, with a focus on Canada.
The crux of the investment thesis is that ARE’s profitability since 2021 has been negatively impacted by losses from its four key legacy projects (signed before 2019) due to a perfect storm of Covid-related construction delays and significant cost inflation coupled with the fixed-price nature of these projects. The company was forced to record significant write-downs on the legacy projects of $66m, $120m, and $215m in 2021, 2022, and 2023 respectively. This compares to $239m, $219m, and $143m in total EBITDA (including write-downs) generated by ARE during the same three years. These write-downs have caused a number of EBITDA estimate misses since late 2021, leading to a significant share price drop as investors had seemingly lost faith in the company.
However, four legacy projects are now finally approaching completion, with one project completed in 2023, two expected to be completed by the end of 2024, and the final one during 2025. With these projects set to fade into the background shortly and the write-down cycle expected to come to an end, ARE now appears to be on the brink of a substantial profitability inflection.
Here’s how ARE’s normalized EBITDA could look in 2024:
$143m in 2023 EBITDA.
Plus $215m in 2023 legacy project write-downs.
Less $25m in EBITDA generated by ARE’s recently sold road-building business and 49.9% stake in Bermuda International Airport concession.
Assuming a 5% organic growth rate, this would result in 2024 EBITDA of $350m or a massive 2.5x above 2023 levels.
This estimate would imply an EV/EBITDA multiple of 3.1x. This valuation is too low given a number of reference points:
ARE’s estimated forward EV/EBITDA multiple is at a steep discount to ARE’s peers trading at 6-14x multiples (see table from Feb’24 below). Keep in mind some of these companies are ARE’s joint venture partners in the legacy projects.
Back in 2017, Aecon agreed to be acquired by Chinese company CCCC International Holding at 9.6x TTM EBITDA. However, the transaction was eventually blocked by Canada’s regulators on national security grounds.
In May’23, ARE sold its lower-margin road-building business in early 2023 for $325m or c. 8-9x EBITDA. The divested asset generated 7% of ARE’s 2022 revenues.
In Oct’23, Oaktree Capital Management acquired a 27.5% stake in ARE’s utility business at an implied EV of $750m or 9.3x TTM EBITDA. ARE’s share of EBITDA generated by the Utilities business at the time of the transaction stood at $58m or c. 40% of total EBITDA.
Pro-forma for the value of ARE’s utilities business, the company’s remaining 50% Bermuda Airport concession stake, and net cash, the core business is currently valued at less than 1x 2024E EBITDA (see table from Feb’24 below).
So, this is the investment thesis in a nutshell. What follows is a discussion of the two potential points of pushback. However, there seem to be decent counter-arguments against each of them.
The first point relates to how sustainable ARE’s ex-legacy project business margins are. Excluding the legacy projects, the remaining business has displayed record-high 10% EBITDA margins on a TTM basis. This compares to the 3% company-reported margins over the same period and the 4-6% levels prior to Covid (2016-2019). This could suggest that the remaining business has been overearning and hence the 2024E EBITDA estimate might be overly optimistic. However, several points suggest that higher margins are likely to be maintained going forward, including 1) the fact that Aecon divested its lower-margin road building business in early 2023, 2) the nature of ARE’s new progressive design-build model whereby the service provider (i.e., ARE) is exposed to capped cost overruns while also benefitting from costs coming in below budget and 3) the challenging operating environment that has led to some of ARE’s competitors leaving certain markets. You can find more details on these points in this extensive comment on the Value Investors Club.
The second risk is that the recent-year write-downs could reoccur in the coming years. Construction and infrastructure development firms often win projects if they manage to offer the lowest price. This could eventually lead to losses or write-downs as the companies might have potentially been able to offer the lowest due to miscalculations regarding project costs. However, what might give some confidence that the write-downs will not reoccur is that ARE did not experience material write-downs during 2017-2020. Moreover, the company has been steadily increasing its exposure to cost-plus vs. fixed-price contracts, with the revenue share of cost-plus contracts at 58% in Q1’24 (vs. 54% in Q1’23).