Industrials | Sell Side Handbook

Contents

1 Industrials Primer
2 Aerospace & Defense Primer
3 Engineering, Procurement & Construction
4 Related Reading for Industrials

Industrials Primer

Industrials are companies that provide secondary activity (manufacturing and value-added services) and transportation and logistics, including the transport of those outputs. Canada has historically been a heavily industrialised nation and includes several as major components in the S&P/TSX 60. Separate airline and rail primers are provided, due to the relevance of Canadian Pacific Railway, Canadian National Railway, Air Canada and WestJet in Canadian transportation and infrastructure. Overviews of other industrial subsectors are provided on this page.

Industrials include:

Commercial Airlines & Passenger Flight
Heavy Capital Goods Dealers
Aerospace & Defense
Original Equipment Manufacturers (OEMs)
Engineering, Procurement and Construction (EPCs)
Air Freight
Railroads

Aerospace & Defense Primer

Aerospace & defense encompasses aerospace and aviation, robotics, advanced weaponry, space technology (including satellites – commercial and military), unmanned aircraft, surveillance and intelligence. Aerospace and defense is a unique business model that requires special relationships with government entities.

Given the USA’s global dominance in defense in terms of military spending and the sensitive nature of defense contracts, military business is largely restricted to US domiciled corporates (Boeing, Lockheed Martin, Raytheon, Northrop Grumman, General Dynamics), leaving most other corporates to compete in the less lucrative commercial segment. Nonetheless, Canada still has prominent A&D companies, including MacDonald, Dettwiler & Associates and Magellan Aerospace.

Aerospace & Defense Contracts

With aerospace & defense contracts, a commercial or government agency may ask for bids on a project, such as a satellite. Once companies who can satisfy the project will offer their price, and the buyer will consider factors including, but not limited to price and decide on who the winning bid is.

Once the project commences, revenue will be recognized on a percentage of completion basis, with payments coming in lump sums based on certain milestones. For instance, for a satellite project, the installation of a certain panel may constitute 25% of completion, and 25% of the revenue will be recognized.

The timing of cash flows themselves may be very different, with payments tending to come upfront, in part or entirely. As such, aerospace & defense projects may not be capital intensive despite the large capital expenditures from the buyer.

As with other construction contracts, A&D can also be bid on at cost-plus (cost plus a margin), but often these bids are fixed and may mean cost overruns translate to a loss for the construction company.

After the project is completed, there may be a warranty provision where the company must pay back a certain amount if performance is not carried out during the useful life. Alternatively, for satellite contracts, a certain amount will be logged as receivables (orbital receivables) where cash flows will continue to be paid for each successive year of performance.

A large difference between commercial and government projects (not exclusive to aerospace & defense) is that government projects are much less price sensitive (and therefore for contractors, much more lucrative from a return perspective, whether return on invested capital or return on equity.

The reason behind this is that government projects, especially regarding national security, have low tolerance for failure and are much more keen to accept a bid with a proven name such as Lockheed Martin or Boeing with low failure rates.

Backlog

The backlog is the number of contracts that have been bid on, won, and booked but have not yet been initiated and earned. A healthy backlog is good and ensures revenue streams on a go forward basis, but too large of a backlog can point to capacity constraints.

Book-to-Bill Ratio

Common in any sector with construction-like cash flows, the book-to-bill ratio is the comparison of new orders booked versus sales recognized. Although additions to the backlog are positive, if the book-to-bill ratio is excessively large and growing, it may mean that the company is leaving money on the table due to the time value of money. The company may want to invest in more capacity so that more cash flows can be realized earlier and customers are not lost if their needs are immediate and choose a competitor.

Sequester

Sequester or sequestration refers to budget cuts in government spending. For aerospace and defense, this is associated with the Democratic Party holding power in the Executive Branch (the Presidency). When budget cuts occur, the government puts out fewer projects for tender and defense stocks tend to fall.

Engineering, Procurement & Construction

Engineering, Procurement & Construction Industry Overview and Primer

Engineering, Procurement & Construction (EPC) companies plan and execute broad construction projects across all industries, government work and infrastructure. Corporates, governments and other organizations who require these services will put tender for bids, and the EPC company that best meets the requirements with their plan will be awarded the contract.

Stages in a project life cycle include planning and conceptualization, design, construction, project commissioning, maintenance, decommissioning (for example, a large oil project runs out of commercially extractable oil and must be plugged), and remediation (for example, a factory closes and the land needs to be decontaminated). EPC firms can consult and provide service across all parts of the value chain, with some specializing (a consulting firm) and some offering a full service offering.

EPC revenues are dependent on the underlying sectors that require service. For example, if there is prolonged strength in oil prices that justify the economics of new greenfield projects, EPCs with a strong oil and gas practice are poised to benefit. Large EPCs have strong practices across several industries (petrochemicals, mining, real estate, healthcare) that diversify cash flows and reduce cash flow volatility. However, aggregate work mandates will still be correlated with the strength of the overall economy.

Government mandates are much less dependent on the economy, and for certain countries, a recession could be a trigger for economic stimulus and infrastructure projects which the EPCs will design and consult on. Having a reputation for quality work across governments and industry is important for ensuring the EPC firm has a strong backlog of work to perform (signed and committed contracts).

As EPC is a human capital intensive, professional services model, similar to law, accounting, management consulting and investment banking, many EPCs continue to operate as partnerships. However, a large number of EPC firms have publicly listed.

Major EPC firms include URS, Fluor Corporation, Bechtel, Jacobs Engineering, SNC-Lavalin (Canadian), AECOM, Hatch (Canadian), Stantec (Canadian), CH2M, and Worley Parsons.

Engineering & Construction Business Model and Revenue Recognition

Gross revenue and net revenue are both reported. Many projects will involve work that the prime contractor will outsource or subcontract to another EPC firm, which depends on each firm’s core competencies and available staff. The prime contractor will pay the subcontractor, but the client will reimburse the prime for the subcontracted work.

The revenue that the prime receives for work performed directly is the net revenue. The net revenue plus subcontractor reimbursements is the gross revenue. Subcontracting is much lower margin for the prime than performing the value added work in-house.

The contract itself can negotiate for a fixed fee or variable fee contract. Revenue is recognized by stage of completion from a revenue-cost approach. Once a % of the estimated or budgeted costs have been incurred, that % of revenue will be recognized. Cash flow payments will align with this, with payments being released at each construction milestone.

Engineering & Construction Investment Banking in Canada

Major Canadian EP&C clients include Stantec, WSP Global and SNC-Lavalin. These firms fall under industrials or diversified coverage. The industry has undergone a lot of consolidation, with large firms such as Stantec acquiring specialized firms and partnerships (retiring partners looking for an exit to cash out).

As a largely human capital driven business, there are obvious cost synergies from having a more concentrated number of industry players as general and administrative costs can be made slashed easily. There will always be new firms starting up as well, so this trend will continue – and there will be no shortage of M&A opportunities for the investment banks.

As EPCs are generally not cash rich, purchases are funded via equity and debt issuance. These will usually be bridge financed by the corporate bank, who also provide EPCs with their corporate credit (via committed revolving credit facilities).

Stantec, SNC-Lavalin and WSP are all global firms with large foreign currency cash flow risk if funds are being repatriated to a Canadian treasury. As such, banks are also large providers of hedging solutions via the trading floor.

Prime Minister Justin Trudeau campaigned on an economic stimulus via public spending on infrastructure platform, and this will translate into road renewal, bridge renewal, tunnels and water system projects over the next few years. This may open up project finance and fundraising opportunities for banks down the road.

Public Private Partnerships (P3) Overview

The private sector is increasingly responsible for the construction and maintenance of public goods and infrastructure. P3s are a good way to incentivize efficient construction and maintenance of highways, mass transit and bridges while government control of influence is retained.

Under a P3 model, the private sector will design, build, own and operate (or any combination of the above) projects that are usually natural monopolies or utilities (competing highways would double the cost without adding to societal benefit). These utilities are allowed to earn a predetermined rate of return to equity that is fair to the private sector – which may be collected through tolls or payments via the government.

Organized labor and unions usually oppose P3 projects, but the model has worked well in countries such as Australia and has appeal to cash strapped governments who do not want to raise taxation.

Public Private Partnership (P3) Primer for Canada

In Canada, the most prominent P3s are large scale infrastructure projects that are privately operated over a long-term lease – as such the government will usually retain control of the asset. These will include highways, mass transit (Vancouver’s Canada Line) and bridges with tolls.

Other public goods separated by one or more levels of government including hospitals, schools, courthouses, auditoriums, airports and water systems, are also turning to the private sector to finance and build assets for sale at a fixed price – which is a way to ensure that there are no cost overruns for the client (EPCs will sometimes have onerous contracts that they are obligated to complete but the costs of performing/fulfilling already exceed the economic benefits/revenue).

Engineering & Construction Stock Valuation

EPCs are standard industrial companies that are valued on price/earnings, enterprise value/EBITDA and a discounted cash flow model. P/E and EV/EBITDA multiples bake in market assumptions for value drivers – EP&C revenue is affected by factors including government spending, population growth, commodity prices, electricity/power demand, the residual life of infrastructure (aging infrastructure requires renewal) and technological advances (are plans now more cost effective).

However, unlike other industrials, EPC is not capital intensive and tangible assets are a small component on the balance sheet. Much of the asset side is goodwill from acquisitions. Expenses are mostly labor, so the only appropriate way to look at an EPC firm is future cash flows. This speaks to the importance of reputation in the industry.

EPC stock analysts may have a view on government spending and will watch federal and provincial budgets closely, how large the deficits are and how likely the government will sustain those deficits.

On a firm specific level, analysts will look at gross revenue backlog and gross revenue compound annual growth rates to see if the company continues to win mandates (stable book-to-bill ratio, growing backlog). The less capital intensive and the more human capital intensive projects are, the higher the earnings multiple. Consulting services will be looked at more favorably then project management divisions (higher margin due to the higher value prescribed to human capital).

Cross sell opportunities are also good revenue drivers to be evaluated on a go-forward basis (as well as a possible merger play). If a EPC performs design work on a large oil and gas project, it is easier to bid on the remediation component from an environmental services standpoint after the project life ends.