SNC-Lavalin was victim of fear

It’s clear SNC-Lavalin’s current problems have everything to do with corporate governance and nothing to do with accounting. So why has the stock taken a 24% haircut since bribery allegations tied to Libya surfaced earlier this year?

If SNC were actually embroiled in an accounting scandal, a 24% pasting would be understandable. When people think of accounting issues, they think of Sino-Forest, Nortel or Enron; something with inflated revenue, missing expenses, or phony assets. That’s simply not the case with SNC.

It’s partly the company’s own fault, however, since their initial press release mentioned the a-word in passing: “The investigation’s current findings support the Company’s accounting treatment of these payments.”

Someone should have been fired for that slip. It’s just not the kind of word to throw around lightly. You can be sure it set off alarm bells with investors, notwithstanding the fact that technically everything is an accounting issue when the financial statements have to be adjusted, no matter how small the amount.

In this case, alleged bribes were made and needed to be written off. But so far, those charges have totalled just $56 million on expected revenue of $7.6 billion and assets of $8.5 billion. Hardly the stuff of Enron fame. Even SNC’s loudest detractors have admitted the current issues have nothing to do with accounting.

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Once the issue is put in perspective, it makes little sense for bribery allegations to carve $1.8 billion off the market capitalization of the company. A quarter of the company should not have evaporated overnight because a lack of internal controls allowed $56 million in alleged bribes to go unnoticed.

With the hyperbole and fear-mongering stripped away, it becomes difficult to believe SNC won’t continue to perform largely as it has in the past—starting with its record $10.5 billion backlog of projects. So what’s a reasonable share price reaction to bribery revelations in a public company?

Moody markets

On April 22, the New York Times reported on allegations of rampant bribery in the Mexican division of Walmart. The article detailed that not only had the company confirmed widespread bribery as far back as 2005, but that top company officials actually squashed the investigation in its tracks, instead of expanding it on the suggestion of the lead investigator.

Walmart’s stock dropped just 4.7% in the following trading session, and has more than recovered since. The market’s contrasting reactions to the Walmart and SNC situations couldn’t be more perplexing. SNC took a massive hit even though its African projects account for just 16% of business. Further, unlike with Walmart, it wasn’t apparent from the start that SNC’s top executives knew about the alleged bribes in advance.

By contrast, Walmart Mexico had for years been seen as the growth engine for the global retailer. The number of retail outlets in Mexico has grown at a compound annual rate of 26% over the past 10 years. Thus, problems in the Mexican division are very significant to the overall outlook for the company, and should naturally alarm investors.

In addition, there were aggravating factors: specifically, revelations that Walmart executives possessed extensive knowledge of the bribes; actively covered up the investigations; and hid their discoveries from law enforcement agencies. Making matters worse, the executive in charge of the company’s international divisions—the largest being Mexico—is now the current CEO. And e-mails clearly show he knew the extent of the allegations back in 2005.

To put it mildly, the optics for Walmart are worse than for SNC. But, for simplicity’s sake, let’s assume an equal discount should be applied to SNC as to Walmart.

Placing a 4.7% discount on SNC’s pre-bribery allegation price (which was already down from $54 on pre-announcement rumblings) would put SNC’s stock around the $46 level, much better than the recent $39.50. Again, the only factor that might account for SNC’s disproportionate hit is the initial confusion over whether there was an accounting issue at SNC.

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In this regard, we can’t ignore that unlike SNC, Walmart didn’t have to contend with reports from analysts—who don’t cover the stock—making blustering accusations that fail to provide any quantification of the potential impact on SNC’s value.

However, simply applying a Walmart-level discount to SNC is fraught with possible errors, so it also helps to examine the reasonableness of SNC’s current share price on an absolute basis.

Share-price disconnect

From any angle you take, SNC trades at a considerable discount to its underlying value. The average target price by analysts on Bloomberg implies upside of 20% from the current price. At Accountability Research, we have a target price on SNC of $54, implying an upside of 37%. Most investors analyze the stock using a sum-of-the-parts methodology.

A major piece of the company’s value is represented by its ICI (Infrastructure Concession Investments). For instance, the company owns part of the 407 toll highway in Toronto, and the estimated value of SNC’s stake in 407 equates to roughly $10 for each SNC shareholder.

In total, ICI and cash represent roughly $26 in value per SNC share,meaning at the recent share price of $39.50, the rest of the company is being valued at just $13.50 per share.

Since we estimate SNC will make over $2 per share in engineering and construction earnings next year, the core business of the company is trading at 6.5 times earnings. Put another way, by using a more reasonable peer based multiple on the company’s core earnings, and factoring out the redundant cash, the company’s infrastructure investments are being valued at just $5 per share instead of $21 per share; representing a 75% discount in value.

Most important, bear in mind that our estimates—and those of the other 13 analysts on Bloomberg—already take into account the estimated financial impact of the alleged bribes, including but not limited to:

• further potential writeoffs;
• additional investigative, training, and compliance rollout costs;
• reputational fallout;
• potential fines; and
• potential class-action lawsuits.

Fortunately, these risks are largely quantifiable, and don’t add up to anywhere near the discount that has been priced into the shares. This seems to be part of the problem for some advisors (we’ve spoken to many on the issue). There are two kinds of risks: those that are already priced into the stock and those that aren’t. The risks to SNC have been more than priced in already.

Even in our worst-case-scenario analysis, the core business of SNC would still trade at only 10 times earnings, versus an average of 11.5 times for its peers.

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But this worst-case scenario assumes all of the company’s business in bribery-prone countries (including all of Asia, the Middle East, and the Caribbean) would disappear overnight. That’s a full 32% of the company’s overall revenue. Naturally, this wouldn’t happen, but it helps to illustrate the huge share-price disconnect.

Everyone in the market agrees the company does not suffer from any accounting issues. And while SNC has to address its corporate governance concerns, there is also massive underlying value in the company that is being ignored by the current share price.

Once the fear-mongers lose interest, it should not take long for the market to discover the opportunity that exists.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, run Accountability Research Corp., providing independent equity research to investment advisors across Canada.