Friday, 9 March 2012

SNC-Lavalin: More trouble ahead or buying opportunity?

At 7:32 am on February 28th, engineering giant SNC-Lavalin (TSX: SNC) issued a blandly titled press release about revisions to 2011 financial results. Though the amounts involved were small for a company SNC's size, at the open of trading, SNC's stock dropped 20% and it has not recovered since as the screen capture below from Google Finance shows.

Investors are wondering (disclosure: including this blogger who owns some SNC shares) - are we looking at the beginnings of another Nortel, Bre-X or Sino-Forest disaster, or is this a one-off bad knock to a solid company that will recover? Ray Turchansky's Keep your head when a stock stumbles to a loss in the Edmonton Journal talks of some past stock disasters and survivors. He gives sensible advice about the kinds of factors to weigh before buying a bargain on the dip (some dip!) or selling out before worse news ensues e.g. is it a one-off event by a rogue person or two, or a widespread corporate culture issue; what effect will it have on current and future financial statements; how does management react? Unfortunately, he does not provide any answers to the questions ... so we will go searching for relevant information to try to fill the gap.

The Problem Situation
  • "A loss of approximately $23 million from a revised position of the Company's net financial exposure on its Libyan projects; Unfavourable cost reforecasts on certain projects in its Infrastructure and Environment and Chemicals and Petroleum segments; and Period expenses of approximately $35 million relating to certain payments made in the fourth quarter of 2011 that were documented to construction projects to which they did not relate and, consequently, had to be recorded as expenses in the quarter" (from the press release). This represents an 18% reduction in 2011 profits. There is an ominous reference in the press release to on-going investigation of "certain other contracts", suggesting more adjustments will be made.
  • A few weeks earlier on February 9th, two senior executives suddenly left the company without explanation (press release here). One of them, Riadh Ben A├»ssa was Executive Vice-President, reporting directly to the SNC CEO and had been in charge of operations in Libya.
  • A Quebec law firm seeks to launch a class action lawsuit against SNC for $250 million in damages (see this Financial Post report of March 3)
  • A securities analyst cited in the Financial Post article speculates that for SNC to fix its problems might cost $300 million on things like investigation, fines, severances, legal defence, new monitoring and control systems.
Widespread Corruption?
  • As the result of a World Bank request, the RCMP in September 2011 raided SNC's Toronto offices (per the Wall Street Journal) in an investigation of allegations of bribery in seeking a contract in Bangladesh. No charges have been laid and there has been no further news.
  • Google searching for the words "SNC, corruption, bribery" brings up only a power project in India from the 1990s in addition to Libya and Bangladesh.
  • SNC was close to the former Gadhafi regime in Libya - see January 14th Globe and Mail, March 1st CBC News. So far, there seems to be no police investigation into SNC's Libyan activities.
Accounting Shenanigans?
  • Of the list in our previous blog post about financial manipulation fraud warning signs, SNC matches a couple - the unexpected departure of senior executives and the delay in financial statements. The other indicators of bad accounting don't match SNC.
  • Martin Fridson and Fernando Alvarez' book Financial Statement Analysis mentions various tests of financial statement numbers for manipulation and fraud. SNC matches one - growing sales, but exhibits data strongly opposite to fraudulent statements on the other measures - number of days' sales in receivables (down instead of the worrying up), asset quality trend, trend in depreciation and gross margin evolution (see many of SNC's good looking financial metrics on ADVFN)
  • Deloitte and Touche have been SNC's auditors for years and have not issued any reservations with regard to financial statements, nor have they bailed out yet following the recent developments.
Governance and Ethics, Good or Bad?
  • The Board of Directors, through its Audit committee, not management, has taken charge of the investigation as the SNC press release noted. That the Board should lead makes sense given that management's possible role or complicity in any wrong-doing is one of the bigger questions at the moment. SNC has a substantial Code of Ethics and Business Conduct but is it generally followed and enforced?
  • The Board's involvement apparently began after an anonymous SNC insider sent a letter making allegations in December 2011 according to this CBC News report of February 28th. The Board responsiveness could be taken as encouraging though it leaves open the question of how the improper activities could have arisen in the first place.
  • A Bloomberg Business Week article by Diane Brady asks about SNC, When did the moral compass break? It cites Libyan ties and suggests there may be some with Syria.
  • The latest annual ratings of Board quality by the Clarkson Centre for Business Ethics and Board Effectiveness at the U of Toronto Rotman School of Management gives SNC a very high rating amongst Canadian companies.
  • In 2010 corporate responsibility magazine Corporate Knights ranked SNC as the 7th, out of 50, most socially responsible businesses in Canada, though Larry Macdonald of Canadian Business asks whether that should still be so.
  • Noted corporate ethics activist and major SNC shareholder (and formerly a Board member) Stephen Jarislowsky expresses confidence in SNC in this French language Canoe.ca article and tells the reality of doing business in countries where corruption is endemic.
Business Repercussions?
  • Possible reputation loss or even outright debarring from contracts is discussed in general terms by the World Bank's anti-bribery Integrity Vice President in this Globe and Mail piece. World Bank contracts are a small part of SNC revenue.
  • Total revenue from Libya in 2010 when operations were at full bore, came to $418 million, or 6% of SNC's revenues per the Management Discussion and Analysis.
Stock Opinions
  • Post price fall, the average rating of eleven stock analysts for SNC is 2.27, a weak buy, according to TMX whereas before the fall, the rating was 1.17, a strong buy. As of March 9th, three analysts rate SNC a strong buy, two as a moderate buy and six as a hold. Yahoo Finance (using Thomson/First Call as source) shows SNC rated strong buy by six analysts, buy by seven and hold by two. Yahoo's ratings are more or less the same after as before the fateful press release. There are no sell ratings among them.
  • TMX shows an analyst average 12-month price target of $52.20 while Yahoo's is $50.87.
  • A National Bank analyst is quoted in the Globe and Mail as recommending not to buy at the current price, though he sets a price target of $45, which is well above the current $39 or so price. A BMO Capital Markets report, available only through BMO Investorline, goes through a valuation to arrive at a $40 price value for SNC stock. More analyst speculation is in this CBC News March 1st posting.
  • Bond rating agency DBRS put SNC credit rating of BBB (high) under review while waiting for developments. Its reason is that "these latest developments could indicate possible deficiencies in the Company’s risk management and project control systems". The rating could be revised downward "in the event that the currently identified issues indicate more widespread problems in SNC’s risk management systems or business model, which could cause material damage to the Company’s capability to acquire, manage or execute on new projects".
  • Short interest on SNC is impossible to obtain online without subscribing to a paid subscription service but the stock does not appear in the latest February 29th list issued by TMX (day after press release) of the twenty most heavily shorted stocks on the TSX. Short sellers aren't betting heavily against SNC.
How does this all add up? A one-off problem with a few people going beyond the rules for a limited number of transactions in Libya who got caught early enough because one employee abided by the company's ethics code and blew the whistle? In this case, the stock troubles are temporary and there is a buying opportunity. Or is it a wider problem that indicates serious future trouble for the company and for investors, where the path leads downwards to further losses? For now, on the balance of probabilities, this shareholder is not selling.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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