Stantec Inc. (STN) Earnings Call Transcript

welcome to Stantec's Second Quarter 2023 Earnings Results Webcast and Conference Call. Leading the call today are Gord Johnston, President and Chief Executive Officer; and Theresa Jang, Executive Vice President and Chief Financial Officer. Stantec invites those dialing in to view the slide presentation, which is available in the Investors section at stantec.com. Today's call is also webcast. Please be advised that if you have dialed and while also viewing the webcast, you should mute your computer as there is a delay between the call and the webcast. All information provided during this conference call is subject to the forward-looking statement qualification set out on Slide 2, detailed in Stantec's management's discussion and analysis and incorporated in full for the purpose of today's call. Unless otherwise noted, dollar amounts discussed in today's call are expressed in Canadian dollars and are generally rounded. With that, I'm pleased to turn the call over to Mr. Gord Johnston. Please go ahead.

Good morning and thank you for joining us today. Stantec has delivered another quarter of strong performance. We continue to execute on our strategy and drive excellent results with solid project execution across all areas of the business. We're delivering some of our highest organic growth rates ever with market fundamentals and demand for our services as strong as I've ever seen them, in my 35-year career. It's the expertise and commitment of our employees that drive Stantec's ability to capitalize on the favorable market environment. As we continue to lead into our core value of putting people first, I'm very pleased that our recent employee survey shows that Stantec's employee engagement continues to strengthen. Corresponding with this, is the continued downward trend for voluntary turnover, which is settling back to normalized pre-pandemic levels. Similar to the first quarter, Q2 was one of our busiest quarters ever for hiring, and we are now at over 28,000 employees strong. With a highly engaged workforce and robust outlook in our markets, I'm very excited about the second half of this year and beyond. And I'd also like to make special mention of 2 other highlights from the quarter. On June 30, we continued to execute on our growth strategy as we closed the acquisition of Environmental Systems Design and I'd like to welcome our new colleagues to the Stantec team. ESD brings their expertise in mission-critical facilities and data center design to Stantec, deepening our strength in smart building engineering capabilities that support the workplace of the future and the emerging trends of decarbonization, building repositioning and adaptive reuse. Next, I want to say how proud I am of Stantec's continued recognition as one of the best corporate citizens in Canada. This stems from our commitment to doing what's right and continuously advancing our environmental, social and governance practices. We've been recognized by Corporate Knights for the 14th time, being ranked first in the engineering and construction category and fifth overall for Canada's Best 50 Corporate Citizens. Turning to our second quarter results. I'm very pleased to report that we've outperformed our expectations as we continue to capitalize on strong drivers while delivering disciplined project execution and operational efficiency. We grew our net revenue by 15% to $1.3 billion, with organic growth of 11%. Our teams across the entire business continued to deliver significant value, with solid double-digit growth in Water, Environmental Services and Energy & Resources and high single-digit growth in Infrastructure and Buildings. We've now grown organic net revenue in each of our regions and business operating units for 6 consecutive quarters. We also continued to drive solid margins resulting in a 19% increase in adjusted EPS. On the strength of our performance to date and our expectations of continued favorable tailwinds, we've raised our guidance for net revenue and adjusted EPS for the year. And Theresa will speak more about this a little later on in the presentation. Looking at the U.S., our teams delivered net revenue growth of 18% in the quarter with 12% organic growth and we achieved organic growth in each business line. Water, Buildings and Energy & Resources all delivered solid double-digit organic growth. Water was driven by projects related to advanced manufacturing, drought resilience planning, water security and water reuse. And we're also seeing a ramp-up of PFAS projects, supporting water utilities as they proactively work towards solutions to the upcoming U.S. EPA regulations. In Buildings, organic growth was driven by strong demand in health care, industrial and advanced manufacturing. Work in the commercial and science and technology subsectors also helped drive strong results in buildings. And our Energy & Resources business continues to see significant activity related to power transmission and reservoir and dam projects. So our U.S. business continues to perform extremely well. In Q2, Canada achieved 10% organic net revenue growth with double-digit growth in Environmental Services, Infrastructure and Water. Environmental work accelerated for permitting and archeological services to support energy midstream and transportation projects, while significant bridge and highway work in British Columbia and major roadworks in Alberta were the primary drivers for the growth in infrastructure. In Water, growth was driven by major projects like the Iona Island Wastewater Treatment Plant in BC and the basement flooding program in Toronto. Energy & Resources continued to see growth driven by work related to power transmission and distribution projects and renewable energy. Year-to-date, Canada has had higher growth than expected and our teams have been able to capitalize on this dynamic. Our global operations also delivered another quarter of solid revenue growth. Net revenue increased 12%, with almost 11% from organic growth. Double-digit organic growth was achieved in Water and Energy & Resources. Our leading global water team continues to deliver significant value, supporting long-term framework agreements and investment in water infrastructure in the U.K., New Zealand and Australia. Energy & Resources increased their net revenue through work on the Coire Glas pumped storage project in the U.K. as well as through mining activities for copper and other metals in Latin America, which will support the energy transition. And now I'll turn the call over to Theresa to review our financial results in more detail.

Thank you, Gord and good morning, everyone. As Gord mentioned, we did deliver another very solid quarter. In Q2, we grew gross revenue by 19% and net revenue by 15%, achieving $1.6 billion and $1.3 billion, respectively. Project margin increased 30 basis points to 54.3% and was up quarter-over-quarter in all of our business regions demonstrating our strong project execution. In Q2, we again saw a material increase in our share price and this drove a further upward revaluation in our long-term incentive plan which amounted to $7.3 million of additional admin and marketing expense and 60 basis points of EBITDA margin. Even with this headwind, adjusted EBITDA margin was 16.9% for the quarter, up 20 basis points from Q2 last year and margin would have been 17.5% without this noncontrollable expense. As we noted last quarter, when this dynamic also occurred, our guidance target for adjusted EBITDA margin excludes this LTIP revaluation impact. But either way you look at it, our EBITDA margin reflects our success on relentlessly driving operational efficiency. Our Q2 diluted EPS was $0.79 compared to $0.55 in Q2 last year and adjusted diluted EPS increased 19% to $0.99 compared with $0.83 last year. Without the LTIP revaluation expense, adjusted diluted EPS would have been $1.04. Looking at our liquidity and capital resources, our strong revenue growth and operating efficiencies led to positive operating cash flow of $68 million for the year-to-date compared to $2 million from the same period last year. Recall that last year's operating cash flow was lower, driven primarily by the Cardno financial system integration. DSO at the end of June was 81 days, consistent with the last couple of quarters, as net debt-to-adjusted EBITDA was 1.8x, up slightly from last quarter, mainly due to funding the Environmental Systems Design acquisition, which closed on June 30. I'll turn it back to Gord now.

Thanks, Theresa. Our backlog grew to an all-time high of $6.6 billion in the second quarter, an increase of over 11% from December 2022. Backlog for each of our geographic regions has grown organically and this has been most pronounced in the U.S. and Canada, both of which delivered 12% organic growth, coming predominantly from Water, Buildings and Environmental Services. Backlog in Water continues to increase with wins around water security, wastewater treatment solutions and water requirements for power generation to support the energy transition. AMP7 in the U.K. continues to see record levels of investment and we are already securing backlog for AMP8. Buildings grew backlog through wins in almost all of their subsectors, particularly in healthcare and industrial. Buildings also benefits from the backlog brought in through the acquisition of ESD. Environmental Services backlog reflects additional project wins related to environmental assessments, including natural resource surveys, regulatory permitting and environmental monitoring for construction projects. Our backlog represents approximately 13 months of work, remaining consistent with last quarter. Our major project wins in Q2 continue to follow the key trends of aging infrastructure, reshoring of domestic production and climate change. Our Water group continues to drive significant growth, being selected for a number of new projects, including the Queensway Sewer and Watermain project in the Regional Municipality of [ PO ] Ontario; and the Apache Junction water reclamation facility expansion in Arizona. Our infrastructure team was recently selected to provide engineering services for the steel repair and corrosion protective coating program for the Macdonald Bridge in Halifax, Nova Scotia. And we're also selected for major design work for Deerfoot Trail in Calgary, which is the busiest freeway in Alberta. Our Energy & Resources team continues to build on our success with yet another major pumped storage hydro project. Through our joint venture, Water2Wire, we were selected to provide the front-end engineering and design for the Pioneer-Burdekin pumped hydro project in Queensland, Australia. At 5 gigawatts, this is expected to be the largest pumped storage project in the world. The energy transition continues to be a strong driver of growth. At the end of July, we were selected by Pattern Energy as the owner's engineer for the SunZia Transmission Project. This project is part of one of the largest clean energy infrastructure initiatives in the U.S. and will deliver 3,000 megawatts of clean power to communities in the Southwest region. Although this is not receiving IRA funding, it's a great example of investment being made towards renewable energy with or without government funding. And we've been engaged to provide advisory services in the development of proposals for the regional clean hydrogen hubs in the U.S. The Department of Energy expects to select approximately 10 hydrogen hubs, which would be allocated a combined total of up to $7 billion in IIJA funding. Hydrogen is expected to play a key role in the energy transition and Stantec is well positioned to capture further opportunities here.

So now turning to our outlook for the year. With a great start to the year and continued favorable market fundamentals, we remain confident in our ability to deliver another very strong year of financial performance. As such, we've revised several components of our outlook for the full year. We've raised our net revenue growth target for the year to 10% to 13% and now expect organic revenue growth to be in the high single digits. In the U.S., we're raising our expectation for organic net revenue growth to be in the low double digits. This growth is being propelled by continued -- the continued imperative to solve water scarcity challenges, protect against severe weather events and transition to a net zero future. We are starting to see government's stimulus funding flow and this is beginning to form in our backlog. We expect continued opportunities to arise with momentum increasing in the second half of this year and a ramp-up in revenues beginning next year. In Canada, we're raising our guidance to mid-single-digit organic growth. This is on the strength of our year-to-date performance and our confidence in sustained high levels of activity for the balance of this year. We do have very high comps to measure against from the second half of last year, so we anticipate our annual growth rate will moderate but remain very robust, nonetheless. In Global, we continue to expect mid- to high single-digit organic net revenue growth for the year with strong momentum driven by water and energy resources. Our performance for the first half of this year and confidence in our ability to maintain operational excellence has led to narrowing the range of our target EBITDA margin to 16.3% to 16.7%. And we're raising our guidance for adjusted diluted EPS growth to 12% to 15%, which results in a range of $3.50 to $3.60 per share. Again, I would reiterate that our target ranges have effectively been normalized to exclude the revaluation of our share-based compensation, which is largely beyond our control. In other words, our target margin range should be thought of as being comparable to the 17.5% we achieved in Q2. Likewise, our target adjusted EPS range of $3.50 to $3.60 would be comparable to our Q2 adjusted EPS of $1.04. So as Gord stated at the beginning of this call, we are very excited about the second half of this year and well beyond. And we believe that we have the right team in place to continue delivering superior results. And with that, I'll turn the call back to the operator and we'll take your questions.

[Operator Instructions] Our first question comes from Benoit Poirier with Desjardins.

Yes. And congratulations for the solid results and very nice to see the strong fundamentals across the board. Just first question, with respect to the impact of the LTIPs, how should we be thinking about the potential for margin improvement beyond 2023? You've been calling out a new guidance of 16.3% to 16.7%. And assuming 14.9% for the year, it looks like there is a 30 bps impact from the LTIPs from a full year basis. So I'm just wondering, looking at 2024, if you -- we should build on the middle of the range of, let's say, 16.5% plus 30 bps of LTIPs, assuming no movement in the share price. And just curious about the sensitivity for LTIPs related to the stock price and if there's some options to neutralize the impact.

Sure. Well, there's a lot in that, Benoit but I'll do my best to cover it all. I'll start with the end of your question, which was around the opportunity to mitigate some of that volatility. And we have, in fact, hedged a portion of our long-term incentives. So the numbers that we are reporting around the revaluation is already net of the effect of having some swaps on our performance share units or sorry, our restricted share units. So that is something that we are already doing. With respect to expectations for EBITDA margin growth beyond this year, certainly our objective to continue driving operational efficiencies. I mean, you've seen in the last couple of years how we have gradually but sustainably raised our EBITDA margin. And that really is to the credit of all of our workforce that has -- is focused on this and really delivered on the various strategies that we have in place. And so it would be our goal to continue to execute on those strategies. As you know that we are in the midst of developing our next 3-year strategic plan. And in that, we will roll out new EBITDA targets. But again, certainly, we would expect that will continue to drive more margin enhancement in the coming years.

Okay. That's great color, Theresa. And just on the M&A front, you disclosed in the MD&A, a cash consideration of $76 million for ESD, which looks higher than typical matrix based on price paid for employees. So I was just wondering if there's anything else to better understand, either with respect to the opportunities going forward, whether the valuation is higher than usual. And maybe if you could comment about the M&A environment and the opportunities you see these days for larger-size deals?

Yes. Great questions, Benoit. We do find multiples vary based on the type of business that you're acquiring, based on their profitability and certainly based on size and so on. ESD was a very profitable firm. And the data center market that they're -- the mission-critical environment that they're in, is a very attractive market. And certainly, I'm sure you've read a lot in the papers lately about the tailwinds supporting that for the next couple of years. So on a per head basis, it might have penciled out to be a little higher but also the profitability for that firm was higher as well. For the M&A market, in general, we do find it to be very robust in different lines of business, really around the world. I'm spending a lot more time really focused on those discussions. And we're, as we always are, in all sorts of levels of discussions from initial conversations about cultural fit to anywhere in different parts through the process. But to your point on size, there is a number of 3,000, 5,000, 7,000 firms that are either on the market now or will be coming soon. So you supplement that with our sort of the typical 1,000 person and less. And I think we're moving into a pretty robust period for M&A activity.

Okay. That's great color. And last one for me. Some of your engineering peers have reported a cash drag this year coming from the U.S. Section 174 tax law which eliminates the option to deduct R&D expense in the year and requires to be amortized. So just given your elevated exposure to the U.S. region, are you seeing any negative cash impact from this?

Yes, absolutely, that has been a factor. And there's a couple of pieces to that. You're right, given our higher earnings there, we will drive higher tax component. But the other element around that is -- it becomes a bit technical. But even though the rules came into play in 2022, there was an opportunity to take a, what we called, a safe harbor approach, which was to pay less than what you thought in the event that perhaps those regulations didn't actually come to pass. And so they, of course, did come to pass and what we found then was we had to do a catch-up payment in Q2 of this year. So just as an example, for the year-to-date of 2023, we would have paid out in cash about USD 34 million under Section 174. Last year for that same period, it was less than USD 8 million. So it has had an impact for sure.

Our next question will come from Yuri Lynk with Canaccord Genuity.

Yes, just want to go back on the EBITDA margin discussion. Is it fair to say that the momentum in the margin improvement is slowing a bit. I mean it looks like you did -- ex LTIP, you did about 16.6% in the -- 16.4% in the first half, that implies 16.6% in H2. That would be about 20 bps lower than the back half of last year. So I know the back half of last year was a bit wonky in some ways. So is that just a tough comp? Or is there additional costs creeping in that would be kind of slowing the momentum a bit.

It's a fair question. And I would say the answer is no. We don't see a slowing of momentum. It's something that we are very trained on and seeing very good success. So there were certainly some things last year -- in the last half of the year that were favorable to EBITDA that we would not necessarily expect to recur. We also had, in the first half of this year, we made a mention in our MD&A certain things that in the admin and marketing that were supportive and perhaps had in the first half of this year maybe a couple of basis points higher than we would typically have seen in the first half of the year. But we always say that the margin improvement that we are driving is really intended to be sustainable and we are continuing to see it grow. So I think we're very comfortable with the target and that beyond this year, we continue to push to grow.

That's fair. Do you still expect Q2 and Q3 to drive 55% to 60% of your net income?

Well, it is typically higher -- slightly higher in the second half of the year. I am just doing math in my head because typically, we talk about Q2, Q3 being about 55% and the shorter quarters being 45%. And I think that, that still holds true. But we do typically see that the third quarter is generally our highest earning quarter and then it moderates a bit in the fourth quarter.

Yes. No, I was just asking 55%, 60% because that was the guidance given at the beginning of the year. And I didn't see a mention of it. So I just wanted to make sure it was still in effect. That's helpful. I'll turn it over.

Our next question will come from Jacob Bout with CIBC.

Very positive commentary and guidance on organic growth. How do you think things play out in 2024? Do you expect the momentum to continue? And then maybe just kind of a secondary question. If we look across the industry, most firms are raising guidance. And what do you think has changed in the past 3 months to drive this?

I do think, as you look at forward, we've talked about the sort of just these -- I mentioned in the prepared remarks, like in 35 years of doing this, we've never seen everything lined up the way that it is from an infrastructure perspective, the government funding. When you look at things like an IIJA, for example. These things are always slower, of course, to take off and you think but we're looking at -- once that ramps up in the latter part of this year into next year, it's going to continue up till 2028, 2029, that's sort of a range. IRA gets going for the next several years. So we're just seeing a lot of these -- and that's just in the U.S., lot of big drivers, other places as well. So it just really feels like there's robust support for Stantec certainly but for our overall industry. And so I think that's where you've seen some of our competitors raising guidance as well and everyone is feeling pretty good about the next 3 to 5 years in our space.

Okay. And then just in Canada here, you guided to mid-single-digit growth for the remainder of the year or for the full year. But implies that second half is going to be relatively muted. Is there just a level of conservatism there? Or is there something we should be watching for?

Yes. I don't think it's a level of conservatism because again, as we said in our remarks that the level of activity is going to remain very high in Canada. And certainly, when we started the year, there was probably a bit of conservatism because we came in pretty strong. And there was just a question about how robust the Canadian economy could be and what it could support. Now as work is continuing, there are a couple of dynamics that we see, is that there are some projects that are winding down or have been winding down in the middle part of this year and that as we begin the ramp-up of new projects. Of course, the revenue always takes a while to pick up on those larger projects. But again, we point people to 2022 where in the second half of the year, Canada had 7.5% and 11.5% organic growth in Q3 and Q4. And so the question is, can Canada stack double-digit growth on top of what was already double-digit growth last year. And I would say that, that feels very optimistic, not impossible but pretty optimistic. So for us, as we look at the level of activity and what we see coming, the backlog is really strong. But how the math works in terms of the actual growth rate, we think it will moderate a little bit.

We have a question from Frederic Bastien with Raymond James.

To get a better understanding of where the 11% organic growth is coming from, obviously, very good. But just curious if it's more weighted to higher employee count, increased utilization, pricing power or a little bit of everything.

It's really a combination of all of those things. We see just really strong market dynamics for us as we look forward and continuing. So I mean, I just finished saying that in Canada, can it stack double-digit growth on top of what was double-digit growth at the end of last year and probably unlikely. But in the U.S., it's absolutely doable just given the amount of work that is flowing, what we're seeing in our backlog, et cetera. So we've grown, as Gord noted in his comments, I mean we had the highest hiring quarter, we've ever had in the second quarter. Voluntary turnover is certainly back to that sort of prepandemic level where we have been leaders in maintaining our staff. So it is a bit of all of those things that you mentioned. .

Great. And given the positive momentum you have with hiring and the retention, you have no concern whatsoever as to your ability to handle on that growth that's coming ahead. Correct?

No, no, not at all.

We're feeling pretty good about it, Frederic. In addition to that, we're expanding our delivery center in Pune and continuing to add resources really in all of our regions.

Cool. Great. And then since you offered it earlier, you are both in London, any special reason why you're there?

No. Just as we move our Board meetings around, every couple of years we like to take the Board to one of our office locations and working with them. We selected the U.K. this time around. So we have our whole Board here with us.

[Operator Instructions] It comes from Devin Dodge with BMO Capital Markets.

I think this question will probably be for Theresa. But when I look at the guidance framework you provided and we kind of exclude that LTIP revaluation figures, it implies roughly even distribution of adjusted EBITDA between H1 and H2, despite -- when we look historically, I think H2 has accounted for a bit more than that, 50% share of full year EBITDA. Just can you provide any color for why the EBITDA contributions in the second half of this year may be a bit lower just compared to that seasonal pattern?

Yes. It's actually -- when you push through the math, the implied range for the second half of the year would be 16.2% to 17%. So it is -- we're heavily weighted towards there being more upside in the second half of the year. And it is a range that largely is somewhat dependent on, again, how quickly or how slowly some of these projects roll out of the U.S. as the biggest driver. But we do expect that the second half EBITDA will likely fall to the, sorry, not fall, will likely be higher in the second half as it typically is.

Okay. Okay. It just seems like on a dollar basis, it's a little bit more evenly distributed, not so much on the margins. But anyway, we'll touch base maybe offline here. Just, if you're in the U.K., maybe an AMP question here but there's been some reports in the media regarding some potential financial distress amongst some U.K. water utilities. I think Thames Water, in particular. Just wondering, have you seen any change in behavior from your U.K. water clients in terms of pulling back on some work? And has Stantec adjusted how it manages its payables for these customers?