Ontario’s Highway 407 cash cow for SNC-Lavalin

Driving growth in both shares and dividends

stake in a southern Ontario toll road remains a “cash cow” for the company and will be a key component of its future growth and dividends over the next decade, according to analysts.

“407 continues to be a value-generating monster for SNC,” wrote National Bank Financial analyst Maxim Sytchev earlier this month. “In addition, with only 80 per cent of lane capacity in operation now, there is natural growth remaining over the foreseeable future.”

At its investor day Sept. 12, the Montreal-based engineering and construction company announced a $5 adjusted consolidated earnings-per-share target for 2020, up from the $3.10 to $3.30 range projected for this year.

At least some of the path to $5 will involve profits from SNC’s stake in Highway 407, a 108-kilometre toll road that snakes through southern Ontario and the Greater Toronto Area, an area that is projected to see steady population growth, which could possibly push more motorists onto toll roads.

Ownership of 407 International Inc., which operates and tolls the highway, is split between three entities: a subsidiary of Spanish infrastructure giant Ferrovial SA, which has an approximate 43.23-per-cent stake, the Canada Pension Plan Investment Board, which has direct and indirect control of 40 per cent, and SNC, which has 16.77 per cent.

As of the end of the second quarter, 407 International Inc. reported yearto-date net income of $212 million, up 33.33 per cent over the first half of 2016. A company presentation showed total trips on the highway have risen at a compound annual growth rate of 1.1 per cent from 2007 to 2016, and that average revenue per trip had gone up 7.7 per cent.

While National cautioned not to expect the 407 dividend stream to grow much beyond what it has been the past five to seven years, its figures, based off a company presentation, show earnings per share from 407 income would make up 95 cents of SNC’s $5 target for 2020, up from 87 cents this year.

Ferrovial, which boasts the largest stake in the toll road, has estimated the total value of the company could reach as much as $45.3 billion by 2026 in a best-case scenario, according to National. That compares to the current consensus of $27 billion and the $28.3 billion valuation calculated by National.

“SNC estimates the value of its stake in Highway 407 could increase to $6.0-$7.0B by 2026, implying approximately 40- to 60-per-cent upside from our current valuation of $4.4B,” said a BMO Capital Markets note.

In a note to investors Sept. 12, Canadian Imperial Bank of Commerce called the 407 a “cash cow,” noting that the Greater Toronto Area’s population is expected to grow by one to two per cent annually, with the province’s economy forecast to grow by about two per cent a year. The Ontario government projects the population of the GTA to grow by about 42 per cent from 2016 to 2041, to about 9.6 million.

“While steady volume growth should increase traffic, we note that 407 International still has flexibility to increase tolls for 81 years,” the analysts wrote, noting the Province of Ontario’s decision in 1999 to lease the highway to the private sector for 99 years, in return for $3.1 billion. “With solid cashflow generation and targets to increase leverage, we expect the company to continue increasing the yearly dividend … and contributing to SNC results.”

Desjardins also said the 407 is “still undervalued.”

“We continue to believe that the asset has not matured and that further value can be extracted,” analyst Benoit Poirier wrote.

The Desjardins Group maintained its buy rating and $69 price target on SNC shares. As of Monday’s close, SNC’s stock was trading at $56.16, up about 2.88 per cent since the investor day, but down about 2.82 per cent on the year.

The Canadian government also announced a consultation Monday on deferred-prosecution agreements, something SNC had been seeking. The DPAs halt criminal prosecutions in return for fines and “admitting to facts that would support a conviction,” the government said.

SNC is “a completely different beast than five years ago,” when corruption allegations began to rear their head, according to investment bank Raymond James.

“This is reflected in the management team, which has been completely replaced since the dark days of 2012, and in the firm’s Board, which will have been fully overhauled by the end of this year,” wrote analyst Frederic Bastien.

The 407 also “has yet to reach maturity,” as lane additions, population growth, and the provincial government-owned eastern extension to the highway will help to boost traffic on the toll road, added Bastien. The first phase of that extension, from Pickering to Oshawa is open to traffic, while another stretch, to Highway 35/115, is scheduled for completion in 2020.

“For these reasons, SNC has no intention of parting ways with its crown jewel asset at this time,” said Bastien. “What investors can reasonably expect, in our view, is a modest increase to the dividend, which has averaged an annual growth rate of 7 per cent since 2012.”