North American Construction Group Ltd. (NOA) Q3 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the North American Construction Group Earnings Call for the quarter ended September 30, 2018. [Operator Instructions]. The media may monitor this call in listen-only mode. They are fee to quote any member of management, but they are asked not to quote remarks from any other participant without that participant's permission. I will now turn the conference over to David Brunetta, Director of Investor Relations.

Good morning, everyone, and thank you for joining us. Welcome to the North American Construction Group's 2018 Third Quarter Conference Call. I would like to remind everyone that today's comments contain forward-looking information. Additionally, our actual results may differ materially from expected results because of various risk factors and assumptions. For more information about our results, please refer to our September 30, 2018 management's discussion and analysis, which is available on SEDAR and EDGAR. On today's call, Jason Veenstra, Executive Vice President and CFO, will begin by reviewing our third quarter results; Martin Ferron, Chairman and CEO, will then provide his comments on our outlook and strategy. Also with us on the call today are Joe Lambert, President and Chief Operating Officer; Barry Palmer, Vice President of Operations; and Rob Butler, Vice President of Finance. After management's prepared remarks, there will be a question-and-answer session. I now turn the call over to Jason.

Thanks, David, and good morning, everyone. As mentioned, I'll provide a summarized financial overview of Q3 results, and I'll close with some brief commentary on the expected closings of the Nuna and Aecon transactions. Starting with the financials. Top line revenue for the quarter was $84.9 million, $15 million higher than 2017. This 21% increase year-over-year is indicative of strong activity in the oil sands was driven by the mine site work at the Millennium, Mildred Lake and Kearl mines. This revenue illustrates the producers' relentless focus on throughput, as they drive down their overall cost per barrel. The Q3 revenue of $85 million was achieved despite the abnormally wet weather we experienced, which negatively affected our operating hours, specifically the earthworks and overburden work at Millennium and Mildred Lake. Of note, the increased overburden removal demand at Mildred Lake was performed under the announced term contract related to the long-term master services agreement. The higher volumes at Kearl were achieved through both heavy civil construction as well as core mine service activity. Outside the oil sands, civil constructions at the Highland Valley Copper mine from our three year contract continued to generate steady revenue. For comparative purposes, 2017 revenue included work at the Fording River coal mine, which was completed in the first quarter this year and civil construction revenue at the Red Chris Copper mine, which was completed at the end of 2017. Another factor in our positive year-over-year revenue trend is the increased work generated from external maintenance services. Martin will expand on this topic in his remarks as it relates to our new facility, but demand continues to grow for our cost-effective and reliable heavy equipment service offering. Moving to the expense side. Depreciation was $10.9 million for the quarter or 12.9% of revenue. From a gross perspective, this was fairly consistent with 2017, but as a percentage of revenue, it's considerably down from 14.6% booked last year. The lower depreciation reflects the benefits of higher utilization in operating hours of the fleet as well as our maintenance initiatives, which are extending useful life of the fleet and their major components. With these positive trends in revenue and depreciation and a strong operational quarter, gross profit achieved was $14.3 million, a 16.9% margin. This compares very favorably to the $5.8 million and 8.2% margin posted in 2017. This $8.6 million increase and a more than doubling of gross profit margin from 2017 reflects the profit that is achievable from consistent and steady demand for our services. Consistent demand, supported by term contracts, enables operations to fully realize the production efficiencies that have been incorporated into the business model. Consistent with this theme of steady demand, it should be noted that included in 2017 results is the operational and disruptive impact of the fire at a customer's plant. Below gross profit, several expenses were incurred that were nonroutine in nature. General and administrative expense excluding stock-based compensation was $6.2 million for the quarter, higher by $1.6 million from 2017. This increase was driven by higher short-term incentive cost associated with our strong 2018 results as well as the onetime legal and consulting expenses required for acquisition activities. Of specific note in the quarter, stock-based compensation expense of $4.4 million was incurred due to the stronger share price and its impact on the carrying value of our liability award plans. Interest expense of $1.7 million for the quarter was consistent with 2017. This expense reflects our current interest run rate of approximately $7 million per year and a 5% overall cost of debt. Before we look at net income and EPS, I'll touch on adjusted EBITDA margin of 22.5%. The profitability trend is consistent with the trend over the past five years of improvements and reflects the drive for productivity and efficiency. Adjusted EBITDA of $19.1 million represents a trailing 12-month EBITDA of $91.5 million and a 25.3% margin compared to the 2017 equivalents of $60.6 million and 22.2% margin. These impressive increases of 51% and 14% are a testament to the incredible job done by operations over the past 12 months. Regarding net income, we recorded $1.5 million of earnings compared to a $585,000 net loss last year. Put simply, this $2 million positive swing can be summarized by the $8.6 million improvement in gross profit, offset by the combined $5 million impact of stock-based compensation and onetime acquisition cost. The remaining $1.5 million is increased G&A and deferred taxes both incurred as a result of higher profits. The positive net income equals basic earnings of $0.06 per share over the quarterly average of just over 25 million shares. On factoring in the stock and other onetime expenses previously mentioned, this is an EPS level of $0.20 per share. Regarding the common shares outstanding, our normal-course issuer bid expired on August 13 after we had purchased 100% of the authorization for 2.4 million shares. After completion of this and NCIB, outstanding common shares were just under 25 million as at September 30. To close out the financial review, I'll summarize our cash flow. Year to date 2018, we generated $73.4 million in adjusted EBITDA. Both working capital fluctuations and sustaining capital expenditures totaled $23.5 million and therefore, this netted the business $49.9 million of free cash flow in the 9 months ended. This $50 million of free cash flow generation in 2018 has been used for growth capital of $32 million with the remainder useful for capital lease repayments as well as the purchase and subsequent cancellation of shares. The majority of growth capital has been invested in the new facility in Acheson, but the investment also includes the purchase of strategic and incremental heavy equipment. The growth capital is being invested with 2019 and the longer-term outlook in mind and provides us a clear line of sight to achieve the profit target of $1.60 per share that we've communicated previously. To close out, I'll provide a quick financial status of our acquisitions, both of which will be fully financed using our credit facility. The Nuna business acquisition is expected to close shortly, and the purchase price is not expected to change noticeably from the $42.5 million price that was announced in September. For clarity, this acquisition does not require a financial upside of our credit facility. As you can see from our published results that we have over $130 million of borrowing capacity. The Aecon asset purchase remains on target to close in Q4 and will be financed, as mentioned, through an upsized and term-extended credit facility. Discussions are going very well with the supportive syndicate, and we fully anticipate closing this concurrent with the asset purchase. With those comments, I'll turn the call over to Martin.

Thanks, Jason, and a very good morning to everyone. Before I get into the meat of my prepared remarks, I would like to clear up some possible confusion around a section of my press release quote, which states that, we hope to post a strong outcome for Q4 similar to last year. Before we recently announced two significant acquisitions, the consensus EBITDA estimate to Q4 was $18 million, which is a number we posted last year. If we achieve that again this year, despite additional one-off acquisition related costs, we will have produced $91.5 million of EBITDA for 2018, as Jason just mentioned. This represents a 45% year-over-year growth rate, which is triple our target rate, after we also grew EBITDA by 24% in 2017. I hope that nobody will be disappointed by this pace of growth. And we also stated in the press release that we anticipate both acquisitions to close in Q4. To add further clarity, the first one could close as early as tomorrow and the second one, perhaps by December 1. However, it is difficult to assess incremental EBITDA numbers until we know a date certain. And so my press release quote implies no extra EBITDA. Clearly, when the deals do close, we can better assess the EBITDA impact on Q4, but I contend that we should perhaps fully focus on 2019 and 2020 outcomes. Okay, with that said, I'm now going to cover three topics today. Earnings per share, EPS, senior debt-to-EBITDA ratio and stock-based compensation. On EPS, pretty much exactly 6 months ago on the Q1 earnings call, I forecasted basic earnings could reach $1 a share, possibly as early as 2020. This piqued interest in the investment community, as I believe the statement put us on the map as a profitable company. Well, here we are today with a basic earnings prediction of possibly $1.60 per share for 2019, assuming that both acquisitions close as expected before the end of the year. This impressive pace of growth will lead to returns on equity north of 20%, which is a level well ahead of any other company in the engineering and construction segment. Apart from the significant financial returns expected from the acquisitions, our organic growth steps will continue to contribute nicely to the overall growth picture. In particular, I am pleased to announce that we'll be moving into our new shop and maintenance facility by mid-November, ahead of schedule for a major internal project that we have brought in on budget. Demand momentum for external maintenance services continues to build, and the timing of the shop opening coincides almost perfectly, with the expected influx of major assets from one of the acquisitions. In the meantime, the operating environment in our core oil sands market continues to improve, with customers looking to us to take on much increased volumes of recurring earthworks. This should also be no surprise if we secure additional term contracts before the end of the year, which will underpin our earnings expectations. I would say, the oil sands bidding activity is brisk, and we are hopeful of building on our revenue diversification efforts in the near term. The bidding activity will likely also include packages related to the recently announced major LNG project in British Columbia. Another notable aspect of our growth story, I will mention, is that we are not sacrificing EBITDA margin as revenues climb steeply. In 2016, we printed 23% EBITDA margin on just $213 million of revenue. This year to date, we have recorded 26% margin on $279 million of revenues. The next year, research analysts expect us to have about 23% margin on around $700 million of revenue. Turning out to our senior debt-to-EBITDA issue. I mentioned on the last call that one of my fundamental business principles is to keep this below 2x on a current-year basis. Now as we will be using a much expanded and extended senior debt facility to fund the two acquisitions, the ratio is likely to be around 2x for a period. This is why you may see us layering some junior debt into the capital structure if we can secure it on attractive terms. Also as one of the acquisitions is an asset purchase, our commercial banks indicate, we'll not take into account the associated trailing 12 months of EBITDA. Therefore, on this backwards-looking basis, the ratio will likely just exceed three until we record some EBITDA with the acquired assets. Hence the related debt facility covenant will be set initially at 4x. We will certainly not breach the covenant, as a recent research report perhaps inferred. This situation does though provide added impetus for us to look at securing some junior debt. Also as mentioned in the press release announced in the second acquisition, it is our clear intention to reduce our leverage by around $150 million over the next three years from operating cash flow. We should get off to a good start with this deleveraging, as we do not anticipate paying any taxes, cash taxes that is, until 2020. Additionally, I would like to stress here that importantly, we will not, I repeat, not be issuing equity at anywhere near current stock price levels to raise incremental capital. Interestingly, one of my executive team members commented recently, "Martin, you really hate equity dilution of any kind, don't you?" He was right, I hate it, which brings me onto my final topic of stock-based compensation. The mark-to-market cost of this aspect of our compensation is over $9 million so far this year, resulting in a reduction of $0.26 of basic earnings per share. This is mainly due to the potential extra cost of cash-settled defers stock units held mostly by long-standing members of our board. On the other hand though, I want to draw attention to the fact that in recent years, we appointed a trustee to buyback over 2.7 million shares at an average cost of around $4.78 per share to hedge our equity, settle restricted and performance stock units issued annually to key employees. The value of those shares today is over $20 million, more than we paid for them. And the remaining part held interest will last several more years. The basis for this shareholder friendly hedge was that I learned in previous cyclical downturns that equity grants made at low stock prices can be extremely dilutive. So the main takeaway from these prepared remarks should be that Martin really does hate equity dilution. With that, I would like to turn the call back over to Melissa, the operator, for the Q&A segment.

[Operator Instructions]. Your first question comes from the line of Yuri Lynk from Canaccord Genuity.

Martin, can we talk a bit about the term contracts that were signed back in June? And how those are proceeding thus far, understanding it's early days. And how do we think about those going forward in terms of maybe remind us how many customers have signed term contracts? And how many more are likely to sign those agreements?

Yes, sure Yuri, I'll try and provide some more color. As you know, we haven't got that many oil sands customers. We did sign two term contracts with one of them, earlier this year. And those are going extremely well. I think the customers are very happy with our performance. So that potentially will drive additional such arrangements with them, but we're also talking to one other customer at this juncture about a more significant term arrangement. It's early days in those discussions, but they should proceed fairly quickly such that we hope, as I said in my prepared remarks, to announce something by the end of the year. Is that sufficient?

Yes, and just -- is the main benefit to the company on the pricing? Or is it just the visibility and the ability to manage around other jobs and maintenance on the equipment?

Yes, the main benefit to us is in the planning. If you're doing the spot work all the time, it's difficult to scheduling your maintenance for example, you don't do the work you'd like to in some periods, so having the ability to plan the work over an extended period could drive incremental margin for us without any need for increased price.

Okay. Sounds good. Last question for me, and I'll turn it over. Can you talk about the opportunity that LNG Canada may present? And if you were a betting man, what are the odds that you might be doing some work on that project?

We're waiting for the packages to arrive for us to look at. We understand that the design has changed significantly since we provided budget pricing. So it's too early to say, the extent of the scope we might be taking on. But I think, the work is going to be highly competitive though. And we'll be looking to earn our usual margin on any work that we bid. So it'll be competitive, but we'll give it a shot and see how that goes, Yuri.

Your next question comes from the line of Maxim Sytchev from National Bank Financial.

Martin, I was wondering, if you don't mind, maybe providing an update on the Competition Bureau looking at the purchase of the Aecon assets, just any color. And maybe any communication that you're having right now with the regulators?

Yes, all I can say there, Max, is that we've submitted the required documentation, notices, et cetera, and we're hopeful that we'll get a positive response by the end of the waiting period or before the end of the waiting period. That's all I can say at this point.

Okay, fair enough. And then in terms of the scaling up of the opportunity for equipment maintenance for outside clients, Martin, do my mind -- I think right now, you're mentioning you have five clients. I mean I think that compares relative to three a couple of quarters ago. Do you mind maybe commenting on the uptake for that particular service?

We're still around the same number of customers, but we've been getting a lot of people coming to walk through, inspect the new facility, and we expect that to generate a lot more interest, lot more activity. People are super impressed as we are with the way that facility has turned out. I think that'll lead to incremental demand in the short term. Also, don't forget as I mentioned in my remarks, the timing is great in terms of getting the hands on the Aecon assets because we'll have to do some NOA upgrades, rebuilds there to get that fleet back to full working capacity.

Do you have an estimate of the amount that you will have to spend on that fleet to bring it to -- I don't know, if it is the right way to think about it, to sort of NOA levels, but maybe to sort of optimum capacity utilization on those assets?

Yes, we're marking $15 million to $20 million here in the next 6 months.

And is this going to be expensed, or is it going to be capitalized?

That'll be a capitalized number.

Okay. And then actually -- while we're on the topic of CapEx, do you mind maybe commenting on what we should expect, if you have those numbers in front of you, for CapEx next year both in terms of maintenance and growth if it's possible?

Yes, so in terms of sustaining capital, with the three pieces of our business now, although, we won't talk about three pieces. It'll be an integrated budget. We're looking on a sustaining-only basis, around $80 million. Growth, we're not looking at much right now because it's kind of full fledge here lately. So I would just focus on the $80 million for the time being, and with your EBITDA estimates for the year, no cost taxes, I think you will easily come to the conclusion that we can delever as planned.

Yes, for sure. And then, some of the questions I am getting right now from investors is just in terms of the ability to take on incremental work, so you feel that if you are successful, let's say on LNG or some of the infrastructure-related opportunities, that you have enough fleet be able to undertake all these contracts?

Yes, we think we can get access to additional fleet of the nature required to do that work. We're still looking for used equipment, although, the supply is drying up somewhat. But we made some nice buys during the downturn. You see that in our numbers already, and we'd like to think that we can take on that extra work.

Your next question comes from the line of Ben Cherniavsky from Raymond James.

My questions actually were just along the lines of what Maxim just asked. But I guess, maybe to elaborate on that, I am wondering if you can just maybe tell us a little more about the intent of the Aecon asset purchase, like how that strategically helps you where they weren't able to utilize those assets as profitably? I assume, some of it has to do with the maintenance facility which you guys just talked about and the extra capacity it gives you, but what does this do for you that they couldn't do with the assets?

Yes, I think, there's been a lot of talk, publications on comparison of their performance against ours. To be honest, we didn't even look at that performance when we decided to make the acquisition. We just wanted to get our hands on the assets, because we thought that we could match our own performance with those new assets over time. And I think if you've been watching us as I know you have, Ben, over the last 5, 6 years, you know the improvements that we've made. So since the assets will be on exactly the same sites, working for the same customers in the same conditions as our present fleet, we think that we can achieve the same performance with them. The customers appear very happy with that situation because they know that our way of working brings extra productivity. I am not being critical of the vendor there, but I'm just saying that the customers think that we can get more out of the assets and therefore, they're very pleased to see us get our hands on them. I don't know if that's helpful, but that's the way we look at it.

So it just comes down to an operating philosophy and practices that you think you're -- and I guess because this is what you do versus it being one of many things that Aecon does, you do it better?

Yes, we're entirely focused on this. It's what we do, right? Whereas you say, they're focused on many other things, and I'm sure they're great as those things.

[Operator Instructions]. Your next question comes from the line of Glenn Primack [ph] from Promus Holdings.

Great commentary, especially concerning the equity dilution. I wish there were more management teams that expressed a similar view. Regarding the, you big oil sands customers, how much do you think that they outsource today to vendors such as yourself? And can that move higher?

It's difficult to give exact numbers there Glenn, [ph] but clearly the operators who have large fleets of equipment themselves do a lot of work. So they certainly handle all of the oil, which we think accounts for around 50% of the total earth that's moved to produce a barrel. And then they do on occasions, some of the other activities like overburden removal. So they, right now, do a fair amount of the work themselves. And that seems to be a cultural factor. That's what they like to do. So over time, as we grow and show them how we can maintain and operate equipments, we might have the opportunity to change that cultural thinking, but I would say that's a few years away. So for the time being, we're just focused on doing the best with our fleet and supporting our customers to make them successful.

Okay, great. So even without any additional, call it, outsourcing or share from those major customers with the asset purchase that you've made, I don't know, looking out another 12 to 15 months or so, the multiple you paid for these assets are probably worth a lot less than what's written on the press release paper, that's basically the sales, right? You're going to be utilizing more of them.

Yes, I would hope that's safe to assume. But don't forget too, as we've said many times, volumes are increasing generally. Our customers are looking to put as many barrels through their production facility as entirely possible. So that's driving volumes for us too.

Your next question comes from the line of Devin Schilling from PI Financial.

Martin, just a quick update on some of the other infrastructure projects that you guys are shortlisted for? I guess just in regards to timing for these projects, when we might hear some more info, both the flood mitigation and the gravel road project? It'd be great.

Well, the gravel road project in the Northwest territories, we think we might hear something in the next few weeks. We are 1 of 3 bidders, and I think we put a strong footfall, so hopeful. But you can never tell in these situations obviously. The flood mitigation project is held up through environmental pressures, but we hope to be getting back to bidding that maybe next year. And then we are looking for work on other resource plays as well as infrastructure projects, and we have several bids in-house to address those. These are term arrangements, where we would secure incremental equipment for long-term contracts, so that's the type of opportunity we're looking for rather than short-term projects that would require us to take equipment from the oil sands.

Okay, great. And I guess with the NCIB running its course here, is there any plan to renew it in 2019 here going forward? Or are you guys going to be redeploying that cash to pay down some of this new debt?

Yes. Our initial focus will be on deleveraging. But you can never say never, depends on what happens with the stock price, right? We've been active buyers of the stock for many years, and if we don't get the right sort of level in the market at a certain point next year, we'll look at it again in terms of renewing an NCIB. We'll see.

There are no further questions at this time. Mr. Ferron, I turn the call back over to you.

Well, thank you, Melissa. And thanks to everybody who call in today. We look forward to speaking to you next time.

Thank you. This concludes the North American Construction Group Conference Call. You may now disconnect.