Stantec Inc. (STN) Q1 2017 Earnings Report, Transcript and Summary

Welcome to Stantec’s First Quarter 2017 Earnings Results Call. With us today from Stantec management are Bob Gomes, President and Chief Executive Officer; and Dan Lefaivre, Executive Vice President and Chief Financial Officer. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer period. [Operator Instructions] Today is May 11, 2017, and this conference call will be recorded and broadcast live over the Internet. It will be archived for future references at stantec.com, under the Investors section. Any members of the media who are joining in are listen-only mode and who would like to quote anyone other than Mr. Gomes or Mr. Lefaivre must ask permission from the individual concerned. Stantec management would like to caution you that this call will include forward-looking statements and forward-looking information within the meaning of applicable U.S. and Canadian Securities Laws. By their very nature, forward-looking statements require Stantec management to make assumptions that are subject to inherent risks and uncertainties. Stantec management would also like to mention non-IFRS measures. I would now like to introduce your host, Mr. Bob Gomes. Please go ahead.

Thank you. Good afternoon, everyone, and thank you for joining us for Stantec’s first quarter 2017 earnings conference call. For those of you following the slideshow, we’re now on Slide 3. I’ll open the call with some introductory comments and then Dan will provide a more detailed summary for the quarter’s results. After Dan provides his commentary, I’ll offer some brief operational highlights and our outlook for the remainder of 2017. Following that, I’ll ask our operators to open the call for questions. Please note that a copy of the slide show is posted on stantec.com, and it will be archived in the Investors section of the website. Today, we released the results of Stantec’s operations for the first quarter of 2017. Stantec had good operating results in the quarter, led by acquisitions completed in 2016 and organic growth in our Water and Infrastructure business operating units, which together make up nearly half of Stantec’s growth revenue. Our operations in the United States also experienced organic revenue growth. We’re also pleased to see that the rate of organic revenue retraction we’ve experienced in some areas of our business is trending in a positive direction, where traction decreased from 4.4% in the fourth quarter of 2016 to 2.4% in Q1 2017. Growth of our new Construction Services business segment is meeting expectations, driven mainly by large project wins in the United States. Earlier this month, we finalized the sale of, Innovyze, Inc., the software – water software solutions firm that was part of our acquisition of MWH, the gross proceeds of US$270 million. Selling Innovyze was the correct strategic choice, because there were no synergies that could be applied to our core business and the sale allows both companies to prosper with the best available resources and support. This transaction results in a reduction of goodwill, intangible assets and debt. Unfortunately, the way we’ve required to record this transaction has a negative impact on our reported financial results. Our operational results paint a truer picture of Stantec’s performance this quarter, which are in line with our expectations and which are trending in the right direction for 2017. Even these adjusted operational results were impacted by the continued full integration efforts of MWH and the investment in that strategy. Those impacts will dissipate over the second-half of this year. Now, Dan will review our financial results for this quarter and explain the impact of the Innovyze sale in a little bit more detail. Dan?

Thanks, Bob. Hello, everyone. This afternoon I’ll start with our Q1 results. As Bob has pointed out, it’s been a good quarter, notwithstanding the impact of the Innovyze sale, which is a positive move for the long-term, but will have some impacts on our reported results through 2017. These impacts will make it necessary for us to report adjusted results something that we said, we are not going to do for the rest of 2017. We’re doing this, however, in the interest of providing clarity and transparency, so investors get a true picture of our core operating results. Gross revenue increased 69% to over $1.2 billion. This is mainly due to acquisition growth in Q1 2016. Revenue was also impacted partially by organic gross revenue retraction in some of our business operating units and the strengthening of the Canadian dollar. Gross margin increased to 54.1% in Q1 2017, mainly due to the mix of projects. EBITDA rose to $89.8 million in this quarter, an increase of 35%. Administrative and marketing expenses increased slightly as a percentage of net revenue of 43.6% in Q1 2017. This increase is due to higher marketing and business development labor costs and that continuing integration of MWH in large part related to IT costs. Labor expenses will fluctuate due to lower utilization in the winter months and the mix of clients and projects, along with the number of acquisitions completed in each quarter. We’re continuing to report adjusted diluted earnings per share this quarter, and we’re also reporting adjusted net income since we believe these measures better explain our operating results. Net income was impacted by our $90.4 million tax charge, stemming from the recently completed sale of Innovyze, MWH’s water software solution company, as Bob has mentioned in his opening remarks. Note that the divestiture amounts reported are subject to change due to balance sheet adjustments and foreign exchange fluctuations, as we finalize the accounting in Q2 2017. Excluding the tax impact from the sale, our net income for Q1 2017 would have increased 5.9% over Q1 2016 to $32.4 million. Adjusted diluted earnings per share is stable at $0.40. Moving to Slide #7, the impact of the Innovyze sale and $90 million deferred tax charge decreased our diluted earnings per share by $0.79 in Q1 2017. We’ve also provided additional information reflecting the estimated pro forma impact the Innovyze sale will have on our Q2 2017 year-to-date earnings. The net proceeds of the sale will allow us to reduce an estimated $290 million of goodwill and intangible assets, pay down about $200 million of our debt, and results in an pre-tax accounting gain of about $53 million. The tax charge does not impact our liquidity, our cash flows from operating activities were debt covenants this quarter. You can review all of this information on page 29 of our Q1 MD&A. Our 2017 targets – we’re on Slide #8 now, remain, as outlined in our 2016 annual report. At the end of Q1 2017, we met our targets for gross margin as a percentage of net revenue at 54.1%. EBITDA as a percentage of net revenue is at 10.3% below our targeted range of between a 11% and 13%. However, we do expect to achieve this targeted range by the end of the year. Administrative and marketing expenses as a percentage of net revenue are at 43.6%, just above our targets of between 41% and 43%. This is typical in Q1, as seasonality has an impact primarily related to lower stock utilization in the winter months, and as we noted, the integration-related costs. We reported a loss as a percentage of net revenue this quarter of 6.6%, again, because of the tax impact from the Innovyze sale. Without the deferred tax impact, adjusted net income as a percentage of net revenue was 3.7%. Cash dividend of $0.125 per share was declared to shareholders of record on June 30, 2017, it will be paid on July 13, 2017. We believe that we will meet our 2017 annual targets, given our robust backlog, anticipated revenue growth, and reduction in admin and marketing expenses. With that, I’ll hand things back to Bob for some operational highlights for you – those of you that are following along on the slide show, we’re moving to Slide #9.

Thanks, Dan. The takeaway for this quarter is that, we’ve achieved good operating results and are trending in the right direction in accordance with our expectation. It was a good start to the year and we expect our results to improve throughout 2017. As I mentioned previously, we are seeing overall organic retraction at a reduced rate, and we expect this rate of improvement to continue throughout the rest of 2017. As you can see on Slide 10, our infrastructure and water business operating units performed very well this quarter. Together, they make up nearly half of our total business. Infrastructure achieved organic growth revenue growth of 2.3% over Q1 2016. This was due to strong organic growth in the United States transportation sector and stability in the Canadian transportation activities. We’re in good shape for continued growth in this sector. Thanks to our strategic market position in bridge inspection, bridge projects, program management, roadways, and light rail transit. Overall, our transportation business is benefiting from both – on both sides of the border from the continued interest and attention to investments and infrastructure. Stantec’s water business operating unit achieved organic growth, revenue growth of 2.2% over Q1 2016, growth occurring in both Canada and the United States. Onto Slide 11 for those of you following along. Our Environmental Services business operating unit had stable organic revenue in Q1 2017 compared to Q1 2016. This business operating unit continued to be impacted by low commodity prices and reduced capital spending, leading to project delays and cancellations. We’re seeing more request for proposals though, and because of our strong client relationships and expertise, we’re continuing to win a stream of generally smaller projects in North America. Energy & Resources continued to retract because of weakness in the oil and gas sector in Canada and the Middle East. That being said, our oil and gas sector within energy and resources and Environmental Services now represents just 6% of Stantec’s overall gross revenue. And the pace of retraction has definitely slowed. We continue to see signs of a stabilizing environment in our oil and gas and mining sectors, which is good news after the last three years of retraction. Our position in these sectors provides us a market leading opportunity to take advantage of a future recovery. Our Buildings business operating unit experienced organic revenue retraction compared to Q1 2016. But it should be noted that Q1 2016 was a very robust quarter for Buildings, the retraction is again due to continued weakness in the Canadian and Middle East oil and gas sectors, which affected public and private spending. Also, we pursued and won a number of P3 projects in buildings recently. But those won’t start generating revenue until later this year. As Dan noted, the tax implications of the Innovyze sale will have a negative impact on our results for the rest of 2017, but the sale remains a correct strategic choice. The software business is very different from the consultant business. We also didn’t want to divert management attention in capital to growing the software business. It’s not our field expertise, so it made strategic sense to divest. In the end, the sale allows both companies to prosper with the best available resources and it provides us with an opportunity to reduce debt by about C$200 million. By divesting now Stantec takes full advantage of the outstanding performance of Innovyze and the current market value of this firm. We have unlocked that value for the benefit of Stantec shareholders. As noted on Slide 13, this quarter we made substantial progress towards integrating MWH projects and financial into Stantec systems. And we’re very pleased with our progress to-date. We’ve integrated items such as the benefits plan, payroll, IT, insurance and business networks. We’ve migrated 15,000 MWH projects into our Oracle system. And we’re in the process of harmonizing our policies and practices. We expect full integration of MWH to be complete in 2018 except for construction services, which will continue to be operated as a separate business. However, even though the construction business will not be fully integrated, we continue to explore and execute on the synergies of bundling our consulting and construction services on projects and with clients that benefit from that strategy. It’s also – it’s always difficult when you merge two large organizations, but so far we’re seeing that as a very good fit and staff are working well together. We’re very happy about how the integration is going. We should be on track for achieving the US$15 million in cost synergies by the end of the year and we’re identifying opportunities and winning work together. We expect to achieve our revenue synergies over the next year. To review our outlook for the remainder of 2017, there have been no material changes for the expectations outlined at the end of 2016. We expect to achieve a long-term annual compound growth rate for gross revenue at 15% through a combination of acquisitions and organic growth. For 2017, we anticipate continued economic improvements in the United States, increased infrastructure spending in both Canada and United States, increased spending in the water and wastewater sector and strong spending growth in the U.S. transportation sector, especially at the state level. We expect a modest improvement in the energy and resource sectors compared to 2016, continued support for P3s in Canada with increasing opportunities for APD in United States and modest economic global economic growth. Overall, 2017 continue to look better than 2016, with the clear majority of our business poised for growth for stability and a small minority that may need more time to move into organic growth. As we progress through the second-half of 2017, we expect the efforts of the full integration of MWH to have less of an impact on our SG&A costs. As you can see on Slide 15, we have a strengthening backlog of significant projects across a wide variety of sectors and geographies. Projects listed represent just a small sampling of the work we have in our strong backlog. To sum up, this quarter showed that consistent performance is the result of strategic acquisitions and a strategy of complete integration in effect of managements and delivery of a wide range of services across a larger global platform. We’ve built our business to adapt to changing market conditions, industry drivers, and client needs, and are seeing the benefits of that strategy. One final note, we recently published our annual sustainability report, which reports on our ongoing commitment to social, environmental and economic sustainability, our sustainability performance for 2016 and our plans for this year. I invite listeners to read the report on our website at stantec.com. Thank you. That concludes our presentation. I will now turn it back to the operator to begin the Q&A.

Thank you. [Operator Instructions] We’ll go first to Yuri Lynk with Canaccord Genuity.

Hey, good afternoon, guys.

Hi, Yuri.

Can you provide some additional color on the G&A in the quarter and I guess going forward, specifically, as it relates to the impact of the MWH integration activities had – it doesn’t look or sound like there was – these are necessarily costs, or maybe it’s more inefficiencies, but just what’s going on there and what happens in the back-half to make – to provide some better leverage on the G&A?

Yes, I think there’s two things, Yuri, and we can’t understate the utilization impacts in the first quarter. That that is really the impact on the rest of our business, which isn’t really given by the MWH, or the water business. So areas like certainly our Middle East was a little weak still. The buildings practice is still a little weak, again, a lot of time spent in M&BD and our environmental services, which is largely fieldwork, again, have some lower utilization in the winter month. So on top of that the work that we’re doing to integrate MWH, I expect that we will still see some utilization impacts in the second quarter, as we – as Bob mentioned, we migrated all the projects and everything now is getting them ramped up and learning the new process and new tools and new systems in order to be effective. So we’ll see better that impact still in Q2. The other thing is that, there were some IT-related costs. We moved all of our IT or all of our staff certainly in North America and across a number of the other geographies around the globe onto our single domain. So there’s some additional IT costs related in getting those people all up on to our same platforms.

Okay. I mean, I’m just trying to square the the commentary on the quarter with the results vis-à-vis the target. So I just want to understand – I understand the targets correctly, like I thought that the low-end of your your targets would kind of account for seasonally weak quarters like first quarter and vice versa. So was the quarter in line with with what you were expecting at the onset of the year, or was there some additional weakness somewhere?

I think there’s a little bit of additional weakness in the utilization generally, as I described earlier. But if you look at our EBITDA percentage in Q1 of 2016, is – it was only slightly weaker in Q1 of 2016. And we do expect that to improve as we get into Q2, in particular, Q3.

Okay. Okay, I’ll turn it over and hop back in the queue. Thanks.

Thanks, Yuri.

And we’ll go next to Mona Nazir with Laurentian Bank.

Good afternoon, and thank you for taking my question. I believe at the Analyst Day last June, you stated that you’re allowed for some pricing concessions in the energy and environment sector. And in the quarter, we saw the pricing pressures kind of persist. I’m wondering the timing that you initially put through some of these rate discounts. And can you speak about the contract structure and your ability to increase pricing? Is there a certain time period where prices are locked in, or are you flexible about a third of the recovery that could then help you guys?

So those – some of those pricing pressures certainly continued into Q1 of this year, actually, in some cases we’ve had written agreements with some of our clients that extended into 2017. We do you see that dissipating now. So there is going to be less of an impact on some of those pricing considerations we gave. We do have some long-term MSAs with some of our clients that also had pricing considerations in there. However, most of those contracts or salary multiplier contracts that then we have the capability of going in and getting salary increases to get the multipliers up. We’ve also got other methodologies of getting increases that that business is very volatile. It is cyclical and our clients understand that. So the good news is, when things do get busy that we definitely have that capability of going back and getting some of that back.

Okay, that’s helpful. And just it’s almost a year now since MWH was first announced, I was just wondering, looking back, what kind of the biggest positive surprise that you’ve taken from the transaction? And as you continue to work, what’s an area that you’ve had to put a little bit more energy into than you previously factored in?

Certainly, the positive surprise and maybe it’s not a surprise, because we anticipated that it’s just their presence in that global water space and their position in that global water space. They do truly have a number one water position in a number of geographies and certainly, North America, certainly in the UK. But we’re seeing that their capabilities would really allow us now to bid on just about any water project we feel that we have the capabilities to and we have enough of a status and top tier position to be able to do that. So it’s maybe not a surprise, but maybe a confirmation of why we did this. We’re seeing that come to fruition. Certainly, their position in the UK is an outstanding position in the water business and, again, that’s maybe just a validation of what we had originally thought. Certainly, some of the global operations are, they have a strong mining group in South America, that is certainly an area that’s under stress at the moment because of the mining business. But it’s about 300 people. I think we’ve now together we’ve rationalized the step down there, and we’re in a good solid position based on the work backlog that they have. And they have operations in Australia and New Zealand that certainly will benefit from our diversification strategy, because today they really rely upon a water sector business. So, overall, we’re very happy. The Innovyze sale was, we believe a very strategic opportunity we saw right out of the gate. But it took us sometime to position that business to be able to sell it. And going through that, I think was – it makes the overall transaction look very good now when you go back a year ago and look at the metrics associated with what we did with MWH now, add in some metrics of the $270 million sale of Innovyze. Doing the math, it looks pretty good.

Okay. Thank you for that.

And we’ll go next to Sean Eastman with KeyBanc Capital Markets.

Hi, gentlemen, first question from me is just kind of high-level. I noticed in the MD&A that your kind of framework within your outlook is predicated on a moderate slowdown in the Canadian housing market. So I guess, my question is, just given that this topic has been in the news lately with some of the moves in Ontario. If you could just kind of discuss your direct exposure and then direct exposure to the Canadian housing market, and more severe slowdown might impact the business?

So our residential exposure or exposure in our community development group is really in a greenfield master-planned communities mainly in Western Canada and then I put that into Manitoba, Saskatchewan and Alberta, but probably the majority of that being in Alberta. We have a residential, again, master-planned community exposure in Ontario. Those are really not the areas that are probably being impacted in Toronto and Vancouver, specifically, where we’re seeing the slowdown is mainly here in Alberta just due to the slow growth in oil and gas, the fires in Fort McMurray last year has sort of just put everything on hold for awhile. We see that actually – you know we thought at the beginning of the year being slow. We anticipated the year was going to be, but I think we’re starting to see signs it’s not going to be as bad as we thought it is. It is a business that has matured, I’d say, over the last couple of decades, so it points out not getting over built and are a little easier then to respond to some of the fluctuations in the housing market. So, we’re always cautious, because that healthy market responds quickly to the ups and downs, but we don’t see it as being a major concern right now I think we’ve adjusted for it and now it’s a matter of waiting for how that market is going to recover as the Oil & Gas prices recover in Western Canada. So really it’s more of a Western Canada play and our Ontario play. Dan?

And maybe just to add a bit more context on the community development business, it’s a little less than 10% of our overall revenues and consider probably a little bit less than half of that is Canadian, so if you’re thinking about it as probably less than 5%, our overall revenues is explores through the community development markets into Canada.

Okay. Thanks. And second question is, it’s good to see a little pop in backlog this quarter. It sounded like you did have a couple of lumpy awards in the Buildings segment. So I’m just wondering kind of how you’re thinking about the backlog trajectory through the year. And maybe if you could provide some context with sort of the bidding activity you’re seeing and whether there’s some kind of incremental lumpy big awards that could have backlog in the next few quarters?

I would say that overall – and it sounds like a maybe a too positive of the statement. But overall, this – every one of our businesses right now are seeing an increase in opportunities that includes our Oil & Gas business and mining business. So we’re the only one that were a lot concerned about the opportunities in Environmental Services that’s sort of lagging behind, but certainly every one of our other businesses are seeing more opportunities, are seeing increase in backlog – and an increase in backlog per FTE, a full-time employee. So all those metrics point towards good signs for us. You have still win those opportunities obviously and you have to still execute the backlog well for sort those sort of certainly aren’t givens, but we’re also very happy to see the backlog increase and also very happy to see the opportunities. From an large award perspective, I certainly think that Buildings is a group that probably has had more of their share with some of the P3s, but that probably only makes up about 20% of our revenue in that Buildings operations. They still rely upon a lot of smaller projects at the local level and I think that, again the strength of the company is probably 60%, 70% of our backlog and revenue comes from both sort of smaller and local projects that just continue to feed the backlog and we’re seeing those areas very strong.

Thanks very much, very helpful.

Thank you.

And we’ll go next to Jacob Bout with CIBC.

Good afternoon. Maybe just following on…

Hi Jacob.

…with a question on organic growth. Maybe just talk a bit about when you think organic growth is going to turn positive. What that trajectory looks like. And then maybe talk a bit about the importance of better Energy & Resources, Environmental Services and Buildings and specifically what I’m getting at here is, how important is the Canadian infra spend here is driving that growth and particularly Environmental Services and Buildings?

So, with regards to when, by the end of the year overall for the annualized basis we’ll have positive organic growth. And organic growth will improve in the second-half of the year. So that will give you some general guidelines with the organic growth. With regards to the impact of Oil & Gas, Environmental Services and Buildings will have on it and then the impact of the Canadian economy or the Canadian business on that. There’s no doubt that’s where the retraction has been. The retraction has been in those areas and we see the retraction slowing in those areas, specifically in the Oil & Gas and Environmental Services, really the question will be, how much will they grow? The retraction will continue to be less, that’s really how much lessened in comparison to the growth we get in other sectors. Building is more of a timing issue and some of the larger P3 projects and also a comparison to what was a very strong quarter last year. So we see that improving maybe quicker and getting back to positive organic growth maybe quicker in the Buildings group. But certainly those three will have an impact, because those are the three that right now are having the negative impact. So they’re obviously going to have an impact on the positive turn for us and to positive organic growth, which we’re saying is going to be in the second-half of the year.

Sure. I should specify, specifically the Canadian federal infrastructure spend, how important is it?

I don’t see that as being something we need to turn things around. So let’s put it this way, we’re not looking for a significant bump in our – in what I would call our water business in our transportation business in Canada to necessitate then a positive turn to organic growth. Right now our plans have what we’ve see in front of us and the opportunities we see in front of us really do not consider a huge spike in opportunities in the Canadian infrastructure business.

Maybe just my second and last question here. The pause in acquisitions that we’ve seen over the past six to nine months, is that a function of the focus on the integration of MWH or is it just a function of things are just too expensive right now?

No, definitely it’s a function of a pause for MWH. We knew we had to focus on taking that transaction and because again we fully integrate, you don’t sit there and wait, you got to move very quickly. So we decided to put all our efforts into that. Now that being said, it doesn’t mean that we can – we did not continue to invest in developing some relationships. Continuing on, I would say, with our U.S. strategy, but certainly we weren’t in a hurry with any of those and we would not allow those to sort of evolve and getting pushed them. But certainly we now see the opportunities in the U.S. continuing. We really haven’t seen any change in pricing or multiples. They’re always there, so I don’t see a change significantly in that. Excuse me, now we’re also seeing opportunities for us in the U.K. and Australia and that was the other thing that we took sometime to start focusing on those markets take the time to understand what our opportunities are there, which sectors we wanted to focus on, what relationship that we need to investigate and so we’re working on that as well. We’ve done smaller acquisitions and we’ll continue to do that throughout this year and with the hope again that we could expand that into the U.K. and Australia also by the end of year.

Thank you.

Welcome.

And we’ll go next to Benoit Poirier with Desjardins Capital Markets.

Yes, good afternoon Dan, good afternoon Bob. Just to come back on the organic growth recovery for Building, I’m just wondering if the recovery is due to kind of an easy compare as you started to experience a negative organic growth in Q2 last year, is it really on the back of kind of an easy compare?

That will be a part of it. I wouldn’t say that that’s going to be the sole responsibility for it. We do see some of the larger projects that they have won late last year, into the first quarter starting to ramp up, which will help that revenue growth and therefore help the organic growth. So – but some of it will also be as part of the fact that we’re comparing. So I don’t know if it’s on the back of it or if it’s just contributing to it, but I wouldn’t say it’s all that.

I’d say the Buildings business is somewhat more active in terms of their focus to M&BD last year and it’s starting to pay dividends for us this year.

Okay perfect. And just to come back on organic growth for Energy & Resources, did you say that you will expect to be in a positive territory in kind of the second half?

No, I said we’ll be less negative, I got cut [ph]. We see it improving the trajectory of that improving as it goes through the year. I think something would have to happen in the marketplace to get it to positive. Now, and I’m not saying that’s going to happen, but we have to have a significant advance in the Oil & Gas business hence a very strong increase in Oil & Gas prices for that to happen. Based on the trajectory today, they will continue to improve, but it will still be negative organic growth, but we’ll improve quarter-by-quarter as we move through 2017.

Okay. And just in terms of special items aside the $90 million of deferred tax related to Innovyze, I was wondering are there any non-recurring items or integration costs that we should take into account. And maybe if you could quantify the IT spending in the quarter that would be great?

So on the Innovyze, I think what we’ve tried to do is provide as much information in the materials and the pro forma information around the impact of the sale. So we aren’t expecting anything more to come out and certainly we’re going to have some adjustments certainly looking at the tax implications and all of that as we finalizing the accounting in Q2. So I think, what you’ll see is going to be pretty close to what we end up with. So not expecting anything materially different from what we’ve shown.

Okay.

With respect to the IT costs, there are – there’s a lot of additional effort and time and costs incurred in integrating, and to put an exact number on it would be pretty difficult. But it’s in the order of $10 million, I would say, in terms of the impacts of the additional IT costs that we referred in the quarter.

Okay. And is it fair to say that those additional costs on the IT side are mostly over, or there will still be some in Q2 there?

Well, there will be some in Q2. And remember, when we set our targets at the beginning of the year, we talked about some additional costs setting up our new core infrastructure, our new data center and those type of things. So those aren’t related to the MWH integration. But there are still costs that we will incur through 2017. So there may be some impact there, but I think that’s all tied into our estimates that we have previously. So I don’t see that having a material impact that will change our targets that we set out.

Okay. And pro forma for the Innovyze divestiture, could you then provide where would you expect your net debt to EBITDA to stand at on the pro forma basis?

Sure. I think, we reported in the quarter, I think we’re about 2.4 times as of the end of Q1. I think by the end of Q2, we’ll probably be well below 2 times. I think we’ll be at 1.7 times to 1.8 times is, again, where my expectation should be.

Okay, perfect.

So, we’re very, very comfortable at that level.

Okay. Am I right to say that the – in terms of M&A strategy, obviously, the focus is on MWH integration, but maybe some talk-ins, like you said in the UK and Australia?

Correct. That’s what we’re really trying to do is look at diversifying MWH’s operations in the UK and Australia, and still continuing into U.S. strategy that – which shouldn’t that we still felt that even without MWH, we still had opportunities in the U.S. to continue to fill in a number of sectors in a number of geography. So really, we’re looking at three platforms; the U.S. continued platform, the UK, and Australia and New Zealand. So we anticipate going forward, we’re going to get back to a pretty busy M&A strategy.

Okay. And last one for me, just just in terms of gross margin for construction a slight improvement versus Q4 saw 37.4. I was just wondering if there was some seasonality, or maybe the level in the quarter was a little bit higher than expectation?

Yes, less to do with seasonality, I think it’s just a mix of projects in the quarter. You’re going to see a little bit of fluctuation quarter-to-quarter, materially outstanding there.

Yes, certainly that group is performing very well at this point.

Okay. Thank you very much for the time.

Great. Thanks, Benoit.

Thanks, Benoit.

I’ll go next to Ben Cherniavsky with Raymond James.

Hi, guys

Hi, Ben.

Hi, Ben.

Dan, I know you and I have asked you sort of a recurring question. but the conversion of gross to net revenue, look, it’s quite – the numbers are quite sensitive to that, and they’ve been moving around. I understand, obviously, they’ve gone up with MWH. Can you help us pick a good number as a run rate for what we can expect this year and next on that ratio?

Yes, I think in my mind, Ben, for the – so you have to break it down between the construction business units and the consulting business operating units for operations. And for consulting, I would put the number at around 20%

21%

21% 22% – 20% to 22%. So gross revenue would be 122% in that revenue, I want to make sure I make that clear. And on the construction business, it’s somewhere between 175% and 170% of net revenue. So if you look at it on that basis, I think that’s pretty close to what we’re thinking it would be going forward.

Okay, so it’s tough to break out construction separately [Multiple Speakers]

Absolutely.

Yes.

Absolutely, very different business.

Very different business.

…especially in that metric, they’re really different businesses.

Yes, I know, I understand that, but I mean, assuming your mix doesn’t change the overall impact should be a blend of the two, I won’t do the math right, but like it’s the weighted average of the two. But I guess, what you’re saying is, it wouldn’t be one shouldn’t assume the mix will be the same like we should expect the consulting revenue to have grown construction over time, or how should we work with that?

Over time, yes, but on a quarter by quarter basis, there could be fluctuations then. But over time, I think what we said is, on an organic growth basis and certainly because of an M&A strategy in consulting and not having one in construction, it will all grow up. But that’s probably a longer-term. On a short-term basis probably, the mix is going to change significantly in the next couple of quarters, I’d say.

Have you guys reconsidered at all the divestiture auction of construction? Is that still integral and inseparable to lot of reasons?

We’re continuing to work through that. Everything we’ve seen today, they operated as a separate business. So they really do bundle it well, especially in the UK. The UK is a very different business than in the U.S.. And I would say, the design build is to find much differently in the UK. So they work much closer together and it was really a strategy that was very successful in them winning the majority of the app programs in the UK. So certainly, there is a very evident. In the United States, the design build sector is probably, at this point in the water business maybe 10% to 15% of the overall market. And there is a differentiator going into some clients and on some projects on a bundled basis. So while we’re analyzing, Ben, over the next year is, the value of that, the upside of that versus the additional risk and we’re continuing to go through that. And at this point in time, the business operates well. The last thing you want to do is distract it. So for right now, absolutely focused on maintaining that business and exploring where we could accelerate those synergies.

Right. But I – correct me, if I’m wrong, but I got the impression, the initial strategy was we’re not – it’s not really even an option to separate, and now you’re saying it could be under various circumstances?

We – I think separating is not what we want to do, but you have to continue to explore where the synergies are. The only way you continue to maintain that long-term strategy is understanding where the synergies are and let’s consider, we’ve explored it in the UK and certainly it’s there. We’re exploring it further in the U.S. We’re never saying never, but at this point in time, we have no interest in talking about divesting of construction.

Could you carve out just the U.S.?

Unlikely, today that there are some synergies of working on some clients, especially the process is very strong, the process capabilities of the treatment operations in the UK is very strong, and the way the UK operates is also, I think, progressively a decade ahead of the United States. So we do see some opportunities there. Again we never say never, but certainly, that’s not our intent.

Okay. If I could just ask you to clarify something in the MD&A that we note that the oil and gas sector now represents only 3% of gross revenue. So that’s – so you’re carving out oil and gas within the oil and gas – within the energy and resources?

Correct. 3% oil and gas represents up – the oil and gas portion within energy and resources represents 3%, and oil and gas within environmental services represents about 3%, so together they represent about 6% of our total revenue.

But then there’s other ways that you guys are, I think, in – even in – within the energy, you said there was some impact from low gas prices that’s affecting energy, infrastructure and, of course, the building has a knock-on effect. I mean, what would you say is the overall sensitivity of your business to oil and gas prices?

When you – so the areas that it was impacting was the Middle East operations that their projects and buildings are very connected. Obviously, the clients there are very connected to oil and gas. Some of the buildings operations in Western Canada connected and some of the community development operations in Western Canada connected to that. Yes, you sort of added all up. And I still don’t think it’s more than 10% of our overall business now is probably impacted to-date, because its already been impacted. Those projects in the Middle East, where buildings were already been put on hold. So you can’t go into further on hold, they’re already on hold and not generating revenue. So I think that to-date, the future impact is still less than 10%.

Plus you’ve chunked up your gross revenues with the construction business and you grow on the water side, like you’ve just diluted that business down and it has shrunk. So like compared to two or three years ago, it might have been – the overall sensitivity might have been a 30-year business, is that – I mean. I’m not going to hold you to the number, but just get an idea of how that...?

Yes, I’d say if you turn the cost back, yes, absolutely, I think that to me is what the – that’s the upside opportunity of all this. We need just one thing to change right now to go back to that and that is oil prices to increase, but you’re absolutely right, it was a huge impact, today it’s a much less impact overall on our business.

Okay, thanks guys.

Ben, before you leave, Dan here again. I just want to circle back again, looking at my numbers again. For gross revenue as compared to net revenue I think I said 170, if you use 280% because it’s so much more, a big portion of that is sub consultants, which is included in that gross to net, so if we use 280 % gross revenue to net revenue that would be a better number for Construction. We have been guiding around 170, I think that’s too low, that’s only the sub consultant portion of it, not all of the other floating across.

Okay. All right, great thanks for that.

Okay. Thanks Ben.

Okay. I hope you got cleared that out.

Yes.

And we’ll go next to Sara O’Brien with RBC. Sara O’Brien: Hi, guys. Just one on the water segment, what you need to see to see a real lift in that organic growth. I mean I think it was 2% quarter-over-quarter. Maybe year-over-year, what are you seeing internally at MWH? And what do you expect to see that it’s really going to drive that forward in the U.S. and the U.K. from here?

That’s good question the. The U.K. right now is entering the last phases of its AMP program. So you’re probably not going to see significant organic growth in the U.K. for the next couple years as they wind down at six and they start rebidding on at seven. So it’s not going to be a retraction, but I don’t think you’re going to see significant organic growth there. We’re going to see more organic growth than we’ve experienced in the U.S., because as we continue to now join together, we’re starting to see our win rate go up and we’re starting to see some big opportunities. I think the Australia and New Zealand operations are starting to get their feet under themselves. But that may not be all in water and maybe in some transportation and other sectors. So water if you’re looking at organic growth pick up that is really going to be in the U.S. and it is something that doesn’t come immediately, it really comes as we join with MWH. How successful are we going to be now in winning those projects? The good news is, lots of opportunity, that pipeline is probably as full as we’ve seen it, because it’s just been a wider pipeline for us to capture opportunities, because of having both groups together, operating together. So the 2%, actually we’re somewhat happy with that. I think it could continue to increase, but it’s going to be subject to the U.S. and how well we execute on winning those projects.

That 2% relates to – just to be clear, the legacy Stantec business, because we sold all the other acquired revenue in the acquisition growth.

Good point. We don’t… yes. Sara O’Brien: Maybe can you comment on how the acquired business, MWH has done in the U.S. and the U.K. in terms of organic growth or quarter-to-quarter, because that’s what you have?

Yes, we haven’t tracked, Sarah, the – how they’re done in organic growth relative to their prior year’s revenue. What we can say is that they are meeting their budgets. They’re performing as we expected and actually slightly better than we expected.

And certainly in the water sector I think is where they are exceeding their budgets. So, I’d have to say that intuitively if we would have said what were they doing this time last year in water to this time last year and added it to our organic growth in Stantec, it would be higher than 2.3. Sara O’Brien: Okay. And then just going back to the restructuring cost the $10 million, that was $10 million of expenditures during the quarter for – or expense on the P&L that went through for new platforms and software?

That’s correct. Sara O’Brien: Yes, okay. And is that related to MWH or is that Stantec in general redoing systems and investing?

A lot of it is MWH. There is – you know when you merge companies you have to align your business software and all your other systems. So a lot of it is related to that, some of it is related to the core network, but a good portion of it is really getting everyone on to our domain and a lot of extra effort there.

Yes, the majority of them, the majority is the domain. Sara O’Brien: Okay. And you said we should expect some more of these types of cost in Q2, does it kind of taper off there? Or should we expect it to go on through the year?

I think as I indicated, we’re going to have some more utilization related costs, things that are going to impact utilization, mostly training associated with the MWH folks. And we will get to more IT cost as we go through the year, but we’ll try to articulate that as we go through – it would be less.

It will be less, because I think this one was the U.S. and now we’re moving into other areas. Sara O’Brien: Okay. And then I just wondered on the Innovyze sale, if there were any targeted synergies from that, whether they be tax or cross-selling or something that you had factored in when you bought MWH?

Sorry, synergies associated with Innovyze?

What we had though [ph]… Sara O’Brien: That’s right. Like they have tax loss carry forwards that would’ve benefited?

No, if they had tax loss carry forwards we could have used that to lower…

That was nice but you know…

No, unfortunate. Sara O’Brien: Okay. Thank you.

Thanks Sara.

And we do have a follow-up question from Yuri Lynk with Canaccord Genuity.

Hey, thanks. Was Innovyze – that was included in Q1 EBITDA and it will be included into May 5 of Q2, am I thinking – I just want to make sure I’m thinking about that right?

You’re thinking about that correctly Yuri.

Okay, that’s good for me, thanks.

Okay, thanks.

And we’ll go next to Anthony Zicha with Scotia Bank.

Bob, could you give us a bit of color on the California market and how does it compare to last year at the same time. And how important of a market is it for your overall U.S. growth? And what are some of the prospects in Western USA?

I think California now we have a much larger presence in California because of MWH. So it has become a larger part of our growth and a larger part of our performance. And it is an important market, it’s the size of Canada from a population perspective and when you look at water, especially it has every problem you can think of in water. So last year drought, this year flood. So, it is a very intriguing part of our business right now. And I think we can get stronger in a number of other sectors in that. I think we have now the number one water position in California as a result of combining with MWH. What we’d like to strengthen is our transportation sector in that area that certainly is an area where we’re not as strong as we’d like to be. So I think our growth in California is going to be how well do we execute on combining MWH and Stantec to win what is some great opportunities in California, it’s a very large one. And two, how can we execute better in M&A strategy up and down the West Coast really in the United States where we have not been as successful as we have been in the U.S. East. So that is certainly opportunities for us and California is centered around that.

Okay. And then what about the Western region beyond California?

Certainly we don’t have as much exposure in Seattle and up to the Pacific Northwest if we like to have, even in Colorado. So that whole Western part of the United States, if you look at the Stantec map and look at our density, that’s really where we see some opportunities, both organically and from an M&A perspective. Denver now with having a very strong base of operations of MWH’s headquarters there, we see that’s an area for investments and we did a very small firm in Pacific Northwest this quarter that was really to start strengthening and diversifying. So that is a part of the United States, but from a geographic standpoint we feel it’s an opportunity for us.

Okay. Well, thank you very much.

Thanks Anthony.

We’ll go next to Maxim Sytchev with National Bank Financial.

Hello, good afternoon.

Good afternoon Max.

Dan, I just wanted to follow up on the one-offs or one-time costs. So in terms of IT, it was roughly $10 million and were there any incremental restructuring costs that were incurred in the quarter?

Well, I think you referred to it as restructuring costs, we’re always balancing our workforce wherever there is weak resource for that matter. And so there was some severance cost incurred again in the quarter, we go through that every quarter. I wouldn’t say it was materially different than or a completely different than we had in Q1 of 2016. So they were pretty close in terms of the severance costs that we would have incurred. Other than that, there was really no other – what we’ve referred to as restructuring costs in that.

Okay. And anything specific on the integration costs, or the only impact was the utilization?

It’s impacting utilization, and as we mentioned, some of the IT.

Yes, I think I just can’t stress that enough, though, that utilization is, it’s your most senior people unfortunately that need to get together to figure out how do you work together devising what systems you’re going to use, the best of both companies. It is that full integration strategy, it’s not easy to do, especially in that first year. So I think you’re seeing signs of that, that should improve as we go. But it is still something that we will continue to incur as we go through that full integration strategy?

Yes, for sure. And I mean, just some quicker thought. Is it possible to disclose these numbers on a going-forward basis in the press release or MD&A, because we’ll have to wait basically the entire day to get that granularity, if it’s possible?

Yes, I think what we’ve tried to do, Max, is where there are impacts that are materially different from what we would have previously disclosed, then we’d like to highlight those. But if they are part of our business and part of our business is integration, and we don’t try to make excuses for what is impacting the results then that – then we reported the way it is. But if there are material differences then we’ll highlight those.

Yes. Well, I guess, $10 million in IT costs that it is so significantly?

Well, on a $4 billion business, that’s where you have to kind of weigh whether what’s material and what isn’t.

Right. Okay….

But certainly, I take your point.

Yes, I think MWH just because of its size, some of those costs are starting to creep up to be more material, because it’s just a bigger transaction. But as Dan said, we’ve done the same thing with every transaction we’ve done. We just never really has disclosed it, because it’s never been as big. Now MWH’s business is bigger. It’s a 30% of our company. So that has a bit of an impact, but we really don’t want to go down that path of, okay, let’s start disclosing all this, because as we said, it’s part of our strategy.

While we are adjusting for, we become more importantly.

Okay, that’s helpful. And then I just had a quick question in terms of the U.S. momentum. Just looking at some of the public comps, it feels that the organic growth numbers that are coming from those entities appears a bit higher than you guys. Are you feeling that maybe you’re losing a bit of market share, or is it just really a positioning where some of the legacy energy weaknesses is creeping up in those organic numbers, which that doesn’t make necessarily a sort of an apples-to-apples comparison?

Yes, I told that to compared to other companies organic numbers when you really don’t know how that organic number is calculated and the basis on which is calculated. We can only disclose ours and we feel, the 2.4 in water and 2.2 in transportation are pretty good, and they’re stronger in United States. So we feel, actually, we’re pretty happy with our market presence and our growth in those areas. Yes, you compare to some others disclosed numbers that seem to be higher. You just sort of wonder, but all you can do is, worry about your own business. And we’re pretty comfortable with what we have in transportation and water right now especially in the United States, we get pretty comfortable about.

Okay, that’s helpful. And last question, just in terms of M&A, any commentary in terms of the expectations from sellers? Have we seen any inflation in terms of multiples, any changes there? Thanks.

Well, their expectations are always higher. But the final number you pay, I don’t think, we’ve seen significant changes to that. When you see, especially in the smaller acquisitions, they see the multiples of the larger firms. They see the public company multiples. They gravitate to that and figure that they should get those multiples, but those are expectations you can manage and go back to and really looking at their businesses. But we really haven’t seen significant increases. But when you look at some of the multiples that we have been paid, yes, that’s – they’re at the higher-end and that doesn’t make the job easier convincing a smaller companies that their expectations are unreasonable.

Right. And I mean, in terms of transactions right now, I guess, it’s a combination of small and medium and potentially platform-type acquisitions, right, that are still under consideration, obviously, once you digest MWH, right?

Yes, it covers the whole spectrum right now, Max. It is a pretty, I would say, robust M&A environment out there. All we can say is, Stantec is capable of playing at all three levels at a large level, mid-sized and smaller, and I think that’s what gives us some advantages. We’re not reliant upon one aspect of the M&A world right now. We can play in any area we want.

Okay, very helpful. Thank you very much.

Thanks, Max.

We’ll go next to Benoit Poirier with Desjardins Capital Markets.

Yes, just a follow-up on the Q1 2016, when you were referring to the severance costs. Am I right to see you were referring to the $3.5 million costs taken in Q1 2016?

Yes, that’s correct.

Okay.

It was not the same as what we’ve incurred in Q1 2017.

Yes. Okay, perfect. And just in terms of backlog, obviously, up slightly quarter-over-quarter, who could quantify what was the FX impact on a sequential basis?

I don’t have the FX impact, Benoit. But what I can say is the backlog is up virtually in every business line or business operating unit that we have. It’s either upper or flat, so very positive. And I don’t think the FX would have had a material impact in the quarter from the year-end.

Okay, perfect. And when we look at the free cash flow, Dan, any expectation or thought for the full-year, I mean, looking at your working cap down in Q1, but there’s a lot of seasonality. So any thoughts about the expectation for the year or kind of a free cash flow conversion we should be looking for?

I think we’ll see similar free cash flow conversion as we will have seen in prior years certainly in Q1 consistent with every year that we’re spending in the roll off. We’ve used more cash than we’ve generated. It’s really as a result of the accumulation of short-term incentives and tax payments that are generally do in the first quarter. We do generate start to turnaround generate positive cash flows in Q2 and Q3 and maybe a little bit flat in Q4. With the drawdown of the debt that should reduce some of our cash flows as well around interest expense. So I do see some positive cash flow momentum going through the year.

Okay, perfect. And last one for me, any thoughts on the BC election that just happen, whether you see some positive neutral or slightly negative implication going forward in all of your business segments?

It’s not over yet. So I guess, we’ll have to wait and see what actually – how the dust settles, certainly with a minority government level that was supporting pipeline development and resource development now opposed by an NDP and Green Party that may carry the weight, that could cause some noise. We’re interested to see how. But at this point in time, it’s unknown how it’s going to go forward, but that unknown is also not good. So basically, this is going to cause a pause a lot of companies are just going to wait to see what happens.

Yes. Okay, perfect. Thank, again, for the time.

Thanks, Benoit.

And we’ll go next to Michael Tupholme with TD Securities.

Thanks. Dan or Bob, can you provide a bit more color around how we should think about the organic growth progression within the building segments? It sounds like you’ve won some awards, and I guess, it’s just a matter of time before you start to see some of those kick in. But try to get a sense for how we should think about that organic growth number going forward?

Yes, Dan and I are pointing at each other to answer the question.

Because you weren’t specific on who’s.

So, I guess, I’ll answer it. It is a hard one to look at. We try to dig into see we know how much work they’re doing. We see the utilization increasing. They won the work. Those work – it does – it ramps up, it doesn’t happen overnight. Those projects also are slow to start, because you’re doing schematic design at the beginning. We’re comparing against a – not as strong Q2 as we had in Q1, when you look at last year. So all those factors are, it will be better, whether that will turn to a positive in Q2, it’s hard to tell. We like to hope it is. Hope is never a good strategy, but at this point, there’s not enough clarity to say. But it will be better and certainly throughout the year, we see that turning positive.

I think the other thing to point to is the – we’ve had material retraction in our Middle East business. And we’re seeing some potential opportunities for projects coming back, nothing fully confirmed yet, but things are starting to look better and that’s encouraging.

And I think unfortunately, when we look at the Middle East, it is not like North America. Your clients there don’t give you a clear picture. They don’t follow a schedule for their projects. It is mainly relationships you’re talking about and trying to get a feel for. So, as Dan said, the meetings are going positive. Things are moving in the direction they’re asking for more information. Those are all positive signs. It’s how quick that happens is really we’re having a hard time. We do see all that – does happening though this year. We don’t see a continued delay up into 2018, we see these things happening this year, it’s just a matter of win.

Okay, perfect. And then just lastly, Dan, is there going to be any change in the amortization of intangibles related to acquisitions as a result of the Innovyze sales?

Yes, absolutely. And I think we’ll spell that out in the second quarter reporting. There will be certainly a portion of the purchase price will have gone to intangible assets, as well as goodwill, and we’ll have that all clarified in the second quarter. And yes, but you can expect some of that to go down. I think, what’s important to note, though, is the reduction in the amortization of intangibles, the reduction in the interest expense that we’ll incur will – according to what we’re seeing today will approximately offset the EBITDA contribution that Innovyze provided. So essentially on a full-year basis, it will be more or less a wash.

Right, okay. I think you maybe mentioned that when you first announced that as well, so that’s just to clarify.

Yes, just to clarify that.

Great. Thanks.

Okay. And we have no further questions in the queue at this time.

Great. Okay, thank you very much for your questions. That concludes our call for today. Thanks for joining us and we’ll talk to you next quarter.