Earnings Call Transcript - STN Q2 2022

Operator, Operator

Welcome to Stantec's Second Quarter 2022 Earnings Results Webcast and Conference Call. Leading the call today are Gord Johnston, President and Chief Executive Officer; and Theresa Jang, Executive Vice President and Chief Financial Officer. Stantec invites those dialing in to view the slide presentation, which is available in the Investors section at stantec.com. Today's call is also webcast. Please be advised that if you have dialed in while also viewing the webcast, you should mute your computer as there is a delay between the call and the webcast. All information provided during this conference call is subject to the forward-looking statement qualification set out on slide 2, detailed in Stantec's management discussion and analysis are incorporated in full for the purposes of today's call. Unless otherwise noted, dollar amounts discussed in today's call are expressed in Canadian dollars and are generally rounded. Please go ahead.

Gord Johnston, CEO

Good morning and thank you for joining us today. We're very pleased to report another strong quarter of operational and financial performance. Our second quarter and year-to-date results are tracking very well against our strategic objectives. As such, we remain confident that we will deliver on our targets for the year. There are two highlights for the quarter that I want to touch on before turning to our financial results. The first is an update on Cardno. The integration is progressing very well and is in line with the expectations we outlined at the time of the transaction. We've already achieved our target of US$10 million in run-rate synergies, 18 months ahead of schedule, and we continue to identify opportunities for additional savings. The Oracle financial systems migration in Australia and New Zealand is largely complete, and we're in the final stages of the transition. The US integration is in full flight and is progressing nicely. There's still a lot to be done; however, we expect this to be completed before the end of the year. The second highlight that we are very proud of is that Stantec continues to be recognized for our leadership in ESG. For the 13th time, we were recognized as one of Canada's best 50 corporate citizens by Corporate Knights. We're honored to have earned this recognition, receiving top quartile scores this year for employee health and safety, Board and executive gender diversity, racial executive diversity, and clean investments. This recognition affirms that our long-standing commitment to advancing ESG is having a real impact towards a more sustainable future, and we're very proud of the difference that Stantec is making. Turning now to our Q2 results. We are pleased to have delivered a 34% increase in adjusted EPS. We generated 9.4% organic net revenue growth. Consistent with Q1, we delivered organic growth in every one of our geographic regions and in each of our business units. This reflects our ongoing ability to capitalize on the key drivers that I've spoken about previously and that I'll talk more about towards the end of the call. A common thread through many of these projects is the need for the skills of our Environmental Services business, which delivered a 54% increase in net revenue, of which 12% was from organic growth and 40% was generated by our recently completed acquisitions. Our Q2 results also reflect very favorable margin expansion, with an 80 basis point increase in project margin, and a 60 basis point increase in adjusted EBITDA margin. Taking a closer look now at each of our geographic regions. The level of activity in our US business continues to gather momentum. In Q2, net revenue increased by 27% with 9% organic growth and 14% acquisition growth. We're pleased to have delivered organic growth across all of our business units, as we did last quarter. This is a reflection of the robust level of investment occurring in the US. Investment in the reshoring of semiconductor production has driven a significant amount of activity across multiple business units. Environmental Services net revenue grew by over 80% and continued to be the biggest contributor to US revenue growth. The combined Stantec Cardno team is very well positioned to address the strong demand for environmental assessment, permitting, and cultural resources work in addition to ongoing monitoring and ecosystem restoration efforts. Water shifted into double-digit growth as activity ramped up on several major projects to address industrial and advanced manufacturing project needs and water scarcity in the Western US. And buildings continued its post-COVID recovery with another quarter of organic growth driven by the need for increased healthcare capacity and investment in the civic, industrial, and science and technology sectors. Canada also continued to perform well, delivering 5% organic growth in the quarter. Consistent with the themes playing out in the U.S., our Environmental Services business in Canada had a very strong quarter, delivering double-digit growth on the strength of high demand for permitting work and our archeological services. Infrastructure delivered strong growth arising from the strong housing market in Western Canada. Organic growth in our transportation sector also reflects our continued support of British Columbia's recovery efforts from the extreme flooding that occurred last year. Buildings continued to deliver organic growth on the strength of major public projects in healthcare and science and technology. The growing momentum behind the energy transition and global food security initiatives continued to spur growth in energy and resources. Rounding out our geographic regions, Global had another remarkably strong quarter. Net revenue in our global region grew by 40%. Every business unit in Global grew organically in Q2 delivering 17% organic growth. Recent acquisitions delivered a further 27% growth. The strong financial results Global has generated year-to-date reflect the maturing of acquisitions made in recent years. We're pleased with the way that we're performing together under the Stantec banner. Water continues to perform exceptionally well, delivering almost 20% organic growth on the strength of the U.K., Australia and New Zealand water framework programs. Infrastructure has doubled its net revenue, with very strong growth in Community Development and acquisition growth in Transportation. Our Mining Sector delivered organic and acquisition growth on strong commodity prices, client diversification, and the easing of pandemic-related restrictions. With that, I'll turn the call to Theresa, to review our Q2 financial results in more detail.

Theresa Jang, CFO

Thank you, Gord, and good morning, everyone. As Gord noted, we had a very strong quarter, with an overall 21% and 23% increase in gross and net revenue, respectively. Project margin grew by 25% and by 80 basis points as a percentage of net revenue. This reflects our continued focus on project execution and our heightened diligence in project pursuits. We delivered a 27% increase in adjusted EBITDA, reflecting the overall growth of our business. Adjusted EBITDA margin was 16.7%, 60 basis points higher than Q2 2021, resulting from strong performance across the business. Net income and EPS decreased slightly to $61 million and $0.55 per share, as increased EBITDA was offset by higher acquisition-related costs. We also recorded an unrealized fair value loss associated with our equity investments held for self-insurance liabilities. Adjusted net income and adjusted EPS increased, 33% and 34% respectively to $93 million and $0.83 per share, reflecting very strong earnings from our underlying operations. Operating cash flows decreased to an outflow of $4 million for the quarter. Cash flow was primarily disrupted by the Cardno integration, due to the financial system migrations for both Australia and the U.S. operations occurring during the second quarter, as we had outlined in our Q1 earnings call. To a lesser extent, Q2 cash flow was also impacted by investment in working capital to support the organic revenue growth. We view these causal factors as purely matters of timing, which will contribute to stronger cash flows in the second half of this year as the effect of the financial system migration dissipates, and processing times normalize, particularly in Q4. We've already seen cash flows pickup in Australia after quarter-end, which was the first of the Cardno migrations to occur this year. We continue to be active with our NCIB earlier in the quarter, repurchasing just over 625,000 shares for $37 million. Consistent with the change in our operating cash flow, our DSO is up three days from last year to 79 days. All of these factors, coupled with the funding of Cardno and other acquisitions in the past 12 months, resulted in our net debt to adjusted EBITDA being at 2.0 times, the upper end of our internal range. As our cash flow normalizes over the remainder of this year, I'm confident that our leverage will return to the middle of our target range by year-end. I'm going to turn the call back to Gord now, to review our backlog and outlook.

Gord Johnston, CEO

Thanks, Theresa. Our outlook continues to be very strong at a record $5.8 billion. We grew backlog organically by 13% since the end of 2021, and again delivered organic growth in every geographic region and in each business operating unit. Most notably, we achieved almost 30% growth in Energy and Resources and over 20% growth in Infrastructure, while Buildings also achieved double-digit growth. Our backlog represents approximately 14 months of work, which is a high watermark for us. Before I turn to the outlook for the remainder of the year, I want to comment briefly on the risk of a potential slowdown as a result of inflation and a possible recession. We continue to monitor the situation carefully and have not seen any material slowdown in project or pursuit activity to date. As we discussed this with clients, the consistent feedback we've received is that the risk of cost increases is being outweighed by the need to address a number of pressing challenges, including aging infrastructure, climate change and production capacity constraints, and the reshoring of domestic production. These imperatives continue to translate into investments in major project awards across all of our business units. In Canada, our water business was successful in winning two significant projects: the Buffalo Pound Water Treatment Plant Renewal Project in Saskatchewan and program management consulting for the Iona Island Wastewater Treatment Plant program in Vancouver, which is the largest capital program ever undertaken by Metro Vancouver. In the United States, we won a contract with the Nebraska Department of Natural Resources to conduct floodplain modeling and mapping. Additionally, we won awards in Hawaii and Indianapolis, which support clean transportation to help our clients reach their climate goals and objectives. In our global operations, we were awarded a transportation framework project in Scotland to support climate change adaptation and decarbonization. With respect to capacity constraints and the reshoring of domestic production, there are dozens of projects that we're working on in different industries, including technology with semiconductors, healthcare with vaccine production, and logistics and fulfillment centers to shore up supply. We are seeing significant government funding flowing into these areas. As we look forward for the rest of the year, we are very confident in our ability to achieve our financial targets. Our backlog has never been higher, having grown by well over $1 billion in the past 12 months, and we continue to see project opportunities accelerate. Significant US federal funding is moving forward, and even with cost escalation, our clients expect critical infrastructure projects will advance. Private investment also remains robust, especially in areas of water and food supply and resiliency, healthcare, and industrial. In some instances, federal funding is helping drive private investment, and there's no better example of this than the billions of dollars directed towards the reshoring of semiconductor manufacturing. In late July, both the US Senate and House passed a $280 billion CHIPS and Science Act. From this, $52 billion will go to support semiconductor chip manufacturing, including $39 billion for plant construction. The passage of this act was critical for many chip manufacturers to move forward with private investment, and we are already working with five of the top 10 semiconductor manufacturers. The strength that Stantec brings to projects at this scale is our ability to provide multidisciplinary expertise. Our environmental experts, architects, transportation and water engineers all play critical roles in bringing these facilities into reality. Europe has also passed similar legislation to reassure semiconductor production, so the opportunity for Stantec is tremendous. Looking ahead, our outlook for the remainder of 2022 has not changed from the guidance we provided at the start of the year, and I believe Stantec remains very well-positioned to capitalize on the opportunities ahead. With that, I'll turn the call back to the operator for questions.

Operator, Operator

Thank you. We will now take our first question from Devin Dodge from BMO Capital Markets. Please go ahead.

Devin Dodge, Analyst

Thanks. Good morning, Gord. Good morning, Theresa. The growth in the backlog year-to-date has been really impressive. Can you speak to how your bid pipeline looks, what you see right now, and how that compares to maybe 6 months to 12 months ago?

Gord Johnston, CEO

You know, the opportunities that we're seeing, we have a system we call our Stantec opportunity pipeline. We do track projects that come in. It's interesting that we're seeing continued strengthening of projects in the backlog. I think that as we see these projects in the pipeline, they'll come through the bid process. I believe we see positive support for the backlog growing even further as we progress through the rest of this year and into 2023.

Devin Dodge, Analyst

Okay. And then maybe just continuing on with that. Can you speak to your success in your hiring efforts to expand the workforce? I'm just trying to understand if there was a significant net addition of employees in Q2 and if this is expected to continue into the second half of the year?

Gord Johnston, CEO

Yes, absolutely. One of the things we've talked about is that through this period of uncertainty, we want to continue to be a net importer of staff within our employee base. Through all of 2021 and Q2 of 2022, as we've spoken about previously, I can now confirm that we hired more people than left us. Our headcount continues to grow, and in fact, we're up to a little over 26,500 people now. So, we've had success in those onboarding efforts, and we look for that to continue for the remainder of the year.

Devin Dodge, Analyst

Okay. Thanks for that. Congrats on Q2. The result is really good. I'll turn it over.

Gord Johnston, CEO

Great. Thanks, Devin.

Operator, Operator

We will now take our next question from Jacob Bout from CIBC. Please go ahead.

Jacob Bout, Analyst

Good morning.

Gord Johnston, CEO

Good morning, Jacob.

Theresa Jang, CFO

Good morning.

Jacob Bout, Analyst

So strong double-digit organic growth in the Environment and Water business. Do you expect this to normalize in the quarters ahead, or do you expect to see a step change going into 2023? And maybe talk through some of the revenue synergies from Cardno?

Gord Johnston, CEO

Sure. The environmental business continues to be really robust. I believe we will continue to see really positive performance in that group going forward, not just in North America, but in our global operations as well. The types of synergies we're seeing are projects where, previously Cardno would have to sub out or hire someone else to do archeological work, and now they hire Stantec for it. We have projects where Cardno was strong in one geography, while Stantec was stronger in a different geography; we're now able to offer these combined skill sets to our clients and take on larger, more geographically diverse projects. We're seeing a lot of synergy there. When we went into the transaction, we foresaw that we'd have good linkages and integration between the groups, and it has really exceeded our expectations.

Jacob Bout, Analyst

And with the Cardno and Cox|McLain acquisitions, are you rightsized in environmental now, or maybe just discuss strategically how you're thinking about M&A for your end-market mix?

Gord Johnston, CEO

Yes. The environmental business continues to expand. Even though we've significantly grown the size of our environmental practice through combining Stantec and Cardno, we see continued opportunities to grow that business. We're always in conversations with midsized environmental firms in the US that would really fill in additional geographies for us. We're absolutely not done in the environmental space from both an organic and acquisition growth perspective.

Jacob Bout, Analyst

Thank you.

Gord Johnston, CEO

Great. Thanks, Jacob.

Operator, Operator

We will now take our next question from Chris Murray from ATB Capital Markets. Please go ahead.

Chris Murray, Analyst

Yes, thanks, folks. I guess my first question is just thinking about your SG&A costs. Now that we've had a couple of quarters of a more normal run rate with activity in offices, I just wonder how you're feeling about some of the initiatives you’ve undertaken so far with real estate and your confidence in leveraging existing SG&A, or how we should think about needing to add to support further growth as we go forward?

Theresa Jang, CFO

Sure. As far as our admin and marketing costs are concerned, relative to pre-COVID, we're still seeing that discretionary costs are lower and that aligns with the expectation we had established in the business. They would not return to pre-pandemic levels. They are certainly higher than last year, as that was expected with increased travel and client interactions. This has contributed to our increased admin costs this year, but I don't expect they will continue to rise. I think they have leveled off to some degree. This year, we’re also seeing higher integration and acquisition costs, especially related to Cardno, Cox|McLain, and Barton Willmore. These factors together will contribute to costs, but overall, I believe they have leveled off. We’re focused on business development efforts on major pursuits, contributing to slightly higher admin costs as we move forward.

Chris Murray, Analyst

Okay, that's helpful. Thank you very much. There's a lot going on. In addition, maybe this question is for you, Theresa. With the close of Cardno, you're near the top of your leverage range. Free cash flow is expected to improve in the second half, but we've noticed you guys buying back some stock. Do you feel any pressure to get leverage down to support further acquisitions? I know you’re still inside your range, but at the top of it. How do you think about walking that back over the next few quarters?

Theresa Jang, CFO

Yes, for sure. As I noted in my comments, we view the first half of this year as a temporary dynamic. I'm confident cash flow will normalize in the second half. We’re already seeing evidence of this, especially as we exit the financial piece of the Cardno integration. I wouldn't say I feel pressured. It’s important to maximize cash flow and maintain space on our credit facilities. I don’t believe it hampers our growth ambitions. Access to capital remains strong, enabling us to fund future acquisitions appropriately.

Chris Murray, Analyst

Okay. Thanks, folks.

Gord Johnston, CEO

Thanks, Chris.

Operator, Operator

We will now take your next question from Michael Kypreos from Desjardins Capital Markets.

Michael Kypreos, Analyst

Yes. Thank you, and good morning, everyone.

Gord Johnston, CEO

Good morning, Michael.

Michael Kypreos, Analyst

Some of your peers have been very active in M&A in the last few months. With the early success of Cardno, have you thought about a larger transaction, or is it still the medium to small with 1,000 employees or less?

Gord Johnston, CEO

As we've been discussing over the last couple of quarters, we continue to look at acquisitions of all different sizes. While we've certainly seen activity in the marketplace, we'll stick to our knitting. We're making what we believe to be long-term decisions for the sustainability of Stantec and shareholder value accretion. Yes, we're looking at all different types of firms, geographies, and sizes. In due course, we’ll probably have an opportunity to talk more with you about those transactions.

Michael Kypreos, Analyst

Thank you. Thanks for the color. Additionally, on the US Biden infrastructure plan, have you seen any more clarity or any early signs, or is it still more of a 2023 story?

Gord Johnston, CEO

With the IIJA, we are seeing that the 2022 funding from it has been disbursed to the various agencies. We're currently working on projects related to that as well. We expect more projects to come out while we are generating some revenue from it now. It will certainly continue to strengthen through the second half of this year into 2023 and support for years beyond that. Additionally, the IIJA has the CHIPS and Science Act that will continue to spur development in the semiconductor industry. We are already working on several projects related to semiconductor manufacturing and with five of the top 10 manufacturers globally. We also see additional supports from the Inflation Reduction Act, particularly how it could impact renewable power perspectives—renewable fuels, EV, and charging infrastructure. I believe we see strong supports for Stantec and our industry through the remainder of 2022, 2023, and beyond.

Michael Kypreos, Analyst

Perfect. Thank you. Great color, and looking forward to the third quarter.

Gord Johnston, CEO

Great. Thanks, Michael.

Operator, Operator

We will now take our next question from Mark Neville from Scotia Bank. Please go ahead.

Mark Neville, Analyst

Hi. Good morning, Gord. Good morning, Theresa.

Gord Johnston, CEO

Good morning, Mark.

Theresa Jang, CFO

Good morning, Mark.

Mark Neville, Analyst

Earlier in your comments, Gord, you said you've already achieved the $10 million synergies from Cardno. When you talk about the synergies, it seems more related to revenue and project pursuits you won. I want to clarify, the $10 million to date has been on the cost side. Anything that's revenue or real estate would be additive, is that correct?

Gord Johnston, CEO

You're right. The $10 million we spoke about was on the cost side. That includes real estate, IT systems, insurance, and other similar costs we've been working through. Separately, we are not disclosing the number on the revenue side, but we have hundreds of joint projects underway. So yes, that $10 million was solely for cost run-rate synergy, which we've achieved ahead of schedule due to the strong integration and the way our teams have been collaborating. Stantec has been getting input from Cardno on how we can collectively reduce costs, which has been extremely positive.

Mark Neville, Analyst

Great. That's great. On the real estate opportunity at Cardno, would it be material? I'm curious about the opportunity to size Cardno.

Theresa Jang, CFO

It's hard for me to quantify at this stage. We're just not far enough along yet, Mark, to know. However, I think it could be significant, but we're still working on that assessment. We'll have more to say when we're further along.

Mark Neville, Analyst

Got it. Just a follow-up on M&A: With Cardno's success, would you feel comfortable pursuing something larger now, or is your primary focus still on integration?

Gord Johnston, CEO

A lot of these more substantial M&A opportunities are really opportunistic. We’re always in discussions with firms, and it depends on when they’re ready to come to market. As you mentioned, Cardno is doing very well. If something was ready, would we hold off? No, I don’t think we would. We’ll be prepared to act, but we won’t move forward just because others are. We'll maintain our discipline and act when the time is right.

Theresa Jang, CFO

The point I wanted to make is that regarding our leverage, I don't believe it hampers us from pursuing M&A right now. The strong cash-flowing business model has not changed, and while we encountered temporary disruptions in cash flows for the first half, that will normalize. Therefore, I believe we will have substantial capacity on our balance sheet for future acquisitions. While I can’t completely rule out equity for larger acquisitions, I don't see us needing to issue equity for the size and scale of acquisitions we’ve discussed.

Mark Neville, Analyst

Got it. Lastly, Gord, you mentioned semiconductor manufacturing several times. How significant an opportunity are these chip foundries for you?

Gord Johnston, CEO

When you think about a semiconductor manufacturing facility, beyond the actual equipment inside the building to manufacture chips, Stantec can handle the rest. This includes all the water and high-purity water management, along with general water and wastewater, the buildings, site civil, and permitting. As we communicate with these clients, it’s particularly appealing for them that we can provide multidisciplinary experience for everything except what’s inside the building, and there are others who specialize in that aspect. So this presents an exciting area for us. Additionally, we’re also involved in vaccine production facilities and renewable energy equipment facilities, like solar panel production. All of this work contributes to a strong tailwind for us for many years ahead.

Mark Neville, Analyst

Thanks for the color. Good quarter, and good luck.

Gord Johnston, CEO

Great. Thank you.

Operator, Operator

We will now take your next question from Bryan Fast from Raymond James. Please go ahead.

Bryan Fast, Analyst

Yes. Good morning, Gord, Theresa.

Gord Johnston, CEO

Good morning.

Bryan Fast, Analyst

As you look at the backlog, are you seeing a higher rate of projects pared back or rescoped? Can you comment on the health of the backlog given the shifting macro backdrop?

Gord Johnston, CEO

The backlog is very healthy. The gross margin or project margin in there is robust. We haven't seen material pushbacks, but we are seeing clients approach us for additional assignments to scope projects at lower costs. In many cases, this is actually increasing our fees due to the added value engineering component. It's something we're keeping a close eye on, but as of now, the backlog is solid without any material cancellations.

Bryan Fast, Analyst

Thanks. That's helpful. Regarding project margin, we saw similar trends as Q1 where U.S. and Global margins increased while Canada’s decreased. Is that just related to mix in Canada? How should we think about those trends going forward?

Theresa Jang, CFO

This quarter's dynamics around project mix affected Canada’s margins negatively. Our business will always be subject to these dynamics. It's about how well we execute and price our projects effectively. We've observed increased focus and discipline around those elements. As we look ahead, we believe we can remain in that 53% to 55% range, which we've met this quarter.

Bryan Fast, Analyst

Okay. Thanks for that. Great quarter.

Gord Johnston, CEO

Great. Thank you.

Operator, Operator

We will now take our next question from Ian Gillies from Stifel. Please go ahead.

Ian Gillies, Analyst

Good morning, everyone.

Gord Johnston, CEO

Good morning, Ian.

Ian Gillies, Analyst

Following up on some M&A questions and the success you’re having with Cardno, how does it change your view about sizing from an employee count perspective? A year ago, the target was 1,000 people or less; Cardno was obviously substantially bigger. Given your experiences now, are you willing to consider larger sizes if the right opportunity presents itself?

Gord Johnston, CEO

I think it all depends on the right opportunity. The reason our acquisition of Cardno has been successful is due to the right type of business and a solid cultural fit. Absolutely, if we encounter the right firm that fits our culture and has the right reasons for acquisition that would be additive to us, we would consider it.

Ian Gillies, Analyst

That's helpful. Thank you. I will turn the call back over.

Gord Johnston, CEO

Sure. Thanks, Ian.

Operator, Operator

We will now take our next question from Sabahat Khan from RBC Capital Markets. Please go ahead.

Sabahat Khan, Analyst

Hey, great. Thanks and good morning. Regarding guidance, margins for the rest of the year look roughly in line to slightly ahead. Do you have any commentary on the cadence of EBITDA margin for Q3 and Q4? Any significant factors we should consider?

Theresa Jang, CFO

When considering the cadence of our earnings, including our EBITDA margin, Q2 and Q3 generally tend to be our higher-margin quarters when we are busiest, while Q1 and Q4 are typically lower. I would expect it to follow a similar pattern this year, remaining robust for Q3 and then returning a little lower in Q4. Our target range of 15.3% to 16.3% remains realistic.

Sabahat Khan, Analyst

Great. Looking at the bigger picture growth strategy, you indicated a desire to focus on project management. Several peers have emphasized this area. How do you perceive pursuing more work in that side versus design, and is it a capability you want to develop?

Gord Johnston, CEO

Our program management is an attractive segment. We're always pursuing growth in that area. The Iona Island Wastewater Treatment Plant Project we discussed is massive, and program management will last for five years or more. These long-term projects provide significant opportunities for us to make a difference for our clients, and it is absolutely an area we wish to continue growing.

Sabahat Khan, Analyst

Lastly, I recall you mentioned some projects on the US side that were just initiating late last year. With the growth reported this quarter, should we assume those larger awards are now starting to generate revenue?

Gord Johnston, CEO

Absolutely. We are indeed beginning to generate revenue from several of those larger US awards that we had previously announced.

Sabahat Khan, Analyst

Great. Thanks for the insights.

Gord Johnston, CEO

Great. Thanks, Sabahat.

Operator, Operator

As there are no further questions in the queue, I'd like to turn the call back to your speakers for any additional or closing remarks.

Gord Johnston, CEO

Thank you for joining us today. We look forward to connecting with you in the weeks and months to come as we continue executing our 2022 plan. Thank you very much, everyone.

Theresa Jang, CFO

Thank you.

Operator, Operator

Thank you. That will conclude today's conference call. Thank you for your participation. Ladies and gentlemen, you may now disconnect.