Monday, February 12, 2018

The Caisse's $300 Million REM Cost Overrun?

The Canadian Press reports, Montreal’s light rail system to cost $6.3B, expected to open by 2021:
The project to build an electric light rail network connecting Montreal with its suburbs and international airport was officially launched Thursday, with the transit system expected to open by 2021.

SNC-Lavalin emerged as the big winner and is part of the two consortiums that will build the infrastructure and furnish the trains.

“We have been very conscious of the importance of creating a process that had great integrity from beginning to end,” Michael Sabia, head of the province’s public pension fund manager, told a Montreal news conference.

“And through that process, we’ve achieved the result that we wanted to achieve which is the best quality project at the best possible price.”

The transit project will now cost $6.3 billion — $300 million more than the original price tag — and is expected to be ready by the summer of 2021, instead of 2020.

It is being billed as the largest public transportation project in the Montreal area in the last 50 years.

The Caisse de depot pension fund, through subsidiary CDPQ Infra, will provide $2.95 billion in financing for the project and will assume the extra costs.

Quebec and Ottawa will chip in $1.28 billion each, while Hydro-Quebec will add $295 million and the regional transit agency an additional $512 million.

Premier Philippe Couillard described the project as one of the largest public undertakings in the province since the James Bay hydroelectric project.

“We have come back to the era of major projects in Quebec,” he said at the news conference.

Couillard also struck a reassuring tone for Bombardier Transport, based in La Pocatière, Que., which lost out on the contract.

There will be other contracts in the future, Couillard assured, noting that Montreal’s subway system is expanding.

“There will be (subway) expansions; there may be new lines of different colours,” he said. “There is a lot of work awaiting the people of Bombardier.”

A spokesperson for Bombardier Transport said the company and its employees were “disappointed” at not being chosen.

Eric Prud’homme said the company’s La Pocatière plant, whose workers are building Montreal’s new subway cars, has nothing booked beyond 2019.

“The order book ends in the next 12 months, in 2019,” he said in an interview. “After that, it’s zero.”

The initial conception of the project has been slightly changed and will now include 26 stations, one less than originally planned, along a 67-kilometre automated light rail network.

Montreal’s REM (Réseau express métropolitain) was first announced in January 2015 and construction is scheduled to begin this April.

Sabia announced that a consortium of SNC-Lavalin, Dragados, Aecon, Pomerleau and EBC will be responsible for engineering, procurement and construction, while Alstom and SNC-Lavalin will provide the cars.
You can read more on this project form the Globe and Mail here. I note the following:
Together, the two contracts represent a $3.7-billion contribution to Quebec's economic output, with 34,000 construction jobs and 1,000 permanent jobs, the Caisse said. About 65 per cent of the material supplied will be made locally, it said.

The decision not to choose Bombardier marks another blow for the company's North American rail business, which is struggling to deliver product to customers amid supply chain difficulties. Bombardier has faced repeated criticism from Toronto's regional transit agency Metrolinx and the Toronto Transit Commission alleging it can't produce on time. Last summer, it was also dropped from the bidding to supply a new fleet of subway cars for New York's Metropolitan Transit Authority.

The Caisse holds a 30-per-cent stake in Bombardier's rail unit and is one of SNC's biggest shareholders. The pension fund says the REM tender process was rigorous and monitored by external auditors to ensure its integrity. Still, that Chinese wall might not be understood by all.

"It's going to be hard for Bombardier to explain around the world why one of the owners of their business did not buy from the company they own," said Karl Moore, a corporate strategy specialist at McGill University. "If I were a salesperson for their competitors, I would absolutely bring this up."
As shown below, Bombardier's shares (BBD-B.TO) are up nicely over the last year, helped by it winning a trade dispute with Boeing (BA), but over the last five years shares are down as the company has struggled to implement a succesful turnaround (click on image):


It's the five year chart which explains why Canada's large pensions are leaning on Bombardier, expecting a lot more transparency and accountability from its board and senior managers.

Anyway, it's obvious the big winner from this mega construction project is SNC-Lavalin Group (SNC.TO), but even that company has had corruption issues in the past. Still, its shares are up big over the last two years as it cleaned up shop and focused on its core business (click on image):


I've already discussed the Caisse's REM project, most recently when I went over Ontario Teachers' new infrastructure approach back in June:
[...] what struck me from the article is that OTPP's Infrastructure team is investing in some greenfield projects and Olivia Steedman was mandated to run that team and go out to recruit people with the skill sets to do these investments.

But Andrew Claerhout ruled out pursuing OTPP’s greenfield strategy through funds or separate accounts or going 100 percent direct. Instead, they partnered with experienced teams, set up platforms with them, and use those partnerships to acquire the requisite expertise.

He's not alone. Many other large Canadian pensions use infrastructure platforms to attract qualified and experienced people to help them manage infrastructure investments. But their focus has been predominantly on brownfield, not greenfield projects.

The article discusses OTPP's approach to funding businesses that are developing greenfield projects where the pension owns the business. It gives the example of BlueEarth and Cubico.

This is one approach. Another approach is what the Caisse is doing now with its massive REM project, which is a purely direct greenfield project. The Caisse got a loan from the Quebec government and will receive money from the federal government too, but what Macky Tall and his team are doing in Montreal is unlike anything any large Canadian pension is doing in infrastructure.

[Note: The Caisse de dépôt et placement du Québec just received confirmation of a $1.283-billion investment, by the Government of Canada and Prime Minister Justin Trudeau, in the Réseau électrique métropolitain (REM) project.]

I just finished covering the International Pension Conference of Montreal and PSP's fiscal 2017 results where I noted that PSP's CEO André Bourbonnais is concerned about investor complacency and rightfully warned institutional investors are underestimating valuation and regulatory risks of infrastructure, mistakenly looking at these investments as a substitute for bonds.

In a private conversation with me at last year's pension conference, Leo de Bever, AIMCo's former CEO, told me he thought some of the infrastructure deals were being priced at "insane levels". I can't tell you which deals he mentioned (will let you guess), but he did add this: "what the Caisse is doing with this greenfield infrastructure project is truly innovative and can pay off in a huge way if they get it right."

I agree. There is no large pension in the world which is doing anything close to what the Caisse is doing in terms of a purely direct major greenfield infrastructure project where it controls everything from A to Z.

In order to do this project, CDPQ Infra went out and recruited people with the requisite skill-sets, people with operational experience developing and managing mammoth greenfield projects (not just MBAs and dealmakers but engineers with MBAs who worked at large construction engineering companies like SNC Lavalin and elsewhere).
On Friday, I went over whether this is a correction or something far worse and referred to an article on how Canada's biggest public pension plan sees opportunity in market slump. In it, CPPIB's CEO Mark Machin said last year the fund was being priced out of infrastructure deals because of investor demand for the assets leading to inflated prices, but he also said prices could start to normalize in infrastructure, real estate and private equity markets:
 "It's been increasingly challenging to find those opportunities at good prices so a bit of normalization in markets is quite helpful for us to find more opportunities," he said.
Infrastructure has been a hot asset class for over ten years, prices keep being bid up on large deals, lowering expected return if you're not a disciplined investor. 

A couple of weeks ago, I hooked up with David Rogers, Aaron Vale and Toms Lokmanis of CBRE Caledon as they were in Montreal visiting clients. We talked about how the big infrastructure deals are being bid up to nosebleed valuations but there are opportunities for investors if they know how to navigate the asset class. 

Moreover, they help smaller and medium-sized pensions on other infrastructure deals, including social infrastructure, that the top players ignore because they're too small for them but where returns are better. 

David asked me how the Caisse's REM project is going and I said "remarkably well for a multi-billion project of this scale, scope, and complexity." 

David also asked me if I knew Macky Tall, the leader of CDPQ Infra, and I said no but I know someone that works for him and he has nothing but good things to say about Macky and the entire team there. 

We briefly spoke about the new Canada Infrastructure Bank and we both agreed it was a great move to name Bruno Guilmette as the interim CIO there. Bruno is the former head of infrastructure investments at PSP Investments and I (marginally) helped him with his business plan back in 2005 after helping Derek Murphy set up private equity at that organization. 

[Note to David: Derek is still in Montreal consulting limited partners on getting better alignment of interests in private equity at the firm he founded, Aquaforte.] 

Anyway, back to the topic at hand, the construction of the $6.3 billion REM porject. Unfortunately, the media being the media, they get things all wrong even though the Caisse's president and CEO, Michael Sabia, has explained it so clearly, even a sixth grade student can understand. 

This is why all of you need to read and donate to Pension Pulse. Forget the media, they spin things in the most negative way to sells newspapers. 

A few key points I want to make here:
  • The price tag of this project moved up to $6.3 billion, but this isn't a $300 million cost overrun. Basically, the CDPQ Infra group had estimated costs for constructing and for operating this project and went out to get bids (a very competititve bidding process). 
  • The group came a little short on its estimates of the capital expenditure of the project, so when the bids came in for construction, they fell short by $300 million, well within the normal margin of error for a mammoth infrastructure project of this size
  • However, the group overestimated the cost of operating this project so even though their estimates of capital expenditures were lower than the bids, the estimates of operating were higher than the bids, so it will cost less to operate meaning the margins are higher
  • Importantly, over the long run, this extra $300 million which the Caisse is kicking in as an equity stake (not debt, the Caisse isn't borrowing to fund this project) to construct this project is trivial if user fees stay as planned. Moreover, the lower operational/ maintenance cost will offset this higher capital expenditure, allowing the Caisse to generate an 8-9% annualized return for Quebecers over the long run (see Michael Sabia's interview below).
  • These are subtle but critical points which have been lost or glossed over by the media as they rush to claim "the price tag will be $300 million higher and the project is delayed by a year."
By the way, the media got that wrong too, the first phase of the project will commence in 2021, it's impossible for the entire project to be ready and operational by 2021.

I'm tired of reading sloppy articles by sloppy reporters who don't bother really understanding the scale, scope, and complexity of this mammoth greenfield infrastructure project, one of a kind undertaking by Canada's second largest pension fund and "Michael Sabia's baby".

When this project is done, it will transform Montreal in ways people cannot begin to imagine and make commuting to and from the city's core a lot easier for people living in the suburbs.

In fact, residential real estate prices for those living near the new stations are going to go up (sweet spot is 250 meters to 1.2 kilometers). You're going to literally be able to walk to the train, take it into town and be downtown at a fraction of the time. And there will be a lot more trains coming and going downtown.

It also goes without saying that congestion will be significantly reduced and less money will be needed to maintain our decrepit roads. The media doesn't report any of this.

What else? Even though Bombardier lost the bid to build the trains, this project will be a huge boost to the local economy, something which the Globe and Mail article got right:
Together, the two contracts represent a $3.7-billion contribution to Quebec's economic output, with 34,000 construction jobs and 1,000 permanent jobs, the Caisse said. About 65 per cent of the material supplied will be made locally, it said.
This is important because unlike other large Canadian pensions, the Caisse has a dual mandate to achieve its actuarial rate of return without taking undue risk and to promote Quebec's economy.

But just like other large Canadian pensions, the Caisse is accountable to its depositors, so if something goes wrong on this project and it ends up putting a lot more money into it to complete it, they will need to explain this to their depositors and they will be held accountable.

This is the difference between having the government build a project of this scale and having the Caisse partner up with the private sector to run a world-class operation from A to Z, making sure everything comes as close as possible to the initial estimates.

I emphasize this because if it was the government doing this project, it would have been delayed by five to ten years at billions of cost overruns (lest we forget how long we paid for the Olympic stadium!).

Montrealers need to stop reading garbage the media feeds them on the REM project (the media gets fed garbage by special interest groups that want to torpedo the project) and just listen to Michael Sabia and trust the entire team at CDPQ Infra, the Caisse's infrastructure subsidiary. The people working there have tons of operational experience, not just deal-making experience, and they really know what they're doing. Once this project is completed, these people are going to be sought after to work on other large infrastructure projects in Canada and around the world.

It's also important to note that no other pension plan in the world is assuming such a mammoth undertaking in a greenfield infrastructure project, one that will allow the Caisse to control every step of the process and potentially make a lot higher returns over the long run (in theory, it should, but this being Quebec, there is a political dimension to every large project and if user fees are mandated lower by law, it could impact the long-term profitability of the project).

Anyway, I hope this comment clarifies a lot of the nonsense on the REM project and the supposed $300 million cost overrun.

Below, Montreal's CTV News goes one on one with Michael Sabia, the Caisse's president and CEO. Listen carefully to what Michael is saying because it's painfully obvious most people don't get it. Click here if it doesn't load below.

I also embedded the Bloomberg interview Michael gave at Davos a couple of weeks ago. Again, listen carefully to his views on NAFTA and how important it is to have a long-term view of the economy and your investments. Watch the interview here if it doesn't load below.


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