OMERS, CPPIB and Highway 407

The Financial Post reports that SNC-Lavalin's proposed sale of 10 per cent of the 407 to the Ontario Municipal Employees Retirement System (OMERS) for $3.25 billion precludes the possibility of a bidding war and also puts the company on the hook for a sizable breakup fee if the deal falls apart:

SNC-Lavalin currently owns 16.77 per cent of the 407 and proposed in April to sell 10.01 per cent to OMERS, with $3 billion due when the deal closes in June, and as much as $250 million in payments over the next decade depending on toll revenues.

But the road’s other owners, subsidiaries of Canada Pension Plan Investment Board and the Spanish firm Ferrovial SA, may exercise a right to match OMERS’ offer, which would force SNC-Lavalin to pay about $75 million to OMERS.

Either way, SNC-Lavalin’s chief executive Neil Bruce assured investors the sale would close in June, and provide enough cash to reduce the company’s recourse and limited recourse debt of roughly $3 billion, and make repayments of $600 million, $350 million and $150 million on three separate loans.

In February, S&P downgraded SNC-Lavalin’s credit rating to BBB-, and the company is operating at the edge of its loan covenants. Earlier this year, it negotiated to increase its allowable net recourse debt to EBITDA ratio to four, and it now stands at 3.9.

This morning, the Canadian Press reports that SNC-Lavalin continues to ponder a Plan B that could see the company break up ahead of a potential criminal conviction and stated it's looking to sell the bulk of its 16.77 per cent stake in Highway 407 to OMERS.

David Taylor of Toronto-based Taylor Asset Management, a shareholder of SNC-Lavalin, said the embattled engineering company needs to divest some of its prized assets. “They’ve got great assets within that are being punished and their good assets aren’t being valued properly. So they sort of hypothetically talked about crystallizing that value, and the only way you can really do that is to sell.”

I agree, Highway 407 is an incredible asset, the first electronically operated, open access toll highway in the world.

It generated $41.9 million in cash for SNC-Lavalin in the first quarter of 2019, up 10 per cent from last year, and the sale will help the company pay down its debt.

The $3.25 billion OMERS offered SNC-Lavalin for a 10 per cent stake implies a $32.5 billion valuation of the entire highway.

However, the deal is far from done because in its Q1 earnings report released earlier this month, SNC-Lavalin stated the following:

SNC-Lavalin has been informed that a Highway 407 ETR shareholder may exercise its right of first refusal. If a right of first refusal is properly exercised, OMERS will not be the buyer of the 10.01% shares of Highway 407 ETR, and SNC-Lavalin will owe OMERS a break fee of 2.5% of the purchase price.

The 407 ETR website provides a breakdown of the major owners of Highway 407:

407 ETR Concession Company Limited ("407 ETR") is the operator and manager of Highway 407, which extends 108 kilometres east-west, just north of Toronto. 407 International Inc. is owned by Cintra Infraestructuras Internacional S.L. (43.23%) (a wholly owned subsidiary of Ferrovial S.A.), indirectly owned subsidiaries of Canada Pension Plan Investment Board (total 40%) and SNC-Lavalin (16.77%).

CPPIB and Ferrovial own the biggest stakes on the 407, 43 percent and 40 per cent respectively, so they obviously exercise the right of first refusal over any proposed sale of SNC-Lavalin's stake.

By my calculations, CPPIB received $100.2 million from its stake in the 407 in Q1, annualized that's $400.8 million. Not bad especially if revenues keep growing by 10% a year.

But the proposed sale of SNC-Lavalin stake has its fair share of critics. A former director of SNC-Lavalin is calling for a shareholder vote on what he describes as the company's "cruel and Machiavellian" decision to sell the bulk of its stake in Ontario's 407 toll highway operator for $3.25 billion:

Stephen Jarislowsky said the sale runs counter to responsible management, as the firm's 407 assets comprise about four-fifths of the $5.86-billion market capitalization of a company that he suggested derives only a thin strip of its value from its legacy engineering business.

"The board's decision regarding the 407 in my opinion lacks ethics and goes counter to fiduciary exercise of responsibility. At the very least in this case, a free vote by the shareholders should be mandatory before the 10 per cent sale of the 407 is permitted even if current law permits it," he said in a "personal note" posted Monday on the website of the Canadian Foundation for Advancement of Investor Rights, where he sits on the board.

Listed companies seeking to sell off a business that amounts to 50 per cent or more of their assets -- defined based on the balance sheet or other criteria such as revenue -- must hold a shareholder vote, according to Toronto Stock Exchange rules. Market capitalization is not one of the measures, however.

Jarislowsky likened the investment in the toll highway to a government bond and said it promises higher profits as Toronto-area road traffic increases, estimating its value would double in 10 years.

"Why would one not remain invested in such a superb asset after having suffered in the market?" he asked. "With this 407 sale, shareholders are forced by its own board to gamble on rescuing a now near-worthless asset, a deal that strikes me as cruel and Machiavellian," he added, despite the engineering and construction unit's eight per cent boost in revenues to $9.82 billion last year.

"In effect, SNC-Lavalin as valued today is not an engineering company," Jarislowsky said, less than two years after the firm's purchase of British engineering giant WS Atkins.

Jarislowsky raises many excellent points, he's a very smart man with incredible experience and knowledge but I don't think SNC-Lavalin has much of a choice but to go through with this sale.

No word yet from the Caisse on what it thinks of the proposed sale. Back in February, Michael Sabia said the Caisse will "be a rock" for SNC-Lavalin, but more recently Quebec's pension fund has stayed quiet on the company (a wise decision given a potential criminal conviction looms large).

All I can tell you is when I saw CPPIB's Michel Leduc right before the annual spring pension conference in Toronto, he specifically mentioned that "Highway 407 has been a great investment," one CPPIB will continue to hold for a very long time.

I'm not sure if CPPIB or Ferrovial will exercise the right of first refusal over any proposed sale of SNC-Lavalin's stake but given the sums involved, I wouldn't be surprised if either of them do.

Lastly, take the time to skim through the public presentations of the 407 ETR. I particularly enjoyed the latest one posted from the RBC Debt Capital Markets Conference in Montreal back in February.

I think Stephen Jarislowsky is right, in ten years, the 407 could easily double in value, which is why OMERS and other long-term investors want a sizable slice of it.

Below, Canadian billionaire investor Stephen Jarislowsky is calling into question why Ottawa is holding back on negotiating a settlement with SNC-Lavalin and urging the company to vote on the sale of most of its stake in the highway 407 toll road. BNN Bloomberg's Amber Kanwar and Jon Erlichman have the details. Click here if it doesn't load below.

Update: Wayne Kozun, formerly of OTPP and now CIO of Forthlane Partners, shared some great insights with me after reading this comment:

I have closely followed Hwy 407 since it was first sold by the Ontario government 20 years ago and IMHO it makes sense for SNC to sell it off. Personally, I think they should have sold it off a few years ago, and they have been actively talking about selling it for year.

I respect Stephen J, but I disagree with him on this. SNC is, at its heart, an engineering company and not an Infrastructure fund. I don't think it makes sense to have a conglomerate to have disparate types of companies. What are investors buying when they buy shares of SNC? It isn't clear, and I think it makes much more sense to completely sell off Hwy 407. The engineering side of SNC has a much higher risk and should require a high expected return. The infrastructure asset is much lower risk and therefore should have a much lower cost of equity - which means it gets a much higher multiple.

Hwy 407 is a trophy infrastructure asset and may see strong profit growth in the future. But that will be reflected in the price that investors, in this case, OMERS, are willing to pay for the asset. You can bet that many other investors looked at Hwy 407 such as all other Canadian pension plans and all large infrastructure funds.

People now say that the government got ripped off but that was not the view at the time. The way I remember it there were two losing bidders at $2B and a winning bid at $3.1B. I remember hearing quotes from the losing bidders like "Ferrovial WAY overpaid for this asset - they will go bust in a few years". In reality, it was a steal at $3.1B but that is Monday morning quarterbacking.

Here is a story from 1999 on the sale:

A Quebec-based engineering firm and a Spanish partner are paying more than $3 billion for the continent's longest electronic toll road. That's twice the amount the government invested in the highway - meaning the Tories have made a $1.5 billion dollar profit by privatizing a project started by Bob Rae's NDP government.

I thank Wayne for his great insights and agree with him, SNC should have sold its stake in Highway 407 a few years ago.