DBRS Confirms SNC-Lavalin Group Inc. at BBB (high) with a Stable Trend

DBRS has confirmed the senior debentures rating of SNC-Lavalin Group Inc. (SNC or the Company) at BBB (high) with a Stable trend. The rating action reflects DBRS’ view that (1) SNC’s financial profile is still acceptable for the current rating despite the much weaker-than-expected operating results recently, (2) the Company has taken appropriate actions to address the weaknesses in its internal control over financial reporting and should be able to prevent the recurrence of these deficiencies and associated losses and (3) SNC will be able to stabilize its operating performance in the second half of 2012 and meet its revised 2012 net income target of $325 million to $340 million.

The Company has faced a number of unexpected challenges in the first half of 2012. DBRS placed SNC Under Review with Developing Implications (see press release dated February 28, 2012) following its announcement of an independent investigation of the facts and circumstances surrounding $35 million of payments documented to construction projects to which they did not relate. The rating was subsequently confirmed (see press release dated March 28, 2012) based on DBRS’s view that (1) SNC should be able to maintain its strong financial risk profile and liquidity in light of the relatively moderate impact of the reported payments and related expenses and (2) the recent developments should not materially affect SNC’s business capability. However, the trend was changed from Positive to Stable due to significant challenges facing the Company, reducing the likelihood of the rating being upgraded in the near term. Findings of the Independent Review and an internal evaluation have identified material weaknesses in internal control over financial reporting. SNC has begun to implement the recommended remedial measures. DBRS views the actions taken by the Company to be appropriate and would monitor the implementation of these remedial measures and take negative rating actions if progress is lacking according to plan. The recent appointment of a new CEO has also removed another management distraction. SNC also faces a number of shareholder law suits related to the deficiency in corporate governance and internal control. DBRS notes that these legal actions generally take a long time to resolve and the potential impact on SNC is difficult to ascertain at this time. The confirmation has not taken into account any potential impact on SNC.

The Company’s operating results have been disappointing, suffering sequential declines in the first six months of 2012 despite higher revenue, and most business segments reported lower operating income compared to the same year ago period. Power, Infrastructure/Environmental and Hydrocarbon & Chemicals (HC) segments suffered notable deteriorations. Higher selling and administrative expenses and cost overruns were the key negative factors. Cost reforecast on a major project in Tunisia and a fixed-price services project in Russia led to poor performances at Power and HC, respectively. Despite these setbacks, SNC remained reasonably profitable. The Company still has
a healthy backlog totalling near $10.7 billion, and it expects a meaningful improvement in the last half of 2012 with full year net income in the $325 million to $340 million range. Achieving the forecast would signal that the Company has stabilized its profitability and is back on track with performance commensurate with its current rating.

The current rating is supported by the Company’s above-average business profile. The Company has scale, solid technical expertise and geographic diversity. In addition, the Company has a balanced business mix with a sizeable operations and management business that helps to moderate earnings volatility. SNC has a good track record in controlling project costs. DBRS views the large cost reforecast on the two problem projects to be one-offs and not likely to recur, and the Company’s risk management process remains sound. The Company’s financial risk profile is still compatible with the current rating despite a decline in profitability. All debt coverage ratios remained above average among industry peers. Moreover, the Company continues to maintain a strong liquidity position with cash on hand (cash net of infrastructure concession investments (ICI) cash) in excess of recourse debt) by about $723 million. Furthermore, DBRS believes that the realizable value of SNC’s investment in ICI projects is well in excess of their book value, especially the Highway 407 investment, which has a nil book value. Most of these investments can be monetized adding to SNC’s financial flexibility. The Company has ample financial capacity to support its operations and to weather the current weaker performance.

DBRS expects the Company to turn around its operating performance in the last half of 2012 and meet its stated goal of net income between $325 million to $340 million. Nevertheless, the Company still faces some challenges in regaining its profit momentum, including (1) a slowing global economy that is likely to intensify the competitive conditions in the industry, pressuring project margins; and (2) more unexpected losses caused by the known internal control weakness and from still unidentified weaknesses. The failure to meet the lower revised net income target could trigger another assessment of SNC and may lead to negative rating actions depending on the nature of the factors impeding the Company’s ability to return to a more acceptable profitability level. Furthermore, SNC has a good track record on project management and meaningful project losses are infrequent historically. The sizeable cost readjustment on two projects recently does not bode well for the Company. DBRS has given SNC the benefit of the doubt and treated recent negative occurrences as isolated cases. However, further meaningful negative cost readjustment would signal that the project control process may not be operating as effectively as intended and may also lead to negative rating actions.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Companies in the Engineering and Construction Industry (May 2011), which can be found on our website under Methodologies.