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Stantec Inc
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Welcome to Stantec's Second Quarter 2018 Earnings Results Conference Call. Leading the call today are Gord Johnston, President and Chief Executive Officer; and Dan Lefaivre, Executive Vice President and Chief Financial Officer.Today's call is webcast, and those dialing in are invited to view the slideshow presentation, which is available in the Investors section of stantec.com.All information provided during the conference call is subject to forward-looking statement qualification, set out on Slide 2, detailed in Stantec's Management Discussion and Analysis and incorporated in full for the purpose of today's call.With that, I'm pleased to turn the call over to Mr. Gord Johnston. Please go ahead.
Thank you, and thanks to all of you for joining today's call. I'm going to provide you with a brief overview of our second quarter. Then Dan will get into the details of our results. After that, I'll highlight some additional color and share our operational highlights. Then Dan and I will answer your questions.For those of you following along with the slide show, we're on Slide 4. Our second quarter results highlight the strength of our Consulting Services business and demonstrate that we're headed in the right direction with our long-term strategy of focusing on revenue growth, operational efficiency and successfully executing our acquisition strategy.In Q2, we had solid growth in Consulting Services. In fact, this is our fifth consecutive quarter with gross[Audio Gap]
Ladies and gentlemen, please stand by. [Technical Difficulty]
Thanks, Trina. Apparently, our line got dropped there.So I'll start up again on Slide 4, which is just following the really introductory comment.So for those of you following along with the slide show, we're on Slide 4. Our second quarter results highlight the strength of our Consulting Services business and demonstrate that we're headed in the right direction with our long-term strategy of focusing on revenue growth, operational efficiency and successfully executing our acquisition strategy.In Q2, we had solid growth in Consulting Services. In fact, this is our fifth consecutive quarter with gross and net organic revenue growth. Each was strong, at around 4.5%. In the quarter, EBITDA as a percentage of net revenue reached 13.6% for Consulting Services, which is slightly above our annual targeted range. EPS for Consulting Services was a healthy $0.58 per share.These results were offset by continuing issues with legacy projects in Construction Services. We had hoped the majority of negative impacts were behind us, but that wasn't the case this quarter. However, the core U.S. and U.K. business is strong, and we're taking strides to reduce further impacts. This includes winding down exposure to the U.K. waste-to-energy market and continuing to put a hold on hard-bid projects outside our areas of expertise. We are also making positive progress in our strategic review.And before I pass the call to Dan, at the end of July we announced that we have maintained our status as a top 10 global design firm in 2 key industry rankings. For the second year in a row, Stantec ranked #10 on Engineering News-Record's top 150 global design firms list. We also advanced to #9 on Architectural Record's top 300 architecture firms listing. Both of these lists are compiled based on 2017 revenue. We're proud of our position in the industry. These standings demonstrate the creativity of our staff, the diversity of our business and our growth in some of the world's best design markets.I'll now hand things over to Dan to walk us through our Q2 '18 results.
Thank you, Gord. Good morning, everyone.As Gord mentioned, our Consulting Services business performed quite well this quarter, but that was offset by disappointing results from legacy projects in Construction Services.Let's start with Consulting Services results, on Slide 7. Net revenue for Consulting Services was up. When comparing to Q2 '17, our net revenue increased 3.8%, to $863 million. Organic net revenue grew in all geographies, with increases of 6.9% in Canada, 3.3% in the U.S. and 3.9% in our Global Consulting Services business.Looking at our business operating units, we had organic net revenue growth in Water, Environmental Services and Energy & Resources. We're seeing a strong rebound in Energy & Resources, with 32.4% net organic growth for the quarter.Organic net revenue retracted slightly in Buildings. Low private and public spending in the U.K. and the Middle East are driving the quarterly retraction, but we are reducing our exposure to those markets. Factoring in some of the recent project wins, we expect Buildings will improve over the remainder of the year.In Infrastructure, organic net revenue retracted 2% in Q2 '18 and was flat year-to-date when compared to the same periods in 2017. Our work on several new projects resulted in higher subconsultant costs, which contributed to growth in gross revenue and retraction in net revenue.And in our Transportation business, projects wrapped up in Colorado and Texas, and winter and spring weather conditions delayed work in some regions. Again we have some key project wins that add to our backlog in the U.S. Transportation business, such as our work on the Hampstead bypass in North Carolina.Looking at the income statement, on Slide 8, gross margin in Consulting Services decreased slightly, to 54.5%, in Q2 '18. This is primarily due to project mix, competitive pricing and increased revenues across all of our Energy & Resources sectors. Growth in these lower-margin sectors impacts our overall gross margin.In Consulting Services, administrative and marketing expenses were lower as a percentage of net revenue. It was at 41.3% in Q2 '18 compared to 42.3% in Q2 '17. We can attribute this improvement to our ongoing focus on operational efficiencies, higher utilization, lower integration costs and lower occupancy costs.Adjusted EBITDA increased 9.2%, to $117.9 million, in Q '18 (sic) [ Q2 '18 ] compared to the same quarter last year. This was because of acquisition growth, organic revenue growth, decreased admin and marketing expenses, as I noted previously.When comparing Q2 '18 to Q2 '17, Consulting Services adjusted net income was up 5.8%, to $65.7 million, and adjusted diluted EPS was up $0.04.Now we'll move on to Construction Services, on Slide 9. During the quarter, we recorded an additional negative revenue and cost adjustments of $16.3 million for U.K.-based waste-to-energy projects; $5.4 million on major design-build contracts in the U.S.; and $3 million on legacy U.S.-based hard-bid projects. These adjustments resulted from continued project delays and performance issues. Adjustments related to these projects negatively impacted consolidated gross margins, EBITDA and decreased earnings per share by approximately $0.17 in the quarter.The U.K. waste-to-energy projects are legacy projects that were outside MWH's core area of water expertise. They were bid on about 4 years ago, and at that time the waste-to-energy market benefited from government incentives and was set to be a lucrative opportunity. After the Brexit vote, the incentives were no longer available and the market lost its appeal. So we are winding down our exposure.Settlement agreements in 2 of the 3 waste-to-energy projects have been agreed upon in principle and minimal additional costs are expected, as these are 100% complete. Further costs associated with the remaining project are related to additional estimated costs to complete. However, we are expecting to achieve project takeover in -- to occur in the third quarter.The U.S. projects were also awarded several years ago when MWH was expanding its U.S. construction operation into new markets. The projects were outside MWH's core regional areas of expertise, and we have placed additional oversight on bidding on work like this.In addition to impacts to margins, EBITDA and EPS, these project adjustments affected our effective annual income tax rate. It increased from 27% to 29% in Q2 '18. This is mainly due to losses incurred in our U.K. Construction Services operation. The losses attract a tax benefit at our U.K. expected tax rate of 17%, which is much lower than our Q1 effective tax rate of 27%.The relationship between the tax rates and the estimated earnings in jurisdictions where we operate increased the annual effective tax rate. The increase in the annual rate increased our Q2 tax rate to 30.8%, and that had an impact of reducing EPS by about $0.02 in the quarter.And now on to Slide 10 for a look at our results compared to our 2018 annual targets. You can see we're meeting all of our targets in Consulting Services, but we are missing our targets in Construction Services, and that's affecting the consolidated targets for gross margin as a percentage of net revenue and net income. Our consolidated administrative and marketing expenses is within the targeted range, at 41.3%, as is EBITDA as a percentage of net revenue, which sits at 10.3%. As previously noted, this is driven by strong performance in Consulting Services, offset by disappointing results in Construction.Additionally, during the quarter we amended our syndicated credit facilities agreement, making all facilities unsecured. The amendment extended the maturity date of our revolving credit facility and tranches B and C of our term loans. The accordion feature was also increased, to $400 million. This provides us with more flexibility and capacity to operate our business and drive future growth.And yesterday, August 7, 2018, we declared a dividend of $0.1375 per share, payable on October 11, 2018, to shareholders of record on September 28.Now back to Gord for a deeper dive into the operational highlights.
Thanks, Dan. We'll start by taking a look at Consulting Services Canada, on Slide 13. Gross revenue increased 9.7% and net revenue increased 7.9% in Q2 '18 compared to Q2 '17. These increases were mostly due to strong gross and net organic revenue growth of 8.8% and 6.9%, respectively.We had organic net revenue growth in all business operating units, with the exception of Environmental Services. We saw a slight retraction in Environmental Services, mostly due to a slowdown in private sector work in Ontario. We also had a late winter that extended into the early part of Q2. But this retraction was partially offset by growing public sector work elsewhere in the company. And we've had some good project wins and we've restarted some projects that were delayed or had been put on hold.Outside of Environmental Services, we saw growth in the private sector, especially in Buildings, Energy & Resources and Infrastructure. In Buildings, we saw increased revenue in most regions. We're still seeing slow market conditions in the Prairies, but we're seeing an improving market in Atlantic Canada.Our Energy & Resources business operating unit is doing very well in Canada. We're growing across all sectors, and we're seeing increased activity from longstanding clients and all business lines. That speaks to our strong project delivery, focused account management and client relations.Increased urban development led to growth in our Community Development sector.And though we had a slight retraction in Transportation, several key rail projects continue to boost that sector.Moving on to Consulting Services in the United States, on Slide 14, gross revenue increased 3.9% and net revenue increased 1.9%, when comparing Q2 '18 to Q2 '17. Organic gross revenue increased 4.7%, and net organic revenue increased 3.3%. This organic revenue and acquisition growth was partially offset by the Canadian dollar strengthening against the U.S. dollar.Our Environmental Services business operating unit and the Waterpower and Dams and Mining sectors led organic revenue growth in the quarter. Our U.S. Water business performed well and had net organic revenue growth in the quarter. We also won several key projects, which we expect to kick off in the second half of the year.Growth in the U.S. was impacted by a retraction in our U.S. Buildings operation. This was partly due to large healthcare projects winding down. When looking at recent project wins, we expect organic growth in Buildings in the second half of the year. We saw an increase in design-build projects for which we are very well positioned. Public sector work is also growing at both the state and federal levels. And although we had organic retraction in our Transportation sector, we have a solid strategic market position in transit, roadways and bridges, and we've also begun design work on the Long Island Rail Project, which we won in Q1.And in Consulting Services Global, gross revenue retracted 3.5%, but net revenue increased 1.9%. The retraction resulted from the impacts of foreign exchange and a decline in organic gross revenue, which retracted by 3.2%. This was mostly due to a major subconsultant-heavy Environmental Services project slowing down in Italy. However, net organic revenue increased by 3.9%.Water, our largest global business, is growing, and that's driven by new projects in Australia and New Zealand. We also saw consistent revenue volume in the U.K., thanks to our work on the AMP6 cycle.Mining markets continued to strengthen in the first half of 2018, and that translated into more work in Latin America and on Mining sector projects.As we said earlier, our Construction Services business continues to experience issues with legacy projects in the U.K. and U.S. and is detracting from our core Construction business, which is performing quite well. Again, we're looking to mitigate further issues at the project level.We're also making good progress in our strategic review, which we announced in April. The goal is to evaluate a range of options to optimize the value of Construction Services business and provide the best prospects for our shareholders, our clients and our employees. As of today, we're in discussion with a number of interested parties, and we expect those discussions to continue through Q3. We hope to have the review finalized by the end of the year.Outside the issues we're experiencing with these legacy projects, the core U.K. and U.S. business is sound. When you take out the noise, Construction Services is performing to management's expectations and does have a healthy backlog. In fact, backlog for Construction Services increased by approximately 11% when comparing Q1 to Q2 2018.In the U.S., we generated $180.3 million in gross revenue in the quarter and $347.6 million year-to-date. We also have a steady stream of work on major water and wastewater treatment plant construction projects in Florida, Texas and the western United States.In the U.K., we generated $85.9 million in gross revenue in the quarter and $179 million year-to-date. We are the #1 water firm in the U.K., and revenue was driven by ongoing work for water utilities in the third year of AMP6.Moving on to Slide 17, our focus on top line growth is proving successful. Our backlog was $5.3 billion at the end of the quarter: $4 billion from Consulting Services and $1.3 billion is from Construction.We won a number of major projects in the quarter that I'm proud to share with you. The projects that you see on the slide are just a handful of the major wins we secured in Q2, and they highlight the diversity of our services, from the offshore wind farm in Maryland to a major mine in Peru and a 3-year framework with Melbourne Water.Moving on to acquisitions, on Slide 18, we announced and closed our second global acquisition, this time in New Zealand. Our first was in the U.K. last quarter. Traffic Design Group, or TDG, is a transportation engineering firm based out of Wellington. The addition of their talented team opens the door for us to bring our transportation expertise to New Zealand, where we are already a top-tier water design firm.Strengthening our North American operations are the acquisition of Norwest Corporation, an Alberta-based energy and resources firm, and Cegertec, a Quebec-based top-tier engineering firm. These firms will add continued bench strength in the sectors and regions that they serve.In total, we acquired 5 firms in the first half of 2018. This continues our long successful strategy of acquiring small to midsize firms, and that allows us to grow where we need to grow and that they complement our culture and values. Our approach is translating well into our new geographies, and we look forward to more opportunities, both in North America and also outside of North America in the U.K., Australia and New Zealand, through the remainder of 2018 and into 2019.And finally, looking at the remainder of the year, our outlook, on Slide 19, really hasn't changed. We still believe we'll benefit from increased infrastructure spending in North America; we're still focused on expanding our global footprint; and we're committed to our overall growth targets.Looking at our backlog, recent project wins, strategic acquisitions and of course our creative and inspired people, we're optimistic about Consulting Services and our core Construction Services business, going forward. We're focused on the long term, and I'm confident that we're well positioned to continue to win impactful work, execute projects with precision, grow our business and continue achieving positive results for our shareholders.With that, I'll turn it back to the operator to start the Q&A.
[Operator Instructions] We will now take our first question. It comes from Jacob Bout, from CIBC.
Maybe just comment on the strategic review of Construction, what progress has been made to date and talk a bit about has your thinking changed at all. Are you thinking about selling part or all of the Construction business?
Good question, and we were pretty sure that one was going to come up. When we announced our strategic review in April there, since then we've had a lot of discussion with certainly our staff and clients, senior leadership and with the investment community. And we announced as well that we had hired a broker to help us sort of to look at the value of the asset.So we started a very robust process there, significant issue. Some firms expressing issue in only the U.K., some in only the U.S., but a number of firms looking at both assets.We have at this point received multiple indicative offers, and based on the receipt of those offers we were pleased with both the number that we received and the indicative pricing. So right now we're in the middle of management presentations to those interested parties.So we're anticipating that we're going to -- that we'll receive some letter of intents near the end of Q3, early Q4. Our preference would be if we did go forward with the divestiture would be to divest the asset in one. We see a lot of synergy between the U.S. and the U.K. Construction business. But certainly, as soon as we've made any material decisions we'll notify the markets. That's kind of where we're at.
Maybe just a couple of other additional notes for you, Jacob. Once we complete the management meetings, the data rooms will be open for the participants to review all of our materials. We'll be looking for, as Gord said, indicative offers, and then they'll be going through their due diligence process. So it's still got a ways to go, but it's progressing well, certainly along the timelines that we had expected.
And the organic growth that you saw in the Water portion of the Consulting business, does the sale of Construction impact that outlook, at all?
No, we don't think so, Jacob. We've had a number of discussions with both the Consulting folks and the Construction folks. So in the U.S., in particular, our Construction business is a construction firm that we would partner with, but we also partner with other construction firms. So in the U.S., in particular, we see limited opportunities to impact our revenue growth.In the U.K., we do -- as part of the AMP projects, there are some clients with which our Consulting and Construction groups are partnered, and there are others in which our Consulting group is a subconsultant to Construction. So in those cases, in particular, it would be important for us as we looked at various parties to ensure that if we did divest in the U.K., the firm that we divested to didn't have a strong engineering group that would try to push our group out over time. But we truly -- we haven't seen that to be a significant concern at this point in the process.
Last question here, just on the organic growth that we saw in the Infrastructure. So it's negative from a net revenue perspective. You made some comments there about some of the projects were coming to a close. Can you comment a bit on is this just stage of projects or is there just win rates are a little lower here and maybe just comment a bit about backlog and bookings that you saw in the Infrastructure Consulting group.
In Q2 '17, we were flat out on a number of these design-build projects that we were working on in the southern United States. So that was a particularly high quarter. As I look back, I see in Q2 '17 our net revenue growth was 7% over the previous year. So we were coming off a pretty high comp, as well, because we were flat out on those projects.So I do think it's just a little bit of a blip there. As we mentioned, we have -- really are starting to engage on the Long Island Railroad Project in the U.S. and a number of other projects that we mentioned there in North Carolina, and so on. So I think it's just a blip. I think we'll see that come on again, strengthen into Q3.
Our next question comes from Sean Eastman, from KeyBanc Capital Markets.
I'd just like to start on the top line. So really solid award intake this quarter. You guys seem to be indicating some of the softness in Buildings and Infrastructure is set to reverse. So I'm just wondering, is it safe to assume some pretty healthy acceleration in organic growth through the back half of the year? And how are you guys feeling about being able to hit the upper end of that low- to mid-single-digit organic growth target for the year?
Well, I think a couple of things. We are achieving that low- to mid-single digit now and getting closer to the upper end of that. I think when you compare or look at some of the comparables that we have over 2017, I think we're still looking to achieve the same kind of growth as what we've seen in the first half.So we haven't materially changed our outlooks for the remainder of the year. We've sat down with all of our leadership and are looking at our forecasts, and they're coming in largely where we expected them to. So we're confident that we'll be able to still achieve some organic growth. It's always difficult to pin that right down.
But our guidance has been that low- to mid-single digit, and I think that's where we see the back half of the year, as well.
Got it. Okay. That's helpful. And then really encouraging to see the EBITDA margin in Consulting Services well above the targeted range. And we're tracking ahead of the midpoint of that range in the first half here. I'm just wondering kind of what needs to happen in the back half for us to end the year toward the upper end of that range, maybe what the big swing factors would be and whether there's some seasonal aspects that we should be considering.
I think it's again we talked about operational effectiveness. We talked about certainly maintaining our gross margin. But it also ties back to utilization and making sure our staff are utilized on direct projects. I think we'll probably see similar utilization in Q3, as we're in the summer months, but we always have that seasonality in Q4 which tends to drive down utilizations to some extent and, thus, the EBITDA margin.So I think over the year we'll see a bit of a normalization. It will probably come down in Q4, at least I expect it to. That would be normal with what we've seen in prior years due to what happens in the fall with holidays, vacations and things of that such.
And the other part of it of course is our ongoing cost control initiatives. And we spoke about them a bit in the Q1 call, and you see again that we're down 100 basis points over last year, quarter-over-quarter. So we're keeping our focus on the cost control side of things, as well.So working on continuing utilization to keep that higher, working on the cost side. So I think it's the balance of attracting additional revenue, executing it well and keeping the cost side under control. And certainly we won't be removing our focus on any of those items.
Got it. And just lastly, just to follow up on the cost control side, would you kind of characterize this as just keeping costs under control at this point? Or is there still items you're targeting that could be more kind of chunky impacts in terms of cost takeouts?
We don't see that there's material cost takeouts. It's about maintaining that control. Now there are little pockets within the organization that we want to continue to pay attention to, but beyond that it's about managing the business as tightly as possible.
Our next question comes from Devin Dodge, from BMO Capital Markets.
Just wanted to come back on the margin kind of question here, but it seems like historically Q3 represented the high water mark for, I guess, both net revenues and EBITDA margins for the Consulting business. I don't want to trap you guys into trying to provide guidance here, but is there any reasons that we should be thinking about why this pattern wouldn't hold in 2018?
I would expect the pattern to be consistent in 2018. This is where our entire business gets busy, especially areas like Environmental Services gets a lot busier. We had a late spring, a pretty harsh winter, and we can't get out into the field. We see some of that in Transportation, as well. So I would expect to see similar, assuming the weather holds, similar results to what you would have experienced in prior years.
Okay. That's helpful. And I guess, can you provide some color on the organic growth that you're experiencing in the Energy & Resources sector? I'm just trying to get a sense for how sustainable the stronger revenue performance is for this business given that your outlook suggests a modest recovery in the sector.
We're seeing lots of activity in all of our business lines in Energy & Resources. We see in Mining, after years of operational improvements, a lot of our clients have strong balance sheets. And so we're seeing them to begin to roll out some capital projects.Power is really strong for us. We're seeing a lot of conversion from hydrocarbons to renewables. We're working on that. We're seeing a lot of interest in storage, of course. And that Power group is almost half of our Energy & Resources business. So a number of years ago, we were very, very heavy on Oil & Gas. Certainly, you saw the retraction in that over the last number of years. Now Power is over half of that Energy & Resources business.But we are seeing that Oil & Gas is rebounding. And I think we've talked in previous quarters about our strategy of staying with our clients during the downturn, and that's really paying off now as we're starting to see some strengthening in the oil and gas markets.So that's -- I do see some continued growth and some continued strong tailwinds in Energy & Resources for the remainder of the year.
Our next question comes from Mona Nazir, from Laurentian Bank.
I was just wondering out of your current headcount how many individuals are currently in the Constructor division?
I think it's around 2,100 in total, or something like that, Mona.
And it's roughly equivalent split between the U.S. and the U.K., but perhaps a touch heavier into the U.K.
Okay. And then just your comments around the Constructor division and you were saying that you were hoping to finalize a deal by year-end and that you could sell the entire Constructor division to 1 party or break it up into the U.K. footprint and then the U.S. segment. But I'm also seeing wording that "we're looking at a number of strategic options to optimize the value." And now you're putting on hold some of the fixed-price work. I'm just wondering and really wanted to confirm that there are no other options being contemplated outside of an outright sale. Would that be correct?
Well, I think we can't -- given where we are in the process, we can't definitively say that we're going to accept an offer that comes in that would be too low or well below the value of the business. So to pin us in a corner like that and say we're absolutely going to sell the entire thing I don't think is the right thing to do for shareholders, for clients or our employees.So we believe the, as Gord mentioned in the opening comments, we believe that the indicative offers that we got are good, they're relative to what we were expecting. So we just have to continue on through the process. So I don't think it's quite right to say it's absolutely 100% for sale, but certainly that's the direction we're headed if we get appropriate results through the process.
Okay. Perfect. Yes, that's what I was referring to. That's your kind of top choice there of what you would like to see for the division.And then just secondly, I have a confirmation question, and sorry again if I missed this, but your comments were related to bidding on some of those waste-to-energy projects 4 years ago, if I'm correct. And was that related to the $16 million U.K. charge? And also is that legacy work?
Yes, and yes. It was 100% related to the waste-to-energy projects, of which 2 are now finalized. As I mentioned, we have a signed, at least indications of agreement, and we're expecting to get those closed very shortly. And then the third project, we've actually made some significant progress in the quarter and since the quarter of getting what they call a turnover, where essentially we've got the plant up and running, it's functioning. We achieved a key milestone at the end of July. So that's moving forward, as well. So we're expecting that we'll get that thing resolved in Q3. And so that's looking a lot more positive than it did, say, 6 months ago.
Okay. And so the $16 million was legacy work from 4 years ago. And then the $3 million in the U.S. hard-bid project, that was also legacy. Was the $5.1 million U.S. design-build also legacy?
That $5 million is also, obviously, legacy coming from Construction, but it relates to a major manufacturer that, if you recall, we had some project hits in Q4 and we made some recoveries in Q1 on the Consulting side. This is now that normalization of the combined project as it has to be accounted for, achieving a normal margin over all of the Consulting and Construction. And so we've taken a very hard look at that, our estimates to complete, and that is the remainder on that one. We don't expect any more significant breakdowns on that project. But yes, it was started before Stantec had had acquired MWH.
Our next question comes from Yuri Lynk, from Canaccord Genuity.
In Q1, you had some execution issues in the Consulting Services Buildings segment that negatively impacted the prior quarter. Can you just give us an update on those projects, if they had any impact on Q2 in the Buildings segment?
We made some significant progress between Q1 and Q2 in improving our execution in Buildings. We've put a lot of emphasis on that, some additional leadership and project management expertise to mitigate some of the issues. We certainly have taken a hard look at our estimates to complete on these projects. We're making what I would say a continued progress in the Buildings sectors, as we said we were going to do at the end of Q1.
So what would you say the odds are of kind of it would sound like a surprise at this point, but further negative cost reforecasts on some of those building projects? Or you feel you're out of the woods on those? And I'm talking obviously within the Consulting business.
We think we're largely out of the woods. You're always -- a key part of project management is always doing your earned value and looking forward on what your estimates to complete are, and that's where we're really focusing our attention on some of the projects that are nearing completion. But we think for the large part of it we are through the worst of the execution issues there.
And I think we've made -- we commented as well that we do see Buildings returning to positive organic growth in the second half of the year.
I think it's also fair to note that some of those projects, a good number of those projects, related to acquired projects where the margins were not necessarily available to us post closing the acquisition. So we're through the worst of that, as well.
Okay. Can you elaborate a little bit on the loss of architectural clients you're seeing in the U.S. from some of these acquired firms and how you can stem that within the Buildings segment?
The way that works is the architectural industry and the engineering industry collaborate and work together. And generally, the engineer is the subconsultant to an architect on any project.As we acquire engineering firms, Buildings engineering firms, the architectural firms that those firms would have worked for don't necessarily want to work with Stantec because we are an integrated architecture/engineering firms. So what we're talking about is losing some of the external architecture clients but picking up Stantec architecture internally as a client, which offsets some of that external revenue that we'd be losing. Hopefully that's clear and not too circular.
Clear as mud. No, I got it. Last one, just real quick. The 3 buckets of problem projects, the waste-to-energy, the U.S. design-build and the U.S. hard-bid, the waste-to-energy, can I assume this one is done in Q3? Or is there a chance of a last cost reforecast? If it's starting up and running, it's finished?
In our Q2 accounts, we had assumed that this would take us to the end of July in terms of our estimates to complete to get this thing up and running. We achieved that. I think there are still some ongoing issues with the actual performance of the plant which will continue a little bit, but certainly we don't expect it to be anywhere near the cost impacts that we've seen to date on this project. So it's improving, and then it will move over into O&M, which we don't have any projected downside on, at all.
Okay. And then the 2 other U.S. projects, are these finished now?
The U.S. hard-bid projects are essentially complete. I'm just looking at my notes here, and they're all in the 99%, 95%, 99% complete. So not expecting any material impacts there again.We did talk about the industrial project. It's really related to the last 6 months, really, of getting that sorted out between Construction and Consulting. So we think we're there, as well. But you never know with construction projects. They can always surprise you with a change in the environmental condition, site conditions, and so on.
The next question comes from Benoit Poirier, from Desjardins Bank Capital Markets.
I just want to circle back a little bit on the Construction. You made some great comments, great color about what could turn wrong in the third quarter. But if you strip the potential impact with the waste-to-energy projects, what type of margin can we might see in the second half for Construction? Is it fair to say that it should be ranging between 7%, 9%, which is mostly in line with the guidance provided for the year?
I think that's what we should expect, stripping out any project execution issues. As we've said, the core business in the U.K. is operating well. We won't see a lot of organic growth there because it's tied into the AMP6 programs and we're now bidding AMP7. And the U.S. business, the core business, is performing well, as well, stripping out the legacy projects. So, yes, I think if without any project issues, we expect to return to better EBITDA margins.
Yes, absolutely.
Okay. And Oil & Gas, you made also great comments about firing in all cylinders: Power, Oil & Gas, Mining. But would it be -- could you break down a little bit where we experience the strongest growth? Would it be in Power or mostly Oil & Gas that bring the number close to 32%?
I think we're actually seeing really strong activity and growth in all of our business lines. Waterpower and Dams is good. Power is good. Mining. Oil & Gas. We're seeing some great growth, great project opportunities, project wins in all of those groups. We saw 32% quarter-over-quarter, admittedly coming off a low comp a year ago, but we're feeling pretty good about it.
That's pretty good. And could you comment a little bit about the pricing environment, whether it should improve as the business becomes greater, and if we could see a slight expansion on gross margin?
We've been in discussion with a number of our clients. When the oil and gas industry turned down, they were pretty quick to come at us with fee reductions, us and all of our competitors. Now that things are getting stronger, we're hiring significantly. We're going back to talk to them about expanding, growing our fees. We're having some success, but certainly the fees came down faster than they're going up. That said, we are getting some movement in an upward movement of fees, but it's certainly not as fast as they came down.
Okay. And in terms of M&A, you performed 5 acquisitions year-to-date. However, given the strategic review of Construction, should we expect kind of a slowdown in the pace of M&A? Or not at all?
No, we don't see any slowdown in our pace of M&A, Benoit. And in fact, we've been focusing significantly on refilling the M&A pipeline following MWH. We did from a plan perspective take a bit of a hiatus as we integrated that.But over the past 6 months to 1 year, we've been working hard to fill that pipeline, both in North America but also in the U.K. and in Australia and New Zealand, sort of the 3 locations outside of North America where we've stated that we're focusing. I do think you'll see some increased momentum through the last half of 2018 and into 2019.
Okay. That's pretty good. And last one for me, for Consulting in the U.S., you mentioned that some key Water projects will kick off in the second half. Could you comment about those projects, the size and what could be kind of the magnitude we might see in the second half?
We've achieved -- we've won a lot of projects in our Water group over the past quarter, pretty broadly spread. We won a -- I think we've press released a nice one that we won in Louisiana. We've press released, I think, we've won some good work recently in the northeast with some of the large cities up in that area. So it's pretty broad-based, Benoit, in terms of the wins. Some of the larger ones we've press released, but just a real solid growth in even those small to midsize projects. So it's pretty robust in the Water sector. We had a couple of slower quarters in early Q4 of last year, but we really feel like we've recovered well in Q1 into Q2.
Our next question comes from Mark Neville, from Scotiabank.
I just want to follow up, a few follow-up questions, actually. Just first on the strategic review, I think you mentioned you've received some indicative offers. I'm just curious if you've received offers for the entire asset, if that's the case.
Yes. For both U.S. and U.K., yes.
Great. So obviously this has been a big drag in recent quarters, but you sound fairly positive on the core business. So I'm just trying to, I guess -- is there a scenario or can you envision a scenario where, obviously everybody has to do their due diligence, you don't get maybe a price that you find attractive, where you actually end up keeping and running this business?
The core business is really solid. And as you see from the provisions that we took in Q4 of last year, the provisions that we took this quarter, we are really cleaning up those legacy projects, putting a lot more certainty back into the business, and I think that makes it more attractive for potential acquirers.So any -- I guess there's a possibility of any scenario occurring, but certainly based on the interest that we've seen to date I don't think that's a significant possibility. But you can never say never, I guess.
Okay. And I guess in that scenario again you would just continue to run it, again as opposed to winding it down, if that [indiscernible]?
The core business is solid. So I think you're right. If we did not proceed with a divestiture, the core business being solid now that we've kind of reigned in from some of these projects they took on 3 or 4 years that got them in trouble, we think it is a very attractive asset. As we look at other firms that have exposure to construction, we think it's an attractive asset, perhaps more attractive to one of those firms.But should -- we believe it's a good asset. And as Dan mentioned earlier, this isn't a fire sale. So if we got fire sale pricing, we might look at that and say on behalf of our clients and our shareholders a divestiture would not be the right thing. But to date, our indicative pricing hasn't led us to think that would be the case, but time will tell.
Okay. I understand. That's all very reasonable. I guess just on the margin in Consulting, in Q2 very strong. I guess the G&A efficiencies that you've achieved, they seem sustainable, maybe a little more to come. Q3, again seasonally strong. I was just trying to get a sense for maybe if you can handicap the 11% to 13% range, I guess your confidence in coming sort of above midpoint or closer to the high end at this point, just given where we're trending.
Ladies and gentlemen, please stand by. [Technical Difficulty]
Mark, are you there? We got cut off again.
Yes, I'm here. Can you hear me?
Sorry about that. We can hear you now, yes.
We don't know what's going on.
So did you get that question?
No.
No. Could you repeat that, please?
It's just on the margin in Consulting. Obviously, Q2 was quite strong. The G&A, the efficiencies seem sustainable and maybe a little more to come. Again gross margin has been fairly steady. So just again just trying to handicap sort of the 11% to 13% range for the year, sort of where you think you end at this point, whether it's sort of closer to the high end, again just given sort of where you've been at, the Q3 being seasonally strong and the efficiencies you've achieved.
I think tied into a previous question that we had is again we expect Q3 to be similar to Q2 in terms of margins. So they generally operate around the same. And then lower at the end of the year. So the expectation is, is that we will fall in within that 11% to 13% by year-end. We could be at the top end, but I would suggest it would be from middle to top end given how our current performance is, especially in Consulting.
Our next question comes from Ben Cherniavsky, from Raymond James.
It's a pretty simple question, at least the first part of it. I'm just curious, in the disclosure around the drag, like, when you segment the Construction Services business down to the EPS and you say it lost $0.17 per share and that the specific projects that you identified accounted for about $0.17 a share of special costs, is that the -- am I reading that right, first of all?
So what we -- certainly there is overhead costs and allocations and everything else in the numbers to get that and certainly the tax impact. All of those things combined bring us down from the EBITDA numbers down to a $0.17 per share loss.
So if you didn't have -- if these special projects or special costs hadn't transpired, Consulting would have been breakeven. And so I guess my question is, would that have been satisfactory for you in and of itself? You guys presumably would have expected this business to remain profitable without any kind of special costs or projects that went sideways.
Absolutely.
So was there anything else going on? But it appears that it would have only been breakeven.
We expect it would have achieved a profit, Ben, in the quarter without this. Actually, some of the core business actually did achieve a profit, which offset the Construction losses, project losses.
Right. But you said adjustments related to these projects negatively impacted EPS by $0.17 and that you reported a $0.17 loss. So without the negative impact, it would have been zero. [indiscernible]
Perhaps that maybe isn't quite articulated correctly then, in that we would have achieved I believe some earnings in Construction without these project losses.
Okay. All right. I just wanted to clarify that. And then just you go back, what's it been, 2 years now, since the MWH acquisition. If we'd had a conversation 2 years ago about what 2018 might have looked like, I assume these issues in Construction wouldn't have been part of what you expected. So what are the lessons learned? And what does this say about the due diligence process you went through in acquiring MWH? And what are some of the takeaways and lessons learned now that you've gone through this experience? Because I can't imagine this has gone according to plan.
The Consulting business has more or less gone according to plan. We certainly have seen a lot of synergies and opportunities around the Consulting business.You're right, the Construction business absolutely has not gone according to plan. Nobody anticipated these kind of losses from these legacy projects. Even the Construction folks didn't expect that. For all 3 of these waste-to-energy projects, they were supposed to have achieved significant margins, but they were new projects. They were in an emerging business opportunity. And they were very early in their stages. A couple of them hadn't even quite started when we were in discussions early in 2016. So there's not much we could have done from a due diligence perspective, Ben, on those projects.The other projects around the legacy hard-bid projects, we did know about those, and we did put appropriate provisions in based on what we knew at the time. Certainly again not enough, based on what we've seen in the last couple of quarters. But now we believe we're through the worst of that, for sure.With respect to learning more about or doing more around due diligence, we've done a number of things not only with the MWH acquisition but you're always learning as you do due diligence and where you need to place more emphasis. We're placing a lot more emphasis on projects, project margins, making sure that our due diligence process is really picking up weaknesses in project execution, looking at the margins that have been recognized to date on the project, what's remaining from an estimate to complete perspective. We're doing a lot more due diligence there. We're being more conservative in terms of our opening balance sheet. And if we do believe there are additional costs to incur, we're going to record that appropriately, as appropriately as we can, on the opening balance sheets. And at the same time is really working hard on just uncovering everything we possibly can.Now we've had a good track record on due diligence. The Buildings groups have been difficult for us in the U.S. over the last couple of years. We haven't seen, other than these Construction projects, any material weakness in our due diligence in the Consulting business in Water. It's actually performing exactly as we expected it to.
Of course. I guess there's a tendency to think you're only as good as your last game, but definitely you guys have had -- this is more the exception than the rule with respect to due diligence. I wonder if it means anything about future acquisitions that might come with construction. I don't want to box you in or never say never, but would you be -- would this make you more reluctant to pursue a similar kind of acquisition with a construction services business attached?
Ben, I don't think that we had ever thought that we were going to pursue a firm that had construction. It just happened that MWH was such an attractive firm in the water space. But I think certainly we've learned a lot about due diligence. We've learned a lot about construction. But as we're going through our strategic review, I think we're seeing that this probably isn't something that fits into our long-term plans. So we certainly -- this would be something we would look at, going forward.
The next question comes from Maxim Sytchev, from National Bank Financial.
I was wondering if it would be possible to have Q3 and Q4 Construction EBITDA numbers for last year so that we can sort of properly stagger as the year progresses.
I think we had that in our disclosures last year. I don't know that -- I don't have it handy at my fingertips right now, Max, but certainly I can get that for you. I think we disclosed that.
Okay. I'll double check. And then the other thing, as well, in your cash flow commentary you talk about the drain of $62 million in Construction Services. So how should we envision the cash flow dynamic, post the sale? Are you expecting a material free-up? Or how should we think about that?
We expect to achieve some improved cash flows coming from a sale. We also expect to improve our cash flow from operations on the Consulting business. Our days sales aging has gone up, and that's an area of focus for us, going forward for the remainder of the year, to improve that, as well.
And the days sales have gone up, exactly why?
It's just you get busier in the summer months. We've seen the WIP and the AR go up around $60 million from year-end. That's just the trajectory of the business. But the aging needs to come down, and we'll be focusing on that in Q3.
Okay. In terms of -- I know that right now you have broken out Consulting versus Construction, but post the Construction, hopefully, divestiture, how should we think about the SG&A on a consolidated basis? Is there any potential sort of further pickup for you guys? Or how should we think about that?
Again an area of continued focus, but I don't think you're going to see material pickups. As I mentioned, again third quarter should be similar to second, and fourth will be lower, similar to the first quarter.
Right. And then last quarter, correct me if I'm wrong, you were talking about some major midstream projects going ahead and you feeling better about Energy & Resources. So can you maybe provide an update relative to your commentary in Q1 on that front?
One of the major projects is, again we don't name these, is still subject to a [ special license ], if you will. And so we are beginning -- we've kind of slowed down and done minimal work on that. We're starting to see that progress with some changes in the macro environment there. And so that should help us into the fourth quarter. There are other projects that we're waiting for FID on, that if those proceed that should help us, as well.
And how material the potential LNG go ahead could be for you on a going-forward basis?
Really, our exposure there is going to be in the transmission of product to the port, and there may be some environmental work around the port facilities.
Transportation.
And any other infrastructure work. The real heavy lifting around the port, I believe -- I don't know it was Fluor that got the early indication from LNG Canada. It was either Fluor or Jacobs...
I think it was Fluor and JGC.
On that one. But we wouldn't be involved in necessarily the terminal work, per se, from an engineering perspective, but we certainly could see some environmental work. Gord?
Yes, absolutely.
And then maybe just the commentary around capital allocation. Obviously, it looks like again big focus on M&A, some share buybacks. Do you mind maybe qualifying where you wanted to spending the improving free cash flow on a going-forward basis?
Certainly, we're looking at the growth of the business and reinvesting it back into the business. And if we have surplus cash, we'll be paying down debt to drive down the debt levels.
Okay. So no share buyback focus right now.
At the appropriate price, Max. Again we look at where we believe the shares are undervalued. I haven't looked at them yet today. I'm not sure I want to or I need to. But certainly where it gets below a certain value, then we will buy back shares where we believe it's too low.
Our final question comes from Chris Murray, from AltaCorp Capital.
Just quickly, Dan, on some of the cost reforecasts that you've booked right now, how much should we think that those have a reserve component into them? And that do you guys have any opportunity to go back to third parties and get any recovery for any of those costs?
The reserve for -- we always try to be conservative in the estimates to complete. So there is some contingency built into these reforecasts on the projects. A lot of these, as I said before, are virtually at completion. So there isn't going to be a lot more cost to incur. There are a few projects that still have some completion to do. So we want to be conservative there. That was the first part of your question.The second part was...
Can we recover [indiscernible].
Recoveries. We're tracking at about USD 20 million of potential recoveries on the projects that are remaining. So we haven't recognized the full amount of revenue or recovery on these projects, where there's potential of around USD 20 million in terms of recoveries.Now these are not certain. We're being fairly conservative in that regard. And still it results in either litigation, settlements, having change orders that have not been accepted, et cetera, et cetera. But that's the process that you go through on these construction projects. And certainly we're pursuing that.That will be certainly an area of discussion in any sales process and how those are treated. So it's certainly another area of focus for us.
Okay. Great. And along those lines, you did mention you were talking a little bit about AMP7. Does your divestiture or your planned, your thinking around the strategic review of the construction business, is that impacting your ability to bid AMP7, at all?
No, we don't believe so. And in fact, we already with our Consulting group won the first, and we press released this one a while ago, the first AMP7 award, which was in Yorkshire. And that was completely a Consulting award. So we don't see that being an issue.A lot of the contracts that we have in fact are a 5- or a 6-, 7-year contract with the opportunity to roll it over and sort of re-up it. So we don't see a significant loss of opportunity in AMP7 should we divest of Construction.
Okay. Fair enough. And then just the last question for me, just we kind of talked a little bit about M&A, but just wondering if there's been any change or any thought around what's going into your pipeline at this particular point. Are we still thinking -- you had talked about the strategy, part of the MWH strategy when you acquired it was to be able to take what you've done in Canada and the U.S. and start leveraging it into other parts of the world. If you were to think about where your portfolio is right now in terms of potential M&A targets, is that still the case? Or is it starting to change a little bit, your thinking around what you want to add to the portfolio, just as we've seen some shift in certain of the segments?
A very good question, Chris, but very much so that remains our strategy. For example, in the U.K., we're easily the #1 water firm, but we're single-sector water. Now we've added ESI, so we have a small environmental footprint, as well.But when you look at all the service offerings of Stantec and the opportunities to bring in additional service offerings to our existing clients, we can expand there in Transportation and Buildings and more Environmental Services. And all of the service offerings that we have in North America, we see the opportunity to use Water as sort of the thin edge of the wedge to get us continued growth into the U.K. and a similar strategy in Australia and New Zealand.So we certainly are not taking our foot off the gas from a North American acquisition perspective, but we are really focusing as well on those 3 locations, primarily the U.K., Australia and New Zealand.
Okay. And is Brexit changing -- Brexit has been morphing, but is that changing either the response from potential sellers in the U.K. or changing multiples or doing anything like that?
We're really looking at Brexit hard in terms of what it could do to overall industry there. You're starting to see of course in the papers some manufacturing clients are starting to be concerned about their supply chain and what that could look like.But really, the work that we do, that core infrastructure work, we see in the U.K., as an example, a lot of commitment from the government to continue to build housing. We're looking at high speed to the rail. We're looking at a lot of school and hospital work that has been announced. So a lot of the core infrastructure work that we still do will be strong, we believe, there.
We'll now take our next question from Derek Spronck, from RBC Capital Markets.
Just quickly, I think you've largely answered it, but if you were to get a significant proceed from the sale of the Construction business, any particular plans for that proceed? Or as you mentioned, it would just fall within your capital allocation priorities that you've mentioned previously?
I think there's a couple of things. We don't know the exact details yet because we don't have any -- we're not far enough along in the process. But there will be a potential tax impact in the U.S. That business is not unlike Innovyze, but certainly not to the same extent, where that business has been grown largely organically. So there's not a very high tax basis for the U.S. asset. So that could have a bit of a drain on the net cash received, because we'll have to pay tax. But the remainder of whatever we earn or get from that sale would be going straight to paying down debt.
Okay. Makes sense. And the acquisitions that you've completed year-to-date, how should we think of that run rate revenue lift in 2019 from currently completed acquisitions?
The ones that we've contemplated to date have been near the smaller size of our range: 250 people, 300 people and smaller. So I don't know that it will have -- Dan, you could comment, but I don't know that it would have really, at this point what we've done so far, a material impact, going forward.We're still -- as we look at the acquisitions, our sweet spot is really still in that 1,000-person or less range, and that's where we'll continue to focus. So I think the ones that we've announced and closed on so far, Dan, unless you have any thoughts, we've probably added less than 1,000 people on our 22,000.
It's going to have a couple of percent impact, I think, on a full year run rate basis. Certainly as we look at more acquisition opportunities, we expect that to go up through the remainder of the year.I think it's going to be about [ $300,000, probably $300,000 ] impact year-to-date, or going forward. Or is that 300 people? Sorry. 300 people is what we've added year-to-date. So you do your metrics on that.
Okay. And just more generally, the public money flowing in the U.S. from a state and federal level, is that coming down as expected and as quickly as expected? Or how do you see that environment right now in the U.S. from a public infrastructure spending perspective?
We've all been talking for 6 months or more about the opportunity for a comprehensive infrastructure bill in the U.S., and we haven't really seen that come to fruition yet. That said, the market is still really robust even without that additional funding. So if we do see a comprehensive infrastructure bill in the U.S., I think that will only add to an already fairly robust market, but we haven't really seen a lot of that coming yet.
Just in general, is the bidding environment more rational because of the amount of work both on the private and public sector side?
We're seeing actually a number of contractors beginning to talk about restricting the number of projects that they would bid on because they're reaching capacity in the U.S. And we're seeing that from some engineering firms, us included, being more selective on what we can bid on. So we're seeing less just people just chasing whatever they can find to stay busy and becoming a little bit more discerning.
On the flip side, does that -- any concerns around labor inflation in that sort of environment?
Absolutely. That's something we're monitoring on a daily basis. We're seeing poaching between firms becoming more and more common. So we're doing all we can to ensure that we stay competitive in these markets and ensure that we remain competitive.So that is -- there is some salary pressure. There is also just general pressure on ensuring that your staff are treated well and that they feel valued and give them interesting projects and geographic opportunities to move around. So we're seeing a lot of that in the first half of the year, and I anticipate that that will be the same in the second half.
As there are no further questions from the phone, I'll now turn the call back to your host for any additional or closing remarks.
That's great. We certainly appreciate everyone's time this morning, and we look forward to chatting with you through the quarter and then formally again at our Q3 call. So thanks very much.
That will conclude today's call. Thank you for your participation, ladies and gentlemen. You may now disconnect.