Stantec Inc

TSX:STN

Earnings Call Transcript 2018-Q4

[Operator]

Welcome to Stantec's Fourth Quarter and Year-end 2018 Earnings Results Conference Call. Leading the call today are Gord Johnston, President and Chief Executive Officer; and Theresa Jang, Executive Vice President and Chief Financial Officer.Today's call is a webcast, and Stantec invites those dialing in to view the slideshow presentation, which is available in the Investors section at stantec.com. All information provided during this conference call is subject to the forward-looking statement qualifications set out on Slide 2, detailed in Stantec's management discussion and analysis, and incorporated in full for the purposes of today's call.With that, I am pleased to turn the call over to Mr. Gord Johnston.

[Gordon Allan Johnston, President, CEO & Director]

Thank you, and good morning. I'll start with a brief overview of the year. Then Theresa will share details of the results. Following that, I'll share some operational highlights from across our business.In 2018, our consulting business achieved all the financial targets we established at the start of the year. We also made significant progress on the business objectives that I set out early last year. The first objective was driving organic revenue growth. We achieved this in every quarter of 2018, culminating in a 3.3% organic net revenue growth compared to 2017. We generated organic growth in all geographies and in our Environmental Services, Energy & Resources and Water business.My second objective last year was to reinvigorate our focus on strategic acquisitions after we had paused to digest MWH. Last year, we acquired 7 strong firms that add to the diversity, depth of expertise and geographic reach of all our businesses, and notably, 3 acquisitions were outside North America, marking a big step forward in our strategy to build on the global platform we acquired through MWH.Thirdly, we wanted to achieve cost efficiencies. While we will never compromise on health, safety or our ethical standards, we recognize that maintaining an efficient administrative cost structure is critical to our competitive advantage and profitability. In 2018, we looked closely at administrative costs and successfully reduced spending in several areas. We continued to see incremental improvements in utilization and reduced our admin and marketing expenses as a percentage of net revenue.And my fourth objective for 2018 was to complete a strategic review of Construction Services. As I reflect back on the MWH acquisition, I can say that despite the turmoil caused by the construction business, Stantec is stronger with the addition of MWH's design practice. It brought us a global footprint, added strength to our established teams and gave us a mature and leading presence in the U.K. water sector.However, that narrative was overshadowed by poor performance in Construction Services. We closed the sale of Construction Services in November and are in the process of reviewing the closing financial statements with the purchaser. With this chapter largely behind us, we're looking forward to refocusing all our attention and energy on continuing to grow our core consulting business.And yesterday, our board declared a dividend of CAD 0.145 per share, an increase of 5.5% from last year. This signals the board's confidence in our strategic direction and our ability to execute on our growth strategy, while recognizing construction has weighed down our earnings and cash flows in the last 2 years. The board believes a 5.5% dividend increase strikes an appropriate balance in our capital allocation, offering a meaningful dividend increase while supporting investment growth and -- investment in growth initiatives that will create long-term shareholder value.Now I'll hand the call over to Theresa to walk us through our results.

[Theresa B. Y. Jang, Executive VP & CFO]

Thank you, Gord. Before I jump into our earnings review, I'll note that we've made certain changes to the presentation of our financial results, mainly as a result of following accounting rules for discontinued operations, which became a requirement when we sold Construction Services.First, earnings and cash flows for Construction Services have been classified as discontinued operations for the current period, and restated as such in comparative periods. Second, the accounting rules for discontinued operations required that certain corporate costs historically allocated to Construction Services be reclassified with continuing operations because those costs are ongoing in nature. The effect of this has also been incorporated into our restated results.Unrelated to the sale of Construction Services, we've broadened our definition for adjusted EBITDA, adjusted net income and adjusted EPS from continuing operations. We'll discuss these changes in greater detail, and we've done so on Page M-3 of our 2018 Annual Report, and as well, we've provided some supplemental financial information as an appendix to this presentation and in the Investors section of stantec.com.So let's move on to our results from Consulting Services, starting with Q4 2018. All the comparative data I'll reference relates to Q4 '17. Adjusted net income from continuing operations was CAD 45.5 million, or CAD 0.40 per diluted share, representing increases of 14.6% and 14.3%. These increases reflect solid net revenue growth in Consulting Services, reduced admin and marketing expenses as a percentage of net revenue, and decreased amortization of intangible assets.Q4 net income from continuing operations was CAD 21.2 million, or CAD 0.19 per share, increasing by 35.9% and 35.7% respectively. Q4 net revenue increased by a healthy 11.4%, reflecting 3.5% organic growth and 6% acquisition growth. Gross margin increased 7.3% but declined as a percentage of net revenue by 2.1% to 53.8%. This is largely due to our project mix, downward fee pressures in certain business segments and project execution challenges in some of our Canadian Buildings operations.Admin and marketing expenses increased 9.1%, partly due to certain unusual and nonrecurring items. Excluding these items, that increase would have been 4.3%. As a percentage of net revenue, admin and marketing would have decreased by 3.1% to 43.7%, mainly due to improved utilization, operational efficiencies and reduced share-based-compensation charges. Adjusted EBITDA increased 26% to CAD 84.2 million, increasing by 1.2% as a percentage of net revenue to 10.1%.Now looking at discontinued operations, we recorded a CAD-32.2-million after-tax loss in Q4, CAD 35.8 million pretax. This includes operating losses incurred by Construction Services up until the November 2 divestiture, project losses associated with the remaining U.K. waste-to-energy project, CAD 5.8 million for past service costs resulting from a court ruling related to equalization benefits for the U.K. construction-defined benefit plan, a CAD-1.5-million gain on sale and the corresponding tax expense. The waste-to-energy project has experienced EPC-related delays, but we are now 20 days into our 30-day acceptance testing.In calculating adjusted EBITDA and adjusted net income, we've excluded certain unusual or nonrecurring items because we don't believe that they are reflective of our underlying operations. For Q4, these items include a CAD-12.8-million charge for a lease exit liability related to our Edmonton head office move, a court-ruled CAD-4.7-million past service cost adjustment for our U.K.-defined benefit pensions and a CAD-5.5-million unrealized loss on investments held for self-insured liabilities. We've provided a reconciliation of these adjusted measures to net income in the appendix of this presentation.And now moving to our full year 2018 results, where all comparative data referenced relates to full year 2017. Adjusted net income from continuing operations was CAD 206.6 million or CAD 1.82 per diluted share, representing increases of 5% and 5.8%. This demonstrates our success in growing organically and through acquisition while maintaining an efficient cost structure. For comparison purposes, had we not been required to change our methodology of allocating corporate costs, Consulting Services would have reported adjusted net income of CAD 215.5 million, or CAD 1.89 on a per-share basis, increases of 11.1% and 11%.Unusual or nonrecurring items for the year included the Q4 items previously discussed as well as a CAD-10-million tax recovery because of proposed U.S. federal tax regulations in August. Losses incurred from Construction Services coupled with the unusual or nonrecurring items had a considerable impact on net income. 2018 net income was CAD 47.4 million, or CAD 0.42 per diluted share, decreases of 51.1% and 50.6% respectively. Net revenue increased 5.7% to CAD 3.4 billion.As Gord mentioned at the top of the call, we achieved 3.3% organic net revenue growth with growth across all geographies and in our Environmental Services, Energy & Resources and Water businesses.Gross margin increased by 3% to CAD 1.8 billion but declined by 1.4% as a percentage of net revenue to 54.1%, and this is largely due to overall project mix and execution challenges in our Canadian Buildings operations, compounded by the 2017 Innovyze divestiture, which was a higher-margin business, and several positive 2017 revenue adjustments.Admin and marketing, excluding unusual or nonrecurring items, fell by 2.1% as a percentage of net revenue to 42.3%, demonstrating the effectiveness of our focus on operational efficiency.Adjusted EBITDA increased by 11.1% to CAD 392.5 million, representing 11.7% of net revenue.As for discontinued operations, we recorded an after-tax loss of CAD 123.9 million for the year, and in addition to the items described in the Q4 discussion, the full year loss includes a CAD-53-million, noncash goodwill impairment charge and a CAD-13.8-million tax charge on the disposition.Despite this, overall, Consulting Services had a very good financial performance year, while all of our financial targets were achieved. And before we move to highlights from operations, I'll touch on our liquidity and capital resources.Underpinning our pursuit for growth is a commitment to protect and strengthen our balance sheet and to optimize our capital structure. While we've always benefited from strong liquidity and access to capital, our 2019 priorities include further strengthening our cash flow and leverage metrics by improving the efficiency of our working capital and by being disciplined on how we allocate capital.Our days sales outstanding have crept up over the past year from 94 days to 103, and that is higher than we'd like it to be. We know that we can do better, so we're committed to lowering that number, and we've taken targeted measures to do so. I should note that in calculating our DSO we do not net off deferred revenue from accounts receivable and work in progress, and others may. I think this practice is mixed in our industry. But doing so would drop our DSO to 88 days. This doesn't change our focus on reducing our DSO, but I did think that it was important to highlight.In terms of our borrowing capacity, at the end of 2018 we had approximately CAD 223 million of undrawn capacity on our credit facility and access to another CAD 400 million under our accordion feature if required for future acquisitions. Our net-debt-to-EBITDA ratio was 2.42 at year-end, below our target of 2.5 and well within our covenant requirements. Nevertheless, we're focused on reducing this metric to further enhance the efficiency of our capital structure.We've also been very active in repurchasing common shares through our normal-course issuer bid program. In 2018, we repurchased and canceled over 2.4 million common shares at an average price of CAD 31.09 per share, for an aggregate price of CAD 76.7 million, and so far this year, we've repurchased and canceled a further 195,000 shares.Lastly, in Q1 of 2019, we'll transition to IFRS 16, which will introduce significant changes to our financial statements, including increased assets and liabilities related to our leased assets and reductions to our admin and marketing expenses, offset by higher depreciation and financing costs. Our transition is still a work in progress, so we can't share specifics of the extent of the impact yet. We know IFRS 16 will change the complexion of EBITDA and other metrics, so we're working to develop our disclosures with the aim of providing transparency and comparability. We'll provide an update to our 2019 guidance in our Q1 '19 reporting.And with that, I'll turn it back to Gord for a closer look at operations and our 2019 outlook and targets.

[Gordon Allan Johnston, President, CEO & Director]

Thank you, Theresa. In 2018, our Canadian operations performed quite well, with net revenue increasing by 5.9% in the year. That breaks down to 3.7% net organic growth and 2.2% growth from acquisitions completed in 2017 and '18.Our Power and Oil & Gas sectors were our strongest performers in Canada, largely due to significant progress on several major projects in the Power sector and a ramp-up of midstream work in Oil & Gas. Our Water business also had strong growth, driven by major projects in Western Canada, where we continue to build a top-tier presence. And although we saw a slowdown in Community Development work in the western provinces, we offset this with a steady stream of work in the east. Environmental Services retracted year-over-year, but it grew organically in the fourth quarter. Prospects in Canada are positive, with midstream Oil & Gas work continuing to increase. Growth in our Canadian Buildings business was impacted by major projects nearing completion and by certain projects that required more specialized consultants. The result was a year-over-year retraction in -- for buildings in Canada.Moving on to Slide 15. Our U.S. operations also had a solid year with 3.5% net revenue growth, which includes 2.5% organic net revenue growth. And with the exception of Buildings, all our U.S. businesses and sectors grew organically. Roughly 1.3% of overall net revenue growth was due to acquisition growth.Our U.S. Environmental Services business achieved organic growth in several sectors, and we continue to capitalize on our environmental mitigation expertise and build on our remediation and recovery practices. And with commodity prices on the upswing, we experienced organic growth in our U.S. Mining, Oil & Gas and Water Power and Dams sectors. Our Water business grew as well, due largely to our ability to capture a share of the growing amount of work flowing from California and Texas, and when you're looking at year-over-year comps, it's important to remember that we're still comparing against the sale in Innovyze, which had a strong positive impact on our Water business in 2017.Elsewhere in our U.S. sectors, Community Development work is growing in the busy southeast and northeast corners of the country, but this was partly offset by comparative fee pressures in other regions and by projects with higher subconsultant fees. In Transportation, the ramp-up of previously awarded major projects offset the ramp down of other projects. We have a strong strategic position in transit, bridge inspection, light-rail transit, roadways and bridges, and we continue to secure impactful projects. Our U.S. Buildings business had an organic retraction, mostly due to project issues in a large healthcare project that's winding down early in the year. But in the second half of the year, the downward trend reversed with strong organic growth in the fourth quarter and growth in our Commercial, Healthcare and Science & Technology sectors, especially in Florida and the Northeast.In Global operations on Slide 16, we generated very strong net revenue growth of 14.3%. That includes 5.4% net organic growth and roughly 9% acquisition growth, primarily in our Environmental Services and Infrastructure businesses.Leading net revenue growth within Global operations was our Water business, propelled by new projects in Australia and New Zealand. Our Mining sector continued to benefit from improving commodity prices and a steady flow of Environmental Services work in Latin America. Our Global Buildings business performed well, with 2 major project awards in Qatar and the UAE. Due to decreased volume on a large project in Europe, Environmental Services retracted. Our Water Power and Dams sector grew as a result of new project wins, but growth was partly offset by projects winding down in our export business.Now we'll shift gears and look at backlog. At year-end, backlog for continuing operations was CAD 4.2 billion, representing 11.7 months of work. Just over 60% of that work is in the U.S., about 25% is in Canada and roughly 14% is in our global operations. We were awarded many significant projects in 2018. Those on the slide represent just a handful of the largest projects in our backlog, and of course, these are supplemented by the many thousands of smaller projects we win around the world, thanks to our strong local relationships.As we look ahead to 2019, we expect organic net revenue growth to be in the low- to mid-single digits, in line with global GDP growth. We remain committed to our long-term average compound target rate of 15% net revenue growth achieved through a combination of organic and acquisition growth.In Canada, we expect that a continued oil price volatility, rising interest rates and increased regulatory restriction on mortgage qualifications will slow economic growth. In the U.S., we expect solid consumer spending and business investment, slightly increasing interest rates and continued strong employment. We anticipate growth in our global markets as we continue to expand our global footprint. We expect healthy GDP growth in the countries where we operate, less volatility in commodity prices helping our Mining and Environmental Services business. We do expect Brexit to create some uncertainty in Europe and the U.K., but we believe our U.K. business is insulated from these uncertainties given our long-term critical public infrastructure contracts.Now looking at our 2019 targets on Slide 19. We remain committed to our previously identified target ranges for gross margin, admin and marketing expenses, EBITDA and net income as a percentage of net revenue, as shown on the slide. The transition to IFRS 16 will impact admin and marketing expenses and our EBITDA, and we'll revisit these targets in Q1 once we've completely assessed how the transition to the new standard will impact us.Our 2019 acquisition strategy is to remain disciplined as we focus on small to midsize firms that will help us deepen our expertise, diversify our services in key regions and create value. We plan to continue to infill in Canada and still see significant opportunity to grow and diversify in the U.S. We need to be a top-tier provider in multiple sectors to operate at scale, and acquisitions are key to growing and diversifying our operations and building vertical depth. Our intent is to achieve the same thoughtful North-American-focused geographic and business line expansion in the key global markets, namely New Zealand, Australia and in the U.K. We remain committed to the U.K. as part of our long-term growth strategy; with long-term infrastructure demands there are plenty of opportunities. But we'll wait and see where everything lands when the uncertainty surrounding Brexit subsides.Stantec steps into 2019 determined to deliver shareholder value while providing solutions to challenges facing our clients and the world. Our consulting business remains among the best in the world. We've worked hard to build a practice as -- that is diversified by business line and geography, providing a stable base against potential volatility in any one sector or region. Our business model is further strengthened by our solid client base, which is well balanced between public- and private-sector clients, and built upon strong local relationships backed by our team of global experts. Our backlogs are strong and we're well positioned to continue winning meaningful work that will grow earnings and help us create communities.As always, I thank our employees, clients and the investment community for their continued confidence in Stantec.With that, I'll turn our call back to the operator to begin the Q&A.

[Operator]

[Operator Instructions]And our first question comes from Jacob Bout.

[Jacob Jonathan Bout]

Wanted to go back to your 15% net revenue CAGR guidance. I guess we would back into, then, a kind of a 10%-plus M&A for net revenue. What is your target areas right now for M&A by geography and sector?

[Gordon Allan Johnston, President, CEO & Director]

And so, Jacob, I'd also like to clarify that that 15% is on a 5-year average. Some years will be higher than that and certainly some years will be lower than that. From a geographic and business line expansion, we -- as we've mentioned earlier, we have -- in the prepared remarks, when we started back in June of 2017 when I was named to this role, we spent a lot of time in the U.K. and in Australia and New Zealand looking at firms. So in the U.K., we've identified, still, a number of really good top-tier firms that would like to join Stantec. At this point, though, we've paused any further additions of firms in the U.K. until we learn a little bit more about Brexit. So with that said, we'll continue to focus on Australia and New Zealand. Certainly we've previously press-released the -- that we've signed an LOI with WGE Engineers, Wood & Grieve Engineers of Perth, and we'll continue to talk to additional firms down there, but we intend to take our foot off the gas at all in the U.S. We still see strong opportunities for growth in the U.S. across all of our business lines. And perhaps just for a moment going back to Australia and New Zealand area, in Australia we have some good presence in Water, an emerging presence in Transportation, and when WGE joins us, subject to due diligence in the first quarter of this year, that'll give us a very strong national buildings presence. So I think we've got a lot of opportunities, still, in Australia and New Zealand, Australia in particular, to continue to focus on transportation firms, additional strength in our Water business, really filling out the full suite of services that typically, within the Stantec -- our 5 business operating units. We're seeing, still, in Australia, a lot of growth in the southeastern corridor from a land-development perspective, Community Development. In the west, certainly a lot of work, emerging work, coming back in the Mining business. And we're hiring there; in fact, having trouble filling some of the positions we want to hire just because it's so robust there. So pretty good geographic opportunities for M&A growth as well as a lot of sectors that we still have a good run rate in as well.

[Jacob Jonathan Bout]

Okay, thank you. That was helpful. And maybe just a question on how the divestiture of your construction business has impacted your E&C Water business. Any impact on win rates or any other impacts? Thank you.

[Gordon Allan Johnston, President, CEO & Director]

We have not seen any impact on win rates or -- at this point, in the U.S. in particular, no impact that I could speak of whatsoever. And in the U.K. as well, we still have -- we haven't seen any impact from the divestiture of construction at this point.

[Jacob Jonathan Bout]

Okay. Last question here, just on the quality of your backlog. What's the embedded EBITDA margin in your backlog you have currently?

[Gordon Allan Johnston, President, CEO & Director]

We feel that the backlog hasn't been achieved through price reductions. So we feel good about the quality of the backlog as well, that it'll be in line with what we've seen historically.

[Operator]

And our next question comes from Yuri Lynk.

[Yuri Lynk]

Just a follow-up on the debt-to-EBITDA ratio. It struck me as rather high; 2.42, I think, is the number provided. Can you just clarify the -- if the EBITDA you're using in that calc is restated for just the consulting EBITDA, or is that including the losses in the construction business over the last year?

[Theresa B. Y. Jang, Executive VP & CFO]

No, that is using our actual EBITDA, not the adjusted metric.

[Yuri Lynk]

Okay, that makes a little more sense. So that should -- I guess the thinking, if we were to tie that into the plan to do more M&A, because at face value it looks like you're rather tight there, EBITDA lapping some easy comps, better cash flow, and that kind of gets you into a better comfort range on the balance sheet. Is that the thinking?

[Theresa B. Y. Jang, Executive VP & CFO]

Yes, and keep in mind, I mean, the EBITDA is -- we know it's going to improve now that we've shed the construction business. And so we're anticipating that coverage to improve pretty dramatically as we roll into 2019 and those -- the weak EBITDA from construction rolls off. So we -- it's something that we're monitoring, absolutely, but it's not really, for me, an area of concern.

[Yuri Lynk]

Got it, okay. Can you share with me what the guidance implies for the Buildings segment, particularly around margin? And you described continued execution challenges in the fourth quarter in that segment. I mean, this has been going on for a while. What's being done? What are the nature of the issues? And when might they cease?

[Gordon Allan Johnston, President, CEO & Director]

Yes, when we -- certainly in the fourth quarter of last year, we did a deep dive on these 2 Buildings projects in Canada. That was the Mackenzie Vaughan Hospital and CAMH. And what we found there was -- so the issues -- we trued up, really, with a strong year-end value assessment, the cost to complete the design phase. Both those projects are in construction now, the design phase largely complete, and really those -- we trued up what we believe the year-end value to address with that. Going forward, we have services -- we'll continue with services during construction, but that work, the services-during-construction work, those budgets remain intact. So we believe that the performance in the Buildings sector going forward into 2019, while we don't see it as being spectacular, we don't foresee the degree of impact that we had in 2018.

[Yuri Lynk]

And was the issue there just underestimating the number of man hours it would take to complete these jobs?

[Gordon Allan Johnston, President, CEO & Director]

Yes, those were both P3 jobs. And you're right, they -- the scope -- we found that the scope was not well controlled. The client came back with numerous change orders, and perhaps we hadn't managed that as well internally as we could have. We've changed some people around, we've brought in some additional -- from internally, we've put some of our project management specialists on it. That's where we did the deep dive into the year-end value, did those true-ups in Q4, and that's why, going forward, we expect that we're going to be in better shape there.

[Yuri Lynk]

Okay. So we should see better margins on the whole in '19 versus '18 in Buildings? Is that the message?

[Gordon Allan Johnston, President, CEO & Director]

That would be our anticipation, yes.

[Operator]

[Operator Instructions]Our next question comes from Mark Neville.

[Mark Neville, Analyst]

Maybe just first on the last construction project. Just, can you just remind us, or just let us know when that officially wraps up, and then if there's any cash flow impacts that we should expect in Q1?

[Gordon Allan Johnston, President, CEO & Director]

So we -- so, good question, Mark. So as Theresa noted in her remarks, the -- we're focused right now on this 30-day acceptance test. And we're over 20 days into it, so that's the next big milestone, is to achieve that 30-day acceptance period. Once that's complete, we still have -- we have O&M contracted for a 5-year period, so we're not particularly focused on the O&M contract right now, but we have received interest from a number of firms who would be interested in picking up that O&M contract from us, and thereby us shedding all go-forward liability on that, so that's kind of something that we're certainly interested in, and we'll engage on -- in those discussions once we've completed this -- our 30-day performance test. And again, we're over 20 days into that.

[Theresa B. Y. Jang, Executive VP & CFO]

Yes, as far as the cost goes, we took a pretty hard look in the fourth quarter at what we needed to provide for with respect to completing this project, as well as the anticipated impacts of the O&M contract over its 5-year life. And so from an earnings impact, we feel that we've been conservative in providing our best estimated amount, and so the goal would be that as we move into 2019 to not see material losses recorded in the year. And so that's the approach that we've taken from a cash flow perspective. Of course, that timing will be as the project unfolds and over the course of that O&M contract.

[Mark Neville, Analyst]

But maybe just related to the actual -- ignoring the O&M, as the construction portion of these ramp up, I mean, in Q1, is there a significant cash outflow tied to that?

[Theresa B. Y. Jang, Executive VP & CFO]

I don't think it's significant, no.

[Mark Neville, Analyst]

Okay. And maybe just in the area of -- looking at your 2019 guidance, I'm just trying to reconcile sort of everything you're saying. Are you actually expecting growth in the Canadian ops next year?

[Gordon Allan Johnston, President, CEO & Director]

Yes. Yes, we are forecasting organic growth in Canada for next year.

[Mark Neville, Analyst]

Okay. I mean, it looks like a fairly difficult comp in '19 versus '18 in Canada, but like, consolidated, you're sort of roughly in the same range as what you did in '18, so I'm just curious if there is some softness in Canada or if it's down from last year, the growth rate, just maybe where you expect to make that up?

[Gordon Allan Johnston, President, CEO & Director]

We're seeing really good activity in the Transportation sector in Canada. At least there's -- we've been shortlisted on a number of projects in the GTA area there, here, Ontario, Milton Corridor, Lakeshore West. So a lot of good opportunities in transportation, particularly good opportunities continuing in the -- in both Environmental Services and Environmental and our Energy & Resources group as they relate to Coastal Gas, LNG Canada and Trans Mountain, should that be approved to move forward. So we do see some green shoots in a lot of our operations in Canada.

[Mark Neville, Analyst]

Okay. Maybe just one last one, then, for Theresa. Just on the reclassification of the corporate costs, I apologize if I missed this in the MD&A, but the 11.7% margin that you did in '18, does that -- is that sort of reclassified, or is that sort of on the old classification of the corporate?

[Theresa B. Y. Jang, Executive VP & CFO]

Yes. So it's -- I don't blame you, it's a little bit of a mind-twister in following through. So the 11.7% on the EBITDA margin, that piece is related to adjusting out those unusual and nonrecurring items. It doesn't take into account the reallocated costs. If you do adjust for the reallocated costs, we would actually have been at 12%.

[Mark Neville, Analyst]

12%, okay. And I guess for -- I guess that's my question, for '19, the baseline, then, is 12% or 11.7? Just for guidance and -- yes.

[Theresa B. Y. Jang, Executive VP & CFO]

So for '19, the basis would have to be 11.7% because the new methodology of allocating cost is now the go-forward approach.

[Mark Neville, Analyst]

Okay, so the 11.7% is the reallocated number? Maybe I'm not fully understanding, and I apologize, but the 11.7% is reclassified?

[Theresa B. Y. Jang, Executive VP & CFO]

Yes, that's correct.

[Operator]

Our next question comes from Maxim Sytchev.

[Maxim Sytchev, Managing Director and AEC]

I had a -- maybe a question for Theresa to start off. The reported tax rate in MD&A, you talk about 10.9%. So is that what you use to calculate the CAD 0.40 for the Q4 adjusted EPS?

[Theresa B. Y. Jang, Executive VP & CFO]

The tax rate -- it would have included the adjustment for the CAD-10-million provision -- or, sorry, recovery that we adjusted for in arriving at adjusted net income. So the lower tax rate would have the recovery included; the normalized rate would have it backed out.

[Maxim Sytchev, Managing Director and AEC]

Sorry, the normalized -- so the normalized EPS that you calculated the CAD 0.40, because, like, I'm just going through, right now, through the spreadsheet. So was that imputing a 27% tax rate or the 10.9%?

[Theresa B. Y. Jang, Executive VP & CFO]

That would have been imputing a 27% tax rate.

[Maxim Sytchev, Managing Director and AEC]

Okay, okay. Thank you. And then in terms of -- when we look on a by-divisional basis, gross profit percentages are trending downward sort of across the board, and especially when you combine it with potential wage pressure due to relatively low unemployment rate. How should we think about the gross profit percentages on a prospective basis? Your comfort level around being able to bring those back up?

[Gordon Allan Johnston, President, CEO & Director]

So the -- yes, Max, as we look at gross margin, you're right, that has been kind of trending in a downward direction. We're pretty focused, as we did last year, on the cost side. This year we're going to continue to focus as well on -- and you're right, there is wage pressure in a number of our areas. And we're also really having a look at our overall work force, the demographics, the organizational structure, in looking for how we can continue to optimize that and bring down our overall average cost per hour of labor. So I think as we continue working through these initiatives in the first half of 2019, we're hopeful that that will, as we bring down that average cost of labor, that our gross margin will continue trend back upwards.

[Maxim Sytchev, Managing Director and AEC]

Right. And so do you mind maybe expanding a little bit on additional efficiencies that you can drive through kind of the system? Because I mean, like, it's easy, obviously, to say, like, it's going to go up by 100 basis points, but what is exactly behind that?

[Gordon Allan Johnston, President, CEO & Director]

So we're -- when we look at our overall structure, Max, we're looking at how we can continue to lean out the structure a little bit more, how we can get less people looking at administrative-type tasks and more people back working with clients and on projects. So we're continuing that work. We have -- we've presented some initial work to the board yesterday, and we're going to continue working through that. In terms of just how can we become leaner and meaner, we need to do that now, but I think you've brought up in the past in some of our discussions that as our -- as the U.S. expansionary cycle has gone on for quite some time now, do we see it as some point softening? And if so, how quickly can firms respond to a softening? So we're making sure that we're working hard to get out ahead of that.

[Maxim Sytchev, Managing Director and AEC]

Okay, no, that makes a lot of sense. And last question/clarification: You've added the adjusted net income to net revenue target, better than 5%, and I think consensus is already implying kind of, like, 7% for 2019. So what was the rationale of adding that additional target to your list, if it's possible?

[Gordon Allan Johnston, President, CEO & Director]

It's something that we've always tracked internally, Max. It's been our -- something that we've used, and so the thought was that if it's something that's important for us to track internally and hold ourselves accountable to, that from a transparency perspective, we didn't mind sharing that with you as well.

[Operator]

And our next question comes from Mona Nazir.

[Mona Nazir]

So my first question is just following on the last line of questioning. You had 11.7% consulting margin in 2018, which was a year that effectively there was a lot of noise surrounding the business. You had challenges within your construction division, you were trying to sell that, new management transition, and given the noises have subsided for the most part and your recent comments surrounding optimization, do you think it's possible to hit the upper end of the guidance range for EBITDA? So 12.5% or more?

[Gordon Allan Johnston, President, CEO & Director]

Mona, we're going to continue to focus hard on that, both through efficiencies, increasing our quality of delivery and so on. We feel that that range of 11% to 13% is reasonable. Often we get asked, would we ever get above 13%, and I don't think that getting back in those 14% numbers that we had several years ago is -- could happen. We're going to focus hard to do as -- to get the best we can there, but certainly I think the midpoint is probably a reasonable objective for us to think about.

[Mona Nazir]

Okay, that's helpful. And then just secondly, I wanted to turn to infrastructure spending initiatives, both in Canada and the U.S., and it's been slow to take off on both sides. And from calls dating back to last year and even 2017, there was an overall optimization within the sector, and we saw strong rallying, albeit it's somewhat died down since. I'm just wondering if your current organic-growth forecast of low- to mid-single digits, does that factor in any uptick in spending, or is it based on the status quo?

[Gordon Allan Johnston, President, CEO & Director]

It's really based on the status quo, Mona. Like, the -- certainly there's been a lot of talk both north and south of the border of a significant increase in infrastructure spend, but we really haven't seen anything that has materially come along. The market is pretty close to capacity both on the design and the construction side, so if there was a big injection of significant infrastructure funds either north or south of the border, part of my concern is that that would lead to some significant inflationary spirals in our industry. So -- but to your point, no, we have not included in our forecast a significant uptick in infrastructure spend.

[Operator]

And our next question comes from Derek Spronck.

[Derek Spronck, Analyst]

Can you provide any updates on the AMP6 to AMP7 transition?

[Gordon Allan Johnston, President, CEO & Director]

Yes, that process is going well. We're currently, as you know, in AMP6. AMP7 will -- really kicks in in April of 2020. So as we have a number of AMP6 clients in which we have the provision as they roll into AMP7 of just renegotiating the contract, we will not have to re-compete, so we're in discussions with a number of clients on that now. But there has only been 2 AMP7 contracts that have gone out, 1 for Yorkshire Water and 1 for SouthWest Water. And we were successful on winning both of those AMP7 agreements -- those AMP7 contracts going forward. Both run through 2025 with an option to extend past that. So we feel pretty comfortable with where we are in the AMP6 to AMP7 transition.

[Derek Spronck, Analyst]

Okay, that's great. Thanks, Gord. With the backlog, CAD 4.2 billion, you indicated that you're feeling relatively comfortable with any sort of uncertainty that might arise with Brexit due to the long-term nature of your contracts there. If we were to look at the -- your CAD-4.2-billion backlog, how much of that do you expect to be converted over the next 12 months? Or what's the duration of that, of the backlog?

[Gordon Allan Johnston, President, CEO & Director]

Well, as you know, with the new accounting rules that rolled in last year, we used to always report on our upcoming 12 to 18 months' backlog; now we're required to report on our full backlog. So certainly, that gives us 11.7 months. In terms of how much do we plan to convert, it will be just our continued taking from where we are in 2018 as we roll forward with our organic growth into 2019. I don't see -- well, we won't consume all of that, because we have, certainly, a number of additional projects coming on. [Indiscernible].

[Derek Spronck, Analyst]

But by and large, it gives you pretty good visibility for 2019. I mean, the majority . . .

[Gordon Allan Johnston, President, CEO & Director]

Oh, yes. We feel quite comfortable for 2019, absolutely.

[Derek Spronck, Analyst]

Okay, that's great. And then just one more for myself. You indicated the gross margins were down largely due to changes in project mix. Is that just the quarterly variance, or do you see that trend continuing at all in the future? And maybe a little bit more color there would be helpful.

[Gordon Allan Johnston, President, CEO & Director]

What we -- we do find that some of the Energy & Resources work that we do on the large pipeline jobs and large Oil & Gas jobs are at a lower margin than some of our other lines of business, so I think as that work increased a bit in 2018, we saw a little bit of margin impact from that. But going forward, we don't see margin contraction in a lot of the new work that we're either bidding or being awarded. So coupled with the types of projects that we're getting in the door, coupled with us working to increase our average cost of labor efficiencies, we're optimistic that the gross margins will not -- will see no further deterioration. It'll either be stable or increase through the year.

[Derek Spronck, Analyst]

Okay. And then just one last one, quickly, for myself, before I turn it over. Did you see any sort of impact from the U.S. government shutdown there in the first quarter?

[Gordon Allan Johnston, President, CEO & Director]

We really didn't see a significant impact on our U.S. operations due to that. A big part of our work is for agencies like FEMA, and their funding was unaffected by the shutdown, so we really didn't see much of an impact at all.

[Operator]

And our next question comes from Devin Dodge.

[Devin Dodge, Analyst]

Some of your U.S. peers continue to generate really strong organic growth, high-single-digit, low-double-digit kind of range. It was good to see a bit of a lift on your U.S. organic growth in the quarter, but it still seems like there's a bit of a gap between yourselves and some the larger players like AECOM and Jacobs. Is this just a function of the specific markets you're in, or the end markets you serve, or are there other things that we should be thinking about?

[Gordon Allan Johnston, President, CEO & Director]

No, and you're right, when you look at our organic net revenue growth in Q4 in the U.S., we had 4%. We've kind of seen strengthening from Q3 '18 to Q4 '18, and so we see some continued strengthening. We are projecting in the U.S. that we'll have higher organic growth this year, certainly, than in Canada, so we've got some good project wins. We've referenced a couple of the big Transportation projects. We've got some good Water projects down there. In Water in particular, our backlogs are at an all-time high, and we're working through that process of, we need to hire more people, get them in the door, in order to get the work out the door. But we're trying to still be very disciplined and -- in our hiring practices and certainly in our pay, that we don't fall into a cycle of just continuing to escalate our pay, which would then -- the pay profile, which would then lower our margin. So we're trying to be disciplined and balance that discipline with our need to consume the backlog and get the work out the door. So it's a -- we're trying to balance a little bit there, and I think we're having some success in Water so far this year. We're -- we've hired a number of people at the production ranks, upwards of -- well, without getting into the numbers, but we're certainly having some success there in hiring people and maintaining our pay profile in the way that we want to do so going forward.

[Devin Dodge, Analyst]

That's -- thanks for that, it's good color. Maybe just switching gears here, but last quarter you talked about the acquisition pipeline was as full or fuller than it's ever been. I guess, how has this evolved over the last 3 or 4 months? And maybe just further to that, I just want to make sure I have this clear, but I think Theresa mentioned that there's a desire to strengthen the balance sheet, maybe reduce leverage. Does this in any way suggest that M&A could slow down in 2019 versus maybe what it was last year?

[Gordon Allan Johnston, President, CEO & Director]

No, we don't see that occurring. So from -- first I'll talk about the pipeline perspective. From both within North America, primarily in the United States, and outside, Australia, New Zealand, there's some good opportunities in some of these solid Western European countries, up in the Nordics as well. Some good opportunities there. So the pipeline remains very, very full, and probably even fuller than when we had that discussion last quarter. In terms of the capital allocation and our growth going forward there, perhaps I'll let Theresa answer that question.

[Theresa B. Y. Jang, Executive VP & CFO]

Yes, I think it's really a matter of ensuring we maintain our discipline. There are so many opportunities in the M&A pipeline that in selecting the ones that we will actually pursue, it will be about ensuring that that's the best place to place our capital, and that's really what that optimization will be about, as I talked about earlier.

[Operator]

And our next question comes from Benoit Poirier.

[Benoit Poirier]

And just for -- to come back on the M&A, could you mention if you saw a step up in the valuation that took place over the last year given the overall improvement in valuation in this space?

[Gordon Allan Johnston, President, CEO & Director]

We've been -- we've continued to be pretty disciplined, Benoit, as we look at these. The ones that typically would go to an auction and see even higher and higher prices, we're -- we typically don't participate in those because the seller's motivation to sell and be part of a strategic buyer like Stantec is very important to us. We see that [ 6 ] to [ 8 ] range maybe over the last year or so has kind of gone from -- to a little bit of a [ 7 ] to [ 9 ], but we still maintain our discipline and our focus in paying what we believe to be the right price for the acquisitions. And if money is the only reason for an acquisition to join us, then oftentimes we'll find that they might be better to go elsewhere.

[Benoit Poirier]

Okay, perfect. And just in terms of capital allocation, Theresa, sorry if I missed the answer at the beginning, but funded debt/EBITDA stood at 2.4x at the end of the year. I was wondering what type of level would you like to be going forward, and also, what type of free cash flow generation we should be looking for in 2019.

[Theresa B. Y. Jang, Executive VP & CFO]

Yes, so as I mentioned earlier, the 2.42 is based on our actual EBITDA. That does include the impact of the construction business. And so as we start to roll away from having those results in that metric, we know that the metric will improve. Where do we want it to be? I think historically Stantec has said, 1.5 to 2.5. So we're well within where we want it to be. It is about improving it further, and we know that that will occur as we continue to grow and, again, as we shed the construction impacts. From a free cash flow perspective, I think you're going to see the same thing, that our cash from operations is forecast to increase from our consulting business, and along with that, 2018 was a heavy year for us from a capital expenditure perspective, mainly because of the move into the new tower. And so we expect that spending to come down in 2019. And so both of those effects of higher cash from operations, lower CapEx, will, we think, dramatically improve our free cash flow.

[Benoit Poirier]

Okay. Have you provided the number in terms of CapEx for 2019, Theresa?

[Theresa B. Y. Jang, Executive VP & CFO]

Yes, we provided a range of CAD 60 million to CAD 65 million for capital expenditures and CAD 5 million to CAD 10 million for software additions.

[Benoit Poirier]

Okay, perfect. And would it be fair that the free cash flow conversion, you're still expecting kind of the 100% of the net income going forward, or is there any changes that we should take into account?

[Theresa B. Y. Jang, Executive VP & CFO]

No, I think getting close to that 1x is certainly what we're shooting for.

[Benoit Poirier]

Okay, perfect. And the last question for me, could you talk a little bit about the overall environment for Energy & Resources? Obviously strong organic growth and earlier this year it seemed that it was strong across each segment, so Mining, Power, Oil & Gas. I would be curious if it's well balanced between those 2 segments, and also, what type of -- if you could provide kind of an outlook for this segment going into 2019? Thank you.

[Gordon Allan Johnston, President, CEO & Director]

Sure. We -- certainly we don't see the continued 20% type of growth that we saw in that group over 2018. It was coming off some pretty low comps in 2017. But there remain very good opportunities for that overall group. In the Mining sector, for us, a big part of that is in Latin America. We're seeing that group very busy. We're seeing continued hiring in Latin America, really in all 3 countries where we're active. We see mining work in Western Australia picking up again. We've talked about some of the hiring we're doing there and how we're having trouble filling some of the positions we're looking to hire there. Certainly the Power side remains robust for us. A lot of renewables-type work there. And then in our standard, sort of more the engineering side, which for us is a lot of midstream pipeline, we see good opportunities in both Western Canada and some opportunities in the U.S. as well. So I think we'll see continued growth in Energy & Resources in 2019, but certainly not in the 20%-plus range that we saw in 2018.

[Operator]

And our next question comes from Michael Tupholme.

[Michael Tupholme, Research Analyst]

You provided some additional disclosure around the backlog in terms of backlog by reportable segment, geographic region, this year, which is helpful. Thank you for that. Can you provide a bit of context around how each of those regions, the backlog would have changed Q4 versus where it would have been, say, in Q3, or even earlier in 2018?

[Gordon Allan Johnston, President, CEO & Director]

I think we would have seen not a material change. While we've had some large projects awarded in one geography or another, there wasn't a -- when you're looking at a CAD-4.2-billion backlog, even if you win a very large project, CAD 100 million in fees or so, it doesn't materially make a difference in the big picture, so I don't think that the geographic mix would have changed significantly between Q3 to Q4 or even on a quarter-on-quarter basis. Pretty similar. That's -- and the backlog is more or less in line with where we find our headcount and where we're proceeding from that perspective. So we feel pretty good about it overall.

[Michael Tupholme, Research Analyst]

Okay. So no one region would have driven a disproportionate share of the change one way or the other? It was -- it's pretty balanced?

[Gordon Allan Johnston, President, CEO & Director]

Theresa and I are looking at each other, thinking no, that we think it was pretty balanced.

[Michael Tupholme, Research Analyst]

Okay, that's helpful. Thank you. Can you talk a little bit about the outlook for your Community Development activity both in Canada and the U.S.?

[Gordon Allan Johnston, President, CEO & Director]

Yes. So we still see that in Western Canada, things are a bit slower than they had been a decade ago, and that's just as a result of the slowness in the Oil & Gas business. Certainly, the coast, Vancouver is still very robust. We're seeing some good activity in Eastern Canada, Toronto and so on, and then still a lot of good activity in the U.S. in the Sun Belt states, whether it's Florida and California, those areas. We're seeing a good uptick in our land development business in the initiative that we rolled out called Urban Places, and that really brings together all of our groups from across the company looking at mixed-use development, sort of the creation of new urban downtown cores, redensification. We're seeing a lot of that in the larger cities. So that actually is an initiative we started several years ago, and we're seeing really strong uptick in that area.

[Michael Tupholme, Research Analyst]

Okay, thank you. And then just lastly, just to confirm, the Wood Grieve acquisition, has that now closed?

[Gordon Allan Johnston, President, CEO & Director]

It has not closed. We've been -- we've issued our letter of -- that we had to sign a letter of intent there some time ago. We're just working through the due diligence, and we've stated that we anticipate that closing in Q1, and that's still our thought process.

[Operator]

Our next question again comes from Max Sytchev.

[Maxim Sytchev, Managing Director and AEC]

Sorry, I just have one follow-up. Theresa, I can't seem to find the reconciliation to the noncash working capital changes in the financial statements. Is there a reason why that's not there, or am I missing something?

[Theresa B. Y. Jang, Executive VP & CFO]

Yes. So it won't be in the financial statements, but it will be in the MD&A.

[Maxim Sytchev, Managing Director and AEC]

Okay, so the same reconciliation to the indirect method is somewhere in the MD&A, right?

[Theresa B. Y. Jang, Executive VP & CFO]

Oh, I'm sorry. No, I'm sorry. You're talking about the cash from ops on the cash flow statement. No, we did not put that in the financial statements. In my drive to reduce the number of pages on the financials and the notes, that was not a required disclosure, and so we did not include that in the notes this year.

[Maxim Sytchev, Managing Director and AEC]

Because just -- it's kind of hard for us, like, looking from the outside, to get a better view on what's happening on each of the -- kind of the buckets of noncash working capital.

[Theresa B. Y. Jang, Executive VP & CFO]

Yes. It's -- there's a number of complexities involved in that this year, particularly with the Construction Services effect, and so that was one of the other reasons that we didn't put it in there, and I'm -- I don't know that I can commit to -- ordinarily I'd say, if there was something you needed, we'd put it on the website for you. I don't know that we can commit to that just because of the complexities required to get that number or that information right, but let us take that away and see if we can't figure something out there.

[Maxim Sytchev, Managing Director and AEC]

Yes, that would be very useful. Thank you very much.

[Operator]

Next question comes from Yuri Lynk.

[Yuri Lynk]

Yes, sorry, Max took my question, but I would just echo, if we could get that information at least on a go-forward basis, it would be appreciated. It's pretty important. Thanks.

[Theresa B. Y. Jang, Executive VP & CFO]

Okay. Noted.

[Gordon Allan Johnston, President, CEO & Director]

Okay, thanks, Yuri. Good perspective.

[Operator]

And we'll come back to Benoit Poirier.

[Benoit Poirier]

Just a follow-up question. I was wondering if you see any impact of the Vale disaster within the Water segment, especially with regards to the dam work.

[Gordon Allan Johnston, President, CEO & Director]

Yes, we have not seen any impact from that at this point, Benoit. Certainly that's an area of expertise that we have. We were not involved in that particular dam, so we don't see any downside. Could be potentially some upside as the -- that particular firm or other firms need to really have a look at their tailings ponds and their impoundments to make sure that they're up to standard. So we have not seen any -- certainly any negative impact. If anything, going forward, we might see a positive impact.

[Operator]

And our final question comes from Mona Nazir.

[Mona Nazir]

I was just wondering, what's your U.K. geographic exposure post the construction divestiture? And then the Peter Brett addition?

[Gordon Allan Johnston, President, CEO & Director]

Exposure, Mona? So the 2 types of work we have, there's certainly the AMP6/AMP7 work that we're doing in the Water business, is -- I think with regards to a Brexit would have very little to no impact of a Brexit there. The work that's being done, that the capital programs are committed, and in fact, as we go into the AMP7 cycle, we see them increasing. With the addition of Peter Brett, certainly some solid infrastructure work there that we continue to be involved in. So I don't see considerable exposure. And in fact, that's the reason why we went forward. Of the number of the firms that we were considering in the U.K., that really was the reason that we went forward with Peter Brett, because we saw them to be least exposed to any downside coming from a Brexit.

[Mona Nazir]

Perfect. Do you have a number as a percentage of revenue on a pro forma basis or a headcount?

[Gordon Allan Johnston, President, CEO & Director]

In the U.K., we have -- I'm going to say roughly 1,800 to 2,000 people. Of that, roughly 1,200 would be the legacy MWH folks who are involved in the water company work, so I would see no potential for a downside there. If there was a potential with regards to any downside, it would be with the Peter Brett folks, which are in the 600- to 800-person range. But again, a lot of that work we don't see having significant downside either.

[Operator]

Thank you, and we have no additional questions at this time.

[Gordon Allan Johnston, President, CEO & Director]

Great, well, thanks, everyone. That concludes our call today. Thank you again for joining us, and we look forward to catching up with many of you over the coming quarter.

[Theresa B. Y. Jang, Executive VP & CFO]

Thank you.

[Operator]

And this concludes our call today. Thank you all for joining.