Stantec, Inc. (NYSE:STN) Q3 2020 Earnings Conference Call November 5, 2020 9:00 AM ET
Gord Johnston – President & CEO
Theresa Jang – EVP & CFO
Conference Call Participants
Chris Murray – ATB Capital Market
Jacob Bout – CIBC
Benoit Poirier – Desjardins
Sabahat Khan – RBC Capital Markets
Mona Nazir – Laurentian Bank
Michael Tupholme – TD Securities
Maxim Sytchev – National Bank Financial
Welcome to Stantec’s Third Quarter 2020 Earnings Results Conference Call. On the call today are Gord Johnston, President and Chief Executive Officer; Theresa Jang, Executive Vice President and Chief Financial Officer. Stantec those dialing in to view the slide presentation, which is available in the Investors section stantec.com. Today’s call is also webcast.
Please be advised that if you have dialed in, while viewing the webcast, you should mute your computer, as there is a 20-second delay between the call and the webcast. All information provided during this conference call is subject to the forward-looking statement qualification set out on slide two, detailed in Stantec’s Management Discussion and Analysis and incorporated in full for the purposes of today’s call. All amounts discussed in today’s call are expressed in Canadian dollars and are generally rounded. And with that, I’m pleased to turn the call over to Mr. Gord Johnston.
Well, good morning and thank you for joining us. I’ll begin our call today with a review of our third quarter performance. Theresa will then delve deeper into the financial results, review our 2020 outlook and provide our 2021 targets. I’ll then return to provide closing remarks. We delivered another solid quarter in Q3 with net revenues in line with the outlook we provided during our Q2 call. Our business discipline, coupled with the improved operational efficiencies driven by our 2019 reshaping initiatives, ongoing staffing management and controls on discretionary spending, drove a strong 17.3% adjusted EBITDA margin, a 5.1% year-over-year increase in adjusted diluted EPS and a 5.4% increase in adjusted net income, in sight of net revenue and gross margin retractions.
Backlog grew organically in Q3 to a record high of $4.8 billion and our balance sheet continued to strengthen. Subsequent to the quarter, we closed on our $300 million bond offering in very attractive terms. Theresa will discuss it in more detail in the resection of the presentation. At the end of the presentation today, I’ll review how our core value creators of people, excellence, innovation and growth continue to underpin our competitive advantage and further enhance shareholder value. Q3 net revenue was consistent with the outlook we provided in our Q2 call. Compared with the same period last year, net revenue for the quarter decreased 3.8% or $36 million to $915 million. Revenue retracted organically 4.7% in the quarter. Year-to-date, net revenue is holding up very well despite the COVID-19 pandemic with an organic retraction of only 1%. Water demonstrated a strong year-over-year organic growth in the quarter with healthy activity continuing in the United States, United Kingdom and Australia.
As discussed on our last call, this was driven by significant project awards in the U.S., the M7 framework awards in the U.K. and a multiyear framework award in Australia. Looking ahead, we’ve just started to mobilize for the Irish water seven year framework.
And just last week, we announced our leadership role in San Diego’s multibillion-dollar pure water initiative, which will supply to sustainable water to the city’s 1.4 million residents. Environmental Services continues to perform well and slightly ahead of expectations. Essentially, all of our Environmental Services connected backlog remains in place and is being executed with limited COVID-related delays or cancellations. Key projects in LNG facilities and pipelines continue to advance. As well, existing large infrastructure projects in our Northwest territories, Manitoba and Alberta grew in scope during the quarter.
Energy resource has had a strong quarter even in the ongoing pandemic. Increased midstream pipeline work in Canada was offset by reduced mining activity in both Canada and our global operations due to pandemic-related shutdowns and deferred industry spending.
We’re seeing increased opportunities in renewables, particularly in solar. While this market slowed recently earlier in the year, it’s picked up and we were recently awarded large-scale solar projects in Canada, the U.S. and Australia. In general, given the critical nature of power generation and transmission infrastructure, the utility market has not slowed. We’re seeing strong growth in electrical transmission opportunities, especially in the U.S. because of resiliency programs, the growth of renewables and power trend mitigation. Infrastructure revenues retracted in the quarter, primarily due to several large rail transit projects in the United States, which we’re beginning to wind down.
At the same time, the ramp-up of some of our other big transportation projects has been a bit slower than normal. We expect our Transportation business to be a beneficiary of various infrastructure silos programs as they’re announced around the world. And while we have seen concrete stimulus spending commitments in various locations, there will be a time lag between when these programs are announced and when we begin to generate meaningful revenue. That said, our participation in Edmonton Valley line West LRT was announced just last week. The commercial airport and hospitality sectors in our Buildings business continues to impacted pandemic, how we can work for e-commerce clients.
We’ve also seen a significant increase in the pursuit of activity in the healthcare sectors and we were recently named the lead designer of the preferred performing team for the $1.4 billion puts Hospital in Melbourne, Australia.
Our public sector in Buildings remain greater than 50%, which is higher than many of our peers. And we’re seeing a trend toward greater exposure to a publicly funded project in our Buildings business, which should bolster future resiliency. While Q3 2020 net revenue in the U.S. retracted slightly more than anticipated compared with Q2, we’re seeing continued growth in water and strong performance in Environmental Services. The pandemic has had an unfavorable impact on Buildings and has contributed to lower ramp-up of from major Transportation projects. Gross margin as a percentage of revenue decreased 1.7% in the quarter to 52.9%. This reflects a shift in our project mix, primarily driven by the major project in our Transportation center.
During the quarter, we won a number of new major projects, including the San Diego pure water contract, the Arctic Research Support and Logistics contract and the IIT 3 North Street North York widening project in Pennsylvania. In Canada, Q3 net revenues were slightly ahead of Q2, which was consistent with our outlook. While Canada experienced a 5.3% organic retraction compared with Q3 ’19, we’re seeing growth in our Energy & Resources business, largely due to midstream pipeline work and in our Transportation sector. As well, Environmental Services performance has remained consistent year-over-year and the COVID-19 pandemic was more pronounced in Buildings and community development. Gross margin decreased 1.8% as a percent of net revenue in the quarter to 15.4%. This was mainly due to a shift in our project mix, driven largely by the increased volume of lower-margin work related to our midstream pipeline and rail transit work. Some of the major contracts we won in the quarter include the design for Canada’s water infrastructure on rates in both Alberta and Quebec and a new integrated academic student housing facilities in British Columbia.
Net revenues in our Global business achieved 5.8% growth over Q2, which was generally in line with our expectations. Year-over-year, Q3 net revenue grew nominally as favorable foreign exchange rates offset a slight actuate traction. Continued strong performance in our U.K. and Australian water business, our work in New Zealand’s Transportation sector and progressive recovery in core markets in our U.K. infrastructure business all contributed to a strong showing in our global operations in Q3. The impact of COVID-19 was more pronounced in our U.K. and Australia Buildings and European Environmental Services business.
Our Mining business was also affected by pandemic related short-term mine closures in Peru. Gross margin as a percentage of net revenue decreased 3% in the quarter to 53.5%. Margins were impacted by project mix and some ongoing pricing pressures for our services in the U.K., Europe and Australia. Additionally, localized challenges on certain projects reduced gross margin in our Middle East Water and Buildings business. During the quarter, we were awarded a number of major contracts in our global operations.
As I mentioned earlier, we were selected as a building services engineer for the Plenary Health Consortium, which has been selected as a preferred proponent for the new Footscray Hospital project. And we were also selected by the European Commission to support development of a continental generation and transmission master fund to meet Africa’s growing power needs. Backlog expanded in Q3 to a record $4.8 billion, which represents approximately 12 months of work. Backlog has grown 12.7% in the end of 2019, of which 10.6% is organic growth.
And since Q2, backlog had grown organically by 3.2%. Our book-to-burn ratio for Q3 2020 was 1.1 compared to 1.0 for Q3 2019 and it is greater than one across each of our five business operating units. Overall, our sales pipeline remains healthy after the brief activity we saw in Q1. The number of new pursuits in our pipeline has returned to more typical levels. And not surprisingly, we’re seeing more opportunities in the public sector than we are in the private sector.
I’ll turn the call over to Theresa now for a review of our financial performance and our outlook.
Thank you, Gord and good morning, everyone. Adjusted net income from continuing operations increased 5% to $70 million in the third quarter or 7.6% as a percentage of net revenue. Adjusted earnings per share increased 5% to $0.62 per share. This is largely due to a 9% decrease in administrative and marketing expenses and a 33% reduction in net interest expense. Gross margin for the quarter decreased 7% to $479 million. As a percentage of net revenue, gross margin was 52.3%.
The pandemic disrupt our and our clients’ operations to a degree, causing some inefficiencies in project execution, as demonstrated by our solar adjusted EBITDA margin of 17.3%. We’re managing the business carefully and we’ve taken steps to mitigate COVID-19’s impact on organic growth and gross margins. Our balance sheet remains strong.
At September 30, net debt to adjusted EBITDA was below our targeted range at 0.8 times. Day sales outstanding was 82 days at quarter end compared with our target of 90 days. The remains unchanged since Q2 and was not seeing any notable impact due to pandemic.
Moving on to liquidity and capital allocation. We generated $124 million in free cash flow for the quarter, a 31% increase compared with Q3 2019. Sequentially, our free cash flow has improved every quarter for the past four quarters on a trailing 12 on basis. On October 8, we closed our inaugural bond offering issuing $300 million in senior notes for the 10-year term with interest at 2.048%. The note $300 million facility is currently largely undrawn, giving us significant dry powder to weather the pandemic and the fund growth through acquisitions. As the result of the uncertainty created by the pandemic, we withdrew our 2020 guidance in May. We remain committed to our strategic plan launch in December 2019. However, disruption caused by the COVID-19 pandemic will likely delay the achievement of our targets within the original time frame. At this time, we’re unable to get a revised time line with a high degree of confidence. Today, we’re reiterating our outlook for 2020 as set out in August. We’re also providing our target for 2021. New targets assumed a continued gradual global recovery that may not be knowledge or geographies experience and severe worsening of the pandemic.
In terms of our revenue expectations in the U.S., we expect the step down results of Q2 to Q3 to continue into the fourth quarter due to the effect of project slowdown, combined with the difficult downturn in activity related to the onset of colder weather and seasonal holidays. For the full year, we expect U.S. net revenues to be comparable to, although slightly below, 2019 in native currency. We expect the same seasonal dynamic to be in Canada, which will result in Q4 2020 net revenues retracting relative to Q3.
Given the weak outlook for Canada before the pandemic, we expect a nominal retraction in revenue for the full year compared to last year. In Global, we expect that Q4 2020 net revenues will be down slightly relative to Q3. Our U.K. Buildings practice appears to be more impacted by pandemic-related headwinds than anticipated. However, we have done a strong performance from our Water business in U.K. and Australia and our Transportation sector in New Zealand, which has largely offset the impact of project slowdown in the private sector for our other businesses.
We expect this to result in 2020 revenue being comparable to although slightly below 2019. Taken together, we e2020 net revenue is better comparable to although slightly below 2019. Adjusted net income and adjusted EPS are expected to be comparable with 2019 as a result of lower admin and marketing costs and lower interest costs. As though last quarter, we expect to achieve roughly 55% of our 2020 earnings to be concentrated in Q2 and Q3 with 45% in Q1 in Q4. Our balance sheet is strong and we continue to have actual liquidity. Our capital allocation priorities have not changed. Our M&A activity has been reengaged and we’re committed to returning capital to our shareholders to the payment of our dividend and we’ll continue to repurchase shares opportunistically.
Moving on to our targets for next year. We expect our business to continue to demonstrate resilience and believe we’re well positioned to generate solid earnings. For 2021, we anticipate the lower to mid-single-digit organic net revenue growth. We anticipated net revenue growth in the U.S. in low single digits. While we believe we’re well positioned to benefit from stimulus spending, we haven’t yet incorporated any potential upside to this in our revenue expectations, including the uncertainty around the timing of such legislation being passed. I should also note that our element for 2021 and some in U.S. to Canada exchange rate of 0.76 saw a weaker U.S. dollar than the average we saw in 2020. Organic growth in Canada is expected to be in the mid-single digits, driven by work in the industry and pipeline or activity is anticipated to be at key levels in 2021. Excluding this activity, organic in growth Canada is expected to be in the low single digits.
Global organic growth is also expected to be in the mid-sales, benefiting from strong performance in the regulated water market and with stimulus funds beginning to slow. And while we reengage our M&A activity, we have not incorporated any acquisitions into our 2021 outlook as it is difficult to predict the cadence of when a particular transaction may close. For 2021, we’re targeting adjusted EBITDA to be in the range of 14.5% to 15.5%. This range is the result of our expectation that gross margin will hold steady relative to 2020 while given marketing costs normalize. We anticipate gross margin to be somewhere in the range of 52% to 53.5%, which reflects our expectation that the pandemic will continue to impact productivity, both within our operations and that of our clients and an anticipated meaningful increase in the cost of employee group benefits.
We also expect 2021 gross margin to be impacted by an increased volume of the lower work on our large midstream pipeline project and on several of our lower margin, $14 billion Transportation projects, which are nearing completion. Meanwhile, admin and marketing costs will likely return to the typical range of 37% to 39% of debt revenue. This range reflects a more normalized level of discretionary spending relative to 2020, but not a return to prepandemic levels. We do, however, anticipate an increase in nondiscretionary costs, including insurance and play group benefits associated with indirect labor. As well, we’re increasing our investments to drive innovation in IT systems to support our growing U.S. Federal government projects. We expect to jump the net income to be equal to or greater than 6% of net revenue and we benefit from lower interest expense and depreciation and amortization.
Return on invested capital is targeted to be equal to or greater than 9%. And we expect to generate 40% of our earnings in Q1 and Q4 and 60% in Q2 and Q3. We continue to advance our strategic initiatives to optimize occupancy costs beyond those locations identified to date, which could result in the recording of these asset impairments, noncash charges that not would change in our plans to utilize space that is currently under lease, with the long-term benefit of reduced occupancy costs and increased earnings and cash flows.
As our analysis is ongoing, our 2021 targets do not yet include potential benefits from further optimization. And again, I note, our targets do not include any acquisitions given the unpredictable nature of the size and timing of such acquisitions. Finally, our continued prudent management of leverage will keep our net debt to adjusted EBITDA would be below 1.0 to 2.0 times and we’re committed to maintaining our BBB credit rating.
With that, I’ll turn the call over back to Gord for his concluding remarks.
Thanks, Theresa. We continue to execute well on our strategic plan, which we read out to our employees in the investment community in December of last year. I want to thank our employees for their continued commitment to serving our clients and helping them through the unprecedented disruption caused by the pandemic. Our results for the quarter are truly accretive to our goal. By keeping the tight grip on administrative and marketing costs, we continue to mitigate the compression of our gross margin.
Our reshaping efforts in 2019, ongoing cost-reduction initiatives and a significant reduction in discretionary spending during the pandemic continue to protect our industry-leading adjusted EBITDA margins. We continue to invest in and develop innovative solutions for ourselves and our clients to meet the challenges posed by COVID-19 and to ensure that we emerge from pandemic an even stronger competitive position.
We’re also implementing strategy to conduct M&A activities by leveraging local resources even more when travel is restricted. And we’d utilize these strategies to the integration of Cashman, a small but strategic acquisition that we announced subsequent to the quarter. We remain confident in the resilience of our business model and our ability to navigate the ongoing challenges caused by the COVID-19 pandemic.
Given everything that Stantec has done in the last year, including our 2019 reshaping initiative, aligned with our organizational structure, continued focus on discretionary cost management and the staffing strategies we put in place, meaning that we’re very well positioned as we head into 2021.
And with that, we’ll open the call up to questions. Operator?
[Operator Instructions] Our first question today comes from Chris Murray of ATB Capital Market. Please go ahead.
Maybe turning to your 2021 guidance. Can you just — maybe we can dig into this a little bit more. Can you talk a little bit about how the niche you believe is going to be the part of the impact on gross margin. Just I guess the EBITDA margins coming in maybe a little bit lower than we thought and so any color there would be appreciated.
Sure. Great. I think we caught all of that. You were telling on a little bit soft, right? I think we caught your question around 2021 gross margin…
And project mix.
And project mix. So yes, I mean, I think it — is that right?
Okay. All right. Great. So I mean I think what we thought in 2020 and it’s important and we beat into 2021 is some compressoin in our gross margin relative to the range debt that we have historically seen.
And really, that has been driven by a combination of reduction in productivity, which is really hard to measure and had to drill into, but we do believe that there’s some of that occurring both on our side and our archive solution, the time line is around, which we’re able to conduct their work and have responsiveness to our clients. There is also a component of overall project mix and that has driven our gross margin down and that’s what we’re expecting to see some continuation of next year.
The transmountain project is somewhat outsized for us relative to our other projects, still overall less than 5% of our total net revenues. So as we’ve always said, we don’t really have any number of projects that are big enough to really push things in one direction or another — one particular project and contract is larger than most and it is at a relatively gross margin. And so that, as we move into next year, becomes more prominent the overall mix and then brings our gross margin down. And what’s important around a particular project, though and we have emphasized this in the past as well that because the nature of that work with the employees are working out in the field, there is virtually no cost admin associated with that project.
And so on balance, that the EBITDA margin it generates is comparable — a little bit lower overall than of our project work. But the gross margin reduction is not indicative of what flows through ultimate EBITDA line. So with that picking up in next year as well as where we are in the stage of our — a number of large transportation projects that are winding in that lower gross margin range, that is the dynamic we’re seeing that’s going to keep our gross margin around where it is — I work really hard to bring it up. We think there is some opportunity to improve our gross margin. But we were acknowledging, as you can see from the range we put out there, we’re not seeing a rise back to 15% to 55% which has historically been the gross margin range we’ve targeted.
Okay. And then I don’t know who would like to take this one. But I guess there’s a couple of pieces around the question around occupancy. And I guess first of all, Gord, I’m curious about your thoughts around how you see the organization change as its gone through COVID? And how you think about in an office setting and what that does with your footprint? But then what does that do to your Buildings business? And how are you guys thinking about that business longer term? So the cost side is a savings for you, perhaps. But then it’s also — how offices get used in the future, maybe it’s a little bit different as well.
Yes. So I’ll start with the overall occupancy side. We’ve seen — and I think our industry overall has seen, based on some of the panels that I’ve been on over the last couple of weeks, that across the board, we’re seeing utilization numbers are holding up reasonably well. But there’s some concern about the amount of productivity per billable hour.
So there is some benefit to having people together in the offices. There certainly is some visits from a project perspective, particularly as you think about junior and intermediate staff, the ability to walk by someone’s office and ask you questions and then continue to work in a more efficient manner. So there is some benefit to that. So as we think about overall occupancy, we’ve been surveying our staff. We’ve been talking to others in the industry. And we — as we think of occupancy going forward, we begin to think about certainly a percentage of people in the office full time, a percentage of people — that would be the majority likely, a percentage that would be in and out, a couple of days in the office, a couple of days at home perhaps and then a smaller percentage that would work from home exclusively.
So we are thinking about that as we think about our longer-term footprint. We’re not coming out and making any bold statements like we’ve seen from others in the tech sector that nobody is coming back to the office or much less than 50%, whatever coming to the office. We don’t think that’s the reality in the long term. With that said, you have what the impact it might have on our business, our Buildings business in particular. We do have a workforce group in our Buildings business that is certainly advising us as well as a number of our clients on these sorts of decision, how might we reconfigure an office. Perhaps if these folks coming in the office three days or four days a week, at home others, maybe those individuals should not expect to have a dedicated workspace for them.
So they’re looking at how do we move from a perspective where there’s a dedicated workspaces for people who choose to some shared or hotel in that space. In terms of how you think how that might impact our own Buildings business, certainly, that is the commercial, the office space segment of our Buildings business has been the most impacted due to the downturn in the pandemic side and our Hospitality group where we’re designing new multi-storey hotels and those sorts of things. As we talked about, we have seen a bit of a pivot due to some of the activities where people are responding differently. E-commerce work is up. We’re seeing healthcare work is up.
But as you saw in Q3, our Buildings business did retract organically, again, I think in Q2. So while that event is occurring, that healthcare work that we’re seeing, in particular, there’s a lot of healthcare work, big project coming out in Australia and in Canada, in particular. That work is starting to ramp up we announced the Footscray. But I think the rapid decline that we saw in commercial and hospitality haven’t been yet offset by the increase that we’re seeing in healthcare, e-commerce and so on. So we’re watching it pretty carefully, matching our workforce to the type of work that’s available.
Our next question today comes from Jacob Bout of CIBC. Please go ahead.
And I’m going to apologize upfront, I think up at a fairly static in line here. So I hope you can hear my questions. My first question just goes back to the EBITDA margin target. And maybe you can talk a bit about in a post-COVID world, where do you actually see EBITDA margins normalizing?
Sure, Jacob. I mean I think the reality is it’s hard to say what COVID margin looks like. I think where we have been in our strategic planning is thinking about and mapping of opportunity to look for EBITDA margin improvement and we still believe that those opportunities exist. I feel a little bit like the goal post have moved for us though as to the pandemic, whether in the shift and yes I pointed to employee group benefits. That’s a step change increase in cost that has, of course, being a people company is pretty significant. And so it seems like that it’s hard for us to know where that settles out, whether this is kind of a new normal level of cost that we are expecting to bear or not. And so there’s a bit of back and forth on this.
So again, our partner ally can do where we think is going to land post pandemic. But certainly, our efforts are around continuing to strengthen our EBITDA margin, very focused on it. But really felt that for 2021, the range that we put out is a realistic outcome and function of what we’re seeing from a gross margin and an overall cost perspective. And so whether that takes us beyond the pandemic is really hard to say at this point.
Okay. Yes. I guess from my view, I think if I heard your comments correct, mix also played into this as well. And I thought it a normalization of mix, unless you think there’s a step change there as well post-COVID will happen?
Yes. I don’t know if that was the case. Yes. I’ll just interject here. I don’t — I mean the project will all be factor, for sure. But whether that always — that means that permanently business case down, I don’t think we would say that, that was case. I think we are in an interesting period right now where we’ve got this one large project that is clearly having an impact on gross margin. I don’t know that we would anticipate anything of that size and what is that kind of a margin profile as we go on to the future.
Yes. My last question here is just on the organic roles. And when I look across business lines, clearly, Water stands up with very strong organic growth in the quarter. All the business lines, negative. Can you talk a bit about what happened in the quarter and how sustainable this is?
Yes. We’re very pleased with the 3.2% organic growth shift in Q3 and then over 10% year-to-date. Because particularly in the pandemic, that’s a tough period we saw in Q2, some of the — some of their opportunities retracting as our clients move form as well. But they’re back now, too. So we’re seeing our — we track on a daily basis.
The number of opportunities and the volume of the size of the opportunities that are in our sales pipeline, those numbers are back at sort of more normal pre-COVID-type numbers. We’re seeing a little bit more from the public sector than the private sector. It’s interesting that the amount of work, the amount of opportunities and our timing from dollar value has never been an eye before. Now I think there’s a couple of reasons for that.
One is the number of opportunities has kind of returned to more normal sizes. A bit of a go-to could be the squeezing out the bottom. Some of those opportunities aren’t being awarding play quickly. But I think it’s positive for us to see, though, that the size of opportunities or the overall volume of opportunities in the pipeline is — continues to rise. So I do think that from what we’re seeing right now, Jacob, that the organic growth number that we’ve put out for 2021, they feel it already. And again, that’s absent any significant stimulus because it’s hard to predict the timing of when that might occur.
Thank you. Our next question today comes from Benoit Poirier of Desjardins. Please go ahead.
Just to come back on the question on the mix that will impact 2021. I was wondering what drove the process, we will see downward of the large project that you just mentioned and whether there could be other projects that could impact the mix in 2021.
No. I think the big project that Theresa referred to is a big transit pipeline is a big, big job. And we see while we’ve been ramping up over the last number of years, 2021 is the — will be the major year where we’ll expand the majority of our effort and receive the majority of the revenue.
And so that’s why I think that 2021, that has sort of an outsized impact on pulling down gross margin a bit. The impact of that will be lesser in 2022 and 2023, just because the majority of the work will phase on. So that would be, I think, the bigger one, a lot that would have impacted. Again, it will be primarily in 2021 and then it should lessen in 2022. And we don’t see anything of that size and lower-margin profile currently in the pipeline.
Maybe one comment, Benoit, around [indiscernible] I think it’s important we’re it’s very get a bit of attention because of its size and because of the impact it’s having on our overall gross margin. But this is a project, as we talked about before, that is mainly sold to contract workers. And so this is a project that we are able to kind of ramp up and down the base of work that consume the project.
And it’s not de case that there’s a choice to be made for us around competing projects and we are deploying our average toward the one project on to the detriment of another or the choice of other projects that might have a different margin portfolio. This is purely incremental for us. And I think from that perspective, I want to touch on that because I think it’s important to understand that it is from an incremental perspective, from a return on our working capital perspective, still positive us.
And so I don’t want to leave the impression that this is a project that we shouldn’t be doing because of the right in our gross margin. Gross margin is an important as a metric, but there’s so many other factors that we need to consider when we look at the work that we do and the earnings that we generate. And so from a return perspective, this one is — it’s a good project for us.
Okay. That’s great color and with respect to the potential interment that you might take in order to reassess the real estate or cost-reduction initiative, I was just curious what would drive the decision? Is it purely a function of organic growth utilization rate? And what could be the magnitude or the potential impact we might see in 2021?
Sure. So on the occupancy cost trend, this is work that we pointed to in our strategic plan. And so this is something that we have been analyzing for some time still. And certainly, as we moved into the pandemic, it gave us some real live data as to what was possible from a reduction of our footprint. But as Gord said, there’s — I think we need to resist the urge to then this is our new normal and empty of all of our office spaces to reduce occupancy cost. We need to get an understanding of what is normal, what is long term, our occupancy, what is that going to look like. And so it will be driven by the work that we have done pre-pandemic around what is the appropriate amount square footage per employee.
And we’re blending that with now some new information around what do we, as an employer, expect from having our employees in the office relative to what our employees want, how much do they want to be in the office, that rate base as well. And then are there places where we’ve got leases that are — that are maybe coming to maturities within the next couple of years or raising an opportunity to exit now as opposed to later.
So it’s all of those dynamics that we’re looking at. What’s the scale of it? It’s really — it’s tough to say at this point. And — but I think it’s fair to say that we believe that there’s a significant opportunity there. And so unfortunately, when you do these kind of things, the accounting rules have a [indiscernible] I mean you take a noncash charge right away. But overall, it should — you’re doing it to improve your earning profile and your cash flows. So we think it will be a good trade-off to make. But we don’t — we try to have an order of magnitude for you.
The next question today comes from [indiscernible] of Raymond James. Please go ahead.
I’m a bit surprised by your — what I’m a bit surprised by your relatively muted growth expectations for the U.S. next year. Can you provide a bit more detail on what’s behind that outlook?
A number of things that we’re looking at. We do feel that there will be some infrastructure stimulus that will come forward and will continue to drive things here. We’re seeing some good activity still in the Water space.
We see some good activity in Transportation, certainly power, some of the renewables, solar. And on the Building space is going to be interesting next year there as we continue to talk about that pivot from commercial pivoted from hospitality. We haven’t seen as much of an uptick in opportunities in healthcare in the United States as we have in Canada and Australia and so on. And so I think you’ll see that from our perspective on next year that we’re being a little cautious and let cautiously optimistic perhaps on things. But we haven’t included acquisitions.
We haven’t included the stimulus. But I think that’s just sort of the future is a little unwritten there still. And so we’re taking a bit of a cautious wait-and-see attitude toward it.
Clear. I think it is a prudent way to go. Speaking of M&A from that standpoint, are you — given current conditions and a lot of moving parts out there, but are there any regions or verticals that you’re particularly attractive to right now?
We continue to look for opportunities in many of our verticals. As we’ve spoken about before in our strategic plan, we’re really focused on continuing to grow in those noncyclic businesses, Water, Transportation and so on. And the Buildings component, there would be less cyclical and the healthcare components and so on. So certainly, we’re looking for activity in those groups.
We continue to look good opportunity, still for some infill in Canada. We are looking in the U.S. and certainly, we haven’t changed our geographic profile where we’re looking outside North America. Still looking at the U.K. with a bit of a cautious look to Brexit in the short term. Looking at as some of the Nordics, Western Europe and then certainly down in Australia and New Zealand.
Okay. Are you still — are you still actively engaged in discussions with especially M&A and obviously, there’s that uncertainty around COVID, the timing of transactions and things like that. Are you still comfortable and happy with the number of discussions you’re having right now?
Yes. A lot of the discussions, interesting over the last little while, I think we previously provided some color to that. We saw a slowdown in activity in March, April time frame as people would kind of look inwards to manage their own business. Maybe the existing discussions, the ongoing discussions that we are having were paused. But those have really been reinitiated over the last several months.
And it’s also interesting to note that there’s been a number of new firms that have initiated discussions with us over the last, really, months to six weeks.
These are firms that we’ve been having some discussions with. It’s just very, very cursory, but really — not that they’ve suffered during the COVID. The number of firms, as you know, are continuing to do just as well now as they were before. But I think they’re just looking at orders and transition and having a little bit more time to think about some of these things. So I’d say that the discussions that we have ongoing pre-COVID and haven’t continued and we’ve initiated some additional new discussions over the last month to six weeks.
Our next question come from Sabahat Khan of RBC Capital Markets. Please go ahead.
Great. Just a little bit more on some of the commentary around specific end markets. I think part of the U.S. market, you noted some Water activity there as well. Can you maybe talk about how much there is a bit of a variance within the Water market across geographies. Can you maybe provide a little bit color there on what you’re seeing global?
Sure. And so when you talking end markets, just within the United States? Or sort of maybe look at that from a larger perspective, let’s talk about the U.K. U.S., Canada and Australia, is that sort of where you’re thinking?
Yes. Just I think it was mentioned in the U.S., it seemed like it might be a little bit softer. But yes, just globally, that’s what you’re seeing. It seems like U.K. is still doing well. Just curious, yes.
Yes. So looking at Water overall, certainly in the U.K., water is a regulated industry in the U.K. It continues to be driven by the neo directives. And interesting that those are unlikely to be relaxed in any way after Brexit. M7 is now well under way. We’re, in fact, aggressively hiring to continue as we ramp up. I see, of course, that is difficult during a hand on it. So we’ve been very successful.
We haven’t seen a drop in 2020 given Water in the U.K. Australia and New Zealand, we’ve got a couple of good framework. Awards are ongoing in Australia. I think that will continue to drive growth for us in the water industry through the remainder of 2020 and certainly into 2021. And in North America, water, we’ve had organic growth in Water for the last five, six quarters of strong growth. We saw it again in Q3 and we are projecting continued growth — organic growth in Water into 2020 as well. North America, the backlog projects in the water space, it’s very strong.
I think there’s — because we’re active in so many spaces and dominate really in North America in a number of — everything from closer resilience tied to work to water, wastewater treatment, big water conveyance, a lot of resources projects. So we see continued good opportunities in Water really in all of our major geographies for the remainder of 2020 into 2021.
And then I guess just on the 2021 commentary that you provided, I appreciate the fact that M&A is not included in there. I guess can you maybe comment on maybe the scale or size of potential transactions that you’re currently engaged with? Just trying to see if there’s potentially some needle-moving opportunities in the pipeline. We understand it’s still uncertain given the backdrop, but what kind of conversations are you having? Is the larger players or smaller players typically?
Yes. We haven’t really changed our philosophy there, which is still to target those small to mid — smaller to mid-sized firms, kind of less than 1,000 people. That’s really is our area of focus. That said, there will be larger ones. But how I think in 2021, we’ll have a look at them. But our primary area of focus is still on that small to midsized, less than 1,000 people types of space.
And then I think you made some comments earlier — some commentary earlier that the healthcare work is picking up in some markets and not in the U.S. That’s somewhat surprising. Can you maybe shed some color on why that region might be a little bit different on that front?
Yes. There’s a lot of ongoing discussions still in the U.S. But we’ve just seen less pursuit activities over the last quarter, quarter and half in the U.S. than we have in Canada and the — and Australia, in particular. I do think that we’ll see it coming back. Perhaps there’s some of these larger projects where we’re waiting to learn more about the impact of any potential stimulus that might be coming onboard. U.S. also has more private healthcare sort of operations down there. So we may be waiting just to see a little bit more how some of these things shake out over the next quarter or so. There is still great opportunity there. It’s just that over the last quarter, quarter and half, we’ve seen less opportunities come to market in the U.S. than we have in other locations.
Okay. Good. And then just last one for me. I think you mentioned earlier on the barge project, which it sounds like is the gross margin might be lower, but there’s less SG&A or discretionary costs associated with it. Can you maybe talk about what’s driving that? Is it just the nature of the work you’re doing there that’s resulting in lower SG&A?
Yes. So Theresa mentioned that the vast majority of the individuals that we have working for us on that job are contractors. And so really, they’re build. Typically, they won’t see the inside of a Stantec office. These are folks who are hired specifically to be on-site and working on that with that project. So a lot of the admin, there’s really no marketing costs for those folks who are involved. And when working on other proposals, they often will build a day rate for the work that they do there.
So there’s really limited to no administrative time, certainly the marketing time. And then the expenses are covered. So there’s really none of those discretionary admin and marketing costs, for the most part, where see with we other operations. So very well the gross margin on the work is lower. Really, there is –‘s you can never say none, but it’s very, very limited, admin and marketing costs. And so on the switch side, the utilization rates are virtually 100%.
Our next question today comes from Mona Nazir of Laurentian Bank. Please go ahead.
Good morning and thank you for taking my questions. Prior conference calls, on the back of the COVID, you stated that there were some pricing concessions put in place. And I believe the majority of those are short term in nature, three to six months. I’m just wondering if they have come out at all? Or are there further concessions? And I’m just wondering, related to that, if you see increased competition or pricing pressure?
Yes. Thanks, Mona. So certainly, some of those that were of shorter duration have come off. Others will stay for a bit longer. But we factored all that into our forecast for the remainder of this year and for next year as well. In terms of what we’re seeing going forward, this is always a price-competitive market. But we haven’t seen some of the pricing pressures from a competitive environment that we saw early on in the pandemic. We’ve seen a bit of a lessening of that. You’ll see from other firms that you look at in the space, these companies are still doing very well.
So the need to continually beat each other up and continue to drive prices down to secure additional market share has become less of a concern of people as the pandemic as proceeded. That said like, as I say, it’s always a competitive market. But a lot of that pricing pressure that we saw in the first couple of months of, as people move forward, really has come off to a degree.
That’s very helpful. And then just secondly, on M&A. I know you did speak to a number of questions on this. We have not seen a number of transactions within space. I think Tesla is kind of one of the only ones in my covered universe. I’m just wondering, you mentioned the various geographies that you continue to target, U.K., Nordics, Australia. I just wanted to confirm that there’s not a higher probably M&A in Canada or the U.S. just given the location and proximity, travel restrictions. And then on that, I’m just wondering if you’re comfortable with the ability to do due diligence from the financials for the companies that you’re targeting and related integration.
Yes. So look, in terms of where we’re looking, what’s really important to us is that where we’re looking for a firm, we have solid presence from a Stantec perspective. We have people that understand what it takes to go through due diligence, to source the firm, what the cultural set look like. And we feel very comfortable with the leadership that we have in place in the U.K., Western Europe, Australia and New Zealand, in addition to the leadership we have in place in Canada and the United States. So as long as we’re in a location where we have that strong leadership, I think we feel very comfortable continuing to move forward. And we are having ongoing discussions, really, in all of those geographies that you that you mentioned then.
So from the perspective of conducting due diligence and so on, again, our are leaders in these various areas where whether you do any project on diligence, HR, accounting, taxation, we’ll have people on the ground. But we’ll always be in contact with sort of our — the groups — the group of people that leads that initiative, just to ensure that we’re asking the right questions, we’re pushing forward with due diligence appropriately. So I don’t really see that these travel restrictions at this point are really significantly inhibiting our ability to move forward with our M&A discussions.
Okay. That’s very helpful. And just lastly, for me. appreciate you providing 2021 guidance, particularly in such challenging times. I understand that there are a number of questions surrounding the outlook, but this is just more of a clarification. Just given you stated that organic growth target kind of feel right, but then you’re also somewhat cautious. Just from the own purposes, would it be fair to say that you would characterize the overall guidance as being realistic based on how things are sitting right now or perhaps somewhat conservative?
We feel good about it, Mona. I think we feel that it’s realistic based on what we know now. And we do feel comfortable with where we are. We didn’t want to put out our sort of our target that we thought were kind of unachievable because then that will cause the issues all of next year. So I think these are realistic numbers that we feel reflect how we’re thinking about the environment at this point.
Our next question comes from Michael Tupholme from TD Securities. Please go ahead.
I wanted to go back to the discussion of the strategic initiative to look at optimization of occupancy costs. Theresa, is this — just in terms of timing, it sounds like you’re sort of still in an evaluation or at an evaluation stage here. I think it’s not included. No benefits included in your 2021 guidance from this. But what is the timing for potentially coming to some conclusions through this process? And then how quickly could you expect to see some benefits from that?
Well, I think based on where we are, it’d be realistic to think that in the next sort of three to six months, we almost draw to conclusion. And again, because the whole situation around work from homes continues to be fluid and we’re trying to make long-term decisions, it may take longer than we expected. But we’re bouncing — we have 350 locations around the world. There’s a lot of data to crunch through and have a lot of thinking around what’s the appropriate pricing that we want to put in place.
So our expectation is that it would be in, I would say, the three to six month period, but with a caveat that it could take longer just as things kind of change that extensively.
And if it is within that period in terms of sort of the decision-making process, I know it takes time to get out of leases or to sort of rearrange things on that front. What would be a realistic expectation for when you would start to begin to see the benefits?
Well, I think what’s interesting about the way the accounting rule works is that when you make a determination and you would have established pretty firm with what your plans are around the use of that space, you have to assess it and take that impairment charge like right away. And because if you take that charge right away, you then start to see the benefit through lower occupancy costs mostly through depreciation and interest expense line items, but also just on extending your G&A line item. We start to see that right away because you’ve now kind of unburdened yourself from that lease. So it is pretty immediate. The cash flow impact could be slightly lagged depending on when you’re able to release or sublease that space. From an earnings standpoint, you would start to see that pretty much right away.
Okay. That’s helpful. And then second question, Gord, I think you were speaking earlier, you mentioned that you see the opportunity pipeline, the awards pipeline as being very strong. Just thinking back to the last quarterly releases call, there was some discussion about observing some slowdowns in current projects and awards in the second half of 2020. So I’m just trying to sort of reconcile the strength of that pipeline with the commentary last quarter about the pipeline, the new awards sort of activity slowing a bit. I mean the pipeline is suppose going to be very robust, but are you confident sort of in the conversion of those opportunities to awards? Or are there still some pressures given the environment in terms of that conversion?
Yes. Sometimes some the award process could take a little bit longer. But yes, you can see from the 3.2% increase in organic growth in our backlog in Q3, we have been converting those. So I think that we’re getting back to a more normal cadence. Although I still sometimes it in an environment where all of the clients are working on home, we can take a little longer to get all the paperwork on to move all these things forward. But again, really just the fact that our backlog increased organically by 3% in Q3, I think you sort of provide me some comfort that we are — we’re seeing that conversion from opportunities to backlog.
Okay. So has there been a — that makes sense. I’m just wondering, has there been an actual improvement from your perspective in terms of the — I guess relative to those comments you made last quarter about slowdowns of hospital awards? Like has that situation sort of improved from your perspective?
And I think, Michael, it’s interesting because my thought about over the next period of time is going to be one of the flexibility because I think if we look at now the U.K. for the next month, when the U.K. has now gone into lockdown, I think we’re going to see — now we’ve got all where it’s going and the projects are under way. But for new awards in the U.K. during a lockdown in the next couple of months or next month, sorry, I think you might be a little bit slower.
And conversely, if we look at Australia, where they just — which is pretty active, Australia, New Zealand, where our offices are open, we’re back. Melbourne has reopened after their lockdown. I’d expect to see award in a open area that perhaps have been a bit slower during lockdown speed up a little bit again. So I think it’s going to be — it’s hard to make a broad-brush statement at this point because the world is going to be — I think it has moved forward, lurched backwards, moved forward, lurched backwards. So it’s going to be somewhat of the word that we’ve been using internally is just be flexible and understand that some things are going to happen faster, some things are going to happen slower.
But on balance, we feel like we’re on the right track. Backlog is growing, both for burn greater than one in each of our visit operating units in the quarter. So that is pretty impressive. But it’s — the future in just in the same way as we talked about 2021. I think we’re just being a bit cautious to make any broad statements because the world is in a bit of an unknown place still.
Right. That makes sense. Now I appreciate the fluidity and the fact that regions differ. So that makes sense. Just final question for me. In the discussion around the 2021 outlook, there was some commentary about looking at a meaningful increase in cost of employee group benefits. And I apologize if I missed this. But can you just explain to me and provide a little more detail on what’s behind that and what’s driving that?
Yes. I think what we’re seeing is to the pandemic, it was interesting because initially people went home and kind of stopped doing everything. But at the time were on, the use of employee benefits has really increased pretty — at a pretty high rate.
And so people are going to — getting the transactions done. They’re going to lease there, getting all the [indiscernible] here and there in more or taking advantage, whether it’s challenging the sort of emotional support that offers through employee programs and that is, of course, why those programs exist. But I believe what we’re seeing now is the pricing into the programs for next year that’s reflective, assumed higher usage. And the people company, that can have quite a quite dramatic effect on us when the cost of those vendor programs increase and so that’s what we’re seeing. and that’s what is factored into what, I think, whether it’s current or not, I have no idea. But over next year, we are seeing a significant increase.
Our next question comes from Maxim Sytchev from National Bank Financial. Please go ahead.
I just wanted to shopback to at your commentary around book-to-bill being about 1. As we look at the backlog, which is strong than organic growth on the revenue side obviously did. How should we think about sort of the change in the run rate or there is literally, not just timing, which is kind of impacting claims. So I guess my question is, how quickly can we see organic growth actually coming back into volume territory given the backlog trends?
Yes. So we have seen that some of these projects are stretching out a little bit longer than they had. And so as we look into 2021 and our sort of low- to mid-single-digit organic growth assumptions that we put forward there and certainly, as we’ve spoken with our leaders in the various business lines and the different geographies, that’s sort of a number that is — everyone feels pretty comfortable about.
Certainly, we see in a group like water, probably to the higher end on that. And other groups, different positioning in the organic growing spread. But — so I think we feel pretty good make about that low- to mid-single-digit organic growth in 2021 based on what we see in the pipeline and based on what we’ve gone into backlog.
I guess I mean can you there by kind of Q1 or Q2 is going to be sort of the first quarter where you see sort of positive comps?
I think as part of what we typically see from a seasonality perspective, Q1 is always a little bit slower because we are certainly up here in the north. We don’t have a lot of fuel programs moving anything. So I think while — and knowing, of course, that Q1 of ’20 was still prepandemic, so that is going to be a higher cost. Where we get into Q2, we’re looking at a post-pandemic. So we’re going to see — while the revenues might be reactive, as we would expect from a seasonal perspective, from an organic growth perspective, as we look at Q2 ’21, we’re still comparing to that higher Q1 ’21, we’re still referring to that higher Q1 ’23 pandemic comps. So I think we’ll probably see it numerically reflects much better in Q2 because we’re ramping up and coming off a lower full pandemic comp.
Yes. No, that makes sense. And then lastly, just given sort of all the moving parts on the Building side, do you feel that the headcount that you have in that division specifically is sort of appropriate given the revenue opportunities that you guys have seen on the horizon? I guess my question is, if you could have you sort of contemplate Stuff.
Yes. That group has been managed extremely well through the pandemic and we’ve been matching headcount at different levels in the organization to available work throughout. So I think we’ll continue managing it very judiciously as we have. So I don’t see the need for any more significant headcount reductions because it’s going to run very well throughout the pandemic.
That will now conclude the question-answer session. I would like to hand back to our speakers today for any additional or closing.
Great. Well, thanks, everyone, for joining us on the call today. We look forward to seeing to speak with you about our future programs and have a great day and again, stay healthy. Thanks very much.