SNC-Lavalin’s Faulty Structure

Richard Croft
April 16, 2012
5 minutes read

Engineering and construction company SNC-Lavalin Group Inc. (TSX: SNC) has certainly hit some rough waters recently. Its murky dealings in Libya, recent departures of high-ranking executives, and last week’s police raid on its offices in Montreal are starting to make investors nervous. Share prices, already on the way down since last July, plummeted as the RCMP executed its search warrant related to individuals no longer employed by the company.

It’s not surprising for investors to be nervous when police pull up to the front doors of the company. According to the Montreal Gazette “within 45 minutes of the news hitting Twitter, the already battered stock had lost more than five per cent, and had fallen seven per cent before it began to bounce back. By 7 p.m. it had returned to $38.40, down $1.67, or 4.17 per cent since the start of the day.”

That the stock was able to bounce off a low should not be a big surprise. After all, apart for the optics the raid was really the continuation of an ongoing saga. In other words, more of the same!

In the end, we are talking about US $56 million of payments that an SNC internal investigation found to be suspicious and then turned over to police. The company is fully cooperating with law enforcement. If it turns out that the payoffs were to secure construction projects then the payments breeched the company’s internal code of ethics and may be illegal. The latter would be an issue for the departed executives.

The company is doing everything it can to distance itself from the rogue executives that purported to make or approve the payments. Still, until we see some closure, these allegations will hang over the company as a thickening black cloud. At the very least it will be hard to build a bullish case for the shares.

Speculative options traders might want to place bearish positions on SNC stock, in the expectation that further revelations, raids, or contract cancellations (as has already happened with the World Bank) could lead to even more loss of investor confidence and further downdrafts in share price over the short term.

The normal response to this type of trade would be to simply buy puts. However, with at-the-money options trading at a 33% implied volatility, the premiums are in the top quartile of all Canadian options. Which is to say it is expensive to buy SNC puts.

There are two approaches that bearish traders might consider; the first is a bear call credit spread the second is a bear debit put spread.

The bear call spread would involve the sale of the SNC May 40 calls at 85 cents together with the purchase of the May 44 calls at 15 cents. This trade would create a 65 cent credit in the account which would be the maximum potential profit on the position. If SNC closes below $40 per share at the May expiration, both options will expire worthless and you will retain the net premium.

The risk is that the stock rises sharply, which is why we are hedging against a sharp upside move by purchasing the SNC May 44 calls. The May 44 calls limit exposure to the upside as they will offset any losses in the May 40 calls above the $44 strike. Price.

The second strategy involves a debit spread, where you would buy the SNC May 38 put at $1.55 and sell the May 34 put at $40 cents. The net cost for the put spread is $1.15 per spread, which is the maximum you can lose on the trade. The best case scenario would see SNC decline below $34 per share by the May expiration. At $34 per share, the May 38 put would be worth $4.00 and the May 34 put would expire worthless. As such, the maximum return on this trade is $4.00 with a maximum risk of $1.15.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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