Contractors face trying times

Worley Parsons and Monadelphous face a tough environment of rising margin pressures, cost inflation and shrinking project sizes.

The peak of engineering construction spending is going to be a distant memory in no time, for a variety of reasons. A recent JP Morgan survey concluded conditions have waned for established contractors over the past six months. And it looks set to get worse.

Non-mining service contractors will be in the spotlight following the appointment of Nigel Hadgkiss to the Fair Work Building Industry Inspectorate. First take has those in the construction industry fearing Hadgkiss will disrupt the existing order of business that has prevailed following the abolition of the Australian Building and Construction Commission. Read: profitability will be hindered.

In short, Hadgkiss is viewed as unfair and anti-union.

Mining service contractors have bathed in unwanted attention this year as the outlook for capital expenditure from major miners has been chopped and chopped again. Consequently earlier this year mining service contractors were trading at greater discounts to the market than during the global financial crisis. The reality is, since then the outlook has only got worse as earnings downgrades were the focus through reporting season.

Companies like Worley Parsons and Monadelphous have fallen out of favour with investors due to their leverage to mining and as they face increasing margin pressure. There is noticeable cost inflation, which contractors can find difficult to absorb. Adding to the woes is shrinking project sizes, reducing scalability benefits.

Until the appointment of Hadgkiss, it was a very different outlook for companies like Downer EDI and Lend Lease. There are plenty of opportunities across the infrastructure space, but could be subject to sweeping changes.

In absence of any changes the immediate outlook for Downer looks bright. It has a strong order book and significantly improved balance sheet following an aggressive reduction in gearing levels. Recent history suggests Downer can deliver strong margins, largely driven by on-point execution.

Beyond this, Downer has shifted to be more focused on infrastructure as opposed to mining. Downer has a strong exposure to oil and gas projects late in the cycle through their electrical and instrumentation business.

Recent strength in Lend Lease’s share price has been justified by improvements from residential sale volumes and sale of land profits at Barangaroo. Development and on sale of real estate has proven to be very successful. Lend Lease anticipate $45 billion of infrastructure projects will be issued in NSW over the next few years, which they could stand at the front of the line for.

Originally cash flow and balance sheets were to be the primary driver of share price performance over the coming twelve months, but now it will be how companies can manage any industry changes.