Deconstructing Leighton's problems

The Leighton saga is a rare event. It’s a long time since we have seen a large public company under such detailed scrutiny in the media with issues involving corruption and possible offences that involve heavy fines and jail sentences.

It’s not my purpose today to even attempt to pass judgement on the Leighton issue but rather to look at the company as an investment. Leighton shares have been declining for some time, as if the market knew that there was something wrong.

The shares reached a peak of around $40 and, of course, are now trading well below $20.

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To try and get a fix on where a company like Leighton stands, my first port of call is always the same – the last set of accounts. And rather than read the directors’ comments you go straight for the cash flow statement, because in times of difficulty it usually tells most of the story. That was certainly the case with Leighton.

The company reported in the half-year to December 31 a healthy profit of $366 million, but an underlining profit of $255 million. But in the cash flow statement I discovered a different story – the underlying cash generation from operations was a negative $8.7 million after deducting interest. Why did an underlying half-year profit of $255 million convert to a cash loss, which forced the company to borrow money to pay a dividend?

Unpaid bills

When you went to the directors’ report the explanation of this was both buried and muffled, but this is how I interpreted it. Basically, incorporated in the profit was revenue from people who didn’t pay their bills, and this is confirmed by the sharp jump in receivables from $3.76 billion in December 2012 to $4.39 billion in June 2013. There was no detailed explanation as to the type of customer that wasn’t paying. No doubt many were involved, but almost certainly some of the delayed money was owed on the Iraq contracts. Since December 31 no doubt some payment has been received from Iraq, but my guess is that the eruption of this crisis will probably delay payment as the Iraqis determine whether they really do need to pay Leighton. I suspect that the company won’t receive all the $500 million it is reported to be owed. If, theoretically, Leighton settled for half, it would therefore result in a loss of $250 million, which is about a half-year’s operating profit.

On that basis the stock has been discounted for the Iraq problem, but the difficulty for Leighton is that this problem is not going to go away because there is still an Australian Federal Police investigation. That investigation may decide that there is simply no case to answer, or that the case is too difficult to prove. If there is a case to answer and the company and/or past and present executives are charged, then the offences are likely to carry heavy fines and even conceivably jail sentences if people are found guilty. But perhaps more serious is the fact that a long court case and regular publicity would undermine the strength of the company.

Rising debt

Even if everyone is subsequently found innocent, very few large companies remain unscathed if there is an extended period of damaging court case evidence about its executives or former executives. Leighton has shareholders’ funds of around $3.14 billion and interest bearing borrowings, including lease liabilities, are around a similar figure of $3.12 billion. Six months earlier interest bearing borrowings, including lease liabilities, were $2.76 billion, so debt is rising. Most of the liabilities are not current. But that level of gearing means the company must be careful with its total operations. Leighton has lost mining contracts (revenue down 20%), but Australia is about to embark on a massive investment in infrastructure and Leighton is clearly very well placed to get a number of major contracts.

Its greatest problem may be that the Middle Eastern situation will make people look twice at whether they will give the company a contract. In addition, back home, Leighton and Lend Lease are involved in a cat and mouse game with the state and federal governments.

Union deals

Lend Lease has been on the front line, and Leighton has been very happy to stay in the background, but what is happening to Lend Lease applies to Leighton. Lend Lease and Leighton have workplace agreements with the building unions that give the unions enormous power over building sites and who can be subcontractors. This inhibits productivity and makes Australian commercial construction among the highest cost in the world. But it’s marvellous for profits because it limits competition. These arrangements have been banned by Victoria, New South Wales and Queensland, and the Abbott Government also plans a ban. But when the Victorian government implemented its legislation and banned Lend Lease from government contracts, the building unions effectively moved in to help their partner, Lend Lease.

The unions took the matter to court and won the first case, so overturning the ban on Lend Lease. That case is now subject to an appeal. If the appeal is successful and/or the Commonwealth inserts the required regulatory guidelines, it will be very difficult for Leighton and Lend Lease to gain major contracts from any of the state governments given their agreements with the unions.

On the other hand, the unions will cause a lot of disputes if Leighton and Lend Lease are banned because of their agreements with the workers. Leighton and Lend Lease have been very skilled in the lobbying game with conservative governments to mitigate the effect of this and, of course, they have been helped by the union. Not everyone in the state governments wants to face the controversy that will come with lower infrastructure building costs.

The Victorian government is very confident that it will win the appeal, but you can never be certain in these things.

And so, Leighton has two major issues – first the Middle Eastern corruption scandal and second, the difficult situation created because the state and federal governments are challenging Leighton’s culture and management methods and its agreement with the unions.

When a company faces two major challenges like this, it’s best to stay away from the shares. And then there is a third matter. There has been quite a turnaround among executives who have corporate secretary/legal positions with Leighton. In addition, there have been three chairmen in a relatively short time. These matters may mean absolutely nothing, but they destabilise the company during periods of turmoil.

The bottom line

Leighton has an incredible $40 billion of work in hand and has obtained a lot of new contracts in recent times. This contract book has the ability to underwrite its future profits. Around the traps, a few competitors say that Leighton has been too aggressive on price to gain recent contracts, and has taken quite a risk as a result. That could be sour grapes, although when you have a company under pressure often it does silly things.

I do know that Leighton has won a couple of jobs on the basis of its own tenancy (in other words, Leighton is both the developer and partial tenant in the project), which is not the best practice when you are being challenged in many different directions. And so, should you buy Leighton shares on the basis that they have been hammered in the hope that they will come good and be restored to their previous price? I would be reluctant to do this, even at $17.