PORTFOLIO POINT: Leighton’s project pipeline has narrowed as more local projects are shelved and companies such as Incitec Pivot move to invest offshore instead.
Two items came across my desk during the week which captured my attention. They are two sides of the same story and they are important in looking at future investment strategies.
The first was the Leighton Holdings decision to sell its telecommunications infrastructure operations, which have been an important profit powerhouse for the group.
And the second was the decision by Incitec Pivot not to proceed with its fertiliser plants in Newcastle, but instead take steps to invest in the US.
Had Incitec Pivot proceeded with its giant Australian fertiliser plant it would have been a big boost to Australian commercial construction, and Leighton would have been a front runner to gain the contract.
Let’s first look at the Leighton telecommunications announcement. I started by going back to the Leighton interim report for the six months to June 30 and discovered that leaving aside what directors said was the profit, in fact Leighton had a $243 million operating cash flow deficit after interest etc for the half year. Then it invested another $600 million in plant and other assets and paid out a $200 million dividend.
So all in all, the group was out of pocket almost $1.1 billion in that half year. That is an enormous outflow of cash. There are all sorts of book entries and fun and games that made the company show a profit, but you can’t escape the cash outflow. To cover such an enormous cash outflow Leighton borrowed just over $450 million, did a sale and lease back which raised about $250 million, and ran down its cash reserves by about $400 million (I am netting transactions to simplify the process).
That cash outflow really knocked the Leighton group around, and so just after June 30 Leighton sold its Thiess Waste Management business and was able to report that, after that sale, net debt plus operating leases to net debt plus operating leases plus shareholders’ equity was 46%. In other words, gearing was 46%. That’s still too high. The target for the company was between 35% and 45%. It was just as well it sold that Thiess asset. Now it is looking at selling its telecommunication assets and there are other assets for sale.
A lot of the pressure on the company stems from the fact that its shareholders in Spain and Germany are over-extended. Unstable controlling shareholders is a situation I never like. But even without that problem Leighton itself is in strange situation.
As at June 30 the group had an amazing $47.3 billion in construction contracts plus another $11 billion in the value of its mining contracts. But then let’s look a little deeper. The very largest contract it has is an $8 billion Holland contract to maintain the Victorian suburban rail network. After that, a bit over half its construction contracts are in resources, which are dominated by the Gorgon gas project in Western Australia and Curtis Island plus some assorted coal and gold projects.
In terms of major new investments, Australia is in the process of pricing itself out of the global gas market and it has certainly done that in coal and iron ore. Currently Leighton is constructing about $1.6 billion each month, so it has got a bit over two years of work. A few months ago the company was optimistic there would be a vast amount of new work, but as we now know a great deal of that will disappear because the resources investment boom is coming to a screaming halt. It still has some various assorted infrastructure projects around the country, but the outlook for Leighton is now very different to just a few months ago.
In addition Leighton has had difficulty with unions in a number of its projects. In Victoria the Baillieu government has now instituted rules for new construction contract activities and Leighton will have to dramatically change its management practices if it is to get future Victorian government contracts.
Every other state is looking at what Victoria has done and, if as is likely the Victorian actions cut the costs of infrastructure between 20% and 30%, it will be followed by all other states. That means an enormous management shake-up will be required at Leighton to manage in a new environment. Those telecommunications earnings would have been very handy.
Leighton is a great organisation and it is Australia’s largest contracting company. It’s not going to go away, but it faces challenges that it could not have foreseen even six months ago. And I never like it when there is high gearing in shareholders (as is the situation with Leighton) because it puts enormous pressure on boards to take actions to release cash that they might not otherwise do. I suspect the telecommunications sale is one of those actions.
There are a lot of opportunities in our stockmarket and many of them are safer than Leighton.
Then came the Incitec Pivot announcement, and it triggered in my mind what a dramatic situation is taking place in global energy. Australia has completely messed up its energy policy and we are exporting vast amounts of gas out of Gladstone that we haven’t actually found yet and that may cause domestic shortages in New South Wales.
With a proper energy policy we could have transformed our economy. And that is exactly what the Americans are doing. There is a free market for gas and they encouraged people to look for it and they found vast amounts of shale and coal gas.
The Americans are planning to completely change their economy and base their transportation on gas and revitalise their manufacturing. They will also export. There is going to be enormous job creation as a result of this. Incitec Pivot is therefore almost certain to build its new ammonium plant in America based on low priced US gas.
We are seeing a revival in rural fortunes around the world and the fertiliser market is going to increase and margins are likely to improve. Incitec Pivot is extremely well placed to take advantage of this. In Australia we will simply have to import more fertiliser and pay the price of transport. Our primary industry will be affected by our energy stupidity.
Incitec Pivot shares are priced around $3. The result for the year to September 30 won’t be a happy one because fertiliser has been depressed. The company will do well in explosives, but obviously growth will stabilise in explosives as the shine is taken off the mining boom.
Nevertheless that fertiliser momentum is likely to send the profit in the year starting October 1 above 30 cents a share, and that puts the company on a price earnings ratio of less than 10. It is one of the very few Australian companies that is in a position to be a major beneficiary from the US gas revolution.
BHP in theory will benefit, but of course currently the gas prices are low and it overpaid for its newly acquired business. Incitec Pivot gives investors in Australia a chance to participate in better rural fortunes and the American gas revolution.
Having said that, explosives and fertilisers are very volatile. However, Incitec Pivot is a well-managed Australian company that is extremely well placed to benefit from up swings like that we are seeing in fertiliser.