Goldmine of reasons for easing
While there are still some big mining projects going ahead, including Gina Rinehart's Roy Hill and the liquefied natural gas (LNG) projects, many have been axed or pared back in reaction to a fall in commodity prices on the back of a slowing Chinese economy.
In recent years, total construction activity has been supported by the capital expenditure boom in mining and LNG - to the point where it had become half of all construction activity, versus a historical average of less than 20 per cent.
Put simply, mining has been propping up the economy for the past few years. If it winds back to its historical average of less than 20 per cent, Australia could face billions of dollars being sliced off GDP in the next two years, which would have a big impact on economic growth.
From Downer EDI's perspective, it was able to offer investors the comfort of guidance of a flat net profit in 2014 of $215 million. But it warned that 2014 wouldn't be easy with a greater emphasis by mining companies on costs, which is a polite way of saying the miners will continue to put the squeeze on contractors and service providers.
The squeeze began in earnest a year ago when commodity prices started falling and mining companies started resetting their contracts. Mining services and construction companies got caught in the crossfire with their work cut back and margins squeezed.
It resulted in profit downgrades and a bloodbath on the sharemarket. An insight into the sort of tactics being employed by miners was no better highlighted than the decision by the BHP Billiton Mitsubishi Alliance to terminate a $300 million contract with Leighton Holdings at its Peak Downs coalmine in April. It wasn't so much that Leighton lost the contract but that it was replaced by a smaller operator, HSE Mining.
Besides the loss of the contract stripping Leighton's book by an estimated $260 million, this hardball act was seen by the industry as a portent of things to come.
Downer released its full-year profits for 2013 with the market generally pleased it was able to meet guidance. It was able to do this with the help of a few favourable one-offs as well as approaching clients a year ago to discuss ways to cut costs to ensure they didn't suffer a similar fate that befell Leighton at Peak Downs.
For this reason Downer stands out in sharp contrast to most of its peers in the sector, which have already issued profit downgrades. The latest was the downgrade by the engineering group Ausenco on July 25, which resulted in a 30 per cent smashing in the share price on the day. It follows a dive in Orica's share price the week before, after announcing a 10 per cent earnings downgrade. Others that issued downgrades in May and June include Lend Lease, WorleyParsons, UGL, Coffey, Calibre Group and Transfield Services.
Leighton has stood by its guidance and will release its interim results on August 14 but all eyes will be on its underclaims in Indonesia, Australia and the Middle East.
Leighton's net contract debtor balance at December 31, 2012, stood at just over $2 billion, but it is believed to have increased in the past few months. Some of this can be attributed to late payments, and some relates to disputes.
Ben Brownette, at Commonwealth Bank Equities Research, estimates the sector as a whole will be exposed to 100-200 basis point margin declines in the next 12 to 24 months based on tendering activity from industry contacts, depending on the level of competition and sub-segment.
Downer's shares closed 0.5 per cent lower on a day when investors pushed other stocks with an exposure to mining and infrastructure much lower. For instance, UGL closed 1.3 per cent lower, Leighton lost 2.1 per cent and Emeco was down 2 per cent to 24¢, compared with 82¢ a year ago. Other stocks to suffer included the world's biggest drilling company, Boart Longyear, which dived 4.3 per cent, as investors dumped stock in preparation for the loss of future projects. Not surprisingly, hedge funds have targeted the sector.
But it isn't just listed companies that are struggling with the downturn. This column revealed last week that two companies a day in the construction and building-related sector are collapsing, as late payments from creditors worsen, activity dries up and banks put the squeeze on funding.
It showed that between June 1 and July 18, almost 100 companies in the construction and related industries collapsed, 23 of them in Victoria, 45 in NSW and 15 in Queensland.
It supports the general economic statistics, which showed that in the seasonally adjusted March quarter gross domestic product figures, construction activity fell 2 per cent.
Given construction contributes 14 per cent of Australia's economic output and further evidence of slowing in China, it explains why the Reserve Bank decided to cut the official cash rate to 2.5 per cent.
Twitter: @adele_ferguson
Frequently Asked Questions about this Article…
The article says the RBA cut the cash rate to 2.5% largely because lower mining investment and budget pressure on government infrastructure spending were weighing on construction activity, and slowing growth in China reduced commodity prices. For investors, a rate cut usually aims to support economic activity—it can lower borrowing costs for businesses and households but also signals weaker underlying growth, particularly for sectors exposed to mining and construction.
Mining and LNG capital expenditure had boosted construction to about half of all activity (versus a historical average below 20%). If mining investment falls back toward that historical level, the article warns billions could be sliced off GDP and construction work would drop, squeezing revenue and margins for contractors. Investors should expect tighter tendering, contract renegotiations and potential profit downgrades among construction and mining services firms.
Downer EDI guided to a flat net profit in 2014 of $215 million. It's notable because Downer met market expectations while many peers were issuing profit downgrades. The company also relied on some favourable one-offs and proactive cost discussions with clients to help protect margins, which set it apart from others in the sector.
The article cites a string of downgrades and share-price hits: Ausenco (a downgrade on July 25 that triggered about a 30% share-price fall), Orica (a 10% earnings downgrade), and other firms that issued downgrades in May and June including Lend Lease, WorleyParsons, UGL, Coffey, Calibre Group and Transfield Services.
Key risks described include aggressive contract re‑tendering by miners that squeezes contractor margins, late payments and contract disputes (which can inflate net contract debtor balances), bank funding pressure on smaller firms, and targeted selling by hedge funds. Commonwealth Bank analyst Ben Brownette estimates the sector could face 100–200 basis points of margin decline over the next 12–24 months, depending on competition and sub-segment.
On the day referenced, Downer fell 0.5%, UGL closed 1.3% lower, Leighton lost 2.1%, Emeco was down 2% to 24¢ (compared with 82¢ a year earlier), and Boart Longyear plunged about 4.3%. The article highlights broad investor selling in stocks exposed to mining and infrastructure.
The BHP Billiton Mitsubishi Alliance terminated a $300 million contract with Leighton at Peak Downs and replaced it with a smaller operator, HSE Mining. That move stripped an estimated $260 million from Leighton's backlog and was viewed as an example of miners using hardball tactics—signalling tougher conditions ahead for large contractors and potential loss of future projects.
Between June 1 and July 18 nearly 100 construction and related companies collapsed (23 in Victoria, 45 in NSW, 15 in Queensland). Construction activity fell 2% in the seasonally adjusted March quarter, and construction accounts for about 14% of Australia’s economic output. The scale of these failures and the decline in activity help explain the RBA’s decision to cut rates and highlight potential downside risks to economic growth.
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