Goodbye Leighton

The time has come to say goodbye to one of our favourite management teams.

Regular readers of the West Australian will know that Leighton Holdings has had a torrid time with its Perth–Mandurah rail link joint venture. In fact, the project was one of the few black marks in the construction and contract mining giant’s recent half-year result, with an undisclosed loss being recorded on the project.

This loss followed last year’s roadside collapse at the Lane Cove tunnel in Sydney, and high-profile losses incurred on the revamps of Spencer Street Station in Melbourne and the Sydney Hilton. In case you’ve lost count, that’s four major stuff-ups in the past couple of years.

But these problems are not overly surprising. Construction is a tough business where the occasional mishap is an unfortunate fact of life. What is somewhat surprising is that, despite these issues, the group’s share price has soared by more than 125% since May 2004, when we upgraded the stock to an outright buy.

It was a classic value investing opportunity, being remarkable only for the speed with which sentiment has turned around. But you’ll note from the recommendation accompanying this article that we now think this stock has come full circle, but more of that later.

We have great respect for Leighton’s management duo, Wal King and Dieter Adamsas. They have overseen Leighton’s tremendous growth in recent years and have steered the group to the powerful strategic and financial position it occupies today.

At December 31, 2005, Leighton boasted a net cash hoard of $507 million. This balance sheet strength affords the group two important advantages. First, it can easily withstand the financial impact of any project difficulties, such as those mentioned earlier. Second, it allows the company to capitalise on any acquisition opportunities that might come its way.

The purchase of Henry Walker Eltin’s contract mining operations back in December is a good example. That business added $1.6 billion to Leighton’s already burgeoning forward order book, bringing the total to more than $15 billion. That’s almost two years’ worth of revenue. And new work continues to be won, such as the $330 million contract to develop the Poitrel coal mine in central Queensland, announced on March 2.

In addition to the Henry Walker Eltin acquisition, Leighton’s existing operations have also continued to grow at a healthy clip. Geographically, management sees opportunities in India, China, Macau, Thailand and the Arabian Gulf. It truly seems like Leighton now has the world on its own platter.

Management has confidently predicted a 15% rise in net profit for the 2006 financial year and a rise in dividends of a similar magnitude. That implies a net profit (adjusted for the new AIFRS accounting rules) of $247 million, or 89¢ a share, and a total annual dividend of 57.5¢. On those numbers, the stock is trading on a prospective price/earnings (P/E) multiple of 20 and a skinny, partly franked dividend yield of 3.2%. And it’s here that we run into our own project difficulties.

Let’s try to put that price into perspective. We’ll start with the premise that you demand a decent return on your investment for accepting the risks in this business. This is a tough industry after all, even if Leighton’s management team makes it look easy most of the time. So, what might be a decent return?

That’s obviously down to the individual, but we’re going to opt for 12% a year. In other words, through some combination of dividends and capital gains, we need to arrive at a figure of at least 12% a year to justify remaining invested in this stock.

We’re in a generous mood, so we’ll assume an average dividend return of 4%, bearing in mind that the current prospective yield is only 3.2%. So we need an average capital gain of 8% a year to bring us up to the 12% total.

Doing some straightforward calculations using today’s price of $17.70, an 8% annual capital gain over the next 10 years would imply a share price of $38.21 in early 2016. That leads us to the next step in our analysis: what has to happen for Leighton Holdings to be priced at $38.21 in 2016?

Let’s consider it on a P/E basis. Assuming that, in 2016, the world is at a more moderate point in its economic cycle, an appropriate P/E range for a quality construction and contract mining company might be 12–16. Arguably, it could be lower, but let’s take the optimistic scenario of a P/E of 16 in 10 years’ time.

Using the $38.21 share price needed to give our total return of 12%, a P/E of 16 would imply earnings per share of $2.39 in the 2015 financial year ($38.21÷16). So how likely is Leighton to achieve that?

To get an idea of the answer to that question, we’ll enlist the help of a crude financial model (see below). The modelling starts with “beginning shareholders’ equity per share” in the 2006 financial year of $3.28. It then assumes a return on equity (net profit/shareholders’ equity) of 27.3%, which lands us very close to management’s forecast earnings per share figure. From that, we subtract the dividend we expect to be paid, 57.5¢, and finish with ending equity per share of $3.60 (or 359.9¢ to be precise).

This “ending shareholders’ equity” then becomes the “beginning shareholders’ equity” figure for the following year. Following this process through until the 2015 financial year, with the assumptions you see in the table, gets us to the earnings per share of $2.40 which might (note the emphasis) be able to justify a share price of $38.21 in early 2016, giving us our targeted total return of 12% a year.

The problem is that we’ve had to assume a return on equity of 30% for each of the financial years from 2007 through to 2015. A lower return just won’t get us there. But Leighton has never achieved a 30% return on equity, so to assume that it can hit that figure in 2007 and then maintain it through to 2015 could hardly be described as conservative.

Cast your eye back over the list of recent project stuff-ups at the start of this article and you’d have to be extremely optimistic to believe that Leighton can maintain a 30% return on equity without a single misstep.

We’ve also assumed an average payout ratio of 65% from 2007 onwards, whereas Leighton’s historical payout ratio has averaged 71% since 1996. Using that figure in our model, earnings per share would fall well short of the mark (though, admittedly, the dividend return would increase).

Taking the lower 2016 P/E of 12, the group would need to reach earnings per share of $3.18 to justify the $38.21 share price ($38.21÷12). And by the time we get to the assumptions needed to hit that figure, we’re truly in cloud cuckoo land. Especially when you consider that, by then, King and Adamsas '” both now into their sixties '” will most likely have retired.

Leighton could potentially achieve a huge increase in value if it is able to find an acquisition or new business opportunity that enables it to employ a huge amount of capital at a very high rate of return. But that’s not a scenario that we’re keen to hang our hard hats on.

So, less than two years after upgrading the stock to an outright buy, we’ve arrived at a point where we think it’s no longer prudent to hold on; don’t ever say there isn’t excitement in the construction sector.

The stock has gone ex-dividend the beginning of March when we rated it a hold at $18.22 and we’re selling the 450 shares in our Growth Portfolio and 850 shares in our Income Portfolio. It’s difficult to part company with such a great stock and management team, but someone somewhere wants in more than we do and they’re prepared to pay us handsomely to move on. We’re content to leave them to it. Sell.

A LONG WAY TO GROW
	2006	2007	2008	2009	2010	2011	2012	2013	2014	2015
Beginning shareholders’ equity (¢/share)	328	360	398	440	486	537	593	655	724	800
Return on equity (%)	27.3	30	30	30	30	30	30	30	30	30
EPS (¢)	89.4	108	119	132	146	161	178	197	217.2	240
Payout ratio (%)	64.3	65	65	65	65	65	65	65	65	65
Div per share (¢)	57.5	70.2	77.6	85.7	94.7	105	116	128	141.2	156
Ending shareholders’ equity (¢/share)	360	398	440	486	537	593	655	724	800	884