Infrastructure and Leighton

March 5: I've been highlighting the critical need for a significant increase in domestic infrastructure spending to alleviate the major supply-side bottlenecks within the Australian economy. However, first I think it is important to reflect on a very important issue: the urgent need for domestic infrastructure upgrades is a global phenomenon driven by the industrialisation of the BRIC countries (Brazil, Russia, India and China), and the developing economies, particularly Asia.
In this regard I think it is important to highlight an interesting statistic from the Xstrata 2006-08 result. According to Xstrata, $US22 trillion is expected to be spent on infrastructure in the next 10 years in the developing economies alone. Asia will account for the majority of emerging market infrastructure spend over the next decade, at $US14.5 trillion or 67%.This is a staggering figure but more importantly, Australia is the largest commodity exporter to Asia. As a result Australia is superbly leveraged to this theme.

Consequently, the expected surge in infrastructure spending in Australia is directly linked to expanding our raw material exports to the developing economies, to service their commodity-intensive industrialisation and infrastructure developments. In addition, I expect this to represent a structural theme and not a cyclical event. Make no mistake: the global and domestic infrastructure boom is a multi-decade theme and companies leveraged to this theme will attract a premium in their price/earnings (P/E) multiples.

Yesterday I mentioned the positive long-term fundamentals for WorleyParsons (See the attachment, Breaking bottlenecks) a "de-bottlenecker" leveraged to the expected multi-decade infrastructure boom in the global and domestic economies.

Leighton Holdings

Today I am highlighting Leighton, which I believe is the ultimate "de-bottlenecker" in the Australian economy with unprecedented leverage to domestic construction and infrastructure spending. In addition, Leighton is now a major global player in the high growth, Asian and Middle Eastern infrastructure markets

Leighton is the parent company of Australia's largest project development and contracting group comprising: Thiess, John Holland, Leighton Contractors, Leighton Asia, Leighton International and Leighton Properties. The Leighton Group's activities include engineering and building construction, contract mining, environmental services, operations and maintenance, and facilities management.

In addition, Leighton has increased leverage to the domestic residential construction market with a 40% stake in Devine, a major Queensland property developer with a large land bank. Further, it has also taken a 15% interest in MacMahon Holdings, which is expected to provide the increased capacity required to take on the massive increase in infrastructure projects expected in Australia over the next decade. I believe this is a very positive endorsement of the future infrastructure work-in-hand (WIH) pipeline, but also highlights the critical shortage of skilled labour and supply constraints.

Leading infrastructure position

Leighton's industry positioning is unrivalled in Australia, with the leading position in the infrastructure market and a 50% market share in the domestic contracting market. In fact it is extremely difficult to find a major construction, engineering, contracting or property project in Australia without some involvement from a member of the Leighton Group.

Thiess's earnings are driven by the resources market and at present it is the world's largest supplier of outsourced mining services. This year Thiess is expected to extract in excess of 105 million tonnes of coal and 100 million tonnes of iron ore. The transport infrastructure business currently has major contracts upgrading the Pacific highway in NSW, in addition to the Calder and Eastlink highways in Victoria. Also, current rail contracts include an upgrade to the Epping to Chatswood line in NSW and the major Trackstar rail project in Queensland.

John Holland has recently completed the Lane Cove tunnel and has commenced work on 55 new projects, including the $1 billion Gold Coast desalination plant, as well as being awarded the Sydney desalination plant project.

Leighton Contractors is Australia's largest mining services provider, currently operating 22 open cut and underground sites across Australia, including an extension of the $500 million Yandi iron-ore contract plus $1 billion of current coal projects in Queensland. In addition, major infrastructure contracts include the Gateway Highway upgrade in Queensland and the North-South Bypass tunnel in Brisbane, plus the New Perth to Bunbury Highway in WA, in addition to further major rail upgrades in NSW and Victoria.

Leighton Asia is the dominant developer of casinos in Macau, now the world's largest market, with projects including Melco's City of Dreams and the new Wynn Resort .Other major Hong Kong infrastructure projects include the Eagle's Nest tunnel, the Central Reclamation project and the Kowloon Southern Rail Link project.

The work in hand from Leighton Asia has increased by 55% to $5 billion, boosted by the $1.5 billion in new work from the recent Al Habtoor (45%) acquisition, one of the largest construction companies in the United Arab Emirates (UAE). The UAE 2007 yearbook expects $US120 billion in infrastructure and construction spending in Abu Dhabi alone over the next five years. In addition, the UAE has the third-highest per-capita spending on construction in the world, with the sector currently valued at $15.2 billion, and the expectation of doubling out to 2012. I believe the Al Habtoor acquisition will be a major contributor to future earnings.

Make no mistake, the Gulf region, driven by an unlimited supply of petrodollars, represents the next industrialisation growth story after the BRIC economies. Importantly, the Gulf has absolutely no base metal or bulk commodity resources and little infrastructure. I think Leighton is perfectly positioned to capture recycled petrodollars.

Record forward work in hand

At the recent interim, December-half earnings increased 32% to $250 million on the previous corresponding period (pcp). Infrastructure and engineering revenue (63% of revenue) was the single largest contributor, driven by a 26% increase in work in hand to $11.4 billion. Mining and resources (24% of revenue) was the next largest, with work in hand up 38% to $8.8 billion. I think the magnitude of these increases should not be underestimated.

The interim confirmed a record forward workload for the Leighton Group of $26.7 million at December 31, up nearly 27% from June 30 2007. In addition, Leighton expects more than $15 billion in major infrastructure projects, including just freeway and desalination plants alone, over the next three or four years, in which the group is very well positioned to capture the lead role. I believe current levels of work in hand, and the massive future pipeline, will support the current earnings momentum over the medium term.

Record capital spending

In the December 2007 quarterly Access Economics Investment Monitor the value of definite Australian projects, either committed or under construction, was $205 billion up 14% quarter on quarter, or more importantly up 40% year on year. The future pipeline appears more impressive with the value of planned projects at $353 billion. In addition, the recent ABS survey on capital spending forecasts another strong two years, driven by infrastructure and mining investment. The survey estimates plans for 13% growth in capital spending in 2007-08 and a 23% increase in 2008-09.

This indicates capital investment exceeding $100 billion for the first time ever. I think analysts are factoring in peak cycle earnings for Leighton but, as the above figures reveal, clearly the future infrastructure pipeline suggests the peak remains at least five years away. However, I believe this will prove conservative. There is no doubt that Leighton, with the leading domestic position, remains in a real sweet spot for the foreseeable future.

Sir Rod to the rescue

The appointment of the respected Sir Rod Eddington as chairman of Infrastructure Australia is a strong endorsement by Labor for prioritising and fast-tacking infrastructure spending. Importantly, Infrastructure Australia will be represented by five appointees from the private sector, which recognises the Rudd Government's commitment to addressing the infrastructure "bottlenecks" within the Australian economy. This initiative will further increase the already large, future pipeline for the "de-bottleneckers".

Annuity style earnings

In addition, project development in community infrastructure, property or resources, combined with project management of construction and property developments complement the Leighton Group's contracting activities. Project management will be a significant driver of future earnings for Leighton and is very underestimated by analysts.

Over the past five years, Leighton has built a significant portfolio of investments worth more than $500 million, including the Lane Cove Tunnel and the Westlink in Sydney, and Eastlink in Melbourne. In addition, the group has developed and privately financed infrastructure assets such as the M5 Motorway and the Eastern Distributor in Sydney, and the Alice Springs to Darwin railway. The construction of the Eastern Distributor was completed in two years and eight months but Leighton has a 49-year operations and maintenance contract. The increasing contribution from asset management is a very significant development.

The Australian services market across transport, utilities, mining and the property sector is growing rapidly and is now approaching $30 billion a year. The increasing number, and value, of operations and maintenance service contracts, which are long-term by nature, is being driven by the infrastructure boom. It is important to realise that Leighton is not just a construction company.

I believe management's aim is to align Leighton closer to the WorleyParsons model, with the group involved in all stages of the lifecycle for an infrastructure or property asset. The result is a reduction in the cyclicality of earnings and a de-risking of the business with more long-term, annuity-style earnings. I am not saying Leighton is no longer a cyclical business, but I believe this theme will support a higher price/earnings (P/E) multiple over time, more in line with the WorleyParsons model.

Transparency equals P/E expansion

In the current climate of rising risk-aversion and earnings uncertainty, I believe companies with earnings transparency will attract a P/E premium. The weekend financial press was full of calls for more corporate disclosure and transparency, which commentators attributed to the ABC Learning and the Allco meltdowns.

Considering the strong future fundamentals for infrastructure spending, and the leverage to the "de-bottlenecking" of the domestic economy, I think Leighton has unprecedented earnings transparency. Leighton is also the world's largest outsourced contract miner of iron ore and coking coal and is significantly leveraged to the industrialisation of the BRIC economies and the multi-decade commodity bull market cycle. In addition, the majority of revenues are generated through three to five-year infrastructure contracts, supported by long-duration service and maintenance contracts. This generates transparent, defensive long-term earnings streams. I believe the nature of Leighton's workload supports a high degree of long-term earnings transparency.

Pricing power

It is interesting to note a large number of Leighton analysts’ recommendations were downgraded to Neutral after the interim result. Of course, the downgrade to neutral comes after the 30% share price correction. The negative view of Leighton is focused on the current premium of the market cap to work-in-hand relationship compared to historic levels. However, I think this premium reflects an increase of more profitable and higher margin work-in-hand generated earnings. Leighton's EBIT margin has improved significantly over the past few years, to 4.9% in 2007, with the expectation of nearly 6% this year. This is an important development, which I believe represents a structural, not a cyclical change, in an increasing amount of Leighton's contracts.

I believe this positive change highlights two important themes. First, it reflects the improved pricing power of the group's dominant infrastructure industry position and the shift to more alliance-style contracting (MacMahon Holdings and Al Habtoor), which lowers risk and improves margins.

Second, and I believe more importantly, the higher EBIT margin reflects the increasing contribution of overseas earnings. Typically, Leighton generates higher margins from Asia but particularly in the Gulf where Al Habtoor's EBIT margin has been 11%.

Opportunity

In the recent correction, the mentality has been to "shoot first and ask questions later" and consequently any stocks that have slightly disappointed expectations have suffered. In addition, any companies with high relative P/Es, with the exception of CSL or Worley, have been significantly de-rated. In this context, Leighton has fallen more than 30% from the recent high of $64.10.

At the interim, Leighton confirmed an increase in 2007-08 earnings '"of at least 30%" on last year's record profit of $450 million. Subsequently the stock suffered a 30% correction on the disappointment that guidance was not upgraded. Give me a break; the current consensus forecast for 2007-08 industrial earnings per share growth is 2–3%. In addition, Leighton is expected to generate 2008-09 earnings per share growth of about 19% compared to non-bank industrial growth of 5–6%, which I believe will ultimately prove to be too high.

Relative value

In the current environment, I recognise superior earnings growth alone is not enough to generate outperformance. There is no doubt that the majority of high P/E stocks, including Leighton, have been derated. I believe the key to outperformance in the current climate is "relative" value. At a 2008-09 P/E of 17 times, Leighton is not cheap when compared to the non-bank industrials. However, after the recent 30% correction I think it represents "relative" value.

On my forecasts, Leighton is expected to generate 19% earnings growth for 2008-09 compared to Woolworths consensus forecasts of 14%. However, Woolworths is still trading on 19.6 times, or a 15% premium to Leighton at 17 times. In addition, I believe Woolworths’ earnings forecasts are too high, considering my negative outlook for consumption spending with the Reserve Bank's aggressive policy tightening regime. In contrast, I believe Leighton's consensus earnings forecasts are too conservative due to the strong, long-term fundamentals for infrastructure spending.

On "real" earnings, I think Woolworths is trading closer to 21 times while Leighton is closer to 16 times. Essentially, I believe Leighton is still in an earnings upgrade cycle, contrary to the non-bank industrials with the exception of WorleyParsons, Telstra and CSL. Further, Leighton has a pristine balance sheet with a net cash position of $670 million and conservative gearing of 35%. In addition, management has a strong track record of delivering superior shareholder returns, with return on equity currently 38%, and accelerating.

De-bottlenecker equals P/E premium

The Leighton Group has significant leverage to the domestic "de-bottlenecker" theme and a leading global position in the high-growth Asian industrialisation and infrastructure markets. In addition, Leighton has a record forward work in hand of $27.6 billion in a domestic infrastructure market where the pipeline is accelerating. This is generating long-term, transparent, defensive earnings streams, which I believe warrants a P/E premium.

However, despite these clear positives, analysts appear to be forecasting peak earnings. I strongly disagree. I believe Leighton has a unique opportunity and I think analysts are underestimating future earnings growth and overestimating the P/E premium. I believe current guidance is conservative and that Leighton is cum further earnings upgrades. I recommend Leighton as a Buy. This is long-duration structural earnings growth. If you believe the Australian economy needs "de-bottlenecking", you need to be overweight Leighton because there will be no de-bottlenecking without it.