The May federal budget might have knocked consumer confidence, and political deadlock in the Senate might be compromising business confidence, but there is one sector set to benefit handsomely from government policy: infrastructure construction and engineering.
The federal government aims to catalyse more than $125 billion in new infrastructure project spending by the end of the decade, mostly in transport projects. This next round of growth in transport infrastructure construction will mainly be funded by the private sector as public-private partnerships. Leighton Holdings (LEI), Australia’s largest construction and engineering contractor, has a proven record and long-standing client relationships, so it should win its share of the work by positioning itself as an equity participant, contractor and asset manager.
This makes LEI interesting to investors faced with flat revenue in other ASX sectors. At the recent 1H14 result LEI CEO Fernandes Verdes said: “Australia is the only developed market in the world with a strong pipeline of infrastructure development; it is something we wish to capitalise on.” LEI reported a 33% increase in its 12-month tender pipeline versus six months ago, reflecting the outlook for increased infrastructure spending. LEI is currently preferred bidder on about $5 billion of work, including NW Rail (Sydney), up from $3 billion a year ago.
Increased infrastructure activity is needed to replace declining activity for LEI in mining investment. Already the composition of the order book is changing. On June 30, 2014 work in hand (WIH) for the group was $38.1 billion, down 10% on $42.2 billion on December 31, 2013. On June 30 WIH was split 47% infrastructure (up from 44% on December 31), 38% resources (down from 40%) and 15% property (previously 16%).
Current difficulty getting paid by the resources industry
LEI’s participation in the mining investment boom left a mixed legacy. 1H14 net operating cash flow dropped to $78.5 million from $148.1 million in 1H13, partly because current receivables jumped from $5.0 billion to $5.5 billion. Receivables were 24% of sales versus the 14% long-term average. This is largely due to payment problems at domestic LNG projects, where LEI has experienced lengthy payment cycles, extensive scope growth, and complex and time consuming valuation and negotiation processes to agree variations to existing contracts.
LEI was not specific on the timing for resolution of outstanding receivables. Management said the elevated levels are likely to remain until the current domestic LNG projects are completed and final agreements negotiated. There is concern some of the Middle East and gas receivables might not be recoverable.
The need to get paid sooner coincides with an appetite in the business for simplification and debt reduction. Gearing was 37.1% on June 30, down slightly from 38.5% at the end of 1Q14 but still slightly above the targeted range of 20%-35%. LEI’s gearing is volatile due to working capital movements.
Business simplification to reduce leverage
In June CEO Verdes gave an update on a strategic review intended to strengthen the balance sheet, streamline the operating model and improve project delivery. The review did not quantify cost savings or operating benefits but it did outline an aggressive timetable to divest non-core assets and implement a new operating structure by March 2015.
To strengthen the balance sheet LEI intends to recover existing receivables, improve working capital management on new projects and divest the services, property and John Holland businesses subject to market conditions. Also potentially for sale are investments in Devine, Macmahon and Sedgman.
Cash proceeds from receivables and divestments will reduce gearing. CEO Verdes said this “is crucial to improving the group’s competitive position. Prospective businesses need to be backed by a strong balance sheet. Our contract mining and PPP business are capital-intensive.”
Streamlining the operating model will involve grouping similar business units under activity lines (Construction, Mining, PPPs and Engineering) to reduce overhead duplication and save on other costs. The proposed structure is more transparent and should meaningfully and sustainably reduce the cost base.
LEI expects gearing to fall within the target range by December 31, which assumes some collection of receivables but also progress on asset sales. The sale of the Services, John Holland and Property businesses would reduce gearing below the low end of the target range.
Profitability lower as resources work tapers
To value LEI we adopt a sustainable return on equity of 21%, which is broadly in line with consensus and marginally below the five-year average of 22.7%, to reflect the tapering of resources related activity. EBIT in the near term is expected to decline moderately due to the hiatus in construction spending between the resources taper and infrastructure upturn.
We adopt a low required return of 12.6% to reflect LEI’s leading market share in Australia and diversification across different industries and markets, which reduces cyclicality. Multiple brands enable LEI to compete and price for multiple jobs. Our adopted Distributed (dividends) proportion of 14 and Reinvested (earnings retained to grow the business) of 7 are broadly in line with consensus.
Current CEO Verdes replaced Hamish Tyrwhitt in 2013, when majority shareholder Hochtief sought to exert more control over LEI. Spanish contractor ACS holds a majority of voting shares in Hochtief and gained control in 2011. This year, Hochtief/ACS lifted its stake in LEI to near 70% and replaced LEI’s directors and senior management with Hochtief/ACS executives.
LEI shares have rallied sharply this year, pricing in the potential for a takeover bid from Hochtief/ACS, enthusiasm for the infrastructure theme and the benefits of future divestments. The stock is now trading at a small premium to our $20.46 FY14 valuation, though at a discount to our FY15 valuation of $21.75.
LEI is a cyclical business but profitability has been fairly consistent for a contractor (see chart below) with the exception of 2011, which was affected by project delays and cost overruns relating to a desalination project in Victoria and the airport link development in Queensland. Despite its scale, LEI’s profit margins are very small, averaging 3.1% over the last five years and falling to a low of 2.3% in FY13. This leaves little margin for error.
The inherent lack of earnings visibility in even the largest contractors, which reflects poor transparency in individual contracts and project execution risks, mandates a margin of safety when buying. We recommend buying at a 10-15% discount to value, which implies a buy price of at most $19.60.