Leighton is no lay down

Investment decisions boil down to just two things: risk and reward. And when it comes to the cloud currently sitting over Leighton Holdings, we can divide the risks into two categories.

The first is direct risks flowing from the allegations of improper ‘facilitation payments’ paid by its international operations. The result could be government fines and a potential class action which might be even more expensive. Substantial legal fees would surely be incurred in relation to either matter.

Perhaps looming largest of all are the $800m-plus of receivables related to Iraq, around half of which are said by some analysts to relate to the pipeline project at the centre of the main allegations. Will these be recoverable?

We’re not sure and would welcome some candid commentary from management about the situation. You can see the importance of the Iraqi receivables in Chart 1.

Disruption

Indirect risks include the management disruption and distraction from the various investigations and actions which these allegations have set in train. Every hour spent dealing with the Australian Federal Police, Leighton’s own internal investigations and revising internal processes and codes is one not spent pursuing new business, strengthening relationships with existing clients or focusing on other operational matters.

These risks are not to be underestimated but nor should they be overstated. They’re likely to cause significant short-term disruption but will likely have less impact on Leighton’s profits in, say, 2018 than the health of Australia’s economy and the levels of activity in the resources sector, which we’ll turn to shortly.

So, having acknowledged the risks, which we judge to be serious but not life-threatening for Leighton, let’s turn to the question of return.

In situations like this, it’s best to focus your attention on at least a five-year time horizon, when the current allegations are likely to have faded in investors’ memories and the business’s competitive position and industry dynamics should once again be the dominant factors determining the share price.

Required returns

What kind of annual return should investors be aiming for over the next five years in exchange for taking on the risks of Leighton’s current woes on top of the regular risks that come with buying a contracting and construction company?

We’d suggest a minimum 12% but wouldn’t quibble with those who demanded 15%. So let’s look at what a 12% return would mean for Leighton’s shares over the next five years and, in turn, what Leighton’s operations might have to produce to justify that.

First, let’s break our 12% return into dividends and capital growth. If Leighton pays out 90 cents per share next year (about what most analysts are expecting), investors would be receiving a partly-franked dividend yield of 5.3%. Adding in some franking credits, let’s call it a 6.2% grossed-up return from dividends.

That’s almost half of our required return if those dividends were maintained over five years. If that proves to be the case, then we’d need 5.8% per year in capital growth.

Taking today’s share price of $17.11 as a starting point, we’d need a share price of at least $22.69 in 2018. Those seeking a 15% annual return would need a $26.10 share price (assuming the dividend remained flat).

The next question is what level of earnings per share would be required to support a $22.69 share price?

Let’s assume a PER of 12 in 2018. That’s lower than the average stock to account for the tough nature of the industries Leighton operates in (bears might argue it’s not low enough). Dividing our target price by the assumed PER gives us a required earnings per share figure of $1.89. You can follow these calculations in Table 1, or test your own assumptions in the attached spreadsheet.

Assuming Leighton has 350m shares on issue by then (today it’s 337m), that would mean a 2017 net profit of $662m (including profits from joint ventures – note that Leighton has a December year-end).

Using some back-of-the envelope figures to get us to a revenue line, let’s assume a 2.5% net profit margin in 2017, which is higher than the past couple of years but lower than 2009 and 2010.

So, to hit our required $662m net profit in 2017 at a 2.5% net profit margin, Leighton would need to be producing revenue of $26.5bn (including revenue from joint ventures). In the 12 months to 31 December 2012, Leighton generated $23.1bn of revenue. So we’d need to see growth of about 15% over the next five years, or a almost 3% a year.

Boom over

That doesn’t sound like much but in its last full financial year, construction contracting accounted for $11.7bn of Leighton’s revenue, with contract mining a further $5.4bn.

The resources boom has provided a benefit to both: its contract mining operations have surged but its construction businesses have also enjoyed the fruits. Data from Engineers Australia shows that the resources sector accounted for 12% of Australian spending on ‘Economic Infrastructure and Total Engineering Construction’ in 1989. In 2012, the figure was an astounding 45%. We think the chance of this spending leveling out or falling is at least equal to the chance of it increasing, with many projects having been cancelled or delayed over the past six months.

Combine this with the possibility that Leighton might find it difficult to maintain market share in the short term – because clients may be less receptive and/or Leighton management may be less responsive to opportunities as more of its attention is demanded by other matters – and even modest top-line growth might be asking too much.

It may materialise but it’s far from certain. In fact, we wouldn’t even put it in the ‘likely’ category. Chart 2 shows Leighton’s work in hand over the past few years. You can see that it’s fallen noticeably since peaking in June last year.

Low quality profits

The bulls might argue that Leighton could increase its profit by lifting margins rather than revenue. And one of our industry sources has noted that Leighton group companies seem to have bid less aggressively on recent projects, so perhaps this is a more likely avenue for profit growth.

We’ve already accounted for some margin improvement in our 2.5% number (which compares to 2.2% in the most recent half-year) and also have concerns about the quality of recently reported profits.

In its most recent half-year, Leighton reported an underlying profit of $255m. Meanwhile its operating cash flow was a negative $8.7m before capital expenditure totaling more than half a billion dollars. In other words, free cash flow was negative to the tune of about twice the underlying net profit. Combined with our other concerns, this doesn’t fill us with confidence.

All in all, a 12% annual return over the next five years looks like quite a stretch, and that’s the least we’d want given the risks involved.

The stock is down slightly since Leighton Holdings under review on 4 Oct 13 (Under Review – $17.54) and, all things being equal, we’d be more interested below $14. In the meantime we recommend you AVOID the stock.