Business simplification, degearing and derisking are significant equity market themes of the moment and recent years – think Suncorp, Leighton, Caltex and Insurance Australia Group, amongst others. Usually the market responds well and the stock rerates to reflect falling business and financial risk. Higher ordinary dividends, special dividends and capital returns are also often paid as surplus capital is created and released.
Diversified contractor UGL is midway through a similar process. Over the last five years UGL’s financial health deteriorated as gearing, measured by net debt to equity, rose substantially from a low of 15% in FY11 to 55% on December 31, 2013. This is too high given the risks and volatility in the contracting business. The decline in resource sector work as mining capex tapers has made it difficult to reduce debt.
Gearing using UGL’s preferred ratio of net debt/(net debt equity) was 35.3%, up from 33.9% six months earlier and outside management's 25-35% target range. At the 1H14 result management forecast net debt of $550 million - $590 million on June 30, 2014, down from $665 million on December 31, 2013 including cash generated from the sale of non-core properties in 2H14.
This is still an uncomfortable amount of debt, requiring a more substantial asset sale(s). In 2011 UGL acquired DTZ UK to expand its existing property services division. In June 2014, UGL announced the sale of DTZ to a private consortium for $1.2 billion, equivalent to 9x FY14 forecast earnings before interest and tax (EBIT) pre-corporate costs. The company expects net proceeds of $1,000-1,050 million following capital gains tax ($10-15 million), transaction costs and other adjustments.
We expect eventual debt retirement of $420-490 million, reducing the balance to about 1x engineering EBITDA (earnings before interest, tax, depreciation and amortisation). This brings net debt to equity to a suitable ratio for a cyclical, engineering business and also frees $510-630 million of surplus capital for some form of return to shareholders. UGL is evaluating a range of options for the efficient use of sale proceeds. We expect a capital return or buyback given franking levels are low. The sale of DTZ was structured to avoid capital gains tax, so it didn’t generate any franking credits. Hence a capital return is more likely than a franked special dividend. The sale allows UGL to resume paying dividends after not declaring an interim dividend at the 1H14 result.
UGL’s order book remains solid at $4.9 billion, which is 67% maintenance and services work. This gives the engineering division a degree of insulation from the volatile contracting market.
UGL is bidding on significant opportunities in the rail, transport, power and LNG sectors.
Looking forward, management noted an improving pipeline for the engineering business with expectations for FY15 revenue increasing to $2,400-2,500 million and EBIT margins expanding to 4-5%. Opportunities are particularly plentiful in passenger rail and LNG maintenance as well as other public infrastructure work.
UGL is winning its fair share of multi-year maintenance work and has strong share in rail maintenance shared with Downer EDI (DOW). UGL has a competitive advantage in rail maintenance due to its established proximity, for example maintenance rail sidings next to main lines. Further, UGL has strong relationships with General Electric, which provides access to its rail technology.
UGL’s resources sector revenue is under pressure, contributing to the decline in FY13 and 1H14 earnings. At DOW’s disappointing FY14 result, management commented resources-based spending in 2015 is expected to be “flat, or declining, on current low levels.”
Cost-cutting initiatives – UGL said it has taken about $100 million worth of costs out this year – should help offset the decline in resources revenue. Over time infrastructure spending in the economy should outweigh the rundown in mining investment.
UGL Engineering’s diversification by sector and activity moderates the effects of cyclical downturns in certain markets.
Federal and certain state governments have announced substantial infrastructure funding programs. The federal government aims to catalyse more than $125 billion in new infrastructure project spending by the end of the decade. As a leading provider of engineering, construction and maintenance services, with established scale in transport and infrastructure, UGL is positioned to meet this demand. Its pipeline should continue to grow in the near to medium term.
UGL’s FY14 result is due on August 25. The proceeds from selling DTZ won’t appear until after June 30. UGL has guided to underlying net profit after tax of about $120 million, subject to a continued reasonable trading outlook. We do not expect a final dividend but dividends should resume from 1H15. At the result we will be looking for clarity on UGL’s intentions regarding the cash influx from the sale of DTZ, and further detail on the industry outlook.
Our adopted return on equity of 14% below takes a long-term view and is more optimistic than consensus of 7-8%, which is focused on the current downturn in resources work. We are looking beyond this to the upturn in government infrastructure work.
Our adopted required return is a moderate 13% and is in line with our adopted RR for DOW. Contracting is a higher-risk business but UGL and DOW are more resilient and less risky than their smaller, less diversified peers.
Using our adopted valuation metrics we derive an equity multiple of 1.1x and FY14 valuation of $7.94. The above fall in FY15 value to $5.04 reflects a likely capital return of around $3/share.
Note investors are not losing value between FY14 and FY15. The per-share valuation falls because equity per share falls due to the forecast capital return of $3 per share. As such shareholders receive an offsetting capital return for the decline in intrinsic value.
Profits will decline post the DTZ sale, reflecting the loss in DTZ’s earnings, however profitability of the remaining business should improve.
We recommend a 15% margin of safety given UGL’s cyclicality, the low transparency on individual contracts, and project execution risks.
Clime Asset Management owns shares in UGL.