UGL's tainted outlook

Stocks In Value originally placed a “buy” recommendation on UGL for our Eureka Edition on Monday August 18, and then placed the stock “under review” on November 17.

Today we are moving to a “sell” recommendation for UGL due to a combination of the sector risk, and the individual contract risk within the business. While the share price has already declined and it may appear cheap, we don't think the risk is worth taking considering the chances of further bad news.

Sector background

UGL has continued the recent string of engineering contractors to have large share price declines due to problem contracts or loss of work.

Just about all stocks in the sector have been weak, with particularly strong declines for Titan (TTN), Walter Diversified (WDS), and NRW Holdings (NWH).

NWH, at 41 cents, is down about 60% since we put a “sell” recommendation on them on September 8 this year.

Even sector leaders Monadelphous (MND) and WorleyParsons (WOR) have been dramatically out of favour, with MND down from $19 in May to about $9 per share, and WOR down from $19 in June to about $11.

The recent falls in both the oil price and iron ore price are certainly not helping the situation.   

It is not new news that the mining capital expenditure boom is over, but the continued and exaggerated weakness in the mining services sector has caught some bargain hunters by surprise.

There have been many stocks in the sector trading on a price-earnings (P/E) multiple of around five times for over twelve months now.

But the dynamics have turned so badly against contractors that the risks are still often too high even with a P/E as low as five.

There are still far too many contractors domestically for the amount of work on offer. The competitive bidding process has produced large scale margin compression across the sector. For example, some companies have been taking on break-even contracts just to keep their staff employed with the hope they will win work down the track.

Project owners are taking advantage of the situation by shifting risk to the contractor. During the capex boom, when there was large skills shortages, project owners would often wear the cost of scope changes just to keep the jobs on track. But now many changes or cost over-runs are worn by the contractor, dramatically increasing the risk for a mining services investor.

In prior years both WorleyParsons (WOR) and UGL (UGL) prided themselves on having very few fixed priced contracts, with most of their exposure being a schedule of rates, or variable cost project. This meant contract over-runs on either time or cost was a problem for the project owner.

Fixed costs projects on the other hand require a very experienced and capable management team to manage the risk. In some cases a strong management team can't eradicate the risk of fixed priced contracts as projects can turn bad very quickly without warning. The Forge (FGE) downfall was due to fixed cost projects that became a major balance sheet issue, forcing them to be handed over to administrators.

The fact that both WOR and UGL are now taking on fixed-priced contracts really does highlight the dramatic shift in the sector.

Sector exposure

UGL has greater diversification than many of the other domestic listed engineering contractors. Its $5 billion order book is also about two-thirds comprised of maintenance and service work. The company has opportunities in rail, transport, power and LNG.

Resources based contract work is not likely to increase in 2015, but UGL should benefit from government infrastructure programs.

But offsetting the positive outlook from infrastructure work is the unknown risk of the Ichthys contract causing further write-downs, and the risk of other hidden contract troubles.

UGL's problem contract

UGL's recent problems with its Ichthys contract are due to a fixed priced contract. The scary thing is the contract was signed in 2012, and at the time UGL made no mention of the fixed priced structure. It does make you wonder how many other un-known high risk projects are out there for UGL and other contractors. 

History would suggest that fixed price contracts that start badly get worse and good projects get better. The problem here is the Ichthys project is only in the early stages with the major construction to be completed in 2015 and 2016.

The joint venture of CH2M Hill and UGL, together with GE, is building the power station for the Ichthys LNG project. Due to a number of project changes and events in the design and procurement phase of the project and subsequent delays, the joint venture led by CH2M Hill has recognized a provision of $US170 million.

CH2M will book a $US85 million provision in their September quarter accounts, but UGL is still reviewing the cost to complete estimate and given ongoing discussions with the client doesn't feel in a position to reliably measure the provision at this stage. The target is the end of 2014 or early 2015 to close out these issues and have a final estimate of the impact.

Before the details of this problem contract were announced, UGL sold its DTZ business for $1.215 billion and has since returned $2.94 per share to shareholders.

Continuous disclosure obligation

CH2M Hill told its US shareholders on August 8 that it was likely to take a provision from the power station contract due to materially adverse changes to cost estimates.

UGL has claimed it was unaware of the disclosure until November 5. UGL's accounts were released on the August 25, with its annual report on the September 18 and AGM on October 30. In each of these three company events, there was no mention of the problem contract with the focus been on the company's positive outlook.

Given the material nature of the problem contract it is very hard to believe that UGL was not aware of its JV partner's disclosure.

New managing director

Ross Taylor is taking over from Richard Leupen as Managing Director and CEO of UGL from November 24. Taylor brings 30 years of experience in construction, engineering and real estate to UGL.

He was chief executive at Tenix – a privately held engineering and construction company with services in gas, electricity, water, wastewater, heavy industrials and mining services across Australia. Before that he had 24 years with various senior roles at Lend Lease, including recently being chief operating officer.

Kate Spargo is also taking over from Trevor Rowe as chair. Kate joined the board in 2010, and is part of a large scale board renewal program.

The new team increases the risk of further bad news, as they will be keen to clear the decks.

Valuation

If we were to assume an $US85 million pre-tax provision for Ichthys is as bad as it gets, then the stock is slightly undervalued with a $2.49 discounted cash flow (DCF) valuation.

Our 2015 forecast includes four months of the now sold DTZ business. Given the asset sale, it is surprising that management didn't eliminate debt before paying out the capital return. Our net debt forecast for 2015 is $118 million, giving a net debt to equity ratio of 18%.

The stock is trading on an 2015-16 P/E of six, and enterprise value to earnings before interest and tax (EV/EBIT) ratio of 5.2.

Even if the initial $US85 million write-down is factoring in the worst, the uncertainty is likely to hang over the stock for at least six months. Given there are other contractors on similar earnings multiples we don't see any need to own UGL.

With the asset sale and capital return UGL is now a small contractor with a market cap of $345 million. UGL is on higher multiples than most other contractors with a similar market cap.

For example, Decmil (DCG), RCR Tomlinson (RCR), Logicamms (LCM) and Southern Cross Electrical (SXE) are all trading on 2015-16 EV/EBIT multiples of less than three, compared to UGL's 5.2. However, UGL has the advantage of sector diversification, with greater exposure to infrastructure projects than the rest of this group.

We have a “sell” recommendation for UGL, and ideally would look to sell on any strength back towards $2.50. Our $1.87 target price is based on a 25% discount to our DCF valuation due to the higher than usual risk of further contract write-downs.

To see UGL's forecasts and financial summary, click here.