Oz Engineering And Contractor Preferences Updated

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 – Engineering and contractors expectations updated
 – Market conditions turning more difficult as projects are delayed/cancelled
 – Earnings impact likely, forecasts revised
 

By Chris Shaw

JP Morgan's 10th Australian Civil Contractors Survey indicated companies in the sector are experiencing an increase in order book and margin pressures. This means a greater numbers of large contractors expect profit margins and order books to shrink rather than grow when compared to six months ago.

This is the result of recent reductions in the capex plans of major resource companies such as BHP Billiton ((BHP)) and Fortescue Metals ((FMG)). To reflect this, earnings forecasts for capex related segments such as construction and equipment hire have been lowered.

JP Morgan continues to expect engineering construction spending in the Heavy Industry sector will grow in FY13, this given the size of major projects already under construction. Activity is then expected to plateau around FY13 levels over the medium-term.

Long-term JP Morgan suggests the outlook remains one of support for commodity prices and therefore production output increases, but shorter-term the weak global economy is creating a less favourable operating environment.

The only sector still upbeat is the Australian energy sector, this given the large number of LNG projects in Queensland, Western Australia and the Northern Territory that are too far advanced to stop. This is especially the case given the costs associated with delayed deliveries.

In terms of the construction cycle clock, JP Morgan's view is the oil and gas sector remains near the top, while the resources sector has moved quickly into a downturn and the economic infrastructure sector is presently between stabilisation and recovery.

JP Morgan also has a Contractors' Expectations Index (CEI), which is a diffusion index offering a snapshot of survey results over time and an overview of expectations for Australian contractors. The index uses metrics including profit margins, forward order books, labour and material costs, overheads and workforce size.

The CEI now stands at 29.3, down 30% from six months ago. A reading of 50 or more indicates improving expectations, while readings below 50 indicate declining expectations for the coming 12 months.

As JP Morgan notes, the latest CEI result shows large contractors have turned pessimistic about the outlook for the first time in three years, while smaller contractors remain pessimistic as the issues impacting on larger contractors continue to filter down. 

Factoring in its updated view and the latest survey results, JP Morgan has lowered earnings estimates and price targets. Preferred exposure for JP Morgan remains production leveraged contractors, as miners are at least maintaining production levels across most commodity sectors as demand holds up. As well, JP Morgan notes production leveraged contractors have stronger links to output than prices, which implies less earnings pressure over the next year or two.

Ratings are unchanged, with Overweight ratings ascribed to Ausdrill ((ASL)), Bradken ((BKN)), Downer EDI ((DOW)), Lend Lease ((LLC)), NRW Holdings ((NWH)) and Seven Group Holdings ((SVW)). JP Morgan rates LeightonHoldings ((LEI)), Transfield ((TSE)), Boart Longyear ((BLY)) and United Group ((UGL)) as Neutral, while Monadelphous Group ((MND)) and ALS ((ALQ)) are rated as Underweight. Goldman Sachs also rates ALS as Sell, having downgraded from a Neutral rating following recent share price gains.

In the view of Goldman Sachs, FY13 is likely to be the peak year for earnings for ALS, which suggests limited upside over the next 12 months relative to the current share price. Total potential return for the stock is now below zero on the numbers of Goldman Sachs, which supports the downgrade in rating.

Citi notes attendees at the recent Minexpo, which is held every four years, offered a cautious view on the outlook for mining capex. This fits with the broker's own view, reflecting more defensive demand in the gold and copper sectors and weaker demand putting coal and iron ore projects at more risk.

To date Citi notes there are no signs of any pricing erosion, though the broker continues to suggest pricing pressure in a slower growth environment is the main downside risk to earnings for mining equipment providers.

From a longer-term perspective, Citi suggests positive fundamentals remain in place, this reflecting the fact mines continue to go deeper, become more automated and deal with issues such as greater water scarcity. 

Following a number of company meetings and industry conferences, BA Merrill Lynch has taken an incremental negative view of the Engineering and Contracting (E&C) and mining services sector of the market.

Along with a cyclical downturn in the global mining sector, BA-ML notes cost escalation in Australia is putting capex under threat as resource companies are attempting to rein in costs. This implies downside risk to consensus earnings estimates across the sector.

Goldman Sachs formed a similarly cautious view after a number of company visits, as the tone of most meetings reflected a lower level of confidence than previously encountered. In part this is explained by the recent fall in iron ore prices and the flow on impact of this drop on expansion activity. 

One positive in the view of Goldman Sachs was a number of companies were able to present strategies targeting growth in other commodities or geographies as an offset to the decline in iron ore expansion activity. Australian LNG and international gold and copper projects are now a key focus for the sector. 

The other positive was many companies are currently either carrying net cash or carrying low gearing levels, which is a positive given the softening outlook. This also leaves room for further merger and acquisition activity in the sector, Goldman Sachs noting the main interest appears to be in obtaining technology or market leadership in complementary sectors rather than simply acquiring more scale.

Looking ahead, with construction activity likely to fall in coming years, companies are looking at boosting recurring operations and maintenance revenues. This sector of the market is expected to become very competitive, which Goldman Sachs suggests will put pricing and margins under pressure.

Among those for which earnings risk is highest in the view of BA-ML are Bradken and Emeco Holdings ((EHL)), the former as a weaker outlook for capital goods sales is likely to impact on the order book and the latter as backlogs slow and new order lead time shrinks for heavy mining equipment.

In general, BA-ML remains cautious on stocks with significant end-market risk, operating leverage and weak balance sheets. In the current market this implies those stocks most at risk from an earnings sense are those companies operating in coal and iron ore markets. These include Emeco, Sedgman ((SDM)), NRW Holdings and Mastermyne Group ((MYE)). 

Among those companies for which earnings are most protected thanks to higher levels of global earnings diversification according to BA-ML are Ausenco ((AAX)), Imdex ((IMD)) and Bradken. BA-ML's preferred pick in the sector remains Bradken on a valuation basis, while least preferred for BA-ML are Imdex and Ausdrill.

Among stocks covered by Macquarie, the broker rates WorleyParsons ((WOR)), Monadelphous, Downer EDI, Orica ((ORI)) and Incitec Pivot ((IPL)) as Outperform, while Boart Longyear ((BLY)) and Transfield ((TSE)) are rated as Neutral. Underperform ratings are ascribed to ALS, UGL ((UGL)) and Leighton Holdings.

The ratings reflect Macquarie's preference for oil and gas exposures and exposure to production and operating expenditure over capex. Of stocks covered, WorleyParsons has the highest oil and gas exposure at 68% of revenues, followed by Transfield at 30% and Monadelphous at 15-20%.

Largest exposures to opex are the explosives businesses of Orica and Incitec Pivot at 90-95%, followed by Transfield at 80-90% and Downer EDI at just under 70%. At the other end of the scale Leighton and Monadelphous have the largest capex exposure at around 67% of revenues.

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