UGL Shakes Up Market With Corporate Review

This story features DOWNER EDI LIMITED, and other companies. For more info SHARE ANALYSIS: DOW

-Corporate structure review underway
-Outcome may unlock value potential
-But UGL has a lot on its plate
 

By Eva Brocklehurst

Engineering, operations & maintenance contractor and property services conglomerate, UGL Ltd ((UGL)), has embarked on a review of its corporate structure. This may end up entailing a spinning off or possible sale of divisions. Who knows? At this point, as BA-Merrill Lynch describes, it's navel gazing.

The broker is among several which think the timing of such a review is not good. There is a downturn in the engineering segment and there are a couple of newer divisions in property services which are yet to realise their full potential. A problem for BA-Merrill Lynch in all of this is that any de-merger opens up the prospect of lower liquidity and removal from key S&P/ASX indices. The broker understands there is potential to be unlocked in a structural separation but, also, underlines the fact that no decision has been made as yet.

Various alternatives will be considered in the review including maintaining the current corporate structure, reviewing a potential structural separation of the company, as well as the overall merger & acquisition strategy. Tax, debt and management issues that would be associated with a separation will also be examined. An update is planned by the FY13 results announcement on August 12, 2013, if not before.

For Morgan Stanley, it is another opportunity to recommend selling the stock, with the announced review sending the share price up 12%. The broker think the business is under pressure and deserves to trade at a discount to peers. The list of negative aspects for this broker are a lack of cash profits, an engineering business underperforming peers and an unproven property strategy. The broker accepts the fact that opportunity may be unleashed by the review but, as it stands, is not confident in the underlying operations. Moreover, the weak link is not engineering but risks from the DTZ acquisition, in Morgan Stanley's view. These include $141m of provisions that could be a material drag on the business and goodwill of $212m, exceeding the purchase price of $148m, as a result of provisioning. Morgan Stanley's sums generate a potential break-up value of $8.21-10.26 per share. 

Moelis sees it a bit differently. The problem is the market is valuing DTZ in terms of an engineering acquisition, not property. For this broker, one of the key attractions is UGL's diversified earnings stream and this is not reflected in the multiples. Taking what Moelis believes is a more appropriate valuation of the DTZ business, there is upside to be had. The DTZ business could also be a clear takeover target. Moreover, a more focused engineering and Operations & Maintenance (O&M) company is likely to improve market share and attract international EPCM (engineering, procurement and construction management) contractors.

JP Morgan was surprised at the timing, given the underlying operational problems. The review, in the broker's opinion, is an attempt to reduce the discount UGL trades at against a break-up implied sum of the parts valuation, which JP Morgan has at $10.63 a share. A de-merger and/or structural separation could also make it easier for a potential acquirer to pursue a single division.

The broker believes there are two risks which are critical to assessing the benefit of any restructure. The first is dealing with the current operational issues such as lost market share for engineering and the immature roll out of the property business. JP Morgan is concerned that, if a restructure is pursued in the near term, this could distract management from addressing these operational issues. On the second risk, restructuring is likely to incur direct costs and impact each segment's capacity to fund growth. So, ahead of further news, the broker is keeping an open mind and retains a Hold rating, one of five on the FNArena database. The other ratings are two Buys (Credit Suisse, Deutsche Bank) and one Sell (Macquarie).

Macquarie was also surprised at the timing of the review as UGL is only part way through a cost cutting program targeted at DTZ. Taking a bullish view on valuation, Macquarie's estimates are, on FY13 price/earnings, 15-16 times for property and 10 times for engineering/O&M, which is in line with Downer EDI ((DOW)) and Transfield Services ((TSE)). This results in a $11.76 valuation, showing 11% upside from current trading levels. It's just that UGL already has a big ask in terms of the second half, despite cutting full year earnings guidance. Macquarie notes key drivers that are required to fulfill earnings expectations include $9-10m of incremental cost savings, the non-recurrence of a problem project in infrastructure and growth in services from recovery in the American property market, as well as DTZ cost savings.

Credit Suisse had envisaged that UGL would consider a spin-off once DTZ was integrated and believes the timing of the review is to combat the downgrading of the stock that has occurred since the first half result. Credit Suisse thinks the engineering/O&M segment could become an attractive target to companies intent on expanding capabilities in the sector such as DOW, Clough ((CLO)) or Monadelphous ((MND)). Under this scenario, UGL Engineering could command higher multiples. Credit Suisse likes the stock and believes the discount to market at which it is trading is not warranted. Furthermore, the broker believes UGL has scope to gain market share in the US relative to the dominant players there.

The target price on the FNArena database ranges from $10.39 (Macquarie) to $12.30 (Credit Suisse). The consensus target price is $11.03, showing 7.7% upside to the last share price. Consensus dividend yield for FY13 earnings is 6.7% and for FY14 it's 6.8%.

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