Australia | Jun 05 2013
-Project deferrals reduce earnings
-Industrial maintenance most affected
-Cleanaway, landfill relatively stable
By Eva Brocklehurst
Even cleaners are finding the going tough at present. Industrial maintenance and waste remover, Transpacific Industries ((TPI)), has downgraded earnings expectations for FY13 after the second half failed to deliver on several fronts. The company is guiding for FY13 earnings of $405-415 million, which implies the second half will be down 12-16% on the prior corresponding half, on an underlying basis.
JP Morgan took the opportunity to upgrade the rating on the stock to Overweight from Neutral, believing the share price represents value for the longer-term investor. While earnings are likely to be volatile over the next couple of years there is relative value to the Small Industrials Index. The broker's determinant of value in the stock is whether the earnings reduction is structural or cyclical. Structural issues are factors affecting the high margin landfill business, such as state levies, market structure changes from the carbon tax and volumes in some of the east coast business. The main earnings deterioration is pinned on work deferrals, and this is a cyclical item. The question now becomes one of timing of the recovery in these markets.
So, what happened. A drop off in industrial activity was the main contributor to the deterioration in the second half, and where the guidance diverged from most broker expectations. Transpacific experienced the deferral of a large number of maintenance and shutdown projects across the industrial and mining sectors. The positive aspect is that this sort of work, while being delayed, is still largely necessary and so some resumption is expected in FY14.
Management noted the majority of deferred projects have been maintenance rather than capital projects. As well, the liquid waste business was affected by the slowing of the manufacturing sector and reduction in high-margin waste business. In this case, the slowdown could be more permanent. Macquarie suspects it will be some time before a lower Australian dollar revitalises manufacturing. Goldman Sachs too, is mindful of the weak manufacturing environment and remains concerned about the long-term impact of the decline in manufacturing activity on Transpacific.
Another point JP Morgan makes is the factors that affect Transpacific's landfill business are structural in nature, particularly as volumes are influenced by the state tariffs and changes following the introduction of the carbon tax. Both influences can be reversed but legislative changes would be required. The federal election may have to come and go to resolve this. This is one area to watch for Transpacific, as the issues facing the landfill market have had a meaningful impact on earnings given the significant margins that this business generates.
Moreover, arguments could be made that some of the volume declines the company has witnessed are also structural in nature, particularly on the east coast in industries which struggle to remain competitive because of the high Australian dollar. With commodity prices falling and questions over the resources industry capex outlook, exposure to construction and development projects are a concern, although this is a smaller part of Transpacific's overall business.
CIMB highlights the resilience of the Cleanaway business. Landfill volumes are weaker, reflecting soft economic conditions in South Australia, Western Australia and Victoria. Despite this, Cleanaway collection volumes are generally stable and there is modest growth in the commercial and municipal markets. Elsewhere in Transpacific's businesses, trading in New Zealand has improved and commercial vehicles are expected to report good profits in FY13.
Goldman sees a shifting in the business from heavy manufacturing, higher margin wastes to relatively light waste, such as grease trap waste from restaurants where there is more competition and lower margins. The broker's price target of 88c is based on price/earnings parity with the Small Industrials. This reflects Goldman's view that the balance sheet will be close to investment grade by FY15 and hence the valuation will be in line with other small cap industrials by that stage. JP Morgan also observes the barriers to entry in much of the light waste business is low and competition is very fragmented. What drives market share in this respect is largely – price. JP Morgan suspects any cost savings the company is targeting is unlikely to be delivered to shareholders, rather the benefit will be invested back into price and market share.
The appointment of an operational consultant to undertake a review signals to the brokers the likelihood of further divestments. Targets are likely to be the underperforming industrial businesses, in Macquarie's opinion. Whilst the operational review may involve asset write-downs, Macquarie understands the earnings-based covenants for the debt facilities exclude non-cash write-downs and there is significant room in the equity-based covenants.
The company's managing director, Kevin Campbell, announced his resignation at the same time of the guidance update. He will continue to work with the board and management while a global search is undertaken for a successor. Macquarie notes Transpacific is a more stable company compared to when he joined but the timing of his announcement is unusual, given an incoming CEO is usually the one that conducts the operational review.
There are five Buy ratings on the FNArena database and one Hold. The consensus target price is 98c, signalling 27.5% upside to the last share price.
See also, Transpacific No Longer Rubbish on February 25.
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