Australia | Mar 11 2014
-Potential credit rating downgrade
-Hochtief wants more board seats
-Uncertainty for minor shareholders
By Eva Brocklehurst
The bid by major shareholder, Hochtief, to acquire more of Leighton Holdings ((LEI)) has been greeted with a mixture of concern and opportunism by brokers. The final intention may be unclear but what brokers are concerned about is the reduced liquidity in Leighton stock that would come with such a large holding, if the bid succeeds, and a likely downgrade in Leighton's credit rating.
Hochtief has offered to acquire three out of eight shares not owned, for $22.15 plus interim dividend of 60c. This would take its stake in Leighton to 74.23% from 58.77%. Hochtief wants greater board representation, irrespective of the outcome of the offer, and a broad-based review of the operating model.
Chief among broker concerns is the stock's credit rating. S&P currently rates the stock a BBB-minus/A-3 with a stable outlook. Moody's rates it Baa2 with a stable outlook, and has placed this on review after the announcement. Both agencies have said in the past credit ratings could be lowered if there was unexpected control being implemented by Hochtief or its parent, ACS, or if the board's independence was compromised. CLSA thinks a downgrade will ensue, triggered by a change in board control or Hochtief owning over 70% of Leighton. A rating downgrade would cost Leighton $15-20m per annum in additional fees and interest. Performance bonds would become more difficult to source as well. Macquarie considers the intended review from Moody's reflects the uncertainty regarding the future financial and business profile of Leighton and that Hochtief and ACS have lower credit quality compared with Leighton.
Macquarie decided the time was ripe to downgrade the stock – to Underperform from Neutral. The partial offer has realised value in the short term but there is considerable uncertainty regarding $5 billion in Leighton's receivables an the Gorgon jetty and Iraq issues. Leighton, while staying listed, will also not be included in an index at less than 30% free float. Credit Suisse already had an Underperform rating and the bid does not change that view. Credit Suisse reminds all that increased control by Hochtief won't alter the headwinds the industry faces. The broker does not expect Australian infrastructure work to offset the anticipated outcome in Australian resources activity. Additionally, there are issues around the recovery of payments in Iraq and the Indonesian court dispute.
Morgan Stanley's fundamental view on the stock is also unchanged by the offer, with Leighton characterised by significant challenges. The bid represents considerable upside to Morgan Stanley's valuation and the broker will assess the offer once the board has responded. CLSA does not expect a full bid to ensue, given that 75% is a redemption trigger for Leighton's debt. Nor are any sweeteners expected. The broker acknowledges there are index risks but, as Hochtief won't be buying on market, this is likely to have less influence on the stock than a credit downgrade. CLSA thinks the share price is factoring in too many positives and downgrades to Underperform.
While Hochtief does not want to mount a full takeover at this stage it's possible this is a precursor. BA-Merrill Lynch thinks it is a way to creep up the register, which is currently restricted to 3% every six months. CIMB has advised shareholders to get in while the going's good – move ahead of the formal bid and sell into the market while the share price is at a premium to the bid price. The broker warns non-acceptances to the bid offer cannot be recaptured by others wishing to raise their stake.
Deutsche Bank thinks the offer is appealing, relative to fundamental valuation, given Leighton's risks. The broker also expects the offer to receive government approvals. What concerns Deutsche Bank, besides the potential credit downgrade, is the desire by Hochtief to increase its board representation, which the broker views is another departure from governance principles, which ACS indicated back in 2010, it would not alter. The governance principles were about NOT increasing Hochtief's shareholding beyond 55%, which it did last year, the right to appoint up to four of 12 board seats, maintaining the structure of the group, supporting management and the independence of the chairman. Hochtief currently holds three of 10 board seats. Deutsche Bank would not be surprised if, as Hochtief has already departed from two of the principles, it abandons the others.
CLSA thinks board control is the likely motivator for ACS, and a proportional bid the way to achieve this. The broker wonders what ACS cannot achieve with the current board – cutting the dividend? This broker also finds it unsettling that Hochtief's CEO has been anointed for the ACS CEO role.
Moreover, what about the future treatment of minority shareholders? Deutsche Bank lists possible cash flow moving upstream towards Hochtief, and ACS, as well as potential for value-destructive asset sales and an on-market buy-back increasing Hochtief's ownership further. Another concern is changes to the operating company structure which may reduce revenues – but also lower bid costs. There is potential for full takeover and Deutsche Bank estimates that this would increase Hochtief's gearing to 52%, and ACS' gearing to 59% – within ACS' historical range, so it does have financial capacity. The broker delves further and notes ACS has, historically, not paid a significant premium to minority shareholders. Macquarie thinks the minority interests may endure for some time and, while the current share price is already factoring in the prospect of a further bid, it's not necessarily discounting the time it may take.
On the FNArena database there are no Buy ratings. There are three Hold and four Sell. The consensus target is $19.95, suggesting 10.9% downside to the last share price, and compares with $16.77 ahead of the bid announcement. Targets range from $16.60 to $22.75. The dividend yield on FY14 forecasts is 4.6% and on FY15, 4.7%.
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