UGL’s Future Without DTZ

This story features DOWNER EDI LIMITED. For more info SHARE ANALYSIS: DOW

-Question of use of cash
-Leakage of proceeds
-More financial flexibility
-Increased FX risk
-Potential infrastructure catalysts
 

By Eva Brocklehurst

UGL ((UGL)) will dispose of its property services business, DTZ, to a consortium of private equity for around $1.215 billion, guiding to net proceeds of $1-1.05bn. This transaction will now turn UGL into a pure engineering and construction entity.

The company will have a $390m net cash position afterwards, based on UBS' expectations of FY14 net debt of $572m, but the broker remains cautious. Engineering is a more cyclical business than property services and has experienced significant earnings deterioration in the last four years for various reasons. UBS does not think there is much upside for the company and the key question is about the use of the excess cash. Buy-backs and acquisitions are highly accretive but attention needs to be paid to any value accretion in a potential acquisition, rather than focusing on earnings accretion. Hence, the sale does not add value in UBS' view.

Gross proceeds may be in line with expectations but CIMB thinks the net return will disappoint some investors. CIMB suspects many holders of the stock would have expected the difference between the gross and net proceeds would be less. The board, in conjunction with the newly appointed CEO, Ross Taylor, will inform investors later in the year of their intentions, once the transaction has settled. The company has guided to engineering revenue for FY15 of $2.4-2.5bn. However, CIMB cannot find a way to make the standalone business stack up at current prices. On the broker's assumptions, and with the expected proceeds, valuation remains materially below the share price. CIMB thinks the business will only trade on 5-6 times earnings estimates, based on a difficult external operating environment, and a history of poor cash conversion and problem contracts. Hence, CIMB reiterates a Reduce recommendation at a share price above $6.30.

Deutsche Bank thinks the transaction price is fair. The broker describes DTZ as small, less established and with lower exposure to the high growth US commercial real estate market, believing this is reflected in the sale multiples. UGL's high debt levels will now be reduced and the company has the financial flexibility for capital management and/or accretive acquisitions. Deutsche Bank calculates the transaction will be earnings dilutive in FY15, given the company is retaining the proceeds as cash until the board completes a review of the options.

The sale price is below Macquarie's valuation of DTZ at $1.3-1.4bn. This broker also found the net leakage to be larger than expected, reducing cash proceeds for shareholders. Macquarie is not sure if the price justifies selling the business, as opposed to its de-merger. Still, some value must be attributed from the certainty the sale provides for the balance sheet. The broker estimates around $4.06m in surplus funds will be available for a capital return. Acquisition opportunities exist but Macquarie thinks a capital return is the base case. Moreover, the broker thinks the outlook for engineering is improving because of the momentum in infrastructure opportunities. UBS is witnessing an improvement in tenders for the power and infrastructure markets. Macquarie still struggles to envisage much valuation upside at present but an outcome on Sydney's north west rail may be a potential near-term catalyst, perhaps in a consortium with Leighton Holdings ((LEI)).

Morgan Stanley is disappointed. Attention is expected to shift to the quality of the remaining earnings and the broker envisages a weak second half in FY14, continuing a four-year trend where operating cash flow has lagged reported profits. Putting the engineering business on a blended multiple based on peers Downer EDI ((DOW)) and Transfield Services ((TSE)) and the mid point of FY14 net debt guidance implies an equity value of $5.90. UGL will not have a natural US dollar earning hedge now and has not refinanced its US private placement facility, signalling to Morgan Stanley an increased exposure to FX risk. The company may have to either use swaps to remove the FX risk, which increases interest rates on debt, or pay debt holders a break fee. Morgan Stanley remains Underweight on UGL.

BA-Merrill Lynch is more upbeat in the wake of the sale. Management's outlook commentary for the remaining engineering business enhances the broker's conviction that the bottom of the earnings cycle has now been seen. An increased order book over the past six months and lower corporate costs support the broker's more positive view. Merrills has increased forecast earnings for the engineering business by 16% in FY15 and 27% in FY16.

In regard to the sale proceeds, Merrills estimates around $460m will be used for debt reduction and around $590m will be available for a capital return to shareholders. The broker now expects dividend payments to be reinstated next year, one year earlier than previously assumed. While cutting its target to reflect the divestment, the broker retains a Buy rating.

FNArena's database has two Buy ratings, two Hold and four Sell. The consensus price target is $7.00, suggesting 7.5% upside to the last share price. This compares with $7.16 ahead of the announcement.
 

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