Tougher For Longer For Engineering Contractors

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-Few greenfield projects coming on stream
-Morgan Stanley suggests significant downturn
-Focus on the resilience of balance sheets
-More competition in the market
 

By Eva Brocklehurst

It is tough out there in contractor land and brokers fear it may become tougher. Caution and bearishness prevails regarding the outlook for the engineering and construction contracting businesses, as clients continue to reduce costs, cancel contracts and forestall new tendering. Deutsche Bank observes the value and volume of infrastructure work continues to decline while the value of resources construction work fell sharply in the June quarter. The broker anticipates, hopefully, that infrastructure work that has been budgeted for but is yet to be done, such as large road and rail projects currently under tender, should underpin the level of infrastructure spending. On the resource work front the broker notes LNG and iron ore projects that are currently being completed leave few greenfield projects as replacements.

Macro indicators suggest to Morgan Stanley the challenges will intensify in FY15 and the outlook, on average, is likely to disappoint in upcoming earnings reports. The broker thinks stocks have disconnected from the macro outlook. Stocks re-rated significantly when earnings challenges first appeared and the broker thinks this was premature. The market appears to be anticipating a recovery but Morgan Stanley suggests that is unlikely to happen in FY15-16 for much of the industry. The broker thinks the real downturn in capex is yet to materialise, with quarterly activity broadly flat for the past two years. Forward indicators, however, suggest a significant downturn is now imminent. The broker believes most investors expect market conditions will not improve for more than 12 months. Reflecting this view, the broker envisages downside risk to FY15 estimates for all stocks in the sector.

Moreover, while the downturn in the mining industry work has only just started, Morgan Stanley thinks, despite much optimism in the public infrastructure arena, it won't be enough to offset this. Also, domestic operators may capture a higher share of new public infrastructure work but, compared to the recent past, they face a higher concentration of foreign participants in this market.

Much of the industry is substantially exposed to mining operating expenditure, such as Downer EDI ((DOW)), Monadelphous ((MND)), Leighton Holdings ((LEI)) and UGL ((UGL)). The outlook appears substantially challenged in the near to medium term as miners continue to drive costs lower and take much of the work in house. Morgan Stanley suggests a select few in the sector may have seen the low point of earnings, including UGL, Transfield Services ((TSE)) and WorleyParsons ((WOR)). Nonetheless, risk still permeates the recovery.

Macquarie believes attention will be heavily focused on the state of balance sheets, given the expected length of the downturn. A lack of strength in this area is an issue for Ausdrill ((ASL)), Emeco Holdings ((EHL)), Fleetwood ((FWD)) and McAleese ((MCS)) in the broker's opinion, not to mention Boart Longyear ((BLY)). At the other end of the spectrum, balance sheet strength means accretive acquisition capacity, capital management prospects or simply an ability to withstand the downturn. The broker highlights Macmahon Holdings ((MAH)), Mineral Resources ((MIN)), NRW Holdings ((NWH)), RCR Tomlinson ((RCR)) and Seven Group ((SVW)) in this camp. The broker believe the macro context in infrastructure is holding up but it will be an important area to watch for growth in spending intentions and the opportunities that are available, for RCR Tomlinson, Transfield and Cardno ((CDD)), in particular.

Morgan Stanley believes Transfield is a business that is turning around but still characterised by significant risk. Its capital structure is the most leveraged of any stock the broker covers. Transfield is one of Macquarie's top picks in the sector as contract wins support visibility and revised debt facilities have alleviated some of the balance sheet pressures. The company's dependence on performance-based revenue remains a focus for the broker. Deutsche Bank notes Transfield is operating in competitive markets, has high debt levels and capacity for only slow debt reduction but there is potential for some large contract wins which could assist.

Leighton may be assessing divestments to improve its balance sheet but Morgan Stanley notes, in the short term, such divestments may trigger negative outcomes, including large redundancy costs, asset impairments, receivables write-offs and internal and external destabilisation. At the same time, the macro outlook is mixed with public infrastructure work improving but highly competitive. Deutsche Bank has downgraded Monadelphous to Sell given the weak outlook for resources engineering construction and the lack of large projects available. Morgan Stanley also thinks Monadelphous' outlook appears challenging in the medium term and suspects a material de-rating could occur as the capex cycle unwinds through FY15-16. Brokers are awaiting Boart Longyear's strategic review. The weak first half did not surprise them, given weakness in the exploration market, but debt is a major impediment and there remains considerable risk in meeting its March 2015 debt covenants.

UGL has a relatively better outlook. Deutsche Bank suggests the company's strong balance should provide for a capital return in the next six months and the high level of recurring maintenance revenue stands the company in good stead. Morgan Stanley acknowledges these are positive aspects but still believes it is too early to become more constructive on UGL, with the ongoing disconnect between cash flow and reported profit a significant concern. WorleyParsons remains the market leader in the hydrocarbons engineering market and the most attractive, in Morgan Stanley's view. The stock currently trades on a 6% discount to international engineering peers, despite a more favourable position in growing the sub-sea and offshore markets and potential for margin expansion.
 

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