Leighton A Loser If Rio/BHP Tie-Up Goes Ahead

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By Chris Shaw

Leighton Holdings ((LEI)) is one of Australia’s major mining contractors, so it is a reasonable bellweather for the sector as a whole and for some time the market mood has been cautious, given the FNArena database shows the company has four Hold recommendations and six Sells.

This reflects broker concerns about falling margins and a reduction in general contract activity given weaker conditions in the mining sector.

Well, the outlook now looks set to become even tougher as the proposed deal between BHP Billiton ((BHP)) and Rio Tinto ((RIO)), which looks to combine their iron ore operations in Western Australia, includes comments indicating a desire to move towards more of an owner-operator model instead of using contractors.

This, Credit Suisse notes, has significant implications for Leighton’s contracting business given it is the largest contract mining operation in the country.

The issue, according to the broker, is not only that mining volumes are declining as customers reduce the amount of work they contract out, but lower commodity prices in general are putting pressure on mining companies to reduce costs and with labour becoming more available this suggests margins will be squeezed further going forward.

The impact could be significant as on the broker’s numbers every 100-basis point decline in contracting margins means a 5% negative impact on net profit after tax, while the likely increase in infrastructure work on the back of the Federal Government’s stimulus package is unlikely to help prior to FY11, in its view. This means earnings risk remains to the downside for at least another year or so.

While JP Morgan is equally negative on the stock given its Underweight rating matches the Underperform at Credit Suisse, the broker presents some other points, one being the company is unlikely to lose existing contracts given the break fees attached to them, meaning there should be little short-term earnings impact from the proposed joint venture. This is especially the case given it will take some time for the joint venture to be set up.

But the broker agrees with Credit Suisse the trend towards bringing mining operations back in house will put downward pressure on margins for contractors such as Leighton, adding to the pressure already being experienced by the currently weaker iron ore demand outlook.

JP Morgan also sees the potential scope of any earnings impact as reasonable as on its numbers, contract mining accounts for about 3% of forecast revenues in FY09, while iron ore contract mining represents about 5% of the forward order book.

Macquarie agrees, pointing out BHP is the company’s largest customer in the resources sector, which overall accounts for about 28% of group earnings and so is quite important. The broker also points out Leighton itself has had some operational issues in some contracts of late and these are similarly having a negative impact on margins.

A value analysis seems to support the brokers’ negative view, as according to the FNArena database, consensus earnings per share forecasts for the company of 193.4c this year and 198.3c in FY10 imply a price to earnings (P/E) ratio of a little over 12 times, which is not especially cheap given the question mark over group earnings.

Shares in Leighton are weaker today despite a stronger overall market and as at 12.40pm the stock was down 34c at $23.51. This compares to a trading range over the past year of $16.15 to $52.95 and an average price target according to the FNArena database of $21.08.

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