Leighton Provides A Wake-Up Call

This story features DOWNER EDI LIMITED, and other companies. For more info SHARE ANALYSIS: DOW

By Greg Peel

There they all were – brokers, analysts, support staff – wearing silly hats, balancing a glass of champagne in one hand and a plate of pavlova in the other, eagerly comparing boxed trifecta tickets, when suddenly… “They're off!”.

Unfortunately for the revellers, the cry had nothing to do with the seventh at Flemington. It was all to do with shares in Leighton Holdings ((LEI)) which ultimately plunged around 9%, beginning just before the jump in the Cup. Leighton had cheekily chosen a time when the Australian stock market was distracted to announce a 23% downgrade to its FY11 profit guidance, ahead of Thursday's AGM and first quarter profit review.

The downgrade was never going to go unnoticed despite the occasion, and the shock reverberated around Bond Street. This is the sort of announcement the market had come to get used to from the likes of fellow construction contractor Downer, but surely not the mighty, much-loved Leighton. Not the company which had very quickly turned around market sentiment after the GFC with a rapidly building pipeline of projects. Not the company that has the best project risk management track record in the game. Surely not.

For Downer EDI ((DOW)), recent stock price weakness has been all about the disastrous Waratah train project and associated write-downs. Take Waratah out of the equation, and Downer also boasts a healthy pipeline of projects, particularly those linked to Australia's can-do-no-wrong commodity boom. But no matter how often Downer has announced new project wins with much fanfare in the ensuing period, it has struggled to regain market support. The stock price has risen from an overshoot nadir, but valuations now carry a big sentimental discount. Sentimental in the sense that the market perception will not allow the echoes of Waratah and their lessons for unwary investors to be forgotten.

Yesterday stock analysts also learned another valuable lesson. They have always been fully aware, via Downer and many before it, that large, lumpy construction projects, taking possibly several years to reach completion, carry with them considerable risk. And for the most part, that risk falls squarely on the shoulders of the contractor.

Yesterday Leighton announced revised FY11 profit guidance of $510m as compared to market consensus of $667m. For starters, LEI sources around 25% of its work offshore and hence the strong Aussie has impacted on local profits. Next, the recent rail-related (what is it about trains?) profit write-down from Macmahon Holdings ((MAH)), of which LEI owns 17.4%, formed part of the shortfall. But 80% of the downgrade was specifically related to difficulties with Brisbane's $4.1bn Airport Link road project.

Only about a month ago, the analysts at JP Morgan were chatting to LEI management which noted the extent of costs in complying with the Queensland Coordinator General's conditions applied to LEI's request to grant changes in the Airport Link construction schedule. LEI had found difficulty with the ground conditions at the site. Such contingencies were not built into the lump-sum, fixed-price contract, but a contractor always builds in something extra in the quote for unforeseen contingencies. At that stage, LEI anticipated an additional cost of some $10-20m which contingency reserves would cover.

Clearly the problems have proven far greater than assumed back then. And unseasonably shocking weather has only made the problems worse. The cost to LEI of altering the contract now looks like about $125m. Analysts had already made A$ assumptions and adjustments for the Macmahon spillover, but this Link downgrade came right out of the blue.

The lesson thus learned is that no contractor, no matter how impressive its five-year project risk management record, is immune from the risks associated with taking on these huge infrastructure projects on a fixed quote basis. Not only is it the contractor, and not the client, who must wear the cost of contingencies, interim profit payments already booked must also be handed back if problems arise. Analysts, by their own general admission, had become a bit complacent when it came to Leighton. Those risks are real and ever present, no matter who you are.

The good news is that LEI has been in negotiation to sell a 35% stake in its Indian business to a local firm. The proceeds from that sale should cover the write-down of the Link, and hence FY11 profit guidance can be restored to where it was beforehand at around $667m.

The bad news is that analysts had been looking upon the Indian proceeds as a nice little buffer against ongoing risks in LEI's Middle Eastern projects, particularly in Dubai. Now that those proceeds will be accounted for, ME risk is opened up as a possible source of future profit warnings. And that's notwithstanding that the Link is only 60% complete and not due to open until mid-2012 at this stage. What else is around the corner?

As Macquarie puts it, “micro issues are spoiling what remains an attractive macro”. All brokers agree that LEI's substantial pipeline of work ahead, through contracts won, contracts quite likely to be won, and contracts up for grabs, is a solid reason to be invested in the stock. But all brokers also acknowledge that, a la Downer, such sudden profit warnings undermine confidence and provoke the application of a risk discount from the market. LEI stock is popular with overseas investors, and they don't take too kindly to such sudden share price drops, let alone the locals.

And the locals know all too well just what riches are potentially on offer for contractors from Australia's ongoing commodity boom, for its related mining and transport infrastructure, as well as all other infrastructure projects being pursued now in this country whether on private or state/federal government contracts. And furthermore it is easy to envisage further global success for LEI in the burgeoning infrastructure markets of the Middle East and Asia. Even Iraq has come to the party recently.

It is testament to this wider view that two brokers in the FNArena database have today maintained their Buy ratings on LEI. Four others have maintained Hold ratings which had previously reflected a fairly full valuation by the market. Only one – Macquarie – has downgraded as a result of the profit warning, straight from Outperform to Underperform. For Macquarie it's a sentiment thing.

All brokers have slashed their FY11 earnings forecasts by 20-25%. Most have also trimmed latter year forecasts. All bar one has taken a knife to their target price, consensus on which has now fallen from $35.86 to $33.62, which is slightly below the current trading price.

That one dissenter is Deutsche Bank (Buy) which, strangely enough, has increased its price target from $35.80 to $36.55 post the warning.

Deutsche has first taken the opportunity to actually raise its FY12-15 earnings forecasts to build in greater expected revenues from local resource sector projects. Next it has reassessed market multiples for LEI's various businesses and geographic locations and included those upgrades into its sum-of-the-parts (SOTP) valuation. Deutsche's final valuation is the average of its SOTP and discounted cashflow valuations. It is often the case that analysts let the market do the talking, resulting in valuation changes based on changes in market sentiment as exhibited in PE ratios.

So its been a wake-up call for all involved. Rome wasn't built in a day and probably encountered several obstacles along the way. Mining plants, railway lines and tollways aren't built in a day either, and cost an awful lot of money that the contractor has to guesstimate is required before even a sod is turned.

Perhaps the biggest embarrassment for Leighton is that the uncharacteristic downgrade has come five minutes after a new management team has taken over from legendary founder Wal King.

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