Australia | Jun 01 2011
– Rail update shows both opportunities and challenges for UGL
– Earnings guidance reiterated, brokers make only minor changes to forecasts
– Broker opinions on UGL remain divided between Buy and Hold
By Chris Shaw
Engineering and infrastructure group UGL ((UGL)) held an investor day at its Newcastle Rail Facility yesterday, one that saw management highlight what is a positive 3-5 year demand outlook for the business. This growth potential reflects the resources boom, passenger growth and the need to replace older existing rail fleets.
The current project pipeline for UGL is strong, Macquarie noting there has been an increase of 23% since December. The issue is there is something of a time lag for increased demand flowing through to actual orders, something UGL needs to provide renewed momentum in the order book and to support earnings expectations for FY12.
Citi notes while the update showed locomotive demand remains strong, there is increasing competition from Chinese-built locomotives. These alternatives are up to 40% cheaper than locally manufactured locomotives, though reliability of the Chinese models remains an issue.
Medium-term Citi expects the Chinese to improve the reliability of their product offerings, which translates into increased pricing pressure and loss of market share for UGL over a 3-5 year time-frame.
Given the competitive outlook, management at UGL is targeting increased cost savings in an attempt to maintain margins. Citi points out savings will potentially come from improved production processes, low-cost sourcing and better supply chain operations.
Another positive in Citi's view is UGL should benefit from increased maintenance outsourcing, a trend expected to be driven by the lure of additional cost savings. This, plus a positive resource and infrastructure pipeline in general should see UGL remain a major beneficiary.
This focus on costs has UGL well placed with respect to upcoming bids for new contracts, Macquarie noting these include around 800 passenger cars in total for QR and Vic Rail and expansion and passenger car replacement requirements for NSW Rail.
The update saw management at UGL reiterate guidance for 10-15% net profit growth in FY11, Credit Suisse pointing out this is despite some delays to projects such as Moranbah, Pluto and AirportLink. The update also indicated some adverse impact from currency translation effects. As Macquarie notes, UGL's guidance for FY11 earnings growth is the strongest in the sector.
Post the update changes to earnings estimates have been modest, Credit Suisse trimming its earnings per share (EPS) forecasts by 2-5% for FY11 and FY12 to 96.9c and 109.3c respectively. Consensus EPS forecasts according to the FNArena database stand at 100.5c for FY11 and 113.8c for FY12.
When an undergeared balance sheet is added to the equation Macquarie continues to see good opportunities for growth at UGL, though on valuation grounds there is no change in Neutral rating. Deutsche Bank agrees, taking the view while UGL deserves to trade at a premium to the market given strong management, low risk contracts and the potential for further redeployment of capital, this is currently priced into the stock.
The FNArena database shows UGL is rated as Buy three times and Hold five times. Citi has one of the Buys, seeing the potential for a shift from fixed price to cost plus contracts to provide support for the rail business and so generate value in the stock.
Citi's target of $17.22 reflects this as it is at the upper end of the range of targets in the FNArena database. The consensus price target according to the database is $16.24, down slightly from $16.26 prior to the update.
Over the past year UGL shares have traded in a range of $12.72 to $16.48. The current share price implies around 5% upside to the consensus price target in the FNArena database.
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