Guidance The Key For Engineers & Contractors

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 – Outlook commentary a key for upcoming engineering and contracting sector results
 – Guidance expected to be conservative 
 – Stocks with good earnings visibility favoured to outperform
 – Brokers update sector picks

By Chris Shaw

Leading into full year profit results this month for the Australian construction and engineering sector, Morgan Stanley expects results will be broadly in line with forecasts as company specific risks have already been priced into stocks.

This suggests the market's attention will turn to the outlook for FY13, where Morgan Stanley expects strong growth and as a result share price upside. Deutsche Bank is a little more cautious, taking the view guidance statements accompanying full year results are likely to be conservative given an unsure demand environment. This is likely to be most obvious in company order books, where Deutsche expects mixed growth across the sector.

Goldman Sachs agrees outlook commentary is likely to be somewhat hazy, while most companies are regarded as unlikely to offer specific earnings guidance for FY13. This leads Goldman Sachs to suggest those stocks in the sector most likely to outperform post the upcoming reporting season are those offering reasonable earnings visibility over the short and medium-terms.

Specific attributes viewed positively by Goldman Sachs include exposure to maintenance services and production volumes, exposure to hydrocarbons and exposure both across the project life cycle and to the early stages of a project. 

At the other end of the spectrum Goldman Sachs would look to avoid exposure to development capex (capital expenditure), exposure to only part of the project life cycle and exposure to large, fixed price contracts. 

For Morgan Stanley, six themes that could emerge in the broker's view are increased confidence from later cycle names, a new strategic focus on operating expenditure, increasing difficulty with respect to cash generation, labour becoming a reducing constraint, some structural challenges at the margin and an increased focus on offshore growth.

In general, Morgan Stanley suggests those contractors exposed to later stages of engineering construction activity will offer a more positive earnings outlook than will early stage peers. As management look to diversify earnings before any capex slowdown hits, an increased focus on opex (operating expenditure) is likely.

Customers are increasingly likely to hold back on cash payments in the view of Morgan Stanley, which leaves scope for some disappointment at the margin for some plays in the sector. At the same time labour availability is likely to remain a key concern over the shorter-term, though Morgan Stanley sees room for labour issues to moderate as soon as 2013.

Factoring in expectations for market conditions, Goldman Sachs suggests the best mix of attributes among Australian engineering and contracting plays are offered by UGL ((UGL)), WorleyParsons ((WOR)) and Sedgman ((SDM)). In contrast, the worst mix of attributes are offered by Leighton Holdings ((LEI)), Monadelphous ((MND)) and Downer EDI ((DOW)).

Deutsche Bank offers some opposing views, viewing the highest potential for a positive earnings surprise in the upcoming earnings period comes from Monadelphous and UGL, while WorleyParsons offers the greatest potential for a negative earnings surprise given evidence of some customers delaying projects.

This fits with recent comments by Citi, whose analysts note there is increased potential for iron ore capex in Australia to be delayed thanks to the combination of higher costs and falling iron ore prices. If projects such as BHP Billiton's ((BHP)) Outer Harbour were to be delayed, Citi expects engineering and construction companies would likely increase their focus on LNG opportunities. 

Within the sector, Citi points out Monadelphous and Leighton have the best track records with respect to LNG work, while the likes of UGL and Downer EDI would be expected to win some work in the sector.

Leading into results season, Morgan Stanley has made some minor stock-specific cuts to earnings forecasts for Leighton, Transfield ((TSE)) and WorleyParsons, while lifting forecasts for Downer EDI and Monadelphous. 

Expected reporting dates for stocks in the sector announcing earnings this month are Leighton Holdings and Bradken on August 7, UGL and Downer EDI on August 13, Matrix on August 17, Imdex on August 20, Emeco and Monadelphous on August 21, WDS on August 22, Sedgman and Ausenco on August 23, Seven Group on August 28, Transfield and WorleyParsons on August 29 and Boart Longyear on August 30. 

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