Mona Frowns

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By Greg Peel

At the bottom of the GFC, engineering and construction firm Monadelphous Group’s ((MND)) share price was under six dollars. This year the shares peaked over 25 dollars. And that’s just capital appreciation. Over the period Mona has not only paid a handsome yield but continually grown dividends to enhance a market-beating total return.

Mona’s interim dividend, following the company’s first half FY13 earnings result, fell just a little short of analyst expectations at 62c. What’s more, management has decided to initiate a dividend reinvestment plan (DRP) to assist in the funding of future dividends. What does this tell us?

DRPs, in which existing shareholders are offered a discount on new capital if dividends are reinvested rather than cashed, are by any other means a backdoor capital raising. DRPs are often employed by companies desperately attempting to raise more capital without wishing to telegraph too much desperation to the market, such as the banks in 2009. Mona’s case, on the other hand, is a very different one. As BA-Merrill Lynch suggests, it may be that even management sees the current MND share price as overvalued, meaning a DRP is a way of “cashing in”, or it may mean the cash generating power of the business – that which Merrills emphasises as a “hallmark of quality” – is likely to be weaker ahead.

Or maybe both are true. For a company which has built a solid-gold reputation for constantly growing dividends, any move to cut dividends in order to better navigate a period of earnings consolidation would have those yield-chasing investors, of which there are a vast number, rushing for the exits. No one would win. Whatever the case, Mona’s path from here is not quite as clear as it has been up to now, and management has been the first to admit it.

It is a truth now held to be self-evident that the Australian resource sector spending boom will shortly peak, both sooner than expected a couple of years back and at a lower level than previously assumed. The RBA has acknowledged this unfortunate reality several times in cutting its cash rate by 175 basis points over the past eighteen months. The big players BHP Billiton ((BHP)) and Rio Tinto ((RIO)) have been forced to rein in their most ambitious expansion plans and both CEOs have now exited, either through the front door or the trap door. Across the mining sector in general, cost-cutting is now the buzzword. The same is true for the LNG sector, albeit LNG capex is yet to peak.

The future has become a little cloudier. The global economy may be looking a little healthier in 2013 than it has done since 2008 but it’s been a long time coming, and rebound expectations have been both lengthened in timeframe and downgraded in pace. Mining companies are seeing to completion the longer term, big ticket projects they began a few years ago, but thereafter they will play a much more cautious game. LNG companies are yet to see their own mega-projects through to completion, so fingers are crossed.

Meanwhile, the resource sector capex boom up to this point has also meant a boom for the smarter of the suite of resource sector service companies whose offerings and wares represent a significant level of your average resource project cost. A couple of years ago, service companies could just sit back and wait for another anxious miner to bang on the door. Today, with a capex peak in sight, it is the service companies who are chasing the business. With contracts drying up and project pipelines becoming vague, the resource sector service industry has become a lot more competitive.

Monadelphous yesterday announced a first half profit of $79.1m, representing a 36% earnings increase on the first half of FY12. It was déjà vu for analysts who have become used to such performance, including last fiscal year in which earnings grew by over 30%. Revenue growth exceeded earnings growth in rising 47%. With many of Mona’s contracted projects heading towards completion, management has raised its FY13 revenue growth guidance to 35% from 25%.

The guidance upgrade has moved analysts to upgrade their own revenue forecasts, but the discrepancy in the first half numbers has not been overlooked. Revenues grew by 47% but earnings grew by only 36%. This means margins fell in the period. Operating cashflow fell 37%.

The fall in cashflow was largely a result of Mona spending up to support the last-push efforts of clients as projects near completion, and thus to support revenue growth. This drag on working capital will clearly subside after FY13. Margin compression, on the other hand, tells a different tale.

While not so long ago resource sector clients were indulgent spenders, today they are trying to keep costs to the minimum. Nor are clients so quick today to announce new project aspirations, and development/expansion plans are moving forward with caution. The pipeline of new contracts up for grabs for service providers is nowhere near as defined as it once was. Competition in the services sector has thus become a lot more pronounced. Margins are under pressure across the industry.

Analysts acknowledge that the big iron ore, coal and other mining contracts enjoyed by Mona and others will peak in FY13-14 as projects are completed and new contracts will diminish in number thereafter. On that basis, Mona has one last leg to cash in on what management described as the “extraordinary surge” in construction activity up to this point. Hence the FY13 revenue growth upgrade. FY14 will nevertheless be a different picture, to the point management has warned of “consolidation” ahead.

LNG development is set to continue before potentially reaching its own peak in FY14-15. The services industry players will all be chasing a reduced pipeline of opportunities after FY13, leading CIMB to suggest that while Mona will still achieve revenue growth in FY14, some new contract wins will need to be announced before the end of FY13 to ensure this. Those contracts are not likely to impact the bottom line until FY15, underlining management’s “consolidation” call for FY14, and moving Citi to suggest contract wins on the big Wheatstone and Ichthys LNG projects are “key” for Mona.

Mona saw a 47% increase in revenue growth from the first half of FY12 to the first half of FY13. Citi is predicting FY14 revenue growth of 4% and zero growth for FY15. Bear in mind Mona generates significant amounts of revenue and Citi is not forecasting this to abate. The broker is simply suggesting the astronomical growth run is over.

It’s hard to find any real divergence in views from the broker community. Testament to this is no less than six post-result recommendation downgrades from a pool of nine major brokers (seven FNArena database brokers covering MND along with Goldman Sachs and Morgan Stanley). Merrills, JP Morgan, UBS and Deutsche Bank have all downgraded to Sell (or equivalent) ratings from Hold while Macquarie, CIMB and Morgan Stanley have all downgraded to Hold (or equivalent) ratings from Buy. Citi and JP Morgan already had Sell ratings on the stock and Goldman has stuck to Hold.

Views are aligned, and perhaps best summed up by Mona’s own management which suggested yesterday that completion is now greater, margins are under pressure, uncertainty remains around new project approvals and the pipeline of opportunities is likely to reduce in the medium term. Analysts also whole-heartedly agree that Mona is a fabulous success story, driven by a solid team, for which an extraordinary period of growth opportunity is now reaching a plateau, for the time being.

Brokers might anecdotally agree, but when it comes to converting views to forecasts a very different tale emerges. Twelve month price targets for Mona range from JP Morgan (Underweight) at $19.00, or around 17% below today’s trading price, to CIMB (Neutral) at $28.28, or 24% above. If this is confusing for potential investors or current shareholders, perhaps a clue lies in the fact the high marker (CIMB) still felt it necessary to downgrade to Hold.

Differing target prices will reflect variance in earnings forecasts, and thus variance in what different analysts calculate to be Mona’s forward PE multiples. But to take two examples, Citi points out that its forecast FY13-14 PE of 15x is a big number for “a business that derives earnings largely from construction, which is typically lumpy with low visibility, with flat earnings growth in FY14-15”. Morgan Stanley calculates an FY14 PE of 14x, which the analysts cannot justify when compared to Mona’s peer Downer EDI ((DOW)) on an equivalent 9.3x.

Whichever way you look at it, now is not the time to buy into Mona. As to whether it is a time to sell out after a good run, that will depend on individual investment timeframes.

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