Australia | May 16 2013
-Losses, delays equal downgrade
-Fears over loss of value with break-up
-Lack of appeal in engineering
-DTZ the most positive
By Eva Brocklehurst
UGL Ltd ((UGL)), an engineering, mining operations and property maintenance conglomerate, has run into a perfect storm. The slowdown in mining activity, delays and execution issues with projects, particularly in power, and general economic malaise has resulted in the company waving the downgrade flag over FY13 earnings.
The company downgraded earnings guidance for FY13, which didn't surprise brokers, given the current climate. What did surprise was the extent of the downgrade – 39% below prior guidance. Half relates to losses on power projects and the rest to project delays and/or scope cut-backs. The biggest problem project is the Solomon power plant for Fortescue Metals ((FMG)), which is to be completed August. UGL is confident that, having taken a hit in FY13, it will emerge with a clean slate in FY14, but brokers are not so sure.
Credit Suisse has sounded a note of alarm, fearing the company has worn more than its fair share of the scaling back of mining activity, both in terms of operations and maintenance and new investment. The broker suspects UGL is either not cost competitive or is enduring a breakdown in relationships with some customers. Neither is good, and the broker is particularly concerned about the outlook for engineering. Any break up of the property and engineering businesses could open up the separate entities to become takeover targets. Credit Suisse used the opportunity to downgrade the rating to Hold from Buy.
UGL has previously flagged a strategic review, due for August. The company has now stated it will consolidate operations and maintenance (O&M) into engineering and seek an additional $20m in cost savings by August as part of this restructure. At this stage the company believes costs that have been removed are sufficient and the combination of O&M and engineering will produce a business with the appropriate scale. The board has signalled, at this point in time, they are favouring a de-merger of engineering and property services.
When the review was announced brokers were sceptical of the timing. With the downgrade to earnings forecasts and continuing heavy weather in resource-based sectors they remain even more worried about how UGL can extract value from its businesses. BA-Merrill Lynch, while accepting that a united engineering/O&M has benefits in cost structures and margins, is concerned about the reduced margin visibility this implies.
Brokers have looked at the prospect of a restructure and/or hiving off of some segments and have difficulty finding the appeal. Macquarie thinks a de-merger the most likely outcome and, while the broker is attracted to the DTZ property business, the investment case for engineering/operations and maintenance is less interesting, even though an earnings bottom may be reached in the next 12 months.
Macquarie notes UGL earnings are far less defensive than they once were and risk management and/or project execution is falling short of expectations. Peers are doing better in the broker's opinion. Moreover, UGL's FY13 downgrade highlights the risk around the second half performance for the sector as a whole. Macquarie suspects this is possibly going to continue into FY14, when a lack of new work could make growth of any form challenging. BA-Merrill Lynch accepts a separation makes sense but considers the timing is less than optimal given the cyclical downturn in engineering while the property business is yet to deliver on its promise.
The most positive area is property, which is on track for earnings growth in FY13 in the USA and Asia, although conditions remain tough in Germany and France. Management will need to reduce costs and reassess project management, in JP Morgan' opinion, in order to re-establish its reputation for delivery and also to respond to the impact on the non-DTZ business of the slowdown in activity. DTZ has a good outlook, in the broker's view as demand for outsourced property services grows globally in spite of weakness in some areas. Nevertheless, JP Morgan also questions the amount of value that could be released form a change in the corporate structure and things a de-merger at this stage may not extract the full value, given the continued integration work and the impact that pulling DTZ out of the company may have on the ability to pursue and fund growth.
The FNArena database contains six Hold ratings for UGL and one Sell – Macquarie. The one Buy is Deutsche Bank, which hasn't updated for the latest downgrade as yet. The consensus target price has fallen to $8.87 from $10.96, which suggests 18.1% upside to the last share price. The dividend yield on FY13 consensus earnings forecasts is 6.8% while for FY14 it is 7.7%.
See also, UGL Shakes Up Market With Corporate Review on March 27 2013
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