Australia | Aug 14 2013
-Will separation aid re-rating?
-No conglomerate discount for UGL
-Gearing needs to be reduced
-Resources downturn could hang about
By Eva Brocklehurst
There's a lot of work ahead for the engineering and infrastructure conglomerate UGL ((UGL)). The company must not only negotiate the headwinds from a downturn in mining related activity but also justify its decision to separate DTZ (property division) from the Australian-based engineering operations, to be completed some time in FY15.
The FY13 results and outlook confirmed that formidable challenges lie ahead in order to harness all aspects of the business to the growth driver. Normalised profit was $86.3 million in FY13, down 49%. Of the divisions, engineering surprised on the upside for JP Morgan, which suggests cost cutting was better than expected. Operations and maintenance remain under pressure from the pull back in resources and energy spending and there are subdued conditions for infrastructure. The weaker DTZ result reflected stronger-than-expected growth in lower-margin facilities management and slower-than-expected cost cutting. On the broader results, higher-than-expected operating cash flow performance was offset by a materially weaker dividend. UBS expected 11c. Macquarie expected 20c. The company declared 5c.
For brokers, management will need to show just how value can be redeemed from a de-merger as well as coping with the challenges ahead. CIMB thinks the market will start to look at factors such as higher costs associated with a second listing, the debt that can be carried by separate entities and, in the midst, an engineering business coping with a commodity downturn. The broker understands the rationale behind the de-merger, just not the benefits that the board is anticipating. The two divisions are finding it difficult to pursue different strategies under a single banner and the broker concedes investors may want to choose more pure investment exposures. On that basis, a potential re-rating of each part could be greater than the current sum of the parts. CIMB is just not sure about that. The next year will be critical to this debate as the performance of the engineering business could dictate what multiple investors may pay for this division as a stand alone entity.
Citi also falls in with the view that de-mergers should unlock value where a conglomerate discount applies. It's just there's no material discount in UGL's case. A de-merger may increase future merger & acquisition opportunities and the separate listing would command different multiples. In the broker's view the DTZ business would trade at a premium to the engineering business given the lower risk profile, superior growth outlook, higher margins and strong cash flow. It's just that neither of these businesses rank high on a global comparative scale. DTZ lacks the global reach of CB Richard Ellis and Jones Lang LaSalle, the top two market players by market share. Hence, the broker thinks DTZ deserves to trade at a 5-15% discount to these two.
Engineering also lacks scale, while the core markets of resources, rail, infrastructure and operations & maintenance are in decline. Moreover, Citi believes, while operations & maintenance has good capability, the track record on large engineering projects in the resources and power sectors in recent years has been poor. Key to the timetable to de-merge will be a reduction in debt to ensure the businesses are conservatively geared and retain an investment grade credit rating. The company intends to reduce gearing but UBS suspects that, even with potential property sales, there may be a need for a capital raising as part of the de-merger process. On Citi's numbers, in the absence of an M&A bid premium, a de-merger would be unlikely to create significant shareholder value.
CIMB does not agree with management's base case that the bottom of the resource-related activity has been seen. The broker thinks the down cycle will run for several years more. Some LNG-based work may offset the slow down but the broker is not optimistic that will deliver enough. This has triggered a re-rating to Underperform from Neutral. Partly affecting this re-rating is the belief that other stocks in the sector offer better value.
On the FNArena database the stock has just one Buy recommendation. The rest consist of four Hold and three Sell. The consensus target price is $7.84, suggesting 3.9% upside to the last share price. This compares with a target of $8.43 ahead of the results. The dividend yield on consensus earnings estimates for FY14 is 6.6% and for FY15 6.9%.
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