Forge Graduates To The Big Time

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-Big contract raises confidence
-Revenue forecasts well covered
-Cash position improved
 

By Eva Brocklehurst

Construction, electrical and engineering contractor, Forge Group ((FGE)), has won a critical contract which puts the company on a very strong footing. Forge has been craftily diluting its exposure to the Western Australian mining services sector over the past 18 months but still, this contract is a big one and elevates the company's order book to $2.1 billion. Of this, brokers estimate $1.1bn is in hand for FY14.

The latest contract is worth $1.47 billion and is to be performed in joint venture with Spanish contractor, Duro Felguera. The contract is with Samsung C&T and the ultimate client is the Roy Hill iron ore joint venture. Forge's share of the spoils is $830m, easily its largest job. Macquarie expects $300m of revenue will fall in FY14. The full works under the contract terms will not be ramped up until Roy Hill has confirmed debt financing. Nevertheless, the fact the contract was publicised, along with announcements from other contractors in relation to the project, suggests to CIMB this major project is on the starting block.

Diversity has been the blessing for Forge. Macquarie suspects the fact the company covers power, oil and gas, iron ore, coal and metals sectors and has a global footprint, particularly in the US, means revenue can be maintained in the current resources downturn. For FY14, the broker is forecasting revenues of $1.2bn, including Taggart. The order book excludes the $221m Coalspur contract, where Forge is the preferred contractor. Including this contract, Macquarie estimates Forge would have 100% of FY14 revenue forecasts in hand.

This is an enviable position in CIMB's view and shows Forge is ready to play with the big guys. The broker is not yet prepared to crunch the forecasts higher but is increasingly confident. More than 90% of projected revenue is covered in both FY14 and FY15 and CIMB can't think of another contractor with this much revenue certainty. Margins are a dark area in this contract, given the heightened competition in the tender process, but the broker notes Forge had early involvement in this project via the joint venture with Clough ((CLO)) and should know the dynamics. Provided the market remains comfortable about the margin on the contract and Forge's ability to execute, the broker sees little obstacle to a re-rating.

The stock continues to trade at more than a 30% discount to the contracting peer group but CIMB notes the peer group has a relatively lighter order book average. CIMB applies a 20% discount to comparative peer multiples, given the stock's size and liquidity. Any material win, such as in Thailand where the company has entered the power sector but is yet to announce any contract award, would be materially incremental to the broker's earnings forecasts. Moreover, assuming the Taggart business is able to roll over it coal maintenance contract book and create further contract wins for the company in North America, it can only add to revenue coverage.

Citi also thinks the price/earnings re-rating is likely. Despite the recent rebound, the stock is still cheap. Citi removes the discount to peers that was previously applied. Forge has historically traded at a discount to contracting peers. Initially because it was a small starter in a boom market – it's only been around six years – and then because the market was waiting for Forge to trip up, given such rapid growth. With the Roy Hill contract and recent wins with top miners such as Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals ((FMG)), plus an increased proportion of asset management earnings from the Taggart acquisition, Forge is now deserving of a multiple in line with peers, in Citi's opinion.

Moreover, the improved cash position might lead to… dividends and/or more acquisitions? At 30 June Forge reported cash on hand of $104m, enough capital to mobilise and provide bonding for the Roy Hill contract. Whilst this cash number was lower than forecasts because of weak second half cash flow, the majority of the increase in working capital was a function of increased inventories which Citi thinks will be run down in FY14, releasing additional cash onto the balance sheet. Macquarie also notes a large build up of work in progress which should reverse in the first half of FY14. With a net cash position and 25% pay-out ratio, Macquarie sees more dividends on the horizon, and acquisitions.

Citi's on a Buy rating. So are the other two rating the stock on the FNArena database. Price targets range from $6.25 to $6.74. The consensus target is $6.53, signalling 14.2% upside to the last share price. This compares with a consensus target of $6.15 ahead of the contract news.

Citi sees Forge having growth levers that many others don't. These include the power business roll-out in Asia and Africa, the US asset management business and suite of complementary contracting services.Whilst Forge has had a strong price run over the past two days, the stock was considered oversold on its FY13 result last week, so much of the increase is simply seen as a rebound from an over-reaction.
 

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