Australia | Oct 21 2013
-Plans for DTZ to grow in US
-DTZ lacks sufficient scale
-Engineering subdued
-Little upside envisaged
By Eva Brocklehurst
Engineering and property services business UGL ((UGL)) has briefed investors on the developing DTZ de-merger and the opportunities that are presenting in the global property services market in which DTZ operates. The company has reiterated its intention to hive off DTZ by the end of 2014 and looks forward to expanding in the US market. Brokers are finding it hard to get excited. A de-merger makes for a rather forlorn core engineering division in the current climate.
Brokers have been informed that the highly fragmented US commercial real estate market is in the throes of an outsourcing trend, while high-margin transactions are increasing. Management believes DTZ will be able to grow without tackling the share held by the two major players, Jones Lang LaSalle and CB Richard Ellis. Citi, for one, believes DTZ lacks scale at this stage in the US market and margin expansion will depend on the ability to increase scale. Corporate transactions account for 27% of DTZ's revenue and generate earnings margins of 9-12%. In number terms, the broker suggests DTZ has 240 US brokers and needs 1,100 to achieve critical mass. In comparison, CB Richard Ellis has around 3,000. Management acknowledges acquisitions will be required but the timing of such will likely be after the de-merger occurs.
The trouble is, UGL is facing headwinds in resources and infrastructure for its engineering business and this, in turn, means it is reliant on property service to drive earnings growth. The stock's share price seems to retain what upside there is from the planned de-merger, so brokers are asking: where's the value going to come from? The stock trading on 1.3 times FY14 consensus earnings so looks fair valued. Stay Neutral, is Citi's opinion.
Divorce, no matter how amicable is expensive, according to CIMB. There may be a rationale for splitting the assets, as that provides more focus for the individual business units as well as offering potential for merger & acquisition, but there's a cost. Higher expenses and reduced diversification mean challenges mount for the engineering business.
What's also of concern to CIMB is that the timetable to de-merger is taking precedence over other concerns. An equity raising is not out of the scheme of things if it means adhering to the planned timetable. The prospect of a capital raising, coupled with continued difficult operating conditions for the engineering business, means the stock will underperform its peers over the next 12 months. The engineering division continues to operate in a difficult market. This may be cyclical, but the broker believes the down cycle has at least another 12 months to run.
CIMB does not think the market has been sufficiently undervaluing UGL's property business relative to the big two players either, and thinks a discount is justified for the lower size and global scale. This means there is no significant valuation arbitrage from current share price levels to come from corporate activity. On the broker's best case scenario, there's 11% upside potential on current pricing. CIMB estimates a break up valuation of $8.13 per share under the best case scenario, which assumes many things. These assumptions include 5% upside to base FY14 property and engineering earnings estimates, FY14 peer multiples of 11 times for property services – that's the average of the two majors — an 8.0 times multiple for engineering, an additional $10m per annum in corporate costs after de-merger, and $40m in one-off de-merger costs.
Macquarie also notes the need for scale, with the market tending to gravitate to the larger players which have the size, coverage and systems to meet the increasingly global property needs of major clients. The top four have 22% of the $60 billion outsourced property services market. DTZ is one of these at around 3-4% so the fragmentation is substantial. Outsourcing remains a key trend, driven by the lower cost and improved efficiencies which sector specialists can provide.
UGL is targeting over 6% margins in the long term, with an opportunity to achieve 7% margins for the blended DTZ business (5.9% in FY13). Macquarie thinks the de-merger date is allowing time for UGL to deliver on improved earnings and reduce debt, via an improvement in the performance of working capital, lower capex and $60-80m in asset sales. The broker expects FY14 to be a better year for earnings. Nevertheless, the relatively high gearing and net debt is likely to remain a focus for the market and Macquarie thinks valuation upside from the de-merger remains limited.
Moreover, the engineering market is still weak. The NBN, roads maintenance and residential markets may be getting better but, Macquarie counters, these are not areas where UGL is a key player. UGL is seeing some recovery in coal maintenance markets but high gearing and net debt are likely to remain a focus of the market and Macquarie concludes that upside from the de-merger appears relatively limited using current peer multiples.
On the FNArena database there's no Buy rating. There are four Hold and three Sells. Price targets range from $6.30 to $8.46 with the consensus target at $7.70, signalling 2.1% downside to the last share price. The dividend yield on FY14 forecast earnings is 6.2% and on FY15 it's 6.6%.
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