Forge Outlook Blackened By Latest Downgrade

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-Brokers pull back hard on expectations
-New equity considered most likely
-Takeover possibility looms

By Eva Brocklehurst

Two weeks is a long time in the mining services sector these days. Forge Group ((FGE)) has been diversifying its exposure away from the Western Australian mining services sector but the ill winds that have plagued that sector have come back to haunt the company. Two weeks after downgrading earnings forecasts to $45-50m for FY14, Forge has announced it will now make an earnings loss of $20-25 million. This is the third write-down in two months. Brokers have called Whoa! The construction, electrical and engineering contractor now looks to be in line for some painful medicine, definitely new equity and maybe even a takeover is on the cards.

The company stated it needed to generate cash flow and this is affecting profit margins. While there was no update on debt levels the company did say it had the support of its banker. Nevertheless, the downgrade brings to the forefront another capital raising. Macquarie notes Forge has appointed Euroz to advise on its options – which includes the possibility of a third party interest in the company. Macquarie retains an Underperform rating on the stock and believes new equity is what's required.

The company is undertaking major work on two power stations, Diamantina and West Angelas, which has not been finalised. Work is due to wrap up at the end of FY14. The deterioration in the balance sheet started last November when the company announced a $127m write-down on the West Angeles and Diamantina projects, which forced ANZ Bank ((ANZ)) to step in with additional funding. For some brokers the writing was on the wall in December but the company's recent large contract win, at Roy Hill, appeared to stem the deterioration in terms of confidence. Macquarie has warned that history suggests losses on fixed-price contracts are difficult to estimate until the job is completed.

It was looking good back in September when FNArena reported on Forge after it won the key contract at Roy Hill, worth $1.47bn, in joint venture with Spanish operator, Duro Felguera. The company now signals that joint ventures and projects are being impacted by the threadbare balance sheet. Citi observes the turnaround in fortunes is the result of industry-wide margin pressure, project losses and a focus on cash flow rather than profitability, given recent write-downs. The broker considers the company has poor visibility because of weak reporting systems. Citi also believes the impact of the downgrade means near-term funding capacity is exhausted and another heavily dilutive equity raising is almost a certainty. The company may have a solid $1.5bn order book, positive in terms of forecast revenue, but the inability to convert this to profit is a key risk, in Citi's view.

Citi notes Forge has appointed advisers to field bids for the business but, given the gearing and the damage to the company's reputation, along with eroding valuation, the broker doubts this will provide the panacea shareholders need. The broker does not consider the company is investment grade at present and has downgraded the rating to Sell/High Risk from Neutral/High Risk. The turnaround, just two weeks after confirming guidance, has caused Citi to question the operating systems in place and consider the risk of further material contract losses. Moreover, Citi believes the reputation in the Perth marketplace is tarnished as solvency is now the issue.

Showing how quickly a once enviable position can erode, back in September brokers were even contemplating that, with such a strong order book and improved cash position (June results), the company may be able to increase dividends, or even acquisitions. On the FNArena database there are three covering the stock – with two Sell ratings and one Hold (CIMB). The consensus target price is 49c which signals 36.8% downside to the last share price. This target compares with 71.7c ahead of the latest update.

See also, Forge Graduates To The Big Time on September 3 2013.
 

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