Cardno Downgrade Sparks Fears For Dividends

This story features CARDNO LIMITED. For more info SHARE ANALYSIS: CDD

-No upturn seen for 6-12 months
-Heightened gearing of concern
-Takeover target?

By Eva Brocklehurst

The warnings keep coming. Engineering contractor and project manager Cardno ((CDD)) has downgraded FY15 profit guidance to $48-51m, the mid point of which implies a decline of 37% on FY14. Second half profit looks likely to be half that of the first half.

The major reason for the downgrade is a combination of factors in both the US and Australian markets, such as weather-induced delays, slow oil & gas markets, lower recovery in infrastructure spending and increased competition. Slower realisation of cost savings from the new business centre in Denver has also added a negative.

Moelis has a Sell rating and $2.30 target. Value may be emerging, but with no permanent CEO the company is likely to be of interest to a predator. Debt is the primary issue, in Moelis' view. The broker has reduced estimates for FY15 and FY16 by 15% and 25% respectively. One of the reasons the company provided, and of most concern to Moelis, was the underperformance of the US business and the $200m impairment charge against the carrying value of its US and Ecuadorean operations. While management has stated that the impairment will not affect debt covenants the broker suspects financing margins may increase.

Leverage appears uncomfortably high and if cash flow does not improve there is a perceived risk of an equity raising, which would put further downward pressure on the share price. Difficult conditions are expected to continue for the next six to twelve months. A pick up-in Australian infrastructure spending is a FY16-17 story, in the broker's opinion. A recent change of state governments in Queensland and Victoria is expected to dampen investment in infrastructure while NSW remains the bright spot.

The US business is also of particular concern for Deutsche Bank. There has been a slowdown in oil & gas work and a slower conversion of the backlog into project starts, as well as increased competition in the testing services business. This also points to underperformance of recent acquisitions. if cash conversion does not improve materially over the second half, Deutsche Bank envisages a risk to dividends. Australian conditions are tough and the broker agrees the expected recovery in infrastructure spending has been slow to get going.

The second half dividend might be suspended. That's JP Morgan's view. The headroom on lending covenants has likely narrowed and it is unclear to the broker whether capital expenditure/working capital investment has been reduced to maintain compliance. Moreover, further risks are still likely from a contraction in margins across resources projects, as well as Australian infrastructure deferrals and the potential stock overhang created from suspending the dividend, given the high retail holdings. JP Morgan also flags the lack of a permanent CEO. 

Macquarie contends the high-margin construction materials testing business in Australia has been hit hard. Moreover, it remains too early to calculate the full customer reaction to commodity price declines, particularly in oil. Macquarie does not expect an improvement until the second half of FY16, with reduced restructuring costs and a reduction in losses from loss-making businesses as well as a lower exchange rate. The magnitude and timing of the downgrade has tested market confidence but Macquarie highlights the fact the stock is trading at a discount to its larger peers and retains a Neutral rating.

The valuation is fair in the context of a 27% fall in the share price, in Goldman Sachs' view. Hence, the broker also has a Neutral rating. Earnings risk around the large fall in oil prices is partly mitigated by the lower Australian dollar and the cycling of a weak FY15 base, which is impacted by some timing issues.

Where are the more positive analyses? Morgans, for one, has an Add rating. While the extent of the downgrade was greater than expected, and the broker concedes investor confidence will need to be re-built, there are potential catalysts. A reputable CEO appointment – expected mid year – and an improvement in the backlog would be a start. Moreover, the broker suspects the company's global footprint, particularly in environmental services, could attract a buyer, particularly post impairments, which could also be viewed as cleansing the balance sheet.

Morgans assumes FY16 revenue growth is flat and margins improve primarily from office consolidation and cost cutting. Cardno did confirm it expected $10m per annum from US consolidation cost benefits. Longer term, Cardno is well positioned to benefit from an increasing need for environmental regulation and improving economic conditions. Still, there are risks and Morgans cites subdued investment, both public and private, and challenges to integrating acquisitions.

UBS is more bearish. Guidance can only imply that the Australian operations have been structurally impaired by the deterioration in the mining cycle while North American operations are being hurt by the decline in the oil & gas business. The broker downgrades to Sell from Neutral. Balance sheet concerns are a particular risk as, while Cardno refinanced its debt this year and has sufficient capacity ,it is an asset-light engineering business. As such, a net debt to earnings ratio at or above 3.0 is of concern. UBS does not expect a dividend in the second half, nor in FY16 and FY17.

FNArena's database has two Buy ratings, three Hold and one Sell (UBS). The consensus target is $3.23, suggesting 40.5% upside to the last share price and has fallen from $3.71 ahead of the update. The dividend yield on FY15 forecasts is 8.6% and on FY16 it is 8.3%.
 

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