Australia | Jun 07 2016
-Possible loss provisions up to $200m
-Infrastructure aids more positive outlook
-Yet smaller size makes UGL vulnerable
By Eva Brocklehurst
UGL ((UGL)) has thrown a spanner in the works of broker forecasts, advising that commercial negotiations of claims surrounding the Ichthys contracts are becoming protracted. In the absence of a near-term resolution, the claims will have to be concluded via a formal dispute process and the company advises that this could lead to potential loss provisions of up to $200m.
UGL has been in serious negotiations on the SMP (structural, mechanical and electrical package) contract for the last few weeks and submitted the CCPP (combined cycle power plant) claim 1-2 weeks ago, yet management is not confident negotiations will be completed by the end of FY16.
Morgan Stanley's advice to investors is: wait. The company is highly sensitive to the level of costs, if at all, it can absorb. The broker observes this leads to widely divergent scenarios and potential valuations. Risks are likely to have increased but, equally, UGL may be too pessimistic in its assessment. The broker is mindful that no provision has yet been taken. An update is expected by the FY16 results in August.
Given the uncertainty, the broker limits its reductions in forecasts to those costs evident in the update. FY16-18 forecasts fall 4-38% after removing the implied profit contribution from the Ichthys SMP contract. Morgan Stanley no longer assumes UGL will resume dividend payments from FY17.
Further back in 2014 the company had problems, which new management made progress on cleaning up, and Morgan Stanley believes the business is now on a firmer footing. Nonetheless, the admission that a further $200m could be required for work at Ichthys, while still hypothetical, appears to unravel much of the goodwill that has built up.
When the Ichthys contract was signed in 2014 UGL was a larger business, owning DTZ at the time. Now it has less capacity to absorb problem projects. Reflecting on this state of affairs, Morgan Stanley estimates, on a post-tax basis, a $200m provision could wipe out around one third of the equity. This, the broker asserts, coupled with even a small deterioration in the underlying business, could mean the viability of the capital structure may be challenged.
Macquarie takes a dimmer view of the near to medium term, expecting uncertainty will persist until the project moves closer to completion, around 18 months away. The potential provision assumes no negotiated settlement but rather a formal process, which would take a long time to resolve, given other similar situations in the sector. Hence a double-downgrade to Underperform from Outperform.
The broker acknowledges the company's infrastructure exposure means it has a more attractive earnings outlook compared with many of its more resource-exposed peers but believes, in line with the view espoused by Morgan Stanley, UGL is now of relatively small size and the positive macro outlook needs to be balanced by the ongoing risks at Ichthys.
The one positive aspect of the update Macquarie draws on is that the underlying business is tracking to plan, with guidance reiterated. UGL anticipates a 4% margin in FY17, on revenue growth of at least $300m, excluding Ichthys.
Deutsche Bank is disappointed at the turn of events, but suggests the current share price is already factoring in the worst case scenario of an additional $200m in costs. The broker's revised forecasts assume $21m in additional costs on the Ichthys contracts, with the SMP contract not contributing any earnings in FY16 and FY17. This leads to forecast downgrades of 17% for FY16 and 14% for FY17.
Even under the worst case scenario net debt would peak in December this year and Deutsche Bank does not believe the company would be in breach of any debt covenants. The broker retains a Hold rating and considers the risk/reward balanced.
Citi downgrades profit forecasts by 11% and 13% for FY16 and FY17 respectively. The broker calculates that incorporating another $200m in provisioning into forecasts would push FY16 into the red and send gearing above 20%.
The consensus target on the FNArena databases is $2.36, signalling 2.4% in upside to the last share price. This compares with $2.66 ahead of the update. Targets range from $2.05 (Morgan Stanley) to $2.65 (Deutsche Bank). There are three Hold ratings and one Sell (Macquarie).
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