A Golden Era For Engineering Services?

This story features VENTIA SERVICES GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: VNT

Defence, energy, digitalisation industries collide with sustainability to provide a very positive investment spending backdrop for Australia’s engineering services companies.

-Major infrastructure spending is back
-Defence budgets on the rise due to geopolitics
-Net zero targets equal more investment
-The future is digital
-Which companies are set to benefit?
-Worley chasing the sustainability dollar

By Danielle Ecuyer

Ramping up investment in Australia’s future

The rather un-glamorous sector of engineering services might be entering a golden era of major infrastructure spending across what can only be considered as “critical” industries for Australia’s well-being and future.

A big topic with even bigger financial carrots is hanging in the offing. 

In the latest deep dive sector research conducted by RBC Capital, focusing on “disruptive forces”, the broker explores opportunities for engineering services in the defence, energy and digitalisation industries.

The report offers a cursory observation of the shifting sands of geopolitics, explains the need for energy systems to be decarbonised and climate event resilient, as well as the ongoing rise of digital demand across industries, including the burgeoning growth in data centres.

These factors underpin sizable tailwinds for companies exposed.

RBC takes a top-down approach to set the scene for why its analysts have initiated coverage on Ventia Services Group ((VNT)), Downer EDI ((DOW)) and Service Stream ((SSM)); each in possession of downstream exposure to the industries mentioned.

Goldman Sachs shines an ESG light on Worley ((WOR)) investigating whether the company is an “underappreciated solutions provider” to the global greening agenda.

Industry-by-industry outlook

Defence budgets are rising in Australia.

Around 18-months ago I sat with a renowned stockbroker for a coffee at Sydney’s Australia Square who explained to me just why Darwin was the hot new investment capital of Australia.

His observations were prescient.

RBC highlights rising geopolitical tensions, think China/Taiwan as one example in the Indo-Pacific region, which are leading to substantial investments in infrastructure. Australia has consistently spent between 1.8% to 2% of GDP on defence  over the last 20 years, compared to the US at 3.5% and Russia at 4.1% of GDP in 2022.

The latest estimates from the 2024 National Defence Strategy and 2024 Integrated Investment Program explain a $5.7bn rise in defence spending over the next four years and an increase of $50.3bn over the next decade. 

This equates to a rise in spending to 2.4% of GDP by 2033.

RBC explains the opportunities for Ventia, Downer and Service Stream that exist through the $14bn-$18bn spend for the infrastructure and adjacent facilities for the Northern Territory Bases; the $17bn-$18bn on what the broker refers to as enabling facilities such as training, and $15bn-$20bn in Theatre Logistics.

At the midpoint of $53.5bn, this implies only 14% of a total $375bn has thus far been allocated.

Notably, Darwin is rated highly as a significant strategic location and contractors with existing Defence relationships tend to have more “sticky” contracts given the high barriers to entry.

RBC points to the top five defence reportable contract providers as BAE Systems, Boeing, Ventia, RTZ (formerly Raytheon) and Thales.

Tackling decabonisation

When it comes to the carbon challenges for Australia’s energy infrastructure, multiple factors come into play in meeting the country’s legislated greenhouse gas emission targets for a -43% reduction versus 2005 levels by 2030, and net zero emissions by 2050.

The government is targeting 82% renewable energy in the Australian electricity grid by 2030 with RBC explaining renewable energy produced reached 31.4% in 2Q24 based on National Electricity Market data. In 4Q23 it was as high as 42.7%.

Coal fired power stations are reaching the end of their “useful life” and up to 90% of them are forecast to retire before 2035, and the entire fleet before 2040.

Replacing coal fired power stations requires new utility scale generation and storage because of the intermittent renewable energy generation. This decade the grid has added 12.5GW of new generation and 1.3GW of storage with 490km of newly constructed transmission lines.

Current coal fired power stations have 21GWs of capacity, so a mind boggling 20GW of generation and storage with 2090km of transmission lines need to be built.

RBC details the added complexity of the changing demand forecasts. Residential consumption from the gird is anticipated to be basically flat in 2050 because of rooftop solar.

Business, industry, the switch to electrification and emerging hydrogen production are forecast to add additional demand of 45Twh, 65Twh and 55Twh, respectively.

Nuclear energy was placed on the agenda in June by the Liberal Party. This is not viewed a realistic opportunity for Ventia, Downer or Service Stream.

Going digital is a journey

In the latest iteration of the National Broadband Network, the Commonwealth Government announced an additional optic fibre to 1.5m premises or a $2.4bn investment to transition to fibre-to-the-premise from fibre-to-the-node.

Currently 6,000 homes/businesses are upgrading each week, including yours truly a few months ago. In June 2024, 2.3m premises had the new connection with an additional 3.5m premises anticipated by June 2025.

While your mind is probably debating how good or bad the NBN is, ultimately the future lays in the fastest connectivity for devices and use of generative artificial intelligence.

Enter one of the biggest investment spends this decade: data centre build outs. FNArena has written extensively on the topic, see also the dedicated Gen.Ai section on the website: https://fnarena.com/index.php/tag/gen-ai/

Suffice to say energy supply is integral to the build out, as are defence and cyber security.

RBC points to the 2023-30 Australian Cyber Security Strategy which highlighted during the 18-months to December 2023 one cybercrime was reported every six minutes. Ransomware causes -$3bn in damages to the Australian economy every year.

The estimated cost to businesses is advancing at circa 14% per annum.

The broker believes part of the solution is improvements and/or construction of digital infrastructure. Since June 2019, aggregate data consumption has increased at 1.20% compound average growth rate and is only expected to rise.

Just think how many streaming services are in your house.

In the Defence sector digital infrastructure is used via defence data centres, the cloud such as AWS or Microsoft Azure, and hybrids of data centres and the cloud.

Ventia: the all-rounder with quality tilt

Ventia Services Group was created from a merger in 2015 between Leighton Contractors Services, Thiess Services and Visionstream. In June 2020, in what was a reverse takeover, Ventia acquired Broadspectrum (formerly Transfield) from Ferrovial for $465m. The company IPO’ed on November 18, 2021.

Current market capitalisation stands slightly below $4bn with 35,000 people in action across 400 sites in A&NZ. The suggestion made is Ventia occupies a sweet spot for investors with favourable exposure across the three major infrastructure sectors.

Highlighting the strength of the group’s defence exposure, Canaccord Genuity detailed a six-year, $564m contract with the Department of Defence for firefighting services. It is a continuation of an existing contract, starting in 2004 with options to go past 2030.

The new contract at around $94m p.a. marks an increase of $35m-$40m p.a. and represents one of five contracts the group is seeking to renew with the Department of Defence, valued at around $550m annually in defence property and asset management services.

RBC explains Ventia is the largest engineering services company to Defence currently, managing 60k plus social housing units in NSW, and with the largest private firefighting unit domestically. The company services all four of the defence departments including Digital Group, Joint Logistics Command, Security & Estate and Capability Acquisition and Sustainment Group.

Looking at the company’s first half results, Canaccord stated strong growth in Defence & Social Infrastructure and Telecommunications boosted 11% growth in revenues and a 9% increase in EBITDA. Macquarie observed the results met expectations with an upgrade to 2024 guidance to 10-12% from 7-10%, although consensus was already positioned for 11% growth pre the result.

Morgans noted the results were slightly below expectations and consensus but with $17bn work-in-hand the outlook is for earnings growth across all sectors the group operates in.

Ventia is highlighted by RBC as being the provider for Transpower NZ’s Transmission Grid Services (the high-voltage transmission network) for around 25-plus years. The contract was renewed in May 2022 for another five years with an additional five-year option.

RBC envisages the group can make inroads into the Australian market. With a relatively smaller share, it will benefit from growth in the overall market, as outlined in the expansion for the domestic transmission line network.

Regarding the digital exposure, Ventia has designed, installed and commissioned over 50,000kms of fibre across Australia and connected around 6m premises to the network.

With “vast” wireless capabilities and skills in fixed network technology and energy infrastructure, RBC believes Ventia is “well positioned” to service both energy needs and service digital infrastructure.

FNArena daily monitored brokers are all Buy-equivalent rated, except Ord Minnett with a Hold rating. 

RBC Capital initiated coverage with an Overweight rating and a $5.25 target price. The analyst explains a track record of stable earnings, shareholder returns and a position to benefit from structural tailwinds offset a perceived negative by some, as well as a  lack of time in the public market.

The FNArena consensus target price is $4.56 with Canaccord at $4.75 and Buy rated. At current price levels ($4.56) the stock is trading on 2025 prospective price-to-earnings ratio of 16.4x and 4.5% dividend yield.

Downer EDI: Can what’s old be new again?

RBC details the transition Downer EDI has been conducting with new CEO Peter Thompkins, including exiting the Rail Freight and Mining businesses, the divestment of -70% of its commercial laundry business and addressing ICAC investigations and accounting anomalies. The company is now concentrating on Transport, good for around 52% of FY24 revenue, Utilities at 20% of FY24 revenue and Facilities at 28% of FY24 revenues.

Management is also implementing a -$175m cost out program in FY25 with a target EBITDA margin over 4.5% for FY25/26.

The share price has been responding from a low around $4 in January to current levels around $5.75 which equates to a $3.7bn market capitalisation.

Drawing a comparison with Ventia and Service Stream, RBC’s analyst emphasises Downer has a more “capital-intensive approach” to its business model, leaving it open to greater construction risks while the road services business needs more fixed assets.

FNArena daily monitored brokers, Ord Minnett, Macquarie and UBS, acknowledged management’s profitability enhancement targets at the FY24 results, which Macquarie viewed as better than consensus expectations.

UBS pointed to depletion of low-cost contracts in water and Vic gas as benefiting the company alongside its cost out program. While Ord Minnett pointed to the priorities in the energy transition and utilities segment.

All are Hold-equivalent rated with an average target price of $5.623. At current price levels, the stock is trading on a FY25 prospective price-to-earnings ratio of 14.3x and a 4.1% dividend yield.

RBC initiated coverage with an Hold-equivalent rating and $6 target price.

Service Stream slides into other sectors

With a long-established exposure in telecommunications where NBN represented 74% of FY24 telecommunications revenues and wireless the balance, Service Stream’s strategy as detailed by RBC is to expand into other industries such as utilities including water, industrial and electricity, roads transport and more defence, recently.

Add-on acquisitions are part of the strategic thrust with Comdain Infrastructure in 2018 ($160m) and Lendlease Services in 2021 ($310m). As the company diversifies its earnings stream, RBC believes a re-rating is possible.

Macquarie observed at the FY24 results Service Stream secured over $2.2bn in contract works over the period and earnings rose 13.2% on a year earlier, some 2.85% above the broker’s forecast due to strength in telco and utilities. Going into FY25, the work-in-hand pipeline reached $5.2bn across all major markets. 

Citi was equally upbeat, highlighting no shortage of positives from FY24 results, notably robust cash conversion, better utilities margin and an improved 2H24 telco performance.

Ord Minnett highlighted a strengthening balance sheet with an increasing share of revenue generated from less-capital intensive operations and maintenance works at 70%. This allows for improved transparency of earnings and cash flow.

The FNArena consensus target price stands at $1.593 with two buys; Citi ($1.70 target price) and Ord Minnett ($1.67 target price). Macquarie has a Hold-equivalent rating ($1.41 target price).

Service Stream has around a $960m market capitalisation and trades on FY25 prospective price-to-earnings ratio of 16.1x and 3.6% dividend yield.

Sustainability funds hold a US$2trn key for companies

Goldman Sachs estimates the Sustainable Fund universe is worth US$2trn with a wider ranging classification of Sustainable assets under management across asset classes under different mandates and strategies from PWC and GASIA at US$18trn and US$30trn, respectively.

For Worley ((WOR)), the classification of “sustainability” has implications for the stock’s re-rating potential, the broker explains. The company is currently “36% underweight by global sustainability funds” against its benchmark weighting.

Worley is highlighted for the FY26 goal to generate 75% of revenues from sustainability-related projects compared to 52% in FY25.

Due to investor feedback at the FY24 August earnings presentations, Worley has broken down sustainability-related categories into “transitional”, essentially natural gas, and “sustainable”.

Goldman Sachs explains the company’s category of “sustainable” ex “transitional” represents 34% of aggregated revenues in FY24. The broker also views the role of natural gas as a significant transition fuel to firm renewables as energy supplies transition from coal-fired power generation.

Under the EU’s Corporate Sustainability Reporting Directive Regulation from FY26, the new Worley classification has the potential to attract increased Sustainable Fund ownership, the analyst argues.

Addressing concerns over a slowdown in near-term green capex projects, Worley’s sales pipeline is viewed as “solid” with a slant towards sustainability-related works at 41% as at June end and 44% transitional, or 85% in total. 

Equally, the broker estimates $4.2trn of annual incremental green capex is required this decade to achieve global net zero, water and infrastructure goals. 

Worley’s exclusion from Sustainable Funds relates to a view the company is still oil services based, despite the shift to more sustainable projects and a legacy Ecuador business. 

On balance, the broker believes Worley is a green enabler for higher emitting industries, Energy, Resources and Chemical, with potential to build low carbon businesses and/or reduce the environmental footprint, by employing its low carbon expertise.

At the latest 3Q2024 update, Worley revealed a decline in 2H24 backlog and lowered FY25 expectations. Goldmans Sachs observes it’s a “cyclically challenged” macro environment. The CP2 LNG terminal project by Venture Group LNG could generate over $6bn to the company’s backlog as the project edges towards a final investment decision.

Macquarie believes Worley will reiterate FY25 guidance at the upcoming Nov 21 AGM for a split of net profit of 45:55 between 1H25 and 2H.

The broker expects 5% revenue growth over the current fiscal year versus double-digit growth in FY23/FY24.

FNArena daily monitored brokers all have a Buy-equivalent rating with an average target price of $18.26. Goldman Sachs is also Buy rated with an $18 target.

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