-Queries over funding options
-fundamentals remain positive
-Uncertainty in government policy
 

By Eva Brocklehurst

G8 Education ((GEM)) has been accumulating child care centres at a racing pace but broker enthusiasm has waned somewhat. The highlight of the 2014 results was a strong increase in dividends. Dividends will be fully underwritten over the short term to retain balance sheet capacity and flexibility.

The main issue as far as UBS is concerned is the company's ability to source funds for future acquisitions. G8 Education has announced another $29.9m in acquisitions and the broker estimates there is $26m in cash at hand, ahead of free cash flow and dividend investment plan (DRP) underwriting. Based on the broker's analysis, the company can fund the acquisition of 75 centres annually, via a mixture of cash, free cash flow and the underwritten DRP. UBS retains a Buy rating and believes the market, having sold off the stock after the results, is taking a short-term negative view about the company's ability to consolidate the child care industry at the same rate it has managed over recent years.

Citi is concerned about the pace of acquisitions, finding it hard to assess the trend in underlying earnings. Organic growth figures exhibit solid top line growth and operating leverage, but these older centres now represent just a third of the current run rate. The company has signalled strong fee increases across the portfolio and, in the short term, revenue may rise ahead of costs, but Citi expects a clawing back in income as new child-to-staff ratios commence in 2016. How easily the industry can pass through additional costs will depend on government funding policy. The broker is not convinced that the consolidation strategy provides investors with enough value and retains a Sell rating.

Another risk the broker highlights is the Singaporean debt totalling SGD260m. The headline interest cost at 4.75% may look attractive but this debt has not been swapped back into Australian dollars and the company has taken on the currency risk. Citi warns that, by not hedging, interest costs are more attractive but a depreciating AUD/SGD will likely destroy shareholder value.

Macquarie observes that obtaining debt for child care assets in Australia has always been a challenge. Banks require a right of entry clause on the lease in order to lend to operators. As G8 Education acquires the operations as opposed to the property many centres have legacy lease terms, so this clause is regularly omitted. Hence, this has led the company to source unsecured corporate notes as opposed to standard secured borrowing. Macquarie considers the debt position is manageable, but further funding will be required to maintain the growth trajectory into 2016. Any further material acquisitions in 2015 are likely to require another round of equity funding, in the broker's view.

Positives exist in macro terms around child care and the consolidation opportunity, in Macquarie's view. Margins are strong too, as the company leverages the scale benefits of a larger network. Nevertheless, the broker does caution about increased competition, uncertainty over the federal government's response to the Productivity Commission report on child care and narrowing capital management options, which could put downward pressure on the stock in the near term. While still expecting earnings to grow at double digit rates in 2015, Macquarie downgrades to Neutral from Outperform.

Deutsche Bank considers the growth outlook has been strengthened by the addition of the 12 new centres and envisages upside earnings risk in 2015. The broker notes the company did not provide 2015 earnings guidance but did signal that the opportunity for disciplined acquisitions remained significant and the company is well positioned. Morgans finds the operating metrics hard to fault and assumes acquisitions of 50 centres per annum, conceding a more accelerated rate would require funding options to be considered. The broker was also concerned abut the FX translation loss in  2014, estimating that if the current spot rate holds, a further post-tax FX translation loss of $4.0m will be required.

FNArena's database has three Buy ratings, one Hold and one Sell for G8 Education. The consensus target is $5.30, suggesting 28.6% upside to the last share price. This compares with $5.83 ahead of the results. Targets range from $4.00 (Citi) to $6.22 (UBS). The dividend yield on FY15 and FY16 forecasts is 6.3% and 7.0% respectively.
 

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-Reducing uneconomic volumes
-But can volumes hold up?
-What if scrap prices fall further?
-Concern over risks to margins
 

By Eva Brocklehurst

Sims Metal Management ((SGM)) has made sound efforts to turn around its business and brokers believe some benefits are materialising, particularly via improved margins in North America.

The first half was, overall, positive. Sims Metal has reduced uneconomic volumes and controlled costs but, while there is a skew to the second half in terms of cash flow, Morgans wants to confirm the improvement before becoming more comfortable. The broker warns the recent slump in the iron ore price is not reflected in the first half results and will become more apparent in the second half. Morgans believes the fall in iron ore will affect end markets and investors will moderate the multiple they apply to Sims Metal's earnings as a result. Much of the company's ferrous scrap is used as a substitute for iron ore in certain types of steel making. The broker advises investors to use current strength to reduce exposure to the stock.

Deutsche Bank hailed the achievement of some ambitious targets from the strategic review, in the US in particular. The broker believes there is significant upside to be had from the US economic recovery. The scrap price may have fallen over the course of 2014 and there may be further downside, which could make the second half tough going, but Deutsche Bank contends these are short term concerns. The broker suggests looking further afield to FY16 and beyond, given the valuation upside if the strategic review is fully implemented.

Near-term headwinds persist but JP Morgan considers the company is better placed now to withstand the challenges. The broker notes earnings margins were an issue over recent years in North America, being only slightly above break-even on average between FY12 and FY14. Margins are now closer to levels achieved in the past and are coupled with margin expansion in both Europe and in e-cycling. The company has indicated it is operating on a strategy whereby sales are contracted with customers before volumes are procured to fill those orders, instead of purchasing intake without the certainty these volumes would be sold.

In summary, this means management is reducing the risk of being caught long on scrap. Nevertheless, JP Morgan considers the effectiveness of such a strategy may be impacted if the availability of scrap declines to a point where Sims cannot access material. The broker also points out that the company actually expects, in the near term, a decline in ferrous scrap prices to have a negative effect on supply and lead to elevated levels of competition for intake. What should mitigate this risk, the broker hopes, is the extensive nature of the company's trading arm.

Macquarie echoes this view, in that market dislocation from lower scrap prices should not carry over the long term. The broker notes Sims Metal is actively moving its model to avoid uncovered inventory positions. In this way, pricing risks are reduced and volume becomes the main driver. The broker observes management is also confident it can maintain margins despite declines in the scrap market.

Citi does not buy this idea and downgrades the stock to Sell from Neutral. With confirmation that foreign exchange rates and volumes are the key levers for growth, the broker cannot look beyond softer volumes in the first half half and the risks to volumes in the second half. The broker forecasts volumes to fall as scrap markets continue to deteriorate. Moreover, when tonnage is only bought if it has been effectively sold forward, there should never be a surprise with inventories, in Citi's opinion. Operating cash flow should have been a beneficiary of falling inventories, generated by smarter supply chain strategies but the broker observes working capital actually grew in the first half, by $24m.

UBS attributes the working capital build-up to seasonal factors. The broker is upbeat, noting Sims Metal is ungeared and should generate annualised free cash flow that implies a normalised free cash flow yield of 7-8% over the next two years. This should provide scope for capital management and/or acquisitions. The broker finds the multiples undemanding and retains a Buy rating.

Credit Suisse is sceptical and found the message for investors to focus on the 2018 target and not worry about short-term scrap market dislocations as vague and disconcerting. The broker remains concerned about the recent record of shrinking tonnage, in evidence despite acquisitions and yard additions. The broker also cannot understand how there will be no tonnage impact in the second half, given both ferrous and non-ferrous prices are now materially lower than the average of the first half. Moreover, Sims Metal envisages no risk to margins in the second half, when there is far less scrap income to be shared around the supply chain. Therefore, the broker believes the company's expectations for flat inventory in US dollar terms are not consistent.

Sims has three Buy ratings, one Hold and three Sell on FNArena's database. The consensus target is $12.14, signalling just 0.1% upside to the last share price. Targets range from $10.40 to $14.18.
 

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-Potential for more UK acquisitions
-Qld competitive but still favourable
-Strong defensive earnings
 

By Eva Brocklehurst

Law firm Slater & Gordon ((SGH)) continues to expand its horizons, both offshore and in Australia. The broadening into general law should enable the company to generate more reliable cash flow and gain access to more opportunities. Morgans notes, up until the recent half year result, Australian general law was a drag on earnings as it did not have the necessary scale for profitability. With scale now in evidence, and with the help of the Schultz Toomey O'Brien acquisition, the division now contributes around $4.2m to earnings and margins should move towards the targeted range of 12-15%.

Brokers are comfortable that full year guidance can be achieved. UK margins are now in line with Australian margins such that in Morgans' view, scale has been reached. Slater & Gordon has announced two new UK acquisitions for GBP18.7m, providing the firm with a dominant position and increased capability in the area of industrial deafness. The two Welsh firms are Cardiff-based personal injury/general law firm Leo Abse & Cohen and the personal injury firm Walker Smith Way. Deutsche Bank estimates the acquisitions will be 4.0% earnings accretive in FY16 and upgrades medium-term forecasts accordingly.

Brokers observe the Australian business held up well in the half, despite some difficulties in Queensland. Macquarie notes the Queensland market is highly competitive, with several substantial operators in the same field. The broker believes Slater & Gordon should trade on a premium to Queensland-based Shine Corporate ((SHJ)) to reflect its diversification, exposure to favourable structural offshore changes and the options associated with market share gains in the UK.

Weak Queensland operations appear to have been offset by a continued strong performance in Victoria and steady operation in the rest of the states where the company operates. Growth in the personal injury segment was weak, in Macquarie's opinion, but the results were supported by a recovery in class actions, progress in conveyancing, estate planning and family law.

Morgans attributes the softness in Queensland to two issues. The rebranding of Trilby Misso into Slater & Gordon has removed a strong Queensland brand from the market and this means the larger players, Shine and Maurice Blackburn have likely picked up some market share. The other issue is the introduction of a threshold test in Queensland work cover claims, which has probably had an impact on volume and margins. The issues are not systemic and, in Morgans view, increased brand awareness should help increase enquiries and support a turnaround in Queensland market share over time.

Macquarie finds the current multiples undemanding, considering the defensive earnings stream and potential upside from UK expansion. The broker expects the firm will focus on growing multi-track work, which is typically more complex and ultimately involves higher margin cases, such as clinical negligence and industrial deafness. Morgans echoes this tune, suspecting that acquisitions will remain a strategic focus.

The share price collapse of Quindell plc represents an opportunity to take market share in the insurance segment in the UK, although there is little clarity on the potential size of any acquisition. Deutsche Bank notes that due diligence is progressing on the acquisition of Quindell's operating assets by Slater & Gordon but it remains preliminary. Slater & Gordon advanced Quindell funds last December for an exclusivity arrangement in respect to the possible disposal of Quindell's legal services business.

Slater & Gordon ended the first half with net debt of $161m and, given the current debt/equity position, any material acquisitions over the rest of the financial year will require equity funding, in Morgans' opinion. The debt amount included a payment of around $22m made to Quindell for work in progress. Quindell generates a significant proportion of revenue from personal injury cases as well as operating in business process services, telecoms, insurance solutions and medico legal reporting. The three brokers on the FNArena database covering the stock all have Buy ratings. Consensus target is $8.08, suggesting 7.4% upside to the last share price.
 

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-Soft organic growth
-BarrierSafe performs well
-FX, weak demand are headwinds
-Capacity for further acquisitions

By Eva Brocklehurst

Brokers are becoming more polarised around glove and condom manufacturer, Ansell ((ANN)). Some believe a return to stronger growth is underway while others caution that aside from acquisitions, this is far from certain.

Recent acquisitions and the company's flagged restructure make year-on-year comparisons in its segments less meaningful. For example, UBS highlights industrial sales grew 2.1% in the first half, but organically this is almost halved to 1.3%. The broker notes gross margins were narrower, despite lower commodity costs. This disparity was attributed to the integration of BarrierSafe and higher outsourced manufacturing costs.

UBS flags a more challenging FY16, as the company will confront a weaker industrial outlook, FX headwinds and no acquisition benefits. Management has attempted to mitigate this outlook somewhat, stating that brand initiatives and expansions will gain traction while efficiencies should come with the manufacturing restructure. UBS sticks with a middle-of-the-road Neutral rating.

Morgans is more buoyant, retaining an Add rating. The broker is confident earnings momentum will continue despite the challenges. Sales growth forecasts are ramped up modestly across all divisions and Morgans expects new product offerings, lower raw material costs and productivity gains will underpin the near-term, while acknowledging that FX and economic conditions add risk to the longer term outlook. Macquarie is in the same boat, noting the single-use division, which primarily includes the BarrierSafe business, was the stand-out performer, benefitting from high exposure to a robust US market. This division more than offset the lacklustre performance in the medical, sexual wellness and industrial divisions.

Macquarie upgrades to Outperform, highlighting the fact that soft organic sales growth is not unique to Ansell. Moreover, the situation should improve if raw material prices stabilise and industrial activity returns to trend. With earnings risk now significantly reduced and the company in line to meet its FY15 guidance, the broker believes the investment proposition is brighter. Morgan Stanley is also more confident that FY15 guidance can now be achieved.

At the other end of the scale is Credit Suisse, who downgraded to Underperform. While the results were ahead of expectations, FX is considered a major headwind in a difficult operating environment. The broker's updated currency assumptions, notably EUR/USD, have resulted in downgrades to earnings forecasts of around 9.0% for FY16 and FY17. Over time, the broker is more optimistic, expecting new products should deliver growth while headwinds from non-core brands will subside as these products continue to be rationalised.

JP Morgan is also unconvinced by the organic growth story, although acknowledges synergies and restructuring benefits imply guidance can be raised. This broker also points out that the integration and synergy benefits arising from the BarrierSafe acquisition camouflaged the fact that top line growth appears to have faded in the wake of discounting, and because of lumpy contracts.

Caution prevails among other brokers downgrading on the back of the results. Citi downgrades to Sell, disappointed at the weak organic growth and patchy end-market conditions. The broker expects demand to remain uncertain. On the plus side, the company is envisaged to have the capacity to undertake further acquisitions and add incremental earnings, although Citi notes management recently signalled a need to focus on extracting synergies before pursuing further M&A.

Deutsche Bank also downgrades, to Hold from Buy, given lacklustre organic growth, which it suspects will become the norm and cause earnings growth to slow. Acquisition strategies are the main upside risk to the broker's forecasts, along with a surprise improvement in organic growth.

 FNArena's database contains three Buy, two Hold and three Sell ratings. The consensus target is $24.61, suggesting 3.1% upside to the last share price. This compares with $22.19 ahead of the results. Targets range from $20.94 to $27.00. Note that the share price did jump 5% on the report release.
 

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-Confidence hit by downgrade
-Work backlog increases
-Heightened M&A potential?
 

By Eva Brocklehurst

Engineering contractor and project manager Cardno ((CDD)) has warned that first half operating profit will be weak, down around 25% at the mid point of latest guidance, compared with the first half of FY14. The major reason for the downgrade stems from the rolling off of resources work which, as yet, has not been countered by an expected ramp-up in infrastructure spending. Moreover, starting dates for new projects in the Americas have been delayed and costs to integrate new businesses, notably PPI, have been higher. On the infrastructure side, management remains confident that increased spending will assist the bottom line in the second half.  Most brokers are inclined to wait and see just how much assistance that does provide.

Reductions in capital investment in mining and, more recently, oil & gas, in Australia mean the company's materials testing and electrical engineering divisions will underscore the weak outlook. This exposure has hurt both revenue and margins. Macquarie notes margins have been hit particularly hard. The broker lacks confidence in the underlying fundamentals, particularly given the magnitude and timing of the guidance and downgrades to Underperform from Neutral, lowering its target to $3.52 from $6.30.

UBS also downgrades the stock, to Neutral from Buy, and lowers its target to $3.70 from $6.75. Despite the material decline in the share price the broker can envisage no catalysts for the share price to outperform over the next 12 months. Relentless declines in commodity prices, particularly iron ore and oil, suggest headwinds remain strong regardless of the size of Cardno's order book. UBS considers the discount to global engineering peers - around 33% based on forecast FY15 price/earnings multiples - is appropriate.

JP Morgan sticks with a Neutral rating and highlights the fact the company is now trading at a meaningful discount to international peers in an industry which continues to consolidate, and where there has been an uptick in corporate activity over the last 12 months. Goldman Sachs is also Neutral, pointing to the fact that AGM commentary only in October was signalling a return to positive earnings growth and now the company is expecting a decline in the first half. There is value in the stock but the broker is concerned by the sharpness of the deterioration in such a short time. This concern is echoed by Deutsche Bank, which suggests visibility remains poor.

Morgan Stanley is more inclined to believe guidance is signalling a bottoming of the market while the backlog and infrastructure-led recovery should pave the way for a return to growth. The gap between resources and infrastructure spending may have expanded, as Australian business declines and projects in the Americas are slower to start, but as the work backlog is at a record level of $939m, Cardno should be one of the first, and more significant, beneficiaries of infrastructure spending increases. The broker lowers its target by 27% to $5.50 but retains an Overweight rating.

While confidence has obviously been affected, Morgans considers sector M&A activity and a cyclically low valuation may attract value investors. An Add rating is retained, although the broker concedes a fair amount of risk tolerance and patience is required. The order book has been progressively growing for some time and Morgans observes this is typically a leading indicator of future revenue, with lags by around 6-12 months. This suggests revenue growth will occur in the second half and in FY16. The broker cites a number of contract and preferred tender awards in recent weeks including Sydney's light rail, Westconnex and Commonwealth Games work. Longer term, Morgans considers the company will benefit from ever-increasing environmental regulation.

Opinion on Cardno's outlook is varied. On FNArena's database there are two Buy ratings, three Hold and one Sell. Targets range from $3.52 to $5.50. The consensus target is $4.39, suggesting 25.6% upside to the last share price, and compares with $6.80 ahead of the downgrade. The dividend yield on FY15 forecasts is 7.5% and 8.5% on FY16.
 

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