-Significant investment in oil & gas
-Risks skewed to the downside
-Life sciences not compensating
 

By Eva Brocklehurst

Laboratory service provider ALS ((ALQ)) is between a rock and a hard place. The rock is its major clients, the minerals explorers. The hard place is the current downturn in oil and gas drilling activity. The company delivered initial earnings guidance for the first half of FY15 at its AGM recently. It was subdued. Profit guidance for the first half is $74m, 18% below Goldman Sachs' prior expectations and 26% below the prior corresponding half. The reasons for the downgrade remain the same as have prevailed for the past six months: market volatility, pressure on sample testing volumes, rate reductions in the coal business and oil and gas revenue slippage in the northern hemisphere. Positive aspects were few and far between, but brokers noted life sciences and industrial business segments are improving.

Goldman continues to view the stock's 10% discount to the market as appropriate. The ongoing weakness in mineral sample testing is consistent with many broker views that the company is caught in the middle of a multi-year downturn in exploration activity, amid ongoing cost discipline in the mining sector. Goldman notes the company's oil services business has been affected by the shift in oil and gas drilling activity in North America to production from exploration. The company has invested heavily in growing this segment in order to diversify its earnings base and generate revenue synergies by leveraging its laboratory testing skills. With net debt increasing, Goldman expects ALS will now focus on organic growth and reducing gearing. The broker maintains a Sell rating.

Deutsche Bank also has a Sell rating, unable to envisage a minerals recovery occurring in the next 12 months. The broker thinks the stock is expensive, trading on a price/earnings ratio of 16.6 times FY15 estimates, while revenue is volatile and could disappoint further. The deferral of oil and gas work may just be a shift in revenue to the second from the first quarter, but the broker observes significant changes to management commentary emanating over the last eight months. The broker attributes the changes to clients becoming more cautious regarding spending and not management performance. Deutsche Bank now considers the oil and gas segment is more volatile than previously thought. The net impact is a 12% reduction in key forecasts for FY15 and 5% for FY16-18.

The second half includes the seasonally weak December-January period so BA-Merrill Lynch suggests the risk is skewed to the downside in the near term. Geochemical sample volumes were down 27% in the June quarter and that is consistent with indications that drilling activity is ebbing. Furthermore, Merrills can find no evidence that suggests the market has bottomed, although the broker does note that its global commodities team is becoming more constructive on the outlook for gold and base metals. In order for the broker to become more positive on the near-term outlook for ALS  there needs to be a sustained level of pricing strength in gold and copper, to entice miners away from a focus on just improving cash flow. That said, the broker has a favourable opinion of the company and thinks the business can deliver in a recovery.

UBS is attracted to the company's leading position as a provider of minerals testing and its track record, but observes the acquisition of Reservoir has brought specific risks, being principally a coring business rather than a more traditional lab-based acquisition. Hence, it provides no relief in the current downturn in exploration. JP Morgan notes the growth in the company's life sciences and industrial business, but does not think this is happening fast enough to offset the weakness in the resources based operations. Moreover, life sciences is highly price competitive and this should keep margins in check.

This broker also has little visibility on a recovery. Junior miner equity raisings appear to have stabilised recently but a number of producers have witnessed their market caps fall into the junior miner category. Moreover, a good percentage of the capital raising implemented recently is for capital works, remediation costs or day-to-day operations. Macquarie considers there is a lot to like in the business as it is geographically diversified but, at the moment, earnings momentum remains negative.

The FNArena database is a sea of Sell recommendations. There are five, and the consensus target is $6.57, suggesting 15.0% downside to the last share price and compares with $7.21 ahead of the AGM. The dividend yield on FY15 and FY16 earnings is 4.3% and 4.8% respectively.
 

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-Few greenfield projects coming on stream
-Morgan Stanley suggests significant downturn
-Focus on the resilience of balance sheets
-More competition in the market
 

By Eva Brocklehurst

It is tough out there in contractor land and brokers fear it may become tougher. Caution and bearishness prevails regarding the outlook for the engineering and construction contracting businesses, as clients continue to reduce costs, cancel contracts and forestall new tendering. Deutsche Bank observes the value and volume of infrastructure work continues to decline while the value of resources construction work fell sharply in the June quarter. The broker anticipates, hopefully, that infrastructure work that has been budgeted for but is yet to be done, such as large road and rail projects currently under tender, should underpin the level of infrastructure spending. On the resource work front the broker notes LNG and iron ore projects that are currently being completed leave few greenfield projects as replacements.

Macro indicators suggest to Morgan Stanley the challenges will intensify in FY15 and the outlook, on average, is likely to disappoint in upcoming earnings reports. The broker thinks stocks have disconnected from the macro outlook. Stocks re-rated significantly when earnings challenges first appeared and the broker thinks this was premature. The market appears to be anticipating a recovery but Morgan Stanley suggests that is unlikely to happen in FY15-16 for much of the industry. The broker thinks the real downturn in capex is yet to materialise, with quarterly activity broadly flat for the past two years. Forward indicators, however, suggest a significant downturn is now imminent. The broker believes most investors expect market conditions will not improve for more than 12 months. Reflecting this view, the broker envisages downside risk to FY15 estimates for all stocks in the sector.

Moreover, while the downturn in the mining industry work has only just started, Morgan Stanley thinks, despite much optimism in the public infrastructure arena, it won't be enough to offset this. Also, domestic operators may capture a higher share of new public infrastructure work but, compared to the recent past, they face a higher concentration of foreign participants in this market.

Much of the industry is substantially exposed to mining operating expenditure, such as Downer EDI ((DOW)), Monadelphous ((MND)), Leighton Holdings ((LEI)) and UGL ((UGL)). The outlook appears substantially challenged in the near to medium term as miners continue to drive costs lower and take much of the work in house. Morgan Stanley suggests a select few in the sector may have seen the low point of earnings, including UGL, Transfield Services ((TSE)) and WorleyParsons ((WOR)). Nonetheless, risk still permeates the recovery.

Macquarie believes attention will be heavily focused on the state of balance sheets, given the expected length of the downturn. A lack of strength in this area is an issue for Ausdrill ((ASL)), Emeco Holdings ((EHL)), Fleetwood ((FWD)) and McAleese ((MCS)) in the broker's opinion, not to mention Boart Longyear ((BLY)). At the other end of the spectrum, balance sheet strength means accretive acquisition capacity, capital management prospects or simply an ability to withstand the downturn. The broker highlights Macmahon Holdings ((MAH)), Mineral Resources ((MIN)), NRW Holdings ((NWH)), RCR Tomlinson ((RCR)) and Seven Group ((SVW)) in this camp. The broker believe the macro context in infrastructure is holding up but it will be an important area to watch for growth in spending intentions and the opportunities that are available, for RCR Tomlinson, Transfield and Cardno ((CDD)), in particular.

Morgan Stanley believes Transfield is a business that is turning around but still characterised by significant risk. Its capital structure is the most leveraged of any stock the broker covers. Transfield is one of Macquarie's top picks in the sector as contract wins support visibility and revised debt facilities have alleviated some of the balance sheet pressures. The company's dependence on performance-based revenue remains a focus for the broker. Deutsche Bank notes Transfield is operating in competitive markets, has high debt levels and capacity for only slow debt reduction but there is potential for some large contract wins which could assist.

Leighton may be assessing divestments to improve its balance sheet but Morgan Stanley notes, in the short term, such divestments may trigger negative outcomes, including large redundancy costs, asset impairments, receivables write-offs and internal and external destabilisation. At the same time, the macro outlook is mixed with public infrastructure work improving but highly competitive. Deutsche Bank has downgraded Monadelphous to Sell given the weak outlook for resources engineering construction and the lack of large projects available. Morgan Stanley also thinks Monadelphous' outlook appears challenging in the medium term and suspects a material de-rating could occur as the capex cycle unwinds through FY15-16. Brokers are awaiting Boart Longyear's strategic review. The weak first half did not surprise them, given weakness in the exploration market, but debt is a major impediment and there remains considerable risk in meeting its March 2015 debt covenants.

UGL has a relatively better outlook. Deutsche Bank suggests the company's strong balance should provide for a capital return in the next six months and the high level of recurring maintenance revenue stands the company in good stead. Morgan Stanley acknowledges these are positive aspects but still believes it is too early to become more constructive on UGL, with the ongoing disconnect between cash flow and reported profit a significant concern. WorleyParsons remains the market leader in the hydrocarbons engineering market and the most attractive, in Morgan Stanley's view. The stock currently trades on a 6% discount to international engineering peers, despite a more favourable position in growing the sub-sea and offshore markets and potential for margin expansion.
 

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-Turnaround provides buying opportunity
-Competitive market means risks are high
-Defensive stock, attractive dividend yield
 

By Eva Brocklehurst

Industrial and consumer product conglomerate, G.U.D. Holdings ((GUD)), delivered an FY14 result that perplexed the market. Underlying earnings were ahead of forecasts but restructuring costs were greater and this weighed on cash flow and market sentiment. Key to the outlook is management's expectation of $10m in annual benefits to flow from restructuring and profit improvement programs and, should this materialise, GUD could be a candidate for a review of ratings, in CIMB's opinion.

CIMB accepts there is some uncertainty about whether management can execute on its ambitious growth targets but if it does, the consequence is trading earnings that are materially higher than the market currently implies. The broker thinks the stock weakness is a buying opportunity based on a turnaround story. Sunbeam's (consumer products) results were particularly troublesome. Maybe the warm winter did away with the need for electric blankets. CIMB suspects that a flat sales outlook is a reasonable starting forecast for Sunbeam in FY15, but the momentum in the other businesses provides the confidence that cost savings will not be countered by falling revenue. For the Dexion (storage solutions) business CIMB thinks the light at the end of the tunnel is beginning to show, with a strong order book of $69m going into FY15.

Some confusion around currency benefits probably masked the positives, on CIMB's calculation. The company is obliged to report cost of goods sold (COGS) based on spot rates, rather than at the rate locked in by hedging. This is then offset to neutralise the impact at the earnings level. This may have alarmed some investors but the broker believes there is no cause for that. The FY14 one-off FX gain was offset by an artificial increase in COGS, because of accounting standards. The final dividend of 18c was lower than the 21c CIMB expected. The broker suspects the business is moving to a more sustainable pay-out ratio at around 80%. A restructuring provision of $13.3m, mainly related to the closure of the Dexion plant at Kings Park, probably represents the conclusion of the restructuring provisions but CIMB expects a trailing $8m in cash outflow in FY15.

Automotive products (Ryco, Wesfil, Goss) achieved all-time high margins and profitability and this highlights its reliability. Citi emphasises that this division is essential to the company's earnings, given it contributed 54% in FY14. Key questions for the broker in FY15 are whether the company does maintain its strong margin for automotive and whether the contraction in Sunbeam and Dexion margins can be stemmed. UBS believes a lot of the upside to earnings is already factored in and retains a Sell rating. Moreover, one-offs have been a consistent feature recently and the broker is wary that any normalisation of earnings in FY15 is not guaranteed to generate a corresponding rise in free cash flow. That said, the broker recognises management is making the necessary changes to improve prospects and the stock does have defensive aspects together with an attractive yield.

Credit Suisse is more optimistic. In fact, this broker thinks the market is plain wrong in perceiving the results as low quality. Operating cash flow was ahead of forecasts and, as CIMB pointed out, a $4.5m FX gain was offset by COGS. Credit Suisse also notes a $1.1m reduction in the employee benefits provision, related to a resignation pay-out for the former CEO. This provision was raised in FY13 and paid out in FY14.

Numbers aside, the broker thinks the more important aspect is that the turnaround is progressing well. Credit Suisse also thinks the pullback in the share price is a buying opportunity. Dexion is a key positive business, standing out with a good second half performance. Dexion offers not only the lowest relative risk in terms of achieving restructuring benefits but also strong demand and expanding product. Sunbeam has the most risky trajectory, based on the extent and timing of further sales decline, but Credit Suisse notes management remains fairly positive, implying a bottoming in revenue with some modest market share gains. Improvement should flow into FY15 as the division benefits from logistics initiatives.

Demonstrable profit improvement is necessary for JP Morgan. Sunbeam disappointed the broker while Davey (water products) surprised on the upside. The improvement programs for Dexion, Sunbeam, Davey and Oates (consumer products) are all expected to generate a $30m earnings uplift. Coupled with earnings from the new Dexion plant in Malaysia, this implies FY17 earnings of $79.4m. JP Morgan observes GUD has not generated that level of earnings since FY05, and the market is now more competitive. The broker has erred on the side of caution and forecasts FY17 to be well below that level at $63.0m. Moreover, the broker does not think cash conversion will be as strong as it used to be. This fell to 60% in FY14 from the historical average of 97%, because of growth in debtors, changes in trading terms and the extension of payments in tight economic conditions. All up, the signs are encouraging but the broker wants to wait and see.

Goldman Sachs sums up the outlook thus: GUD's valuation would appear attractive, given a FY15 price/earnings ratio of 13.3 times and dividend yield of 6%, but the turnaround strategy has high execution risks as a result of weak consumer markets, strong competition and cost pressure. The broker retains a Neutral rating.

On FNArena's database broker ratings run the gamut. There are two Buy ratings, two Hold and one Sell. The consensus target is $6.61, suggesting 3.4% downside to the last share price, and compares with $5.99 ahead of the results. The dividend yield is 6.3% and 6.9% for FY15 and FY16 respectively.

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-Will other universities follow?
-Loss reduces growth profile
-Yet macro drivers still favourable
 

By Eva Brocklehurst

Education program provider Navitas ((NVT)) has been dealt a blow. Macquarie University has decided, come 2016, it will take a major partnership program in-house. This represents a large loss of income for the company and there is an earnings gap that needs to be filled from 2016. Will Navitas be able to meet the challenge? Most brokers believe the outlook is favourable but the announcement does elicit a few questions.

The contract, via Sydney Institute of Business and Technology (SIBT) at the Ryde campus, is one of the company's longest standing and most profitable. Macquarie University is the company's highest ranked Australian university partner. The decision to terminate the contract coincides with a new vice chancellor being appointed at the university. Navitas has, in the past, signalled royalty payments to its university partners typically represent 25% of the student fees. There is a replacement contract, as a CBD-based visa processing partner which could supply international students to Macquarie University, but volumes are likely to be lower than under current arrangements.

Will other partners try to take programs in house? Several brokers field this question. CIMB wonders, too, whether other universities may also try to bargain on price. Navitas will likely try to place students into other campuses and this may provide some offset. The upside for Navitas is that it requires scale and brand power for other universities to move programs in-house. The bear case scenario, whereby Navitas loses all the the SIBT students, reduces FY16 earnings by 23%. Still, CIMB does not think the bear case is likely. CIMB reduces earnings forecasts for FY16 by 7% and for FY17 by 16%. The broker sticks with a Hold recommendation but other brokers have seen fit to change their ratings on the back of the announcement. Not all of them are more bearish.

Citi upgrades to Buy from Neutral. The broker concedes the loss of Macquarie University is a significant issue and the university probably decided the move would help lift its ranking. Outsourced first-year pathway programs are rare among Australia's top eight universities. The broker doubts the cancellation was for financial reasons, as Macquarie University could have easily coaxed a higher royalty payment or renegotiated terms. Moreover, Citi thinks Navitas can compensate for the loss, as its model remains attractive for universities, students and investors. The broker believes earnings are yet to fully recover from depressed enrolments caused by visa changes. Also, little success is being factored in for new contracts in North America. Longer term, strong returns are also likely because the company is exposed to Asia's emerging middle class.

The contract loss highlights a risk that the market previously ignored. Hence the sudden drop in the share price yesterday, which is an over-reaction in Citi's opinion. UBS thinks so too, adjusting valuation methodology but noting a 31% fall in the share price is excessive. Now the stock is trading at a slight discount to its revised price target, UBS raises its recommendation to Neutral from Sell. UBS estimates that SIBT paid Macquarie University $18m in 2013, which means it generated $72m in revenue. Applying a 35% margin delivers an estimate of $25m in earnings generated from the agreement with the university and UBS has reduced FY16 earnings estimates by 5.9% and FY17 by 13.0%.

UBS thinks the company's model may fall under further scrutiny. In the past eight years university programs have been affected by regulatory change, and while all agreements have been renewed under materially similar terms and conditions, the broker does wonder whether the balance of power has shifted such that terms will need to become more favourable to the universities as they are re-signed in the future. Such as shift would ultimately lower the value placed on further cash-flow from partner agreements. Credit Suisse cites a preference for being on the sidelines until the long-term impact of Macquarie University's decision is better understood, even though the macro environment for international tertiary education is unchanged and Navitas is well positioned. Credit Suisse downgrades to Neutral from Outperform.

Key pathway contracts that are up for renewal in the next 18 months include University of Massachusetts, Edith Cowan University and Curtin University. While some universities have extension options, terms must be agreed by both parties and, hence, there is some increased risk of cancellations, in Macquarie's (the unrelated investment bank, not the university) view. Macquarie also downgraded the recommendation to Neutral from Outperform because of the earnings hit that will apply in FY16/17 and also because this was a key relationship, now lost. The broker adjusts forecasts, assuming some of the core student numbers are retained, envisaging a loss of 2,400 students. With average revenue per student of $30,000, and assuming incremental margin around 40%, this implies an earnings hit of around $31m. Macquarie reduces earnings forecasts for FY16 by 7.6% and FY17 by 13.1%.

BA-Merrill Lynch believes the macro drivers are favourable for Navitas, with rising income in emerging economies and growth in internationally mobile students. Australia could receive an incremental 50,000 students by 2020 and Navitas is well positioned to benefit from such an environment. Nevertheless, as Morgan Stanley sums up, at the very least the significant premium the stock enjoyed in recent times will be compressed back to market levels as investors assess the sustainability and quantum of earnings growth in the year ahead. 

There are one Buy and five Hold ratings on FNArena's database, whereas the day before there were two Buy, three Hold and one Sell. The consensus target is $5.27, suggesting 3.7% upside to the last share price. This target compares with $7.40 ahead of the announcement.
 

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-Quality base, low churn
-High revenue visibility
-Potential capital return
-Large scale opportunities
 

By Eva Brocklehurst

Spotless Group ((SPO)) is a reformed child, returning to the ASX fold after a 2-year absence. The company is streamlined, having undergone significant restructuring with the divestment of problematic businesses and unprofitable contracts. Spotless provides outsourced facilities management and laundry & linen services across Australia and New Zealand and three brokers on FNArena's database have initiated coverage of the new stock, all with Buy ratings. The consensus target is $2.00, which suggests 15.3% upside to the last share price.

Revenue visibility is high and UBS attributes this to low contract churn, long-term contract structures and a high quality, diversified customer base. The company looks well positioned to benefit from the ongoing growth in outsourcing. UBS finds the valuation compelling and does not believe current multiples reflect the potential. Delivering on prospectus forecast will be the key to developing a track record and achieving a potential re-rating, in the broker's opinion.

Citi spies potential for capital management and/or special dividends from FY16. Debate over the sustainability of margins should be mitigated by the company delivering on expectations. The broker observes a lack of reliable third party data to test top line growth assumptions. Down the track, the market should be more confident. Margins may have benefitted from the period in private hands but sustainability is the key word, in Citi's view. The industry drivers look supportive for outsourcing, particularly in resources and government, where cost efficiency is the prime motive. Scale and experience should therefore favour Spotless. Citi thinks domestic comparisons alone are flawed. The company's competitors are predominantly multinationals and trade at a price/earnings premium on FY15 estimates around 29% above Spotless. A material contract win in the next few months could be a significant catalyst.

Deutsche Bank also thinks Spotless could begin returning capital from FY16 onwards and, while pro-forma FY14 leverage appears high at 2.48 times, cash flow should help the ratio decline to 1.7 times in FY15 and 1.3 times in FY16. Facility services earnings margins have been historically well below global peers. Deutsche Bank observes the restructuring has enabled an increase in these margins to 7.6% from 3.8% back in FY11. Further initiatives are expected to increase margins in FY15, taking the company to the lower end of Australian and upper end of group, relative to global peers. The stock is trading at an 11% discount to Deutsche Bank's valuation and the Buy thesis is based on forecast earnings growth of 14% compound over the next three years. The market position is strong, Spotless being the largest provider of facility services in Australasia by revenue, scale and breadth.

Spotless derived 99% of FY13 revenues from recurring activities and Deutsche Bank observes a high contract retention rate. There are price escalators in almost all the contracts and 57% of contracts are of five years or more duration. Another number that gives heart to the broker - 54% of revenue comes from government-backed agencies. Despite the federal government's rationalisation of departments and the weak retailing sector, Spotless is protected via low exposure to federal business outside of defense and only an indirect exposure to the retail sector, through shopping centre property developers and airport food outlets.

Meanwhile, there are myriad opportunities. Spotless has identified $1.5bn in annual revenue opportunities and a further $2.6bn in near-term large resource and immigration contracts. Deutsche Bank's forecasts do not assume the awarding of any of these contracts, but analysis suggests up to 39% upside to FY16 forecasts could be on the cards if Spotless is successful.

Spotless started life as a dry cleaner in 1946. In May Spotless re-listed on the ASX, following a partial sell-down by Pacific Equity Partners, which took Spotless private in August 2012. In 2013, Spotless derived around 37% of revenue from facilities management, 34% from catering, 19% from cleaning and 11% from laundry & linen services.
 

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