-Broker scepticism increases
-Some see buying opportunity
-Most wary about future visibility
-Is there more downgrading to be done?

By Eva Brocklehurst

Construction manager to the resources sector, WorleyParsons ((WOR)), has confounded brokers. After sticking with full year guidance at the AGM only six weeks ago, the company has now revised FY14 guidance lower. The market was sceptical about just how, when downgrading the first half, the second half was going to provide the answers. That scepticism appears well founded.

On the FNArena database the recommendations have converged on Neutral. There's been an upgrade and two downgrades. There are now two Buy ratings and six Hold. The consensus target price is $18.49, suggesting 16.2% upside to the last share price. This target compares with $23.07 ahead of the downgrade. The dividend yield on FY14 earnings forecasts is 5.1% and 5.8% for FY15.

Deutsche Bank found the guidance downgrade disappointing but was heartened by the fact that 90% of the downgrade was from contracts that were not ramping up as planned. The Buy rating is retained. Work from these contracts should flow through in the future and the broker expects FY15 earnings growth of 34% from the mid point of the FY14 guidance. Deutsche Bank believes this is easily achievable, given FY14 earnings are negatively affected by the slow ramp up of contracts and additional costs in Canada.

The company now expects FY14 profit of $260-300m, 20% below prior consensus estimates. CIMB notes the past several years have shown the company has a seasonal skew to the second half so there is some room for optimism. Nevertheless, the broker is wary. This second, and large, downgrade will make anyone planning to buy the stock very cautious and the share price is likely to spend around six months at current levels until activity supports a renewal of confidence. There appears to be nothing structurally wrong with the business but the short duration between the downgrades is a worry, although for CIMB this is reflective of a multi-year commodity driven down cycle, which is not yet at an end.

Another downgrade and a continuation of a negative earnings trend makes Macquarie concerned about just how much visibility the company has. The greater worry is that, just six weeks out from the AGM, it has likely dented the company's credibility. Having said that, a pullback in the share price in the past has provided attractive entry points and the latest sell-off provides the opportunity for medium to longer-term investors. WorleyParsons is trading broadly in line with its closest peers, Amec and Wood, and at a discount to Jacobs. Macquarie notes WorleyParsons has a larger US business than Amec and more leverage therefore to a renaissance in North American low-cost gas. WorleyParsons is trading at 13.3 times FY14 price/earnings compared with its historical averages of 17.8 times.

The deferred projects could still drive an earnings recovery in the second half but the stock no longer deserves to trade at a premium to the market, in BA-Merrill Lynch's view. The recommendation has been downgraded to Neutral as a result. The company has exposure to global hydrocarbons which retains strong growth fundamentals but Merrills questions the ability of the business to fully capitalise on this. The positives include leverage to a lower Australian dollar, which helps earnings translation, and the fact that WorleyParsons retains significant headroom on its balance sheet even after this downgrade. Again, negative market sentiment is expected to constrain the share price upside until a sustainable earnings recovery becomes evident.

JP Morgan has seemingly gone the other way. The rating has been upgraded to Neutral from Underweight. The broker was not surprised that the negatives have conspired against company but still thinks the medium-long term prospects are intact. The share price is now better reflecting the balance of short and long-term drivers, in the broker's opinion. It's time to upgrade. Moreover, JP Morgan considers the majority of the downgrade is cyclical and the headwinds should ease next year. The stock is now trading in line with global engineering peers and in line with the broker's valuation. Hence investors are being better compensated for the near-term risks relative to the growth opportunities further down the track.

There should be no hiding of such a downgrade and Credit Suisse admits to being caught on the wrong foot. The scale of the surprise shouldn't happen, in the broker's opinion. Certainly not so suddenly. The market has always struggled with visibility in the business and now the broker thinks this must be the case for management as well. Estimates have been slashed. The broker concedes the company operates in highly attractive markets and has delivered historically. Still, until clarity is provided it's hard to invest, despite the attractive valuation/yield.

Another aspect that peeved the broker was that a project like the upstream management contract at QCLNG had a 4-year initial phase and the company has known when it would be ending. Similarly, the company said it had been caught off guard at the last downgrade but had re-sized the business accordingly. So, is a further re-size necessary? The company has said there are no underperforming contracts but Credit Suisse is left wondering, although admitting the alternative scenario is even more alarming.

Moreover, the broker does not think Canada is as plagued by subdued market conditions as many believe. WorleyParsons won big work form PetroChina recently and both Total and Shell have sanctioned major projects in the past few weeks.Then there's complaints about softness in the Middle East but Credit Suisse points to Amec's recent comments about how strong the region is. Maybe WorleyParsons is losing market share? Credit Suisse's rating has been downgraded to Neutral from Outperform and the broker wants to see cold, hard numbers before acting further.

See also, WorleyParsons Rattles Brokers on October 10 2013.
 

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-Utilisation rates stagnant
-Debt reduction substantial
-Cash flow yield shows value
 

By Eva Brocklehurst

It's tough for mining services. That's for sure. What's not so sure is when it will get better. Earthmoving contractor Emeco Holdings ((EHL)) has reduced guidance for FY14 earnings to $90-105m. It didn't surprise brokers. Equipment utilisation rates are stagnant, particularly in the gold and thermal coal segments of Australia and Indonesia.

Based on capital expenditure forecasts of $40m in FY14, the scrapping of dividends and $90m in depreciation, the company can reduce its debt in FY14 by a substantial amount, in Macquarie's opinion. That's a major positive. The outlook may be tough and guidance is weaker but Emeco is trading at less than half its Net Tangible Asset (NTA) value, so the broker retains a Neutral recommendation.

The company has guided to a stronger second half with the driver being Canada, where there is strong visibility via contracts. That fleet is expected to be near full utilisation in the third quarter of FY14. It's the Indonesian business that's the main problem. The whole fleet is parked up at present. CIMB has factored in virtually zero revenue from that quarter in FY14. In Australia, tendering activity has improved but material changes in performance are yet to be seen. Around 70% of Emeco's earnings come from domestic rentals, with the remainder split between rentals in Indonesia and North America and the trading business.

The company should generate $95m in free cash in FY14 and on that basis CIMB is content to maintain an Outperform call. What also provides comfort to CIMB is he fact that such cash flow can be generated even in the current environment. Moreover, net debt of $377m represents a decline of $13m in the past six weeks. The company has liquidated $24m in assets so far with a further $18m coming from Indonesia. CIMB notes these assets were sold at a 15% discount to book value but that's significantly better than the 65% discount to NTA implied by the current share price.

CIMB thinks any fears of an equity raising resulting from the guidance downgrade are unfounded, barring any serious deterioration in the operating environment. Emeco is still operating within covenants and should pay down debt quickly. CIMB thinks it unlikely the banks will force the issue on a business which has a swift amortisation profile. Then there's that free cash flow yield of over 60%. The broker senses the stock is an acquisition target. The company's capital intensity in the initial years of any recovery will be minimal. CIMB has imposed a 45% target free cash yield to estimates, which would be an appropriate return for a potential acquirer. Based on this estimate, this implies a market cap for the company of $211m against the current $153m. The downside risks to this scenario are adverse changes to rental division sales, utilisation and margins.

At an earnings-per-share level UBS envisages Emeco to be loss making in FY14-15. Despite the company's comments about "green shoots" appearing in the Australian market - because there's been an increase in customer enquiries - the fundamentals look challenging to the broker and caution remains the word, particularly in the absence of significant contract wins. Emeco has flagged a weighting to the second half in its guidance. CIMB is also sceptical of forecasts for a strong skew for earnings to the second half in the current environment. In this instance the drivers around the improvement, in Canada and somewhat for Indonesia, are either underpinned by customer contract wins or cost savings that are within the company's control. Furthermore, while the Australian situation remains less certain some improvement is expected in the second half.

On the FNArena database Emeco has one Buy rating and five Hold. The price targets range from 21c to 37c and the consensus target of 31c suggests 22.7% upside to the last share price.
 

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-Are price, FX headwinds abating?
-Improvement expected but when?
-Heavy reliance on Moranbah
 

By Eva Brocklehurst

Explosives and fertiliser business Incitec Pivot ((IPL)) delivered FY13 results that did not diverge too much from expectations but offered plenty of issues to prompt brokers to mull implications for the business in the years ahead.

Similar to competitor Orica ((ORI)), JP Morgan observed the response in the share price to the result was largely as a relief reaction to significant prior underperformance. This broker still does not find Incitec Pivot's valuation that compelling, with high expectations for growth outside of Moranbah factored in. CIMB acknowledges the potential for substantially stronger earnings down the track in the North American explosives market but weak urea prices and the exchange rate make it difficult to add up to growth in the short term. This broker is content to revisit the stock when there is more certainty on these items and a more compelling valuation.

One broker is most confident that headwinds are abating. Credit Suisse maintains that the planned manufacturing closure and the slow ramp up of Moranbah heralds a transition year. Exchange rate headwinds are easing and fertiliser market prices finding a base. The broker contends that macro conditions have been unkind to Incitec Pivot. Recently, the stock has traded as if it were a play on the diammonium phosphate (DAP) price, despite the company moving away from its commoditised price-taking fertiliser operations towards a better structured earnings profile via Moranbah ammonium nitrate (AN), the Pilbara emulsion and US ammonia business.

Still, the start to FY14 has made it tough. JP Morgan thinks simply achieving flat growth in the Dyno Nobel business will require some sort of turnaround, as several factors contributed to an underlying decline in earnings in the second half of FY13, including the loss of the Xstrata contract and cost increases. Macquarie highlights weak pricing for DAP and urea. Regardless of whether it's fair, Incitec Pivot is highly exposed to the DAP, urea price and FX movements. Moreover, Macquarie notes fertiliser markets are relatively well supplied for the medium term and, even though prices may be bottoming, this is likely to cap the upside. The return of demand in India is considered the potential positive for the DAP markets in April-May 2014.

DAP and urea prices may have been soft, but Credit Suisse expects a seasonally stronger period for fertiliser prices in early 2014. Significantly, DAP prices have shown their first rise this week after a long period of decline and should start to improve in early 2014, becoming more evident ahead of the North American planting season, with modest price improvements being augmented by reductions in input costs. For urea, the broker maintains that prices are in the process of bottoming out, although ammonia pricing may experience incremental pressure.

While there are a number of positives in the outlook, Credit Suisse notes the company was very cautious with its commentary and did not provide macro assumptions, or guidance regarding the timing of improvements and volume activity. Nevertheless, Credit Suisse expects that moderating headwinds and the improvements already made by the company should start to show up in the second half of FY14, and investors are expected to increasingly focus on this momentum going into FY15.

CIMB took the other tack. The results did little to convince the broker that the worst was now behind. DAP manufacturing is facing low prices and a relatively high Australian dollar as well as a ste- change in gas costs and an increase in sulphur input costs. For CIMB it means that, without an increase in DAP prices or a material decline in the Australian dollar against the US currency, the profitability of the business may remain marginal. In terms of fertiliser, Phosphate Hill is expected to run at reduced rates ahead of the planned shutdowns. Citi doesn't expect the turnaround cost at Phosphate Hill will exceed the cumulative costs of outages experienced in FY13 but agrees the business is facing sulphur price increases and an assumed increase in gas prices. The company has lost sulphur supply from Mt Isa which was at zero cost and, while the options are still being considered, a new supply is likely to have a negative impact to earnings after FY17.

So what's it to be? It's Moranbah that will have to do the heavy lifting, in Citi's view. Having left FY13 with an annualised production rate of 328.000 tonnes this increases the broker's confidence in the ability of the AN plant to deliver 300,000 tonnes and $54m in incremental earnings in FY14. The remainder of the Asia Pacific explosives business is expected to be flat. Management has signalled the US explosives business is uncertain but Citi expects the second half of FY14 will show an improvement as higher margin volumes grow.

Cash conversion was well ahead of forecasts and hailed by brokers as the most positive aspect of the results. UBS noted it reflected growth of 5% over previous year, despite lower underlying earnings. Cash conversion was driven by tighter working capital management and lower tax. Citi maintains this will be a key feature for the outlook going forward.

On the FNArena database there are two Buy ratings and six Hold. The consensus target price of $2.98 suggest 5.4% upside to the last share price and compares with $2.93 ahead of the result. The range of target prices is from $2.75 (CIMB) to $3.20 (Deutsche Bank). On consensus estimates the FY14 and FY15 dividend yield is 3.6% and 4.5%. respectively.

See also, Reliability Issues Weigh On Incitec Pivot on July 24 2013.
 

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-Resilient explosives business
-Strong cash flow
-New gas contract sourced
-Capital management potential
 

By Eva Brocklehurst

What a difference a quarter makes. Diversified chemicals company, Orica ((ORI)), delivered a FY13 result that was better than broker forecasts and better than the guidance issued in July. Then, brokers responded to the guidance downgrade with key concerns about the company's outlook. These concerns have not been eliminated entirely but, heaving a collective sigh of relief, at least three have now chosen to upgrade recommendations.

Macquarie has upgraded Orica to Outperform as the result was better across the board, albeit from a downgraded base. The broker thinks the stock is still cheap on 12.3 times FY14 estimated price/earnings, which is at a 15% discount to market compared with the long term average of 8%. Growth looks set to resume in FY14 and while the outlook continues to be tough, the broker believes it's now better than feared.

 JP Morgan counters Macquarie's view and thinks the stock is marginally expensive, despite the earnings upgrades. The broker believes a large proportion of the reaction in the share price following the results was because expectations had been materially reduced. The mining services business provided the greatest surprise, driven by a rebound in volumes in Europe/Middle East and Africa in the second half and stronger margins in Latin America. The results may be stronger than expected but for JP Morgan the underlying numbers indicate conditions are still difficult for Orica. 

Deutsche Bank notes the resilience of the explosives business and the benefits of an improved product mix, as well as productivity improvements. Brokers acknowledge the strong net operating cash flow of $1.06 billion, up 95% and well ahead of Deutsche Bank's forecast of $855m. Mining Services' earnings were ahead of forecasts as well. The company is guiding to underlying earnings improvement in FY14, subject to market conditions. Deutsche Bank expects earnings to increase by 14% in FY14, with the depreciation of the Australian dollar and restructuring benefits from Minova to add 13% by themselves.

Minova managed to reach EBIT break even in the second half and, looking into FY14, BA-Merrill Lynch considers the benefits of the restructure provide for $54m in earnings improvement, before any volume and price assumptions. The broker observes Orica reported its best cash flow performance since 2003 and this resulted in debt levels being constant despite the increase in capex, which was primarily for the Burrup ammonium nitrate (AN) investment. The gearing levels of 36% are now at the low end of the company's target range of 35-45%, presenting an opportunity for capital management, in Merrills' view. Based on FY14 forecasts and company guidance the broker expects gearing to be just shy of 35% at the end of FY14 and interest cover at a comfortable 7.6 times. Should the company be comfortable with only a 250 basis points increase in gearing, Merrills highlights the prospect for an additional 48c per share of capital management in addition to a 98c ordinary dividend.

ORI reported FY13 net profit of $602m, 3% above prior guidance of $585m. The final dividend of 55c, fully franked, was up 1c on the prior year. UBS is raising earnings forecasts by 5-6% for FY14-15 to reflect better explosives-driven earnings and lower net interest costs. The broker has lifted the recommendation to Neutral from Sell.

Orica also announced it will use Esso/BHP Billiton to source up to 14PJ of gas for its ammonia manufacturing operations at Kooragang Island in NSW. This has removed a structural hurdle, according to UBS, and the broker thinks Orica has capacity to produce 380,000 tonnes per annum of ammonia. The broker previously maintained that the upcoming renewal of gas contracts with existing suppliers AGL and Santos could potentially cost Orica $55m, using an assumption of over $10/gigajoule for east coast gas from FY17. This new deal appears to have been struck at significantly more attractive levels, adding an incremental cost of just $12m, or around 85c/GJ. Moreover, UBS calculates this deal adds around $1.20 per share to valuation. The other way to look at this deal is via Citi's observations. The new gas sales agreement de-risks future earnings but as the negative cost impacts have been limited to $12m per annum, Citi suspects the current gas contract was struck at a higher underlying price than previously thought.

The other structural hurdle, according to UBS, is the supply deal with CF Industries in North America. Orica has the capacity to sell 1.5mtpa of AN-based explosives in North America but only manufactures around 500,000t, relying on third party suppliers for the remainder. Orica has a 10-year agreement - signed in 2006 - with CF Industries for the supply of up to 500,000tpa of explosives grade. Commercial terms of this contract are unknown but UBS suspects terms are linked to gas feedstock at CF's Yazoo City plant and referenced to an indexed gas price over the contract term. Renewal of the supply arrangement could cost Orica up to $60m but UBS has factored just $15m into calculations, expecting a more positive outcome.

Deutsche Bank notes the company anticipates a more normal year in 2014, with a slightly softer first half and strengthening in the second half. The broker observes an improvement in North American and European quarry and construction volumes in the September quarter and the North American coal market appears to have bottomed. The Australian AN surplus is diminishing and the outlook for sodium cyanide appears sound, given the company's contractual position. Indonesia remains the most problematic region, in Deutsche Bank view, with one customer still not operational and there is a major contract up for renewal in FY14.

Morgan Stanley is not so sure. While upgrading the rating to Equal Weight on the back of the results and admitting the bear case now appears less likely, the broker sees risks still on the horizon. Nevertheless, until these risks materialise, the market is expected to take an optimistic view. The risks envisaged are with Chinese AN, which continues to be exported at a record level. Prices are down 26% from the May 2012 peak and oversupply exists in Australia. The company confirmed that Western Australia may be long 150,000-200,000 tonnes in 2017. The outlook for sodium cyanide is also weak, after several years of price rises amid any ongoing weakness in thermal coal. Other than that, the company has shown resilience in the context of profit and earnings expectations, according to Morgan Stanley. Australian earnings (62% of EBIT) grew 2% and strong cash flow was the main positive, as Orica flexed payment terms. If this is sustained, and with capex expected to roll off over the next two year, management signalled the potential for capital management in FY15.

Orica has four Buy ratings on the FNArena database, with four Hold and no Sell ratings. The consensus price target of $23.58 suggests 2.1% upside to the last share price and compares with $22.07 ahead of the results. The dividend yield on the FY14 consensus earnings estimates is 4.1% and 4.4% on FY15.

See also, Second Half Turns Sour For Orica on July 22 2013

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-Significant contract losses
-Debt covenants still OK
-Sentiment to improve over time
 

By Eva Brocklehurst

The reduction in mining activity has scalped specialist service provider Ausdrill ((ASL)). The company returned from a trading halt decrying a sharp downturn in business in Australia and Africa, reducing FY14 profit guidance to $35-45m, down 60% on FY13. Earnings are under significant pressure and it will be some time before that pressure is alleviated.

There may be longer term value but currently there's enough risk for Citi to stick with a Neutral rating. Return on equity for FY14 is forecast to be at its lowest for the past 10 years and the current cycle looks like its nearing a base. This presents both a risk and an opportunity. The risk is with the carrying value of the assets. Here, Citi thinks the auditors will be taking a close look in FY14 at the carrying value of all assets. Whilst the stock trades at attractive multiples, given the volatility in the gold sector, Citi's confidence in FY14 remains diminished.

The opportunity exists for the medium-term leverage the stock offers for returns when the cycle starts to improve, given Ausdrill's significant fixed-cost business model. Ausdrill is exposed to strong long-term demand drivers, with a multi-commodity exposure to mine production in Australia and Africa. The strategy of seeding new divisions internally and looking for new business opportunities up the value chain should support longer-term returns for shareholders, in Citi's opinion.

Citi assumes a 50% cut to dividends to maintain historical pay-out ratios. Macquarie's dividend forecasts continue to assume a 35-40% pay-out of estimated FY14 earnings. This is a similar level to what the company has paid out in recent years and places the stock on Macquarie's calculations at a yield of 5%.

On the FNArena database there are currently two Buy ratings, four Hold and one Sell (BA-Merrill Lynch). Not all database brokers have updated their forecasts, hence a consensus target price of $1.30 is no doubt doomed to be further reduced. This target compares with $1.66 ahead of the update.

Debt levels are improving slowly and the company plans to lower capex in FY14. Despite the downgrades there is room in the debt covenants, with Citi calculating that earnings would need to halve again to breach current covenants. Macquarie also observes that Ausdrill remains comfortably within covenants, expecting debt to reduce to $355m. This would put net debt/earnings at 1.7 times and earnings/interest cover at over 5.5 times. Based on Macquarie's capex and earnings forecasts, Ausdrill should survive the next two years without tapping equity markets. Macquarie estimates Ausdrill has over $200m in surplus debt capacity following its US$300m note offering last year. Morgan Stanley is also comfortable about the debt covenants and estimates a slight rise in net debt/earnings, to 1.75 times, estimating current net debt at around $450m.

Ausdrill provides a range of specialist services to the mining sector such as drill and blast services, contract mining, equipment hire, assaying, procurement, logistics and manufacturing. The whole spectrum has been affected by both miner cut-backs and lower commodity prices. Macquarie notes Africa was the prime cause of the profit warnings with revenue that was lost in FY13 not replaced. The broker has examined the cost position of key Ausdrill gold mines (65% of FY13 revenue) and found that many are under pressure at current gold prices around $1,300/oz. The company's iron ore book fares better, concentrated on BHP Billiton and Rio Tinto (30% revenue). Together iron ore and gold account for near 95% of the core contracted revenue.

JP Morgan has downgraded the stock to Neutral from Overweight, believing the changes to the earnings outlook are too great. The broker is niggled by the contrast in the company's loss of contracts to growth in underlying mine production volumes. This raises concerns about the ease with which mining customers can reduce demand for Ausdrill's services. The resultant break to the previously strong links to mine production volumes in Western Australia iron ore and gold and West African gold mean it will take some time to rebuild profitability and, hence, confidence. It also raises questions for JP Morgan regarding the timing of recent investments that increased Ausdrill's exposure to more cyclical business, such as equipment hire and mineral exploration. Having said that, the broker still thinks the company has capacity to improve working capital and curtail expenditure.

Morgan Stanley considers there's valuation support at current levels and retains an Overweight rating. Ausdrill will require a stable period of earnings and improving sentiment. The broker observes, beyond the known areas of weakness and previously disclosed cessation of contracts in Africa, the most telling impact from the company's update came from changes to the mine plans at two of the company's largest contracts - Perseus Mining's Edikan and Resolute Mining's Syama. Morgan Stanley expects the share price will take time to recover, with substantial improvement unlikely before the results are reported in February.
 

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-Bottom line weakness prevails
-Compliance issues will diminish
-Still looking for new CEO
 

By Eva Brocklehurst

Just when SAI Global ((SAI)) looked like making up ground and stabilising its business, another downgrade to forecasts comes along. At the AGM the information services and standards auditor announced that revenue growth would be 8-10% in FY14. Earnings would nevertheless grow at a lesser rate and profit would be flat. The contributor to the bottom line weakness is long-running issues in the compliance services division.

UBS is a little exasperated. This is the fifth time since February 2012 that guidance has been provided below consensus expectations. Incorporating the guidance means the broker has raised revenue forecasts, having expected 5.5%, but downgraded earnings forecasts, having expected 8.5%. Now FY14 earnings per share estimates are reduced by 7% while earnings estimates are reduced by 4%. The broker thinks the market is likely to become frustrated with the lack of earnings visibility, which could result in the share price coming under pressure because of multiple de-rating. 

Having said that, and relieved the frustration, the broker was content to maintain a Neutral recommendation. Others on the FNArena database are maintaining their ratings for now. In total there are five Buy ratings and three Hold. The consensus target is $4.33, suggesting 6.9% upside to the last share price. This compares with a $4.48 consensus target ahead of the AGM.

Morgan Stanley also acknowledges that operational setbacks are frustrating but the defensive nature of the company's revenue has been underscored by the guidance. The larger revenue base should translate to higher earnings, eventually.

Delving into the divisions CIMB finds, after no growth in the past 18 months, sales growth in information services is finally turning positive. The broker expects 3% growth in FY14. Property services is expected to grow 28% and will be the largest driver of earnings growth in FY14. After a weak period, assurance services are expected to return to growth around 5% in FY14. So it's mainly compliance services, where CIMB expects earnings to fall 13%, where the weakness lies.

CIMB also observes that with positive revenue trends, the management incentives which were absent in FY13 have now been reinstated on expectations that FY14 budget outcomes will be met. This has added to costs and reduced the bottom line. CIMB has reduced earnings expectations across FY14-15, with nearly 30% of this revision relating to lower FX benefits because the main currency exposure, USD/AUD, has rallied from August lows. The remainder of the reduced earnings is the increased incentives. SAI recently downgraded the aspirational target for compliance services margins to around 35% from 38-42% and, as CIMB has not factored this into forecasts, it represents upside earnings risk.

SAI is suffering from spending over $400m in acquisitions since 2007 with the bulk of these in the compliance space, notes to JP Morgan. They may have added capabilities and expanded the geographic reach but the integration has been costly, culminating in a $90m impairment charge in FY13. The turnaround is expected to take another 12-18 months. Macquarie believes margins will be dragged down by operational issues and cost increases for a while yet but when sorted should translate to higher margins and earnings growth. The stock's valuation is not stretched and the broker is comfortable with an Outperform recommendation.

The investment thesis is still intact and that's enough for Deutsche Bank to retain a Buy rating. The business is achieving improved revenue and the negatives relate to higher cost investment and delayed earnings recovery. Compliance client issues are now stable and the broker thinks the company is implementing a more robust earnings platform.

JP Morgan also observed that the appointment of a new CEO has still not been made. The search has been going on for five months and the broker thinks the uncertainty and timing of the appointment will weigh on the stock until resolved. Current CEO Tony Scotton was to retire by the end of the year but will now stay until March 2014. Macquarie thinks this delay reflects the fact the board has decided to find an external candidate. This is disappointing in the broker's opinion, as the stock is likely to trade with some uncertainty until a new CEO is installed and the changes to operations and strategy are known.
 

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-More miner cost cutting to come
-Spending on parts, service to decline
-Diversity is key to weathering the storm
-No V-shaped recovery in sight

By Eva Brocklehurst

The engineering services sector is in for some acutely painful months, or even years. As mining sector demand unwinds there is little that appears to be taking up the slack. Civil infrastructure building is being hamstrung by governments with no cash in their pockets and Australia's new federal government's infrastructure budget is considered just a drop in the ocean.

Citi has tracked the 12-month outlook for global capex and services spending in mining. The survey shows that participants still expect mining capex to fall by 14% year-on-year over the next 12 months with a greater risk of projects being deferred to 2016 and 2017. Around 78% are still expecting to lower future capex budgets and, of this, 40% is related to equipment spending. Even the most optimistic participants still expect a flatlining recovery rather than anything U or V shaped.

The broker has, for the first time, introduced after-market related questions into the survey. Participants expect spending on spare parts, consumables and service to decline by 4% in 2013 and 5% in 2014. Citi observes that after-market sales/orders in the second quarter declined for both Sandvik and Metso, and this compares with over 10% average growth over the past five years. Even adjusting for FX, the growth is no longer in double digits.

In terms of the highest risk for price declines it is in mining trucks, tractors/dozers and loading equipment. In addition, a majority (78%) of participants are planning to resist prices on mining services. This is particularly the case for drilling equipment, tractors/dozers, mining trucks and to a lesser extent for crushing equipment, pyro processing and pumps. The recent survey of Caterpillar dealers in China pointed to a relatively stable outlook in terms of near-term demand but it's not going gangbusters. Increased infrastructure spending and roadway investment were cited as positives, while mining weakness and tighter credit were the negatives. Higher incentives do appear to be helping reduce dealer inventories, as Citi notes a smaller percentage of dealers are saying inventory levels are too high.

JP Morgan has also surveyed Australian civil contractors and, again, the news is bleak. Expectations for profit margins for the large contracts are firmly in negative. The broker prefers those that have limited exposure to mine production. Overweight ratings are ascribed to Lend Lease ((LLC)) and Downer EDI ((DOW)) with these two having advantages of diversity, relatively lower resources exposure, stronger order books and, in the case of Lend Lease, development businesses. Monadelphous ((MND)) and Transfield Services ((TSE)) are rated Underweight as revenue and margins come under pressure. The large contractor expectations index has recorded three consecutive readings below 50 now. The broker also thinks the peak in Australian engineering construction spending has either passed or is nigh. This is beginning to have a material impact on order book expectations. Competitive market conditions are emerging as project sizes shrink and more interstate or offshore players enter the market.

A corollary to this is that the frequent complaint of skilled labour shortages and wage pressures has also dissipated. Input cost inflation is subsiding, although JP Morgan notes there are certain areas where prices are likely to rise such as in quarry-based, oil price-linked segments. Access to credit for contractors has continued to tighten, with cash flow problems and tougher end market conditions likely to increase the pressure.

BA-Merrill Lynch notes the recent strength in share prices across the engineering and contractors sector is going against the grain of continuing declines in capital and operating expenditure by the global miners. The market could still be underestimating the extent of the downsizing and impact on mining service. The broker estimates that, at this stage, significant changes are still to be made on spending targets and miners are about one third along a US$13.1 billion targeted cost reduction program. An analysis of cost cutting initiatives from the major miners concluded there was still a further US$8.3bn in pre-tax savings to be delivered, representing significant cost pressure globally. Industry-wide cost curves are expected to move lower and service providers will bear the brunt. Merrills suspects, for those exposed to bulk markets, a recovery is unlikely until 2016.

Which stocks are the most exposed to this? On Merrills' list is Leighton, Monadelphous and Bradken ((BKN)), which represent the "build" or capex stage of the mining cycle. Then there's ALS ((ALQ)), Ausdrill ((ASL)), Leighton, Bradken and Monadelphous at the operate and maintain stage. Furthermore, Australia's non-mining infrastructure investment has likely peaked and the broker forecasts declines of 9% and 8% in 2014 and 2015 respectively. The federal government's $4.6 billion increase in road spending will not change this state of affairs. States have traditionally funded most of the road spending and, as they are tightening purse strings, it's likely the amount allocated will decline over FY14-17.

Merrills is most bearish on Leighton. Best choices, with a Buy rating, are Downer, WorleyParsons ((WOR)) and Seven ((SVW)). Downer has a compelling valuation and a leadership position in diverse end markets, WorleyParsons is more protected by its leadership in hydrocarbons and Seven has a good portfolio of brands.
 

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-Plans for DTZ to grow in US
-DTZ lacks sufficient scale 
-Engineering subdued
-Little upside envisaged
 

By Eva Brocklehurst

Engineering and property services business UGL ((UGL)) has briefed investors on the developing DTZ de-merger and the opportunities that are presenting in the global property services market in which DTZ operates. The company has reiterated its intention to hive off DTZ by the end of 2014 and looks forward to expanding in the US market. Brokers are finding it hard to get excited. A de-merger makes for a rather forlorn core engineering division in the current climate.

Brokers have been informed that the highly fragmented US commercial real estate market is in the throes of an outsourcing trend, while high-margin transactions are increasing. Management believes DTZ will be able to grow without tackling the share held by the two major players, Jones Lang LaSalle and CB Richard Ellis. Citi, for one, believes DTZ lacks scale at this stage in the US market and margin expansion will depend on the ability to increase scale. Corporate transactions account for 27% of DTZ's revenue and generate earnings margins of 9-12%. In number terms, the broker suggests DTZ has 240 US brokers and needs 1,100 to achieve critical mass. In comparison, CB Richard Ellis has around 3,000. Management acknowledges acquisitions will be required but the timing of such will likely be after the de-merger occurs.

The trouble is, UGL is facing headwinds in resources and infrastructure for its engineering business and this, in turn, means it is reliant on property service to drive earnings growth. The stock's share price seems to retain what upside there is from the planned de-merger, so brokers are asking: where's the value going to come from? The stock trading on 1.3 times FY14 consensus earnings so looks fair valued. Stay Neutral, is Citi's opinion.

Divorce, no matter how amicable is expensive, according to CIMB. There may be a rationale for splitting the assets, as that provides more focus for the individual business units as well as offering potential for merger & acquisition, but there's a cost. Higher expenses and reduced diversification mean challenges mount for the engineering business.

What's also of concern to CIMB is that the timetable to de-merger is taking precedence over other concerns. An equity raising is not out of the scheme of things if it means adhering to the planned timetable. The prospect of a capital raising, coupled with continued difficult operating conditions for the engineering business, means the stock will underperform its peers over the next 12 months. The engineering division continues to operate in a difficult market. This may be cyclical, but the broker believes the down cycle has at least another 12 months to run.

CIMB does not think the market has been sufficiently undervaluing UGL's property business relative to the big two players either, and thinks a discount is justified for the lower size and global scale. This means there is no significant valuation arbitrage from current share price levels to come from corporate activity. On the broker's best case scenario, there's 11% upside potential on current pricing. CIMB estimates a break up valuation of $8.13 per share under the best case scenario, which assumes many things. These assumptions include 5% upside to base FY14 property and engineering earnings estimates, FY14 peer multiples of 11 times for property services - that's the average of the two majors -- an 8.0 times multiple for engineering, an additional $10m per annum in corporate costs after de-merger, and $40m in one-off de-merger costs.

Macquarie also notes the need for scale, with the market tending to gravitate to the larger players which have the size, coverage and systems to meet the increasingly global property needs of major clients. The top four have 22% of the $60 billion outsourced property services market. DTZ is one of these at around 3-4% so the fragmentation is substantial. Outsourcing remains a key trend, driven by the lower cost and improved efficiencies which sector specialists can provide.

UGL is targeting over 6% margins in the long term, with an opportunity to achieve 7% margins for the blended DTZ business (5.9% in FY13). Macquarie thinks the de-merger date is allowing time for UGL to deliver on improved earnings and reduce debt, via an improvement in the performance of working capital, lower capex and $60-80m in asset sales. The broker expects FY14 to be a better year for earnings. Nevertheless, the relatively high gearing and net debt is likely to remain a focus for the market and Macquarie thinks valuation upside from the de-merger remains limited.

Moreover, the engineering market is still weak. The NBN, roads maintenance and residential markets may be getting better but, Macquarie counters, these are not areas where UGL is a key player. UGL is seeing some recovery in coal maintenance markets but high gearing and net debt are likely to remain a focus of the market and Macquarie concludes that upside from the de-merger appears relatively limited using current peer multiples.

On the FNArena database there's no Buy rating. There are four Hold and three Sells. Price targets range from $6.30 to $8.46 with the consensus target at $7.70, signalling 2.1% downside to the last share price. The dividend yield on FY14 forecast earnings is 6.2% and on FY15 it's 6.6%.
 

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