- Govt changes rules impacting novated leases
- Up to half MMS revenues affected
- Significant de-rating now expected
 

By Greg Peel

“The current system provides a tax concession to those who mainly use their vehicles for private use,” notes Credit Suisse, “because by default, it assumes a large portion of business use”.

Credit Suisse has found as nice a way to say “rort” as one might achieve. And therein lies the moral to the tale of how the rug might have just been pulled out from under McMillan Shakespeare ((MMS)) and its novated car lease business, which may represent up to half the company’s revenue on broker estimates.

Yesterday the government announced that in order to recoup part of the $3.8bn in budget losses stemming from a shift from carbon tax to emissions trading scheme, the “statutory formula” method of claiming fringe benefits tax on cars will be abolished forthwith. ATO stats show around 528,000 cars using this method for tax claims, of which Citi believes around half are employer-provided cars and the other half employee choice “salary sacrifice” cars.

The bottom line is there are two ways to claim the annual cost of a vehicle used for business purposes. The first is to maintain a logbook detailing usage and cost which can be presented to the ATO and, presumably, can justify up to 100% deductions. Tradies, for example, would fit this bill, or travelling sales reps. The second is to not maintain a logbook but simply declare that a vehicle is used “mostly” for work rather than private use (commuting is not “work”) and thus receive an assumed deduction of 80%.

In the second case, an employee can choose to salary-sacrifice to acquire a leased car and pay fringe benefits tax only on 20% and deduct the rest, as can an employee who is given a car by the employer. Presumably the ATO is happy not to spend time assessing half a million log books, so the government has basically let taxpayers get away with making some rather dodgy claims about car use. Under the new legislation, all employees claiming vehicle deductions will have to keep log books, which might just expose, in the odd case, true work use of less than 80%.

The fact that leasing companies, car manufacturers and even the retail sector in general are absolutely spitting chips about the new rule might provide some insight into just how widespread, and widely known, rorting has actually been.

But this is not a story about ethics. This is a story about the market.

Yesterday McMillan Shakespeare went into a trading halt after its shares plunged 15%. It was a sad day for a company that has proven to be one of the market’s stalwart “all weather” performers, having risen from around $2 per share post GFC to almost $18 before yesterday, and paying solid dividends along the way. It is not McMillan’s fault that it was generating revenue from novated leases that may have been used as a bit of a low level tax rort, but the fact remains that the share price plunge yesterday implies that it was. If those claiming 80% work-use are really using their vehicles for commuting or leisure most of the time, then there is less attraction in leasing a car as the level of deductions would fall and the driver would have to assiduously maintain a logbook.

The struggling, and excessively taxpayer-subsidised car industry is up in arms because the 80/20 rule made it attractive to buy a new car under lease, hence demand will fall (perhaps a second hand car will be preferred, assuming a car will still be needed) and complaints stretch right through to the struggling retail industry, which is looking through to consumers with less tax deduction dollars in their pockets.

McMillan management has already indicated that “the changes, if implemented, will have a material impact on the Company’s business”. They have been implemented. What remains in question is whether or not they will remain implemented.

It would have been interesting to see how much the MMS share price would have suffered if it were Gillard introducing  these changes, and not Rudd. Perhaps they would be dismissed of having a shelf-life of only a couple of months. But now that Rudd has dragged Labor back to 50-50 with the Coalition after preferences, on polling, the election is no longer a given. Moreover, if the Coalition wins it will also be looking for income earners as it will scrap carbon pricing altogether. It is thus quite likely a Coalition government would not change the rules back again. Credit Suisse is ascribing a “high probability” these changes are here to stay.

As is the market, obviously.

Citi has downgraded its rating on MMS to Neutral from Buy. The analysts have not yet changed their earnings forecasts because they are awaiting updated guidance from management. They have, nevertheless, removed valuation premiums from the affected businesses to affect a drop in target price to $16.62 from $18.49.

Citi believes the rule changes will “fundamentally change the growth potential and future profitability of MMS”.

Credit Suisse has downgraded to Underperform from Neutral, and dropped its target to $12.10 from $15.50.  CS believes the changes could cause a “potentially material decline in novated leasing demand due to less attractive tax concessions”. The analysts do not know just what split of MMS’ lease customers are claiming for work/personal, but estimates novated leasing income accounts for around 40-50% of group earnings. A 20-25% downgrade to consensus MMS forecast earnings could follow, says Credit Suisse, or worse.

Goldman Sachs suggests 20-35% of profit. The range of outcomes is quite wide because MMS does not break down their published numbers to a sufficient extent to allow a more accurate assumption. Goldman is also waiting to find out, leaving its Neutral rating and $17.08 target in place for now.

When it comes down to it, yesterday’s 14% fall in MMS only wipes out the previous two months of gains. But then the stock went into a trading halt. Problem is, this is not just a little setback. It represents a fundamental shift in MMS’s prospects.

There is always a risk in investing in companies for which earnings are heavily reliant on favourable government legislation.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Spending downturn hits mine contractors
-Diversity is key to spreading impact
-Preferences home in on Downer EDI
-Monadelphous finding it hard
 

By Eva Brocklehurst

FY13 is going to be a difficult reporting season for mining contractors and the mining services sector. Deutsche Bank has minced the figures, noting the global minerals exploration market has grown from US$1.9 billion in 2002 to US$21.5bn in 2012. The broker's analysis suggests long-term global exploration spending will trend around US$15bn, or 30% lower than 2012 levels. That will impinge on those providing mining services.

Deutsche Bank evaluated historical junior miner spending, assuming that, from 2012 levels, exploration spending will fall by 73%. In the gold sector, exploration spending is expected to be down by 20%, with growth in jewellery and industrial demand being offset by reductions in investment and central bank demand. Copper exploration spending is seen increasing by 3%, in line with global GDP, while other commodity spending is seen falling by around 20%.

In this regard, JP Morgan is seeking out those in the contractor and mining services sector which have the best spread of exposures. Falling commodity prices and increased demand by investors for cash returns from the minerals industry has meant miners have curtailed capital expenditure and contractors with recurring elements to their contract and operations are best placed. JP Morgan notes a clear difference between those linked to mine production volumes against other operations and maintenance businesses that are still facing cut-backs as non-essential spending is deferred. 

A case in point is Bradken ((BKN)). Demand for mining consumables linked to production volumes has held up well for this operator. Also, Seven Group's ((SVW)) WesTrac is resilient. Continued strength in underlying production volumes suggests operating hours for heavy equipment are holding up and this supports demand for maintenance/parts and the replacement cycle.

Within the ASX100 coverage JP Morgan eyes Lend Lease ((LLC)) and Downer EDI ((DOW)), giving them an Overweight tag. Lend Lease's sheer size and low resources exposure is expected to shield the stock from the worst ravages of the mining downturn.The recurring themes of delay, scope cut-back and margin squeeze is part of Macquarie's thesis. In particular, achieving guidance for FY13, the quality of the underlying results (on cash flow and balance sheets) and the outlook for FY14 will garner most attention.

Macquarie also highlights Downer EDI as a positive, expecting the company to deliver on FY13 guidance with good second half cash flow. The earnings outlook for FY14 is expected to be flat. UGL's ((UGL)) result should reveal improved cash flow, albeit on a very weak first half. Gearing will likely be at the upper end of the company's 25-35% range because of around 80% in US dollar denominated debt. Macquarie expects a 20c final dividend, well below the prior year's 36c. 

JP Morgan relegates Monadelphous ((MND)) and WorleyParsons ((WOR)) to Underweight. Monadelphous may deliver on revenue growth guidance but, within the result, weaker margins will produce less at the profit level. Monadelphous' declining earnings profile over the next 12 months will make things hard and Macquarie rates it Neutral. Macquarie expects the second half cash flow will likely be down on the prior corresponding half but will show some sequential improvement. It's the FY14 forecast that will be of interest and the broker forecasts a 10% fall in FY14 revenue. In contrast to JP Morgan, Macquarie has an Outperform on WorleyParsons, hailing the attractive offshore exposure, although admitting the weakness in oil sands and resources are risks for FY14.

Ex-ASX100, JP Morgan likes Bradken, Seven Group, Ausdrill ((ASL)) and NRW Holdings ((NWH)). NRW's strong relationships with key blue chip customers in Australia positions the company as a preferred provider.

Gold mining is the toughest place to be, it seems. BA-Merrill Lynch suspects that, with the gold price around US$1,200/oz there is around 20% of worldwide production that is uneconomic and the industry will need to cut capital expenditure and capacity. The negative impact from this should be felt by services providers ALS ((ALQ)) and Imdex ((IMD)) and contractors Ausdrill, Boart Longyear ((BLY)) and Emeco ((EHL)). Based on the more bearish outlook, Deutsche Bank has downgraded ALS to a Sell, believing market forecasts for FY14-FY17 are too high and the stock looks expensive relative to both the market and peers. Merrills believes earnings impacts from rapid declines in miner sales will affect ALS, Boart Longyear and Imdex in particular. Those that have increased gearing to support fleet expansion, such as Ausdrill, Emeco and Boart Longyear, are expected to feel the pinch at the bottom line.

Among larger stocks, Leighton Holdings ((LEI)) is expected to reiterate full year guidance of $520-600 million but Macquarie suspects first half operating cash flow will be poor because of the increase in under-claims while gearing is still relatively high. Transfield Services ((TSE)) will also be scrutinised for cash flow and gearing. The group is due to refinance $242m in syndicated debt maturing in December. 

JP Morgan believes that, despite the pull-back in spending, Mineral Resources ((MIN)) should achieve 15.2% earnings growth to $238.8m in FY13. Crushing services and process minerals are benefitting from the ramp up of production at recently completed mines, increasing demand for these services. Looking ahead, earnings will largely be driven by iron ore pricing and the successful increase in production for mining. Of the small caps, Macquarie prefers Clough ((CLO)) in the oil and gas services sector while RCR Tomlinson ((RCR)) is also rated Outperform considering its iron ore, power, and oil and gas exposure.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Project deferrals reduce earnings
-Industrial maintenance most affected
-Cleanaway, landfill relatively stable
 

By Eva Brocklehurst

Even cleaners are finding the going tough at present. Industrial maintenance and waste remover, Transpacific Industries ((TPI)), has downgraded earnings expectations for FY13 after the second half failed to deliver on several fronts. The company is guiding for FY13 earnings of $405-415 million, which implies the second half will be down 12-16% on the prior corresponding half, on an underlying basis.

JP Morgan took the opportunity to upgrade the rating on the stock to Overweight from Neutral, believing the share price represents value for the longer-term investor. While earnings are likely to be volatile over the next couple of years there is relative value to the Small Industrials Index. The broker's determinant of value in the stock is whether the earnings reduction is structural or cyclical. Structural issues are factors affecting the high margin landfill business, such as state levies, market structure changes from the carbon tax and volumes in some of the east coast business. The main earnings deterioration is pinned on work deferrals, and this is a cyclical item. The question now becomes one of timing of the recovery in these markets.

So, what happened. A drop off in industrial activity was the main contributor to the deterioration in the second half, and where the guidance diverged from most broker expectations. Transpacific experienced the deferral of a large number of maintenance and shutdown projects across the industrial and mining sectors. The positive aspect is that this sort of work, while being delayed, is still largely necessary and so some resumption is expected in FY14.

Management noted the majority of deferred projects have been maintenance rather than capital projects. As well, the liquid waste business was affected by the slowing of the manufacturing sector and reduction in high-margin waste business. In this case, the slowdown could be more permanent. Macquarie suspects it will be some time before a lower Australian dollar revitalises manufacturing. Goldman Sachs too, is mindful of the weak manufacturing environment and remains concerned about the long-term impact of the decline in manufacturing activity on Transpacific.

Another point JP Morgan makes is the factors that affect Transpacific's landfill business are structural in nature, particularly as volumes are influenced by the state tariffs and changes following the introduction of the carbon tax. Both influences can be reversed but legislative changes would be required. The federal election may have to come and go to resolve this. This is one area to watch for Transpacific, as the issues facing the landfill market have had a meaningful impact on earnings given the significant margins that this business generates.

Moreover, arguments could be made that some of the volume declines the company has witnessed are also structural in nature, particularly on the east coast in industries which struggle to remain competitive because of the high Australian dollar. With commodity prices falling and questions over the resources industry capex outlook, exposure to construction and development projects are a concern, although this is a smaller part of Transpacific's overall business.

CIMB highlights the resilience of the Cleanaway business. Landfill volumes are weaker, reflecting soft economic conditions in South Australia, Western Australia and Victoria. Despite this, Cleanaway collection volumes are generally stable and there is modest growth in the commercial and municipal markets. Elsewhere in Transpacific's businesses, trading in New Zealand has improved and commercial vehicles are expected to report good profits in FY13. 

Goldman sees a shifting in the business from heavy manufacturing, higher margin wastes to relatively light waste, such as grease trap waste from restaurants where there is more competition and lower margins. The broker's price target of 88c is based on price/earnings parity with the Small Industrials. This reflects Goldman's view that the balance sheet will be close to investment grade by FY15 and hence the valuation will be in line with other small cap industrials by that stage. JP Morgan also observes the barriers to entry in much of the light waste business is low and competition is very fragmented. What drives market share in this respect is largely - price. JP Morgan suspects any cost savings the company is targeting is unlikely to be delivered to shareholders, rather the benefit will be invested back into price and market share.

The appointment of an operational consultant to undertake a review signals to the brokers the likelihood of further divestments. Targets are likely to be the underperforming industrial businesses, in Macquarie's opinion. Whilst the operational review may involve asset write-downs, Macquarie understands the earnings-based covenants for the debt facilities exclude non-cash write-downs and there is significant room in the equity-based covenants.

The company's managing director, Kevin Campbell, announced his resignation at the same time of the guidance update. He will continue to work with the board and management while a global search is undertaken for a successor. Macquarie notes Transpacific is a more stable company compared to when he joined but the timing of his announcement is unusual, given an incoming CEO is usually the one that conducts the operational review.

There are five Buy ratings on the FNArena database and one Hold. The consensus target price is 98c, signalling 27.5% upside to the last share price.

See also, Transpacific No Longer Rubbish on February 25.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Deaths flat in 4 months to April
-Stock appears expensive
-Digital business key to future
-Longer-term view required
 

By Eva Brocklehurst

Funeral director, InvoCare ((IVC)), has had a strong run recently as investors seek out quality stocks with good growth potential. It surprised brokers at the AGM by offering a year-to-date assessment of earnings growth. At the operating earnings level it was 7.7% for the four months to April, somewhat softer than many had anticipated. The reasons cited were additional costs, digital business initiatives and lower-than-expected case volumes. Case volumes were up 4% in the four months, including acquisitions, while comparative volumes were up just 1%, as the number of deaths was relatively stable. Average funeral case prices were up 3-4%. The broker reaction to more muted earnings growth was far from severe as, while the stock is viewed as expensive, most take a long-term view.

Macquarie is the most upbeat, retaining the only Outperform rating on the FNArena database. The broker notes the attraction in a company that is able to lift prices to, at least, meet inflation levels. Cemetery and crematorium memorial sales are up, with the deferred revenue pool increasing. It's the investment in digital initiatives that should underpin the company's market position longer term. HeavenAddress, Mymemorial and Funeralorganiser.com.au are expected to enhance service, increase consumer engagement and loyalty. The first mover advantage that InvoCare has in digital is likely to be what sets it apart in future years, in Macquarie's opinion.

Given the stronger market, the investment returns on pre-paid funds under management are exceeding the impact of price rises and should boost reported profit. Moreover, the company has improved market share and the Singapore division case averages continue to benefit from package pricing and accessory sales. The concern for some brokers is, as JP Morgan noted, that the earnings multiple expanded with the recent outperformance of the stock, despite the fact that the earnings outlook was relatively stable. InvoCare is trading at around a 90% premium to the Small Industrials Index, at a level not seen since the GFC. The broker has adjusted earnings forecasts downward slightly for FY13 and FY14 and remains Neutral on the stock. 

Deutsche Bank believes the AGM commentary about margin pressure should not have been a surprise, as the company flagged that earlier in the month in a presentation. The magnitude of the impact was the negative. In the context of the market sector in which InvoCare is located, Deutsche Bank finds the earnings growth over the four months was solid. The broker likes the relatively defensive earnings, medium-to-long term structural tail winds, annual price increases, operating cash flow conversion and return on capital. It's just that this is largely captured by the current valuation, hence a Hold rating.

One of two Sell ratings on the database, Citi has judged the stock expensive, despite the quality of the franchise. The broker has made modest reductions to earnings forecasts, around 2%, primarily to reflect higher interest costs. The broker finds the stock is still expensive on an absolute and relative return basis. The stock is trading on Citi's 12-month forward price/earnings multiple of 22 time versus earnings growth forecasts of 9% in FY13, 7% in FY14 and 7% in FY15.

InvoCare is not without earnings volatility. There is the death rate, which is beyond the company's control, but also the high fixed nature of the costs. Should investment return on funds fall below inflation, the margin would be impacted, and in turn the stock would have difficulty achieving targets. The converse is equally true, Citi acknowledges. The business may be well managed and have a favourable industry structure but, trading on 26.8 times the revised FY13 earnings estimate, means, for UBS, a downgrade to Sell from Neutral.

To cap, on the FNArena database there are one Buy, three Hold ratings and two Sell. The consensus target price is $10.49, indicating 0.6% downside to the last share price. The targets range from $9.19 to $11.60. The dividend yield on consensus FY13 earnings is 3.5% and for FY14, 3.7%.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

- Sell ratings dominate
- Analysts spooked by mining capex slowdown
- CLSA sees little near term hope

By Andrew Nelson

The company's interim profit report back in February marked a distinct turning point for engineering and construction services provider Monadelphous ((MND)). It’s not that it was a bad result. In fact, the numbers were in-line with most broker forecasts and even ahead of a few. It still wasn’t enough to keep three FNArena database brokers from downgrading their recommendations on what were then creeping fears about the slowdown in mining capex and the cancellation and/or deferral of projects.

Macquarie, who used the opportunity to downgrade its recommendation to Neutral from Outperform, summed up the broader broker stance back in February. While Macquarie admitted it was another guidance-beating result and FY13 revenue guidance was lifted, it still saw the need for more caution. Margins had slipped and earnings growth was already fading, the broker noted. Macquarie did think management was being cautious about new awards in FY14, warning a period of consolidation is at hand. Yet while Macquarie suggested this may be somewhat conservative, the broker nevertheless saw little chance for outperformance in the short term.

The result was also in line with Deutsche Bank, who lifted FY13 revenue forecasts on the result, which fed through to a 2% increase to net profit forecasts. The broker also noted competition was starting to bite, margins were under pressure and uncertainty remained around new project approvals. Deutsche Bank said back in February it expects the pipeline to keep shrinking, which would put FY14 revenue growth in doubt. BA-Merrill Lynch was of the opinion back then that revenue had peaked for the cycle and despite the company’s oil and gas opportunities, new work will be harder and harder to come by. That was the reason both brokers downgraded to Sell.

Citi and UBS didn’t downgrade their calls at the time, but that’s because they were both already at Sell (or equivalent). In a report this month, Citi was unsurprisingly concerned about the fact that Australian non-residential and engineering work has fallen off so sharply since late last year. What’s worse, so have forward indicators. This caused Citi to push out its recovery forecasts and revise its growth expectations.

UBS also updated its view this month and is also of the belief that end markets are continuing to deteriorate. The broker is also now thinking we’ll see an earlier than previously expected decline in earnings. Probably as soon as FY14 rather than FY16. The broker lifted its FY13 earnings forecasts by 1.5%, reduced FY14-15 by 18% and cut its price target by around the same amount.

Regional broker CLSA Asia-Pacific Markets was on the fence, at least until this week. The broker actually lifted its call a notch back in March on the belief that increasing work in the LNG market would be enough to offset softness in iron ore. Not so, unfortunately, and once the broker came to this view it downgraded back to Sell.

Switching from mildly optimistic back to a Sell call yesterday, the broker now expects a cocktail of the issues mentioned by various brokers above. CLSA sees group revenues dropping 12%, with margins shrinking by 100bps in FY14. This saw CLSA’s FY14 EPS forecast cut by 21%. With the broker now forecasting declining earnings growth for the next two years, it feels the stock simply does not justify any premium to the market and this is despite the quality of this business.

The broker explained that even the highest quality company in mining services cannot remain immune to a commodities slowdown. In fact, with BHP Billiton ((BHP)) and Rio Tinto ((RIO)) both increasing their focus on costs and savings, shelving plans for expansion, CLSA thinks margins for all mining services companies will remain under pressure. The broker sees this continuing to play out over the next twelve months, at least.

Why will margins fall 100bps in FY14? CLSA has laid out a hit list, which includes an increasing maintenance contribution to the revenue stream, fewer positive contract variations, lower headline margins, less shutdown work and the inability to use Sinostruct in LNG.

There is just one true believers in Monadelphous still standing: CIMB. Although it must be noted the last sign of support was back with the first half result in February. The broker said back then that is still saw further growth ahead from cost cutting in the business. This was despite management's assessment that FY14 would be a year of consolidation. CIMB also thought the share price reaction to that admission was too excessive. In fact, the broker saw it as a great buying opportunity and upgraded to Outperform. Back then.

The FNArena Database shows there is currently 25.3% upside to the consensus price target. Broker sentiment for the stock is negative, the database showing a Buy/Hold/Sell ratio of 1/2/5.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Earnings downgrade hits hard
-Company is diverse and resilient
-Hydrocarbons key to growth
-And there's a dividend while waiting
 

By Eva Brocklehurst

Diversified resources infrastructure provider, WorleyParsons ((WOR)), hit the market with an earnings downgrade and investors took out their frustrations on the share price. Is this justified? Brokers are of mixed views on that. Near term, as is the case for many that are providing services to build mine infrastructure, the talk is all about cut-backs to scope and project delays. Longer term? The geographic spread and exposure to the more buoyant hydrocarbons sector means WorleyParsons should be well placed, when things improve.

Cost cutting by WorleyParsons' clients in Western Australia contributed a large part to the downgrade, as well as softening conditions in the Canadian oil sands market. The oil sands company Cord was a key to first half strength but construction activity has softened and it appears this business will not deliver the level of growth previously expected. One of the negative aspects of the Canadian oil sands economics is that Canadian oil sands prices are at a discount to West Texas Intermediate. Greenfield projects are harder to justify. What may deliver a benefit for WorleyParsons, in Macquarie's view, is the Keystone pipeline approval in the next six months. This could deliver improved supply of Canadian oil sands to the US Gulf coast and, in turn, reduce the price discount.

The growth for FY13 is gone, nonetheless, largely courtesy of Western Australia. This is what the market has focused on. The profit guidance of $320-340 million for FY13 compares to FY12's underlying earnings of $345.6m. The quantum of the impact of the downturn was larger than JP Morgan expected and this broker does not expect conditions to get better soon. The company's Improve division - brownfields operations and maintenance - is likely to provide the growth and visibility on earnings down the track but this business does have lower margins compared the execution phase businesses. JP Morgan is just not convinced that all the negatives have been factored in and remains the most cautious of the brokers on the FNArena database, with a Sell rating (sector relative).

Hydrocarbons is the company's strongest division, representing 70% of earnings, and here growth is expected. The outlook for  US downstream activity in refining and petroleum is improving, instigated by cheap US gas. Macquarie notes 45% of WorleyParsons' revenue now comes from North America but the exposure to hydrocarbons is global. WorleyParsons has 33% of segment revenue from Canada, 18% from the US/Caribbean, 13% from Europe and 19% from Australia. Credit Suisse views the company as well placed to win a fair share of new projects in deep water, sub-sea, arctic and unconventional oil and gas where WorleyParsons has a competitive advantage. Management flagged the fact that some key customers in the Middle East and the US were actually intent on increasing capex spending next year in this regard.

Macquarie calls it the "second half club", which WorleyParsons has now joined. The second half is not meeting expectations for a number of companies and they are being forced to issue profit warnings. Macquarie had flagged WorleyParsons' potential to be initiated into the club, but thought the strength in hydrocarbons and diversity of earnings streams would get the company over the line. It seems the Western Australian infrastructure and environment division delivered the biggest blow with resource project deferrals, including Woodside Petroleum's ((WPL)) Browse Basin decision. There is also WA restructuring costs and onerous lease provisions in the second half which are contributing to the deterioration. There was also reduced spending in South Africa, the US and Canada.

Macquarie finds WorleyParsons is now trading at a 17% discount to global peers on a FY13 price/earnings ratio. It is trading at a slight premium to closest peers Amec and Wood but at a discount to Jacob. In spite of this, WorleyParsons is considered one of the few that can deliver sustainable earnings growth over the next few years. The key word is "confidence". Here, guidance at the FY13 results in August will be critical for brokers. UBS has lowered expectations for FY13, FY14 and FY15 earnings by 10%, 23% and 25% respectively, assuming an ongoing deterioration in the minerals/metals and infrastructure & environment divisions. Yet, medium-to longer-term the outlook is robust on the back of favourable oil and gas fundamentals.

The earnings downgrade relates to the underperformance of divisions which account, collectively, for 14% of revenue and on this basis Credit Suisse believes the market reaction was over the top. The stock on Credit Suisse's estimates is trading on a forward price/earnings of 12.1x. To arrive at a discounted cash flow valuation in line with the current share price the assumption must be made that earnings margins stabilise below trough levels. For Credit Suisse this is overly bearish, given the company's dominant market position, solid execution and acquisition track record.

CIMB had formed a view, just before the latest guidance was issued, that WorleyParsons was significantly undervalued given the global footprint and diversity of its business. The broker is not eating humble pie, other than to cut earnings forecasts for FY13 in line with guidance, observing that, within the Western Australian businesses it was the bottom-line leverage of one poor performer, representing just 4% of revenue, that was underestimated.

CIMB admits the market will want proof that the company can grow but, if the Cord problems are mostly about timing and Western Australia is restructured appropriately, then this could be end of the downgrade. Moreover, with a 5% yield in FY14 and a payout ratio under 70%, the broker believes investors will be at lest well paid while they wait.

On the FNArena database the consensus dividend yield for FY13 earnings is 4.6% and for FY14 earnings 4.9%. The consensus target price is $22.62, signalling 14.7% upside to the last share price. There are four Buy ratings on the stock, three Hold and one Sell.

WOR has pursued a strategy of globalisation for its metals, mining & chemicals and infrastructure & environment businesses. In FY10, Australia accounted for 59% and 56% of respective revenue. In FY13, Macquarie estimates Australia will account for closer to 40% of each. Latin America and Asia/China have driven much of the diversification in the former while Latin America and Africa have driven the latter.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Losses, delays equal downgrade
-Fears over loss of value with break-up
-Lack of appeal in engineering
-DTZ the most positive

By Eva Brocklehurst

UGL Ltd ((UGL)), an engineering, mining operations and property maintenance conglomerate, has run into a perfect storm. The slowdown in mining activity, delays and execution issues with projects, particularly in power, and general economic malaise has resulted in the company waving the downgrade flag over FY13 earnings.

The company downgraded earnings guidance for FY13, which didn't surprise brokers, given the current climate. What did surprise was the extent of the downgrade - 39% below prior guidance. Half relates to losses on power projects and the rest to project delays and/or scope cut-backs. The biggest problem project is the Solomon power plant for Fortescue Metals ((FMG)), which is to be completed August. UGL is confident that, having taken a hit in FY13, it will emerge with a clean slate in FY14, but brokers are not so sure.

Credit Suisse has sounded a note of alarm, fearing the company has worn more than its fair share of the scaling back of mining activity, both in terms of operations and maintenance and new investment. The broker suspects UGL is either not cost competitive or is enduring a breakdown in relationships with some customers. Neither is good, and the broker is particularly concerned about the outlook for engineering. Any break up of the property and engineering businesses could open up the separate entities to become takeover targets. Credit Suisse used the opportunity to downgrade the rating to Hold from Buy.

UGL has previously flagged a strategic review, due for August. The company has now stated it will consolidate operations and maintenance (O&M) into engineering and seek an additional $20m in cost savings by August as part of this restructure. At this stage the company believes costs that have been removed are sufficient and the combination of O&M and engineering will produce a business with the appropriate scale. The board has signalled, at this point in time, they are favouring a de-merger of engineering and property services.

When the review was announced brokers were sceptical of the timing. With the downgrade to earnings forecasts and continuing heavy weather in resource-based sectors they remain even more worried about how UGL can extract value from its businesses. BA-Merrill Lynch, while accepting that a united engineering/O&M has benefits in cost structures and margins, is concerned about the reduced margin visibility this implies.

Brokers have looked at the prospect of a restructure and/or hiving off of some segments and have difficulty finding the appeal. Macquarie thinks a de-merger the most likely outcome and, while the broker is attracted to the DTZ property business, the investment case for engineering/operations and maintenance is less interesting, even though an earnings bottom may be reached in the next 12 months.

Macquarie notes UGL earnings are far less defensive than they once were and risk management and/or project execution is falling short of expectations. Peers are doing better in the broker's opinion. Moreover, UGL's FY13 downgrade highlights the risk around the second half performance for the sector as a whole. Macquarie suspects this is possibly going to continue into FY14, when a lack of new work could make growth of any form challenging. BA-Merrill Lynch accepts a separation makes sense but considers the timing is less than optimal given the cyclical downturn in engineering while the property business is yet to deliver on its promise.

The most positive area is property, which is on track for earnings growth in FY13 in the USA and Asia, although conditions remain tough in Germany and France. Management will need to reduce costs and reassess project management, in JP Morgan' opinion, in order to re-establish its reputation for delivery and also to respond to the impact on the non-DTZ business of the slowdown in activity. DTZ has a good outlook, in the broker's view as demand for outsourced property services grows globally in spite of weakness in some areas. Nevertheless, JP Morgan also questions the amount of value that could be released form a change in the corporate structure and things a de-merger at this stage may not extract the full value, given the continued integration work and the impact that pulling DTZ out of the company may have on the ability to pursue and fund growth. 

The FNArena database contains six Hold ratings for UGL and one Sell - Macquarie. The one Buy is Deutsche Bank, which hasn't updated for the latest downgrade as yet. The consensus target price has fallen to $8.87 from $10.96, which suggests 18.1% upside to the last share price. The dividend yield on FY13 consensus earnings forecasts is 6.8% while for FY14 it is 7.7%.

See also, UGL Shakes Up Market With Corporate Review on March 27 2013

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.