-Buy-back in jeopardy
-Asset sales to provide buffer
-Trading contract tenure for price

By Eva Brocklehurst

Orica ((ORI)) has bitten down hard on the bullet, announcing a substantial downgrade to profit expectations for FY15 and signalling a flat outlook for FY16. Several brokers maintain the announcement should have been made much earlier, given broad and well flagged suspicions the operating backdrop, particularly in mining, was deteriorating.

Orica has announced asset impairments of $1.35-65bn and downgraded FY15 earnings guidance to be 25-30% below the prior year, at $425-445m. Brokers also consider the downgrades reflect a reality check by the new CEO, Alberto Calderon.

Having already downgraded forecasts, Morgans downgrades again, with FY15 and FY16 reduced by 12.7% and 10.9% respectively. Of most concern is the deterioration in the second half, considered to be the company's seasonally stronger period. Morgans forecasts volume growth to return in FY17 in the Australian market, believing miners can only hold out by high grading for so long.

The one lingering positive from the challenges throughout FY15 has been the share buy-back but this now looks in jeopardy. The $400m buy-back is under review, pending discussions. To date $53.4m in shares have been bought back. Management stated its priority is to protect the credit rating and dividend. Morgans removes the buy-back from forecasts and retains a steady dividend. Given the buy-back is no longer in place to support the share price the broker is cautious.

Meanwhile, Orica is assessing the options for its Bontang ammonium nitrate facility in Indonesia. Morgans observes, once the new Burrup plant in the Pilbara ramps up in 2016, there is around 60,000 tonnes from Bontang, previously exported to Western Australia, which will have to find a new market.

Competition from China and a tough coal market in Indonesia means pressure is being placed on the facility at Bontang. At this stage, Morgans expects Burrup will generate sub optimal returns as the market will be oversupplied initially.

Management is re-establishing ground support as a separate business unit to provide more options in the future. Morgans notes the fact the company was unsuccessful in selling this business in the past. The company expects proceeds from the sale of the chemicals business, combined with the benefits of its transformation program, to provide a buffer for the current credit rating, although Morgans asserts the head room will be reduced by the lower earnings.

Macquarie estimates gearing will increase to 37%, in the middle of the company's 35-45% target range. The broker considers the downgrade is exacerbated by US price reductions, lower price for Australian volumes and pressure on services. As Australian and US earnings are heavily centred on coal this industry is the main culprit. Still, the forecast for a flat FY16 outcome was of particular surprise to Macquarie, given cost savings and lower FX were expected to deliver growth.

Volume downgrades are a major headwind and the extent of the downgrade suggests to Macquarie that profitability is under pressure, as transformation benefits are overshadowed by pricing pressures and an adverse shift in mix. The broker observes Orica has continued to trade tenure for price, with 90% of FY16 Australia/Pacific volumes now contracted. This is expected to outweigh the benefits of transformation in FY16.

Orica is only now facing up to just how weak conditions really are, Morgan Stanley maintains. The costs associated with this re-basing of earnings are larger than expected but it also confirms what the broker had largely feared. Morgan Stanley also suspects the market is deteriorating further and the prospect for Orica is challenging despite the revamped outlook.

Credit Suisse takes the view that the downgrade has now captured most of the downside risks and assumes the buy-back will be discontinued. Credit Suisse estimates bulk price contracts have been re-set marginally above import parity and this provides a reasonable base for pricing in the Australian market. The broker is not sure what operational flexibility exists at Bontang but cash break-even appears to represents a reasonable floor. 

On Credit Suisse's forecasts the balance sheet appears sustainable under the new earnings assumptions. However, demand growth is not expected to tighten the supply balance enough to produce pricing power before 2020.

The profit warning and impairments, albeit worse than expected, are more a case of re-basing of expectations by the new CEO, from which the company should be able to grow earnings and returns, in Deutsche Bank's opinion. The broker considers the forecast for flat earnings in FY16 is conservative and, while the call does not instill confidence, a Buy rating is maintained with the stock trading at a 29% discount to valuation.

Management would not expand on the quantum of transformation benefits in FY16 but Citi presumes an annualised effect should add to earnings in FY16, with no further deterioration in the underlying operating environment. While the downgrade to guidance was a disappointment, Citi is not so pessimistic about the outlook and believes the announcement reflects the usual re-basing that comes with new leadership.

The biggest risk to achieving a target of $22, the top of the range among brokers surveyed on FNArena's database, is slowing Chinese demand for electricity, steel and other commodities, in Citi's view. Mining services would be immediately affected by a sharp deterioration in the outlook for demand for commodities. Upside would come from a larger than expected rise in US and European GDP growth, or a substantially weaker Australian dollar, as well as more intense use of the company's products at a mine level.

UBS is far more negative and remains concerned about the flat outlook for FY16, cutting forecasts by 10-25%. The broker's forecast for FY16 net profit is below the bottom of the outlook range provided by Orica and implies a drop of 10% on FY15 guidance. UBS considers the probable halting of the buy-back, an uninspiring free cash yield and risks to the balance sheet mean there is not enough capital to support valuation should the outlook worsen.

On FNArena's database there are two Buy ratings, two Hold and three Sell. The consensus target is $17.34, suggesting 11.9% upside to the last share price. This compares with $20.04 ahead of the warning. Targets range from $14.00 (UBS) to $22.00 (Citi and Deutsche Bank). The dividend yield is 5.9% for both FY15 and FY16 estimates.
 

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-FY16 drop in profit forecast
-Rail projects key catalysts
-Could stock be a target?
 

By Eva Brocklehurst

The upcoming twelve months were always going to be a challenge for Downer EDI ((DOW)) but brokers are of the opinion it may be even worse than previously surmised.

The company may have the ammunition to withstand the onslaught better than its broader peer group but as Morgan Stanley argues, this is not that compelling. The scope for further cost reductions is limited and acquisition capacity increasingly constrained. The remaining advantage the company has, diversity, may not be enough.

Downer's guidance for FY16 suggests a 10% fall in net profit and Citi maintains, given the uncertainties, the company has been prudent. The broker points to a quality management team which has a track record of only communicating what it believes is achievable. Increased visibility as FY16 gets underway should enhance confidence in guidance.

What the guidance signals to Morgan Stanley is that the decline in engineering and construction capex is unprecedented. The broker is optimistic the company can derive significant growth from utilities and rail segments, should it be successful in securing its share of the upcoming work on offer.

Still, these opportunities are long dated and unlikely to contribute until FY18. Meanwhile, substantial LNG work will roll off in FY17-18. Morgan Stanley observes, with the exception of the Wheatstone contract, most of the construction work currently on the order book is small-scale.

This may change if the company wins the $800m passenger rail tender in NSW or a similar sized bid in Victoria. Nonetheless, this then brings to the fore memories of the bungled Waratah train project. The scale of these projects could stretch the company's resources too far in the event it secures more than one of the contracts on offer, Morgan Stanley warns.

Citi is inclined to the view the benefits of diversification should help soften the blow from the resources and energy industry slowdown, which is having a worse impact on the company's peers. In any case, a robust balance sheet and strategic alignment to growth projects sets the broker wondering whether the company is a potential target for acquisition.

Citi also believes too much focus on the short term could prove short sighted and upgrades its recommendation to Buy from Neutral. The broker maintains the market is factoring in a view that Downer will be unsuccessful in all the three major rail tenders that are on the table.

Macquarie, too, is upgrading to Outperform from Neutral, suspecting the stock price reaction has been too harsh. The market appears to be ignoring the options in the balance sheet with $400m in capacity to make acquisitions or buy back stock. While FY16 carries a higher than usual degree of earnings risk the company's track record stands it in good stead, in the broker's opinion.

The fact that the FY16 outlook implies substantial underlying earnings declines cannot be overlooked and UBS goes the other way, downgrading to Neutral from Buy. The broker remains attracted to the strong balance sheet, with related opportunities such a buy-backs and further accretive acquisitions, but assumes there is little or no earnings growth for the next two years.

There is only so much that can be done to prevail in a deteriorating environment, despite the competence of management, in Deutsche Bank's opinion, and a Hold rating is considered appropriate at this juncture. This broker also emphasises the power and rail opportunities will be unlikely to contribute until FY17-18.

JP Morgan considers the stock oversold, noting the market ignored the cash flow conversion to earnings of 100%. The result has more implication for stocks leveraged to resources construction and the broker believes Downer's exposure is less than 10% of revenue. Hence, an upgrade to Overweight from Neutral.

On the resources exposure issue, Credit Suisse is concerned diversification and cost cutting are not progressing quickly enough to mitigate the impact of the mining-exposed end markets. The broker awaits hard evidence of a turnaround before becoming more constructive.

Also, Credit Suisse observes bid costs for the three light rail projects have not been considered in FY16 guidance and the company's forecasts could be stretched. Longer term, aggressive price tendering or a "win at any cost" is an emerging risk and this may support near-term earnings at the expense of subsequent years.

With four ratings changes in place FNArena's database now has four Buy ratings, three Hold and one Sell (Morgan Stanley). The consensus target is $4.45, signalling 10.2% upside to the last share price and compares with $4.75 before the results. The dividend yield on FY16 and FY17 estimates is 5.9% and 5.8% respectively.
 

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-Macquarie Uni loss keenly felt
-Margins improve first time since FY11
-Will regulatory risks spread?
 

By Eva Brocklehurst

Navitas ((NVT)), the education program provider, has navigated FY15 despite the hazards. Earnings are estimated to be flat over the next two years as the impact of the loss of the Macquarie University contract washes through.

The result was in line with Morgan Stanley's expectations and there were few surprises. Nonetheless, the broker envisages some downside risk to consensus forecasts, given management suggested FY16 would be broadly in line with FY15.

Materially, the impact of the loss of the Macquarie University programs will take effect from February 2016 but the broker expects this to be mitigated by earnings growth from other contracts and divisions.

Credit Suisse had expected the company might miss guidance, given the headwinds. Instead, on a more positive note, margins in university programs improved for the first time since FY11. The company now suggests university earnings will decline, as growth is expected in other divisions with flat outcome, overall, in FY16.

The broker remains bullish on the long-term outlook for international student growth and, given the fall in the share price, upgrades to Neutral from Underperform. The outlook appears largely priced in and Credit Suisse envisages near-term risks are to the upside.

UBS maintains investors should focus on the long-term growth rate for the university programs and believes there is more risk for upgrades to estimates if new programs can be signed up. To that end UBS incorporates another 10 university partners in forecasts, to be gathered over the next five years.

Even accounting for signing up new partners, the broker estimates earnings to grow at a rate of 6.2% over FY17-25, which compares with the 10% achieved in FY12-15.

University programs are a critical division, representing more than 75% of group earnings, which explains why the outlook is subdued. A wave of strong growth ended in FY15 because of the loss of the Macquarie University contract as well as increased regulatory hurdles.

Stricter criteria were applied to migrant student programs in the second half by the Department of Immigration. This also follows a decline in UK enrolments because of regulatory changes.

Deutsche Bank expects that besides the loss of the Macquarie University contract and other challenges stemming from the tighter UK regulatory environment, the university division will not be able to make up lost earnings over FY16-17. The broker still believes the stock is fairly valued, with growth likely to return in FY18. Goldman Sachs is of a similar view, envisaging reasonable valuation upside but also more opportunity in other small to medium industrial stocks.

Moelis takes a more negative stance. The broker, not included in the FNArena database, is underwhelmed by the results and has a Sell rating and $4.04 target, suspecting the company still has a lot of pain to endure for the next 18 months. Moreover, Moelis believes there is no guarantee that the stricter regulatory changes that occurred in the UK and Australia will not happen in North America in the future.

University partners may also use Macquarie University's exit to negotiate better terms, such as shorter duration contracts, or even trial their own pathway programs in house. While the company's new joint venture model is sound, with less risk up front, Moelis also believes it means less reward, as Navitas receives only 51% of the earnings.

The near-term issues of replacing contracts are expected to hobble the company and keep growth in check, in Macquarie (the broker)'s view. Cash conversion remains strong and underlying margin growth is in evidence based on improved efficiencies and take up of professional courses outside of the migrant English courses. Hence, the broker considers the risk/reward relatively balanced.

FNArena's database has one Buy rating and one Sell, both from brokers that are yet to update on the latest news. There are five Hold ratings for the remainder. The consensus target is $4.70, suggesting 10.8% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 4.7% and 4.6% respectively.
 

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-Revenue upgrade for FY15
-Significant opportunities ahead
-Time to earnings translation
 

By Eva Brocklehurst

Patience is required with law firm Slater & Gordon ((SGH)), brokers contend, as the company digests a large acquisition which, while providing access to a wider range of cases, has risks around integration and execution.

Slater & Gordon has upgraded its revenue target for FY15 to include a contribution from its UK personal injury business acquisitions, Leo Abse and Cohen and Walker Smith Way, a stronger performance in Australian and UK operations and favourable currency movements. However, the firm's newly acquired Professional Services Division (PSD) will be strapped for cash flow over the next 6-12 months as certain cases move through the resolution process.

The firm has provided investors with a comprehensive overview of the PSD business, expecting significantly greater access to cases amid opportunities for synergies. There are a number of positives, Macquarie observes. The company has managed to leverage scale with third party intermediaries and improvement in cash flow should be apparent in FY16. Short-term cost saving opportunities are evident and case volumes are underpinned by channel partners and market share growth. Near term, the multiples on the stock are not demanding and Macquarie believes there is potential for the valuation gap to narrow as the company demonstrates PSD can be operated profitably.

Deutsche Bank found the update a mixed offering, with some negatives. The FY15 revenue upgrade does not translate into an earnings upgrade as the PSD will not contribute because of NIHL (noise induced hearing loss) case losses, while transaction costs are higher. First half FY16 cash flows are expected to be weak, which suggests a skew to the second half. Deutsche Bank also believes there will be challenges for the share price in the near term as the register expands towards large cap investors.

Deutsche Bank observes the FY16 revenue growth outlook for 5.0% in personal injury and 8-10% in general law remains consistent with its expectations. All said, the broker considers the valuation is still compelling and accepts the firm's conviction that the PSD deal will be transformational. The addressable UK market is substantial and highly fragmented and the PSD business is considered well positioned to capitalise on opportunities. The business extends the existing direct-to-consumer channel and opens up the insurer channel. Moreover, it will broaden referrals.

PSD will operate as a standalone business but will not be run in the way of the previous owner, Quindell plc. There will be a stronger focus on case mix and selection as well as case acquisition costs and cash generation.

The recent weakness in the share price suggests some scepticism regarding the PSD transaction. UBS maintains the future performance of earnings and cash flow should ultimately remedy this sentiment. Cash flow will be weak as the NIHL settlements wash through and it may take more than a year before the business produces a regular cash base on which it can be accurately evaluated, in the broker's opinion.

While investors are required to keep the faith, UBS calls for management to improve clarity disclosing work-in-progress balances and case numbers to help them shore up their methodologies. This is particularly important given Quindell had well-publicised earnings growth and margins but challenged cash flow. UBS acknowledges Slater & Gordon will recognise revenue along more conservative accounting lines but investors are still being asked to assume cash will flow from revenue regardless.

There are four Buy ratings for the stock on FNArena's database. The consensus target is $8.30, signalling 60.1% upside to the last share price. It compares with $8.67 ahead of the update. Targets range from $7.90 to $8.98.

See also Slater & Gordon Achieving Critical Mass on February 12 2015.
 

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-Weak FY15-16 likely to pressure shares
-But could provide entry point
-Moorebank development potential ahead
-But not featuring until FY18
 

By Eva Brocklehurst

Qube Holdings ((QUB)) has unveiled the potential of the Moorebank intermodal Terminal development but given a soft near-term earnings outlook, not all broker reviews are positive. In tandem with the company's warning that earnings are reduced due to the expiry of resource contracts, the federal government has given its approval for the Moorebank project, a major transport and logistics hub to be developed in south western Sydney.

In addition to earnings from running trains into the Moorebank terminal, Qube will derive earnings from ownership of the site and fees from being the construction manager. The company will also buy out Aurizon Holding's ((AZJ)) property development rights as each tenant is signed up and deliver cross-docking and services to customers. Aurizon is the 33% partner to Qube in the Moorebank project. The total project cost is estimated at $1.5bn over 10 years with a government share of $370m towards development including funding the rail connection with the southern Sydney freight line.

Brokers have emerged from a detailed briefing on Moorebank with divergent views. Qube Holdings has a consensus target on FNArena's database of $2.84. It suggests 13.6% upside to the last share price. Targets range from $2.25 (Deutsche Bank) to $3.35 (Credit Suisse). There are five Buy ratings, two Hold and one Sell.

Morgans was pleased the agreement on Moorebank with the government was finally reached and expects around $40m could be generated in earnings by FY20. Otherwise, reduced earnings from the ports & bulk division in the near term is a negative. Having already cut FY16 forecasts by 5.0% because of the cessation of contracts, the broker's FY15 estimates are reduced by a further 6.5%, as the company cites flagging volumes and price pressures. Still, Morgans believes markets were factoring in views which were too optimistic on FY16 and these needed to be revised down. The broker remains of the view the company has the potential to build a high quality transport company and retains an Add rating.

The Moorebank development is actually a property play, UBS maintains, with only 30% of the fully developed earnings coming from logistics activities. The broker expects the warehousing and logistics connections will attract volume to the terminal and be important in differentiating the intermodal offering. The broker expects incremental earnings contributions from FY19 and incremental cash flow from FY21. At this stage the broker does not incorporate the project's financials into mainstream forecasts but presents preliminary modeling on a standalone basis and retains a Neutral rating. Moreover, the stock is trading at a significant premium to market average multiples which the broker believes captures much of the upside potential.

Morgan Stanley was impressed with the details on Moorebank but until the tenancy is settled, expects the share price direction will come from the base business. Given this is subdued, the stock is likely to suffer in the near term but the broker believes any weakness could provide an attractive entry point. The positives in the detail include a rent free period to accelerate the rail economics and lower up-front capital expenditure. Qube will also receive the full economic benefit from warehousing and the broker believes the project could be worth $1bn in the end. Still, Morgan Stanley acknowledges risks around tenancy, greenfield development and developer margins.

Outstanding issues remain, Macquarie agrees, citing clarity on warehouse funding and timing. Still, the broker retains an Outperform rating, believing the market will start to factor in the heightened prospects now the project has been approved and discussions with tenants and developers can begin.

One difficulty Citi has with the Moorebank development is how savings will be delivered to customers. There will be differing price ranges and management expects supply chain savings of 20-25%. Citi suspects this will be targeted at key exporters and importers, and savings will stem from conversion to a faster cross-dock operation. The company's capital commitment is easily covered by cash and existing debt. Given the long-term ownership of the property Citi envisages potential in developing and leasing a portion of the warehouse capacity. Management is forecasting a post-tax return of more than 12-15% and Citi believes, if development rights were sold, this could be even more attractive.

Deutsche Bank is more pessimistic about the short term, suspecting earnings would not improve going into FY16 because of the cessation of the Arrium ((ARI)) contract and the restructure of the Atlas Iron ((AGO)) contract, while the opportunity from the Moorebank development is well into the future. The broker understands the strategy to reduce supply chain costs and the longer-term potential for Moorebank to change industry dynamics.

Nevertheless, in the here and now, the broker's FY15 earnings estimates are reduced by 16% and the rating is downgraded to Sell from Hold. Deutsche Bank estimates iron ore represents 23% of port & bulk segment revenue in FY15 and further volume weakness will continue. On most measures, in comparison to peers Aurizon and Asciano ((AIO)), Qube is viewed less favourably.

Credit Suisse expects the promise from Moorebank could be in evidence by FY18. Credit Suisse also downgrades estimates by 16% on the back of the expiry of resource contracts coupled with the loss of margin on the Atlas Iron contract, as well as lower expected rental from Moorebank while the property is developed. In a similar vein to Morgan Stanley, the broker accepts, longer term, there could be attractive upside and entry points could be available in the near term.

Despite the company's iron ore exposure, now the earnings downgrade has been factored in, the broker has come to the conclusion upside for Moorebank outweighs the risk. Credit Suisse believes Qube has unfettered pricing power and can capture a large portion of the efficiency gains in the import/export container supply chain. Hence, rating is upgraded to Outperform from Underperform.
 

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-Double digit growth expected
-Regulatory changes supportive
-Final dividend expected

By Eva Brocklehurst

Recent share price weakness in Veda Group ((VED)) has captured the attention of Moelis and the broker upgrades to a Buy rating. The resilience of the company's business is considered an attractive feature in the current weakening Australian economy.

Around 80% of the company's sales revenue involves "clicks" on credit analytics. There is no listed domestic comparables in the Australian market as Veda is the largest aggregator of credit data on consumers and businesses in Australasia. The company trades in line with the average for Australian information services companies and Moelis notes it also trades in line with international credit bureaux such as Experian and Equifax.

Veda has guided to double digit FY15 earnings growth. Moelis estimates around 12% growth in earnings and 15% in profit in FY15. The broker's upbeat expectations are based on new product rollout, such as Veda Visual Check, which enables customers to use a single visual workspace for credit checks and searches. There are also likely to be increased volumes of credit information required as a result of regulatory changes. Examples include mandatory due diligence requirements for over 14,000 reporting entities in Australia from January 2016.

The broker's target is $2.46, and a total return of 18% is forecast for investors over the next 12 month, comprised of a 15% capital appreciation and 3.0% dividend yield. No interim dividend was declared in the first half, which puzzled some brokers at the time. Management has guided to a 50-70% pay-out ratio and has stated it will pay a final dividend. Moelis suspects management may be conserving cash for acquisitions or organic growth opportunities. The company undertook a number of small acquisitions in the first half.

Downside risks in the broker's view centre on data access and security. Changes to access terms may affect availability and value of the services. Security of the database is also critical and to this end Veda has invested heavily in IT infrastructure and security. Veda Group has some joint venture interests in Asia and the Middle East. Moelis notes some customer contracts have change-of-control terms, which may be triggered by a future sell down by Pacific Equity Partners.

Moelis is not represented, but FNArena's database contains three Buy ratings and one Hold for Veda Group. The consensus target is $2.52, which suggests 13.3% upside to the last share price. Targets range from $2.27 to $2.66.

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