-Risk from smart meters long term
-But maybe an opportunity too
-Discount to global peers widens
 

By Eva Brocklehurst

Spotless Group ((SPO)) will acquire Utility Services Group, which operates under the Skilltech, Fieldforce and Utility Asset Management brands. No details on earnings or the acquisition price - other than it is in a range of $50-100m - were provided and the transaction will be internally funded through debt.

UBS suspects it is a relatively lower margin business compared with Spotless Group's other businesses. Nevertheless, there is a reasonably high predictability for earnings as well as contract renewal rates. The broker believes the acquisition will further diversify the customer base and provide the ability to cross-sell other services to these customers. There is potential for new smart meter installations to pose a long-term risk to meter reading but this, in UBS' view, could deliver an opportunity in terms of installing smart meters.

Utility Services provides retail meter reading and installation in the electricity, gas and water sectors, as well as offering asset management such as maintaining poles and wires and clearing vegetation for electricity distribution. It is the largest operator in meter reading with a 60% market share - estimated by UBS to be around 50% of revenues - and has a national footprint and annual revenue of over $200m, with 1500 employees. This is a small scale acquisition for Spotless, which has group revenue of around $2.7bn.

Overall, UBS is attracted to the growth potential for Spotless and its strong industry position and maintains a Buy rating. Deutsche Bank on the other hand retains a Hold rating on the basis of a low total shareholder return. This broker also believes the business could lose some of its meter reading revenue in the long term as smart meters are rolled out. Deutsche Bank assumes the company was acquired at the upper end of the guided range and incorporates the acquisition into forecasts, estimating a net accretion to earnings of 5-6% for FY16.

Macquarie suspects the earnings margins are below the average for Spotless, which has facility services margins of 9.2%, but the transaction should be modestly accretive in FY16. The broker notes Spotless is committed to improving acquisition margins over time via back office integration and a reduction in overheads. Macquarie forecasts FY15 earnings growth of 27%, driven by a full year of cost savings as well as new initiatives coupled with 7.0% underlying revenue growth. The acquisition is considered strategically sensible, proving exposure to an outsourcing trend which is likely to accelerate as the utilities sector is privatised.

Macquarie observes, since listing in June 2014, the stock has averaged a discount of 18% relative to global peers and, with the recent sell off, this has widened to a 22% discount. After making the relevant considerations relative to global peers the broker retains an Outperform rating.

FNArena's database contains three Buy ratings and one Hold for Spotless. The consensus target is $2.27 , which signals 6.9% upside to the last share price. Targets range from $2.14 (Deutsche Bank) to $2.40 (Citi). The dividend yield on FY15 forecasts is 4.7% and on FY16 it is 5.1%.
 

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-No upturn seen for 6-12 months
-Heightened gearing of concern
-Takeover target?

By Eva Brocklehurst

The warnings keep coming. Engineering contractor and project manager Cardno ((CDD)) has downgraded FY15 profit guidance to $48-51m, the mid point of which implies a decline of 37% on FY14. Second half profit looks likely to be half that of the first half.

The major reason for the downgrade is a combination of factors in both the US and Australian markets, such as weather-induced delays, slow oil & gas markets, lower recovery in infrastructure spending and increased competition. Slower realisation of cost savings from the new business centre in Denver has also added a negative.

Moelis has a Sell rating and $2.30 target. Value may be emerging, but with no permanent CEO the company is likely to be of interest to a predator. Debt is the primary issue, in Moelis' view. The broker has reduced estimates for FY15 and FY16 by 15% and 25% respectively. One of the reasons the company provided, and of most concern to Moelis, was the underperformance of the US business and the $200m impairment charge against the carrying value of its US and Ecuadorean operations. While management has stated that the impairment will not affect debt covenants the broker suspects financing margins may increase.

Leverage appears uncomfortably high and if cash flow does not improve there is a perceived risk of an equity raising, which would put further downward pressure on the share price. Difficult conditions are expected to continue for the next six to twelve months. A pick up-in Australian infrastructure spending is a FY16-17 story, in the broker's opinion. A recent change of state governments in Queensland and Victoria is expected to dampen investment in infrastructure while NSW remains the bright spot.

The US business is also of particular concern for Deutsche Bank. There has been a slowdown in oil & gas work and a slower conversion of the backlog into project starts, as well as increased competition in the testing services business. This also points to underperformance of recent acquisitions. if cash conversion does not improve materially over the second half, Deutsche Bank envisages a risk to dividends. Australian conditions are tough and the broker agrees the expected recovery in infrastructure spending has been slow to get going.

The second half dividend might be suspended. That's JP Morgan's view. The headroom on lending covenants has likely narrowed and it is unclear to the broker whether capital expenditure/working capital investment has been reduced to maintain compliance. Moreover, further risks are still likely from a contraction in margins across resources projects, as well as Australian infrastructure deferrals and the potential stock overhang created from suspending the dividend, given the high retail holdings. JP Morgan also flags the lack of a permanent CEO. 

Macquarie contends the high-margin construction materials testing business in Australia has been hit hard. Moreover, it remains too early to calculate the full customer reaction to commodity price declines, particularly in oil. Macquarie does not expect an improvement until the second half of FY16, with reduced restructuring costs and a reduction in losses from loss-making businesses as well as a lower exchange rate. The magnitude and timing of the downgrade has tested market confidence but Macquarie highlights the fact the stock is trading at a discount to its larger peers and retains a Neutral rating.

The valuation is fair in the context of a 27% fall in the share price, in Goldman Sachs' view. Hence, the broker also has a Neutral rating. Earnings risk around the large fall in oil prices is partly mitigated by the lower Australian dollar and the cycling of a weak FY15 base, which is impacted by some timing issues.

Where are the more positive analyses? Morgans, for one, has an Add rating. While the extent of the downgrade was greater than expected, and the broker concedes investor confidence will need to be re-built, there are potential catalysts. A reputable CEO appointment - expected mid year - and an improvement in the backlog would be a start. Moreover, the broker suspects the company's global footprint, particularly in environmental services, could attract a buyer, particularly post impairments, which could also be viewed as cleansing the balance sheet.

Morgans assumes FY16 revenue growth is flat and margins improve primarily from office consolidation and cost cutting. Cardno did confirm it expected $10m per annum from US consolidation cost benefits. Longer term, Cardno is well positioned to benefit from an increasing need for environmental regulation and improving economic conditions. Still, there are risks and Morgans cites subdued investment, both public and private, and challenges to integrating acquisitions.

UBS is more bearish. Guidance can only imply that the Australian operations have been structurally impaired by the deterioration in the mining cycle while North American operations are being hurt by the decline in the oil & gas business. The broker downgrades to Sell from Neutral. Balance sheet concerns are a particular risk as, while Cardno refinanced its debt this year and has sufficient capacity ,it is an asset-light engineering business. As such, a net debt to earnings ratio at or above 3.0 is of concern. UBS does not expect a dividend in the second half, nor in FY16 and FY17.

FNArena's database has two Buy ratings, three Hold and one Sell (UBS). The consensus target is $3.23, suggesting 40.5% upside to the last share price and has fallen from $3.71 ahead of the update. The dividend yield on FY15 forecasts is 8.6% and on FY16 it is 8.3%.
 

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-Significant leverage to home building
-Concerns about non-paints business
-Acquisitions a potential catalyst
 

By Eva Brocklehurst

DuluxGroup's ((DLX)) paints & coatings business starred in the first half, with earnings up 9.0%, while non-paint earnings, particularly garage doors & openers, were weak, down 27%.

Guidance for FY15 is unchanged albeit vague, expected to be "higher" than FY14. The company expects existing home demand will remain strong but the commercial outlook is less positive. Of note, margins in paints are expected to be flat which implies a sharp reversal through the second half, UBS maintains. Operating margins have expanded by 160 basis points over the last five years but if margins have indeed peaked, then the broker believes there is a risk to the company's premium valuation.

Of comfort is management's record of under-promising. One other concern for UBS is the amount of investment in the non-paints business needed to drive growth, with shareholders seemingly having to take higher costs up front for a future benefit.

Countering these concerns, Morgan Stanley envisages limited downside given lower tax and interest rates and expects the stock to retain its slight premium to the industrials index, ex financial stocks. The broker highlights the lack of clarity in guidance, with management simply indicating a target of making up the losses from the first half in garage doors & openers, and assumes this implies a flat outcome for FY15 versus FY14. The results underscored the importance of the housing market and turnover for the company.

The results underwhelmed Credit Suisse. The balance sheet may be in great shape but there are operational concerns around the businesses acquired from Alesco, such as garage doors, which leave the broker questioning the long-term prospects. Credit Suisse remains attracted to the core paints business but, near term, suspects the premium afforded to the share price could be challenged until there is more evidence of a turnaround in underperforming assets.

Given the first half results were supported by the timing of Easter, guidance for a flat margin outcome in FY15 is difficult for Macquarie to ignore. Estimates are lowered slightly on this basis. Nevertheless, the broker expects the investment in marketing and brand will yield medium-term benefits rather than be a structural negative. Garage doors & openers as a business is undergoing a significant disruption to revenue as a consequence of new products and channels but Macquarie suspects the impact will be temporary. With weaker competitors the business should be in a better position going forward.

Macquarie believes the stock is a relatively defensive exposure among building materials peers and the negative reaction to what is primarily transitory impacts is not justified. An Outperform rating is maintained. Deutsche Bank is more cautious, believing the results raise questions about the company's leverage to increased building and construction activity. This broker retains a Sell rating, noting the first half result was boosted by lower interest and tax expenses and the benefit of the timing of Easter.

Strong growth in the first half from home exposure, boosted by the earlier Easter, may reverse in the second half, Deutsche Bank suspects. New housing construction is expected to be strong in Australia over the rest of 2015 but the company indicated market share growth is likely to be limited in this lower margin segment because of pricing discipline.

The outlook for commercial and infrastructure business, at around 16% of revenue, is less positive, in Deutsche Bank's opinion. The company noted at its FY14 result that major engineering and infrastructure project opportunities were weak, with mining capex winding down and new infrastructure projects still some time away. Also, the company's markets in China and PNG are subdued and expected to stay that way for the remainder of FY15.

Citi believes the weakness in the garage doors & openers business was uncharacteristic, negatively affected by the introduction of a new dealer distribution strategy and the transition to a new product line. The broker acknowledges Parchem sales also fell in the half because of softer civil infrastructure and non-residential markets.

 An acquisition is still a possible catalyst and Citi estimates Dulux can easily fund, via debt, a $170m acquisition. The other trend to watch is the smaller lot sizes, as medium density housing requires smaller garage doors and the average number of these per house has fallen more than 20% with the contraction in lot sizes. Furthermore, as a percentage of building approvals, detached housing has fallen to 51% in 2015 from around 69% 15 years ago. That said, while the rate of growth is slowing, all new homes add to the existing housing stock which currently drives 62% of the company's revenue, Citi contends. 

FNArena's database contains one Buy rating (Macquarie), six Hold and one Sell (Deutsche Bank). The consensus target is $5.85, which suggests 1.7% downside to the last share price.
 

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-Earnings weak but costs decline too
-AN pricing pressure continues
-Able to influence explosives market
-Gaining share in North America
 

By Eva Brocklehurst

Orica ((ORI)) sustained a weak first half, swamped by pricing challenges in mining products, with the one major positive being the ongoing buy-back of its stock. The company's earnings from continuing operations have declined by around 15% and guidance points to worsening conditions in the second half.

It is not as bad as some fear, Morgans maintains. Guidance implies a deterioration in Australian market conditions and there is likely to be material downgrades to consensus estimates. While operating conditions are difficult and earnings uncertainty prevails the broker retains a Hold rating. Nevertheless, the strength of the balance sheet is one positive the broker highlights, with gearing below the company's policy range. Furthermore, despite the lower earnings the interim dividend was maintained, a sign of confidence in the future.

Given the full impact of revised guidance on explosives, Morgans downgrades FY15 earnings forecasts by 6.4%. The company is considered to be in safe hands and has proactively reduced its cost base, although the operating environment may offset much of the benefit, the broker suspects. The share price is likely to be supported by the share buy-back and an attractive dividend yield.

There is one broker that is not half-hearted about the outlook. The result may have been soft but it highlights the resilience and diversification of the business, in Deutsche Bank's view. Early benefits of a transformation are coming through with cash flow conversion of 84% and a reduction in capex guidance. The broker has reduced underlying forecasts by 3-5%, to reflect lower mining services earnings in Latin America, Asia and Australia, partly offset by higher earnings estimates for North America. Deutsche Bank is now treating chemicals as a discontinued item, given the sale of that division earlier this year which leaves the company as a pure mining services business.

The broker observes the interim CEO provided a candid appraisal of the challenges and how the company was meeting the pressures of the mining industry. Deutsche Bank believes this candour will be welcomed, given extremely low expectations of the company's prospects. Orica will review its ammonium nitrate (AN) manufacturing footprint and is exploring options for Yarwun and Bontang. The company remains committed to the Burrup plant, scheduled to start up in FY16.

Morgan Stanley is not convinced, expecting the earnings downgrade cycle to continue. Earnings forecasts are lowered by 5-9% and the broker believes a more bearish view of the outlook will emerge as the market absorbs the information in the update. Pricing pressures remain greatest in Australia where AN prices are seen falling around 20%. Falls in emulsion prices are likely to be even greater, in Morgan Stanley's opinion, given the larger premium historically seen in this product, and competition is strongest in this part of the market. Underweight retained.

If the company does lower capacity, impairments may be required in the second half as the carrying value is assessed. Although ground support is now integrated within mining services, market conditions suggest impairments may also be required against these assets. The one strong area Morgan Stanley contemplates is the balance sheet, which holds sufficient capacity to absorb additional costs.

Credit Suisse believes the share price is undemanding and reflects a structural adjustment to earnings. Although earnings are likely to weaken further the capital expenditure profile is declining, hence cash generation improves across the forecast horizon. This should make it possible to increase the dividend pay-out ratio even on a declining earnings base, in the broker's opinion.

Trading conditions may be challenging but Citi found the company upbeat about its positioning and medium-term outlook. The broker considers the business model is more robust than many assume and the company has the ability to respond to the pressures common in cyclical downturns. Moreover, the multiples do not appear demanding even after a material reduction to forecasts and this should garner increasing attention as the management succession is formalised and visibility improves.

Orica, as market leader, has the ability to favourably influence the domestic market balance which Citi notes has been the cause of much concern given the 30% increase in AN capacity since 2013. Orica can flex production at Yarwun, which materially reduces any likely oversupply. It could also place excess production in export markets, the broker suspects. Moreover, as one of the largest global traders in explosives, Orica'ss merchant margins also benefit from lower industry prices. Citi's forecast now show a much sharper decline in FY15 and into FY16 but, with net benefits forthcoming in FY16, forecasts are substantially de-risked.

Australian earnings are shrinking because of weak end markets and competition, in Macquarie's observation, whilst Orica is gaining share offshore. This is negative for the margin mix, with 7.0% margin in North America versus 27.0% in Australia. The broker believes the transformation benefits only partly offset price declines in Australia in the first half while the company faces a soft second half. Despite the challenges the broker expects the share buy-back will remain supportive.

Orica has now contracted 73% and 63% of its Australia Pacific volumes in FY16 and FY17 respectively and confirmed that price reductions are no worse than import parity, having walked away from business to ensure this is the case. Macquarie estimates, on average, that Orica has experienced around a $100/t reduction in contracted pricing as the premium over imports comes out of the market. While securing longer term offtake is a positive the broker is mindful this has occurred when the market is in a trough.

UBS also found the trends worsening and reduces Australian explosives earnings forecasts. Importantly, management appears more willing to tackle over-capacity via reduced output if poor demand persists, hence the broker's modelling suggests a largely neutral impact from lower explosives prices. Orica's improved transparency should allow the market to re-base forecasts more appropriately to incorporate the pricing risk. Still, metrics are stretched, in the broker's view, given the weaker medium-term outlook and Incitec Pivot ((IPL)) is preferred in this sector. UBS retains a Sell rating.

There is just one Buy rating on FNArena's database - Deutsche Bank, with four Hold and three Sell otherwise. The consensus target is $20.38, suggesting 2.6% downside to the last share price. This compares with $20.17 ahead of the results. The dividend yield on FY15 and FY16 forecasts is 4.5% and 4.8% respectively. 
 

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-Weakness in fertilisers & Asia Pacific
-North American outlook brighter
-Upside from Louisiana start up
-Potential returns to shareholders?
 

By Eva Brocklehurst

Incitec Pivot's ((IPL)) first half may have been better than many brokers expected, but interpreting the outlook hinges on what emphasis is placed on the various parts of the fertiliser and Dyno Nobel explosives business.

Growth in half-year earnings was assisted by improved diammonium phosphate (DAP) income, on higher prices and volumes, along with a lower Australian dollar rate and reduced interest and taxes. That said, core weaknesses in fertilisers and Asia Pacific explosives have caused many brokers to pull back FY15 forecasts. FNArena's database reflects this diversity, with two Buy ratings, four Hold and two Sell. The consensus target is $3.88, suggesting 2.4% upside to the last share price.

Morgan Stanley acknowledges the business is volatile, dependent on fertiliser pricing and the explosives demands of miners, but believes the risks are to the downside. This is despite the promise of a leg-up in earnings when the Louisiana plant in the US comes on line in FY16. The broker is preoccupied with the distribution margin weakness, which frustrates otherwise positive trends such as the benefit of a weaker Australian dollar. The emergence of new production problems at Gibson Island is another headache.

The broker suspects the earnings upgrade cycle has come to an end and a volatility discount is developing in its place, as investors struggle to set a value for operations. Morgan Stanley had believed production issues were behind the company after Phosphate Hill was sorted but now Gibson Island is expected to run at 85% capacity until a fix is completed in March 2016. The broker also complains that despite management stating the Gibson Island issues were known, it was not pointed out in FY15 guidance provided last November. Moreover, a substantial increase in gas costs at Phosphate Hill in the second half could pose challenges to cost targets by the end of FY15.

On the explosives front, operations have been considered a defensive offset to the volatility from fertiliser income. Morgan Stanley has not subscribed to this view but was surprised, nonetheless, by the weakness in Dyno Nobel Asia Pacific. As market conditions are expected to deteriorate the broker retains an Underperform rating. Deutsche Bank also believes the outlook has deteriorated in terms of fertilisers, as well as explosives in the Asia Pacific region. Forecasts are reduced by 2-6% to reflect lower earnings from fertilisers - specifically Gibson Island production - and explosives - reflecting Western Australian services, Indonesia, Turkey and US coal.

Citi remains a holder of the stock because of the approaching step-change in earnings and growth with the start-up of the Louisiana ammonia plant. In the meantime, the broker considers the balance of risks more even than earlier in the year when the share price rose sharply on the back of FX-linked forecast upgrades. The shares may be 16% below April highs and positive catalysts are unlikely to be repeated, but Citi suspects consolidation is likely until the investor tour of Louisiana occurs in September.

On that note Morgans is far more optimistic. A weaker Australian dollar and manufacturing excellence should be supported by the new Louisiana project and underpin solid earnings growth in coming years. The broker recommends shareholders hold on for improved returns. The first half may have missed forecasts because of weakness in fertilisers and Asia Pacific, but overall growth reflected increased volumes at Phosphate Hill and Moranbah, a lower Australian dollar and higher DAP prices.

The broker was also pleased with the North American explosives business, which was better than expected because of margin improvement and price increases, despite total ammonium nitrate (AN) volumes falling on the back of weaker coal and metals markets. In the near term, the stock is considered fair value and Morgans retains a Hold rating.

Various offsetting factors cause UBS to keep forecasts unchanged for FY15-17. Reductions in Australian fertiliser earnings from weaker distribution margins are offset by higher Dyno Nobel earnings which reflect better outcomes in the North American explosives business. The broker also assumes DAP strength should prevail, with sustained improvement in the operations of Phosphate Hill. UBS expects around 20% compound growth in earnings over the next two years upon a lower Australian dollar and completion of the Louisiana plant, as well as some turnaround in fertiliser distribution margins.

Credit Suisse downgrades to Underperform from Neutral, largely because of the appreciation in the share price. The broker also believes the future is in the US ammonia business, offering a solid investment case, admittedly supported by current gas and ammonia prices. The contribution from the Australian explosives and fertiliser segments is likely to decline further, in the broker's opinion, as a result of a contraction in the value chain of bulk AN production and worsening fertiliser economics. Valuation support for the stock, therefore, depends on US ammonia earnings. From this perspective cash flow is seen improving from FY17, raising the probability that returns to shareholders will be increased through capital management.

Macquarie, too, likes the look of the Louisiana investment case. The plant remains on track in terms of timing and budget and is expected to drive a step up in earnings and cash returns to shareholders via dividends or buy-backs. The broker also found the retention of flat US dollar profit guidance for Dyno Nobel Americas a positive, given the deterioration in coal markets. The outlook reflects net margin benefits from renegotiated contracts and accelerated growth in quarrying & construction. The two disappointments for Macquarie were the domestic fertiliser and Dyno Nobel Asia Pacific businesses.
 

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-Difficult to unlock value
-Cheap on several metrics
-Focus on cost cutting targets
 

By Eva Brocklehurst

Marine services business, MMA Offshore ((MRM)), is under a lot of pressure. Contracts are under review by customers as they revise expenditure plans. The company has signalled Australian fleet utilisation fell to around 60% from 82% in the March quarter and day rates are down 10-15%. International vessel utilisation is around 60% as well and day rates are down 15-30%. Supply base activity in Western Australia is also down sharply. Little improvement is expected in the June quarter.

Deutsche Bank observes a solid amount of work remains in place but margins will still be affected by the fierce competition for what work is available. The broker expects a successful outcome on the Gorgon production load-out tender while Dampier slipway activity remains firm, if subdued.  The company expects FY15 underlying profit around $54m, similar to FY14. A cost cutting target of $15m per annum has been reiterated and there are several tender opportunities being pursued. Deutsche Bank reduces FY15 estimates by 11% and FY16 by 33% on the back of the update.

The broker understands investor sentiment has been negative for some time, as the fall in the price of oil raises concerns over the longer-term outlook in Australia, beyond the completion of the next few significant projects in FY17-18 such as Ichthys, Wheatstone and Prelude. Despite the underlying value in the stock, and reasonable operating cash flow that can be generated even in a depressed market, the broker finds a lack of catalysts to unlock that value in the near term.

Beyond FY15 Macquarie notes that as Western Australian LNG spending declines, the company's Australian earnings and revenue will weaken as well. The broker forecasts a 15.1% fall in FY16 revenue and a further 3.3% fall in FY17 before revenue stabilises in FY18. Meanwhile, the company's balance sheet metrics are viewed as reasonable with interest cover forecast to be strong, partially because of low interest rates on US dollar debt taken on to fund the Jaya acquisition.

Macquarie assumes no vessel sales in forecasts. Should any be forthcoming, this could lower debt levels materially. Whilst the stock is considered cheap if forecasts are correct, the broker acknowledges it is still early days in terms of MMA Offshore's customer response to the lower oil price.

Comments around utilisation and day rates were softer than Canaccord Genuity expected but the broker still considers the stock as an attractive value investment, based on very appealing multiples, a high level of asset backing and impressive cash flow yield. Canaccord Genuity lowers its target to $1.34 and retains a Buy rating. The vessel sales program is continuing. The company has signed sales agreements on two barges and expects to make additional sales in coming months. The broker expects a minor loss on the sale of the two barges.

The broker observes there are five new vessels arriving over the next 12-18 months which should support earnings growth, while the major contract with Inpex is expected to start mid 2016. The current capital expenditure program is to be completed in FY16 and no additional purchases are then expected until FY18. The net result, in Canaccord Genuity's estimates, is a rapid increase in free cash flow yield to almost 40% by FY18 from 16% in FY15.

Investors are likely to seek out any signs that utilisation rates are stabilising and delivery on cost reduction targets, Morgan Stanley believes. Moreover, the broker expects investors will want to see value realised through the vessel sales program. In terms of international vessels, the broker highlights, while the market is very challenging, management believes current utilisation rates can be sustained.

UBS also argues that despite the downgrades, the stock is cheap on a number of metrics. The broker calculates that net tangible assets per share at $2.19 and book value at $2.35 are now just 3.2-3.5 times the current share price. The broker's revised target, down to 94c from $1.35, suggests the vessel operations only need to re-rate to 0.46 times the current share price. This multiple is currently in the range of 0.25-0.36 times.

There are two Buy ratings and four Hold on FNArena's database. The consensus target, which excludes Canaccord Genuity, is $1.00, which suggests 43.4% upside to the last share price. Targets range from 75c (Deutsche Bank) to $1.65 (Morgan Stanley). The consensus dividend yield on FY15 estimates is 10.9% while on FY16 estimates it is 8.5%.
 

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