Education provider Navitas has cleared the headwinds brought about by the loss of its Macquarie University contract and brokers respond with several upgrades.

-Concerns over further contract losses allayed 
-University more central in the JV structure
-Scope for further capital management?
 

By Eva Brocklehurst

Education provider Navitas ((NVT)) has finally cleared the headwinds created by the closure of its Macquarie University program over a year ago, and brokers have responded with several upgrades to ratings.

The first half result was messy but in line with Credit Suisse expectations at the headline. First half operating earnings of $76.6m were down 7.5% on the prior corresponding half, primarily from campus closures and currency headwinds. Guidance for FY17 suggests operating earnings (EBITDA) will be flat, ex currency, at the group level.

Credit Suisse expects university partnerships will return to growth in the second half. Further rationalisation of colleges and a possible review of the remaining assets within the professional and English programs could provide scope for further capital management, the broker contends. Credit Suisse upgrades to Neutral from Underperform on valuation grounds because of the recent share price weakness.

The result was in line with Deutsche Bank's expectations at the net profit and EBITDA levels but revenue was well below forecasts. Nevertheless this revenue weakness was offset by significantly better cost performance.

The broker is wary about the step-up in net debt and the low cash conversion during what is still, effectively, a period of transition. The company has confirmed a buy-back will resume, which Deutsche Bank suggests should provide some support for the share price.

Strong International Student Growth

Macquarie upgrades to Outperform from Neutral, believing the company will benefit from strong, long-term international student growth. This should be underpinned by steady fee growth and the additional margin benefits of increased scale and efficiency. The broker forecasts FY18 and FY19 EBITDA growth of 8% and 7% respectively, driven by a respective 10% and 8% growth in the core university partnership division.

Fears of further contract losses have been allayed, following a run of renewals. Macquarie expects all contracts due for expiry in 2017 will be successfully renewed. Regulatory risk is also reduced, with favourable government sentiment in Australia and Canada.

Moreover, international education is economically important in the US and UK, where it contributes US$34bn and GBP15bn annually, and the broker suggests this provides a safeguard against overly adverse policy shifts.

Macquarie expects the decline in UK enrolments will cease and be followed by a period of low growth. Muted growth is expected in the US.

A positive aspect, in the broker's opinion, is the company's exposure to lower-ranked universities which are suspected to be more reliant on its services. Macquarie also believes the joint-venture structure allays concerns held by higher-ranked universities over outsourcing university programs as, under a JV structure, the university will be more central in the maintenance of standards and ultimately in the protection of its brand.

Is The Share Price Full?

The broker considers Navitas large and competent enough to withstand increased government scrutiny of the various courses on offer and their eligibility for loans. Demand is expected to lift as weaker competitors fall by the wayside. The broker also believes the company has a good chance of lobbying for an amendment to the loan cap on nursing, a key employment growth area.

Morgan Stanley is pleased there is finally clear air ahead for Navitas. The debate for the broker now centres on the level of sustainable growth and the right multiple to pay for this growth. Guidance suggests growth levels are robust but the broker notes this also comes with a wider risk profile than existed in the past.

Morgan Stanley believes the current price/earnings ratio of 20x on FY17 estimates, and 18x on FY18 estimates, is relatively full. Therefore, an Equal-weight recommendation is retained.

UBS upgrades to Buy from Neutral. With the transition from the loss of the Macquarie University contract largely completed, and the recent addition of another US college, the broker believes the market can renew its focus on the potential growth in earnings and the other attractive attributes of the stock. These include a high return on capital, strong cash flow conversion and a low-geared balance sheet.

FNArena's database contains two Buy and three Hold ratings. The consensus target is $5.03, suggesting 10.9% upside to the last share price. Targets range from $4.40 (Credit Suisse) to $5.30 (Deutsche Bank). The dividend yield on FY17 and FY18 estimates is 4.4% and 4.6% respectively.
 

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Infrastructure, engineering and mining contractor, Downer EDI, has won a major contract for Sydney trains. Brokers mull over the growth potential ahead.

-Rail projects likely to drive a positive outlook for earnings in FY18
-Over 55% of revenue now generated from servicing public infrastructure
-Yet several brokers consider the stock's valuation is stretched

By Eva Brocklehurst

Infrastructure, engineering and mining contractor, Downer EDI ((DOW)), has won a second major contract out of the three large Australian public sector projects recently up for grabs. The Sydney growth trains contract is worth $1.7bn and follows the contractual close of the Victorian government's $2bn high capacity metro project, with Downer part of the Evolution Rail consortium.

The Sydney growth trains contract includes an order of 24 double-deck trains with options for up to 45 additional sets and maintenance of the trains for an initial period of 25 years, plus two optional five-year extensions.

Macquarie believes rail will drive a positive outlook for Downer's earnings in FY18 and the long-term maintenance business from this latest contract is the main prize. Macquarie estimates $30-40m in potential maintenance revenue per annum once the trains are built. The broker believes this latest win fits well with the company's previous win in Victoria and the Newcastle light rail, providing a solid foundation for growth in the rail business going forward.

The broker also envisages this latest contract with Sydney trains has a much lower risk than the prior troubled Waratah contract. Macquarie considers the sale of the power asset, Ausgrid, provides an opportunity for Downer from the potential outsourcing of power/utilities maintenance in NSW. The broker retains an Outperform rating.

Credit Suisse takes the opportunity to review assumptions and notes the company has positioned itself well for a move away from the challenged mining and engineering, construction & maintenance sectors.

Over 55% of revenue is now generated from servicing public infrastructure customers in Australasia and this should increase as more government spending is directed towards infrastructure. The company maintains strong cash flows and this should contribute to a further strengthening of the balance sheet, leaving plenty of head room for capital management and further M&A.

Yet, quantifying the earnings turnaround is difficult, the broker asserts. Arguably, recurring public infrastructure and maintenance work should warrant a higher multiple, but with a 44% lift in the share price after the FY16 result, and the stock trading at around 16 times forward consensus earnings per share, Credit Suisse believes there is more risk to the downside. The broker considers, despite a strong balance sheet and capacity for growth, the valuation is stretched.

That said, Credit Suisse does not discount the leverage the new contract wins provide for continued expansion of trading multiples. For example, if the Adani Carmichael mine is developed with Downer as a contractor, this could add up to $0.50 per share to valuation.

The broker remains reasonably confident in the sustainability of earnings, yet given the material re-rating post the FY16 result, downgrades the stock to Underperform from Neutral. Credit Suisse contends that the business still needs to prove the earnings multiple inherent in FY19 forecasts.

Deutsche Bank notes the manufacturing of the trains is being sub-contracted to CRRC and Downer will not generate much income from that part of the contract. The broker estimates project management will provide $50m revenue per annum for two years and the maintenance work will provide around $30m in revenue per annum once all trains have been delivered.

Delivery of Australian passenger trains has usually suffered significant cost increases and been unprofitable for the contractor but the broker suspects this one is probably lower risk, given it will be based off the last recently-delivered passenger train. Deutsche Bank adds around 1% to earnings per share forecasts for FY17-21. The broker considered the risk/reward is balanced and retains a Hold rating.

Morgan Stanley envisages the project is relatively low risk for Downer, as JV partner CRRC is accountable for train construction and Downer is assuming a project management and maintenance role. Still, the contract means little in the way of a short-term uplift for earnings.

The broker is also inclined to the view that with the stock now trading on its highest price/earnings ratio ever (16x) and with no known significant catalysts for upside ahead, there is risk to the downside. Morgan Stanley retains a Equal-weight rating.

FNArena's database shows two Buy ratings, three Hold and one Sell (Credit Suisse). The consensus target is $5.42, suggesting 9.3% downside to the last share price. Targets range from $4.01 (Morgan Stanley) to $6.40 (Macquarie).
 

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Expectations for the minerals and life sciences business of ALS Ltd have improved but questions remain regarding the timing of the turnaround.

-Plans to divest oil & gas business and scale up food analytical business
-Little benefit yet seen in the improving geochemistry cycle
-A higher stock rating may attract further corporate interest
 

By Eva Brocklehurst

Analytical laboratory business ALS Ltd ((ALQ)) expects its core minerals division is on an upward trajectory while life sciences, having been affected by several issues, should now turn around. First half net profit of $51.4m was at the lower end of guidance of $50-55m.

Morgans expects the outlook for the minerals business to materially improve in FY18/FY19. The stock is trading at a price/earnings ratio of 20x on the broker's FY18 forecasts, a 60% discount to international peers. The broker believes the leveraging of ongoing improvements in mineral exploration justifies an Add rating on the stock.

The company is looking to divest its oil & gas business, which lost $13.3m in earnings in the half year. ALS expects to continue oil & gas laboratory operations, which are currently making a small loss as they are in the development phase. The FY17 result is expected to still show underlying weakness in resources, but Morgans observes industry data suggests a better environment over the coming 12-24 months.

The broker acknowledges it is difficult to pick the quantum and speed at which fortunes will turn around, but expects investors will be rewarded in the longer term by significantly higher earnings. On face value the stock appears expensive but Morgans continues to believe services businesses should be bought at the bottom of the cycle when they are expensive, as earnings will flow through.

Macquarie also suggests that for cyclical businesses that are coming out of a downturn the turnaround is never as immediate as one would wish. The share price implied great expectations entering into the downturn and guidance remains similar to consensus ahead of the result, so there were no upgrades on which to pin further optimism.

Nevertheless, the company has ended the first half with positive momentum and sample flows continue to accelerate. The broker believes the divestment of the underperforming oil & gas business is a positive as this will increase the company's focus on the core minerals, life sciences and industrials divisions.

That said, it remains unclear as to whether the company will hold onto assets if the divestment process is unsuccessful. The broker envisages the big end of town to be the logical buyer of the oil & gas business, such as Haliburton or Schlumberger.

The company is also in advanced negotiations regarding a number of acquisitions which should be completed by March. This remains consistent with the strategy to scale up the food business. The investment thesis has not changed in terms of the positive leverage to the exploration cycle and the broker considers the oil & gas divestment and sensibly-priced acquisitions are key positive factors.

Macquarie notes there has been no developments since the Bain/Advent takeover approach back in June. The share price is now moved ahead of the $5.30 indicative price and, with a focus on the earnings recovery in the minerals business, provides somewhat of a floor below $6.00, in the broker's opinion.

The results suggest to Morgan Stanley the business remains under pressure and investor perceptions of a rapidly improving geochemistry cycle are offering little benefit as yet. The broker is also concerned about a poor result in the life sciences operation, which is generally considered to be defensive. Life sciences earnings were down 5%. This is also a concern given the company plans to dramatically ramp up acquisitions in this part of the business.

Morgan Stanley is also surprised by the decision to exit the oil & gas business, as the company only acquired it in 2013. The broker believes the shares are factoring in a cyclical recovery which may not be forthcoming and finds the stock is unattractive at this point in time, retaining an Underweight rating.

The outlook commentary was positive and Citi expects management changes in Canada and Latin America should provide support for growth in life sciences. There are also positive signs for geochemistry volumes which were up 30% in the half year. Although positive cyclical indicators are emerging, the broker considers the share price already anticipates a significant recovery, which may take longer than anticipated to realise.

Citi increases net profit forecasts for FY18 and FY19 by 4% and 7% respectively, as a result of incorporating the ALcontrol acquisition and a more positive outlook for minerals. On a broader view the broker notes exploration expenditure appears to have found a bottom as there are early signs that miners are returning to low-cost exploration to shore up longer-term reserves and production profiles.

Credit Suisse's Neutral rating reflects a trade-off between the uncertainty in timing and magnitude of the earnings recovery and further corporate interest in the stock. The broker remains cautiously optimistic, noting uncertainty around oil & gas is being removed and investors are now likely to re-focus on organic and acquisitive growth.

Opportunities in life sciences remain a key driver of growth but, in time, this may be accompanied by a higher stock rating and attract further corporate interest, the broker contends. Credit Suisse also question the timing of the decision to offload the oil & gas business in the context of a broader commodity price rally and a lost option for a higher sale price if conditions improve.

The upside to Ord Minnett's valuation is restricted by a downgrade to margin forecasts and a reduction in the enterprise value/earnings multiple in life sciences. Despite the M&A activity and more bullish forecasts in the minerals business there is still not enough upside for the broker to become more positive and a Hold rating is retained.

FNArena's database shows two Buy ratings, three Hold and two Sell. The consensus target is $5.67, suggesting 8.6% downside to the last share price. This compares with $5.30 ahead of the results. Targets range from $3.27 (Morgan Stanley) to $7.08 (Morgans).
 

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Prices for Incitec Pivot's key fertiliser products are subdued and brokers are unsure when the market will signal a nadir has been reached.

-Promised capital management likely pushed out to FY18
-Decline in softs inventories, higher prices required as signal for fertiliser prices
-Cash-flow outlook suggests moderation in gearing metrics
 

By Eva Brocklehurst

Earnings weakness is expected to persist for Incitec Pivot ((IPL)) as prices of its key products for fertilisers are subdued and its explosives business remains tough. The question for brokers is when the market will signal prices have reached a bottom.

Morgans suspects the challenging conditions may even worsen in FY17. Materially higher interest expenses are also expected to affect profit growth. The broker observes the company's commentary at its earnings release was notably downbeat. Structural changes in the US coal market and a cyclical oversupply of ammonium nitrate in Asia-Pacific and the Americas are expected to weigh in FY17.

Morgans upgrades FY17 earnings forecasts by 1.8% because of lower gas and higher urea price assumptions but net profit estimates are reduced by 9.1% because of the expected higher net interest. Given the tough operating environment the broker believes the capital management that was promised following the commissioning of the Louisiana ammonia plant (WALA) is likely to be pushed out to FY18.

earnings declined 26% in FY16. The fall was driven by a sharp decline in fertiliser commodity prices in the second half. Fertiliser earnings were down 63%, explosives down 6% while industrial chemicals were up 26%.

Deutsche Bank also expects the cyclical reduction in global fertiliser prices may continue into 2017. The broker believes the Louisiana plant will provide a step change in earnings over the next two years and the company will fulfill its promise to return capital upon attaining reliable production. The Australian explosives business, meanwhile, is likely to benefit from higher coal and iron ore prices. Moreover, North American coal trends are improving and inventory declining, the broker notes.

Morgan Stanley remains bearish, especially for the near-term. While investors may be hopeful of a cyclical recovery, the first half could test their resolve. At some point the company will benefit from better fertiliser markets but the broker does not believe that time is now. Earnings per share estimates are lowered by 14-18% for FY17-18. Without a definitive indication that earnings have hit a low Morgan Stanley considers the stock significantly overvalued.

The broker acknowledges recent improvements in urea prices may be a turning point but notes that DAP (di-ammonium phosphate), ammonia and soft commodity prices continue to show negative momentum.

Goldman Sachs concurs. A significant decline in soft commodity inventories and subsequent stronger pricing are required in order to become more positive on the company's fertiliser and ammonia business. The broker, not one of the eight monitored daily on the FNArena database, maintains a Neutral rating.

Overall, earnings were in line with UBS estimates, although net profit was 3% ahead because of lower net interest. The company's manufacturing performance stood out, with production above nameplate capacity across Moranbah, Cheyenne, and Phosphate Hill. Adjusted net debt was also lower than the broker estimated, at $1.4bn.

UBS reduces forecasts for earnings per share by 7% which reflects lower average fertiliser price assumptions and a higher Australian dollar, partly offset by the realisation of $65m in additional cost reduction initiatives. The broker upgrades to Buy from Neutral, believing fertiliser commodity prices are bottoming. Also, the cash-flow outlook, even at spot prices, suggests a moderation of gearing metrics.

Macquarie agrees the explosives business is holding up well despite the challenging markets, while Moranbah hit record production of ammonium nitrate, yet also observes the company's language is softer regarding the near-term prospects for capital management, suggesting the timing is heavily dependent on the fertiliser price and the Louisiana plant running reliably.

Substantially lower capital expenditure after the completion of the plant should mean the gearing ratio falls to 1.8 in FY17 and capital management is more likely in FY18, in the broker's view.

Relative to its global peers, Macquarie notes that Incitec Pivot has the benefits of no potash exposure and a weaker Australian dollar. It also has a company-specific earnings driver in the form of the Louisiana plant, which could allow a significant step up in the free cash flow profile.

Ammonia prices have traditionally traded as a substantial premium to urea in the last 15 years but the broker notes the gap has closed in recent months and the two are now almost a parity. Macquarie does not believe parity will be sustained based on historical relationships.

Confidence with respect to phosphate pricing is critical to Credit Suisse's viewpoint. While there is some optimism in relation to improving coal production in Australia, Moranbah is at full capacity and, beyond some de-bottlenecking of the plant, company benefits little from any upside.

The broker expects the company to be the beneficiary of improving urea prices, where there appears to be some stabilisation in recent months. Credit Suisse asserts ammonia prices are also close to bottoming but believes it would be premature to call for a floor in phosphate prices at present, given large capacity increments are expected in 2017.

The results exceeded Ord Minnett's expectations, primarily because of a higher level of benefit from the business improvement program. The broker observes the company acted swiftly to make deeper and more widespread cuts to its cost base in the wake of persistently deteriorating macro conditions. Ord Minnett raises EBITDA and net profit estimates by an average of 8.5% and 3.6% respectively for FY17-19.

There are four Buy ratings, three Hold and one Sell (Morgan Stanley) on FNArena's database. The consensus target is $3.26, suggesting 4.8% upside to the last share price. Targets range from $2.36 (Morgan Stanley) to $3.95 (Deutsche Bank).
 

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Mining services business Orica will be flat out making sure its business improvements stay ahead of increasing costs and price re-sets, brokers believe.

-If cost reduction benefits are achieved a small improvement in earnings in FY17 may be forthcoming
-Orica may not be as leveraged to a volume recovery as current multiples imply
-Competitive dynamics heightened for delayed Burrup plant
 

By Eva Brocklehurst

Mining services business Orica ((ORI)) has a more positive outlook in terms of the cyclical volumes for explosives but its FY16 result indicates some structural problems remain. Brokers believe FY17 is shaping up as a year where the company will rely heavily on its business improvement measures to counteract price re-setting and increases to input costs.

The company did not provide specific earnings guidance and management has stated it remains conservative, despite some optimism on market conditions. Orica was careful not to call a bottom to the market but indicated there had been some stabilisation in prices.

The headwinds outlined by the company include a $60m negative impact on price re-setting as well as a $50-$70m negative impact for previously-negotiated input material contracts. Increased depreciation and amortisation expense, as commissioning of the Burrup project nears, is expected to be offset by business improvement initiatives.

Macquarie observes the Australian business has shown good sequential volume to date, although traditionally the second half is seasonally stronger. Collectively, the broker calculates $120m in price/input costs are expected to be offset by $30m in non-recurring costs plus business improvement initiatives. Macquarie observes, therefore, there is a bigger ask in terms of the cost reduction program this year, which increases the risk in execution and for which strong volumes may yet be required as an offset.

The stock is considered relatively fully valued and with a potential earnings recovery slated for FY18 rather than FY17. Macquarie prefers Incitec Pivot ((IPL)) in the sector. The broker acknowledges the previous problems with Minova have stabilised and there is more positive commentary regarding Indonesia, as well as coal market improvements and a $10m benefit for Bontang plant from lower ammonia prices.

Yet Macquarie cannot avoid the impression that cost reductions are required to do the heavy lifting. The share price has run up strongly on the back of higher coal prices and a more positive cyclical backdrop, but this appears factored in and a Neutral rating is retained. Be that as it may, the broker believes the stock should still trade at a premium to domestic contractors based on its less cyclical and relatively low-risk earnings.

Ord Minnett notes the impact of pricing re-sets in the explosives business has been severe in recent years, part of which relates to the flowing through of price terms from contracts signed previously. The broker notes there has been very little re-opening of existing contracts in the last 8-9 months and further price re-sets have not been ruled out. The broker factors in a further $20m in price re-sets in FY18.

The current market supports a further strengthening of volumes into FY17, Credit Suisse asserts, and if cost reduction benefits are achieved believes it likely that Orica will generate a small improvement in earnings in FY17. Improving export coal fundamentals are likely to support Australasia while the North American market is being driven by a less adverse outlook for domestic thermal coal. Growth in other regions appears to be a broadly-based improvement story.

Deutsche Bank believes the recent rally in commodity prices is positive, as this reduces the risk of further reductions in miner production volumes and mine closures. While the company is forecasting flat ammonium nitrate volumes the broker believes there is upside risk to its assumptions, given the improving outlook for explosives, while pricing appears to have bottomed.

The main surprise in the results for UBS was free cash flow, driven by lower net working capital and capex in FY16. The broker incorporates a lift in explosives volumes and additional cost reduction benefits into its forecasts to offset around the headwinds relating to lower explosives pricing and higher raw material inputs.

UBS acknowledges its forecasts incorporate a high degree of certainty around the company's ability to execute on another round of cost reductions and believes the stock is now fully valued, with a premium built in for a more positive cyclical outlook.

Given Orica only produces 50% of what it sells, UBS remains concerned that higher input costs and deteriorating end-prices for explosives mean earnings might not be as leveraged to a volume recovery as what current multiples are implying. The broker believes regional oversupply of ammonium nitrate will restrict Orica's ability to realise margin expansion.

The broker's Sell rating is based on the tougher outlook ahead for the main market of Australia. UBS is more cautious about domestic Australian explosives volumes and margins because of weak end-markets for coal and a regional oversupply through to 2020. The broker envisages a combination of weak demand, ammonium nitrate oversupply and a negative mix in the key Australasian and North American regions will weigh on growth prospects for the next several years.

Morgans is less concerned and found the result reasonable in the light of difficult market conditions. The broker believes the stock is fairly priced and that the self-help initiatives will largely offset the industry legacy issues. On the other hand, Morgan Stanley also highlights the need to have faith in offset targets and retains an Underweight rating. In the broker's calculations, the rally in the shares has placed the stock on the richest price-earnings ratio it has ever traded.

Meanwhile, the Burrup plant was delayed by unspecified commissioning issues, one year behind schedule, and is expected to begin operation early in 2017. It is expected to break even on EBITDA (earnings before interest, tax, depreciation and amortisation) in the year.

Despite the benefit of the later start, Morgan Stanley believes the outlook for the plant has materially deteriorated. Recent contract losses suggest the competitive dynamics may have dramatically intensified. Unless Orica can secure substantial new volumes the broker believes the risk is growing that it may need to impair Burrup.

Citi is quite confident that the turnaround has begun and the improvements ushered in are positive, although acknowledges these will take time to be realised. The company has a new customer-centric model based on geography rather than function and has enhanced its executive team. Minova is turning around and gearing has been reduced. The broker suspects the latter could play an important role in improving the medium-term growth profile.

Volume stability is a prerequisite for price stability, Citi asserts, and this should become more entrenched over the next 12 months. As there is insufficient upside to the broker's target price of $17.50, its recommendation is downgraded to Neutral from Buy.

FNArena's database contains one Buy (Deutsche Bank), five Hold and two Sell ratings. The consensus target is $16.15, suggesting 1.1% downside to the last share price. This compares with $15.11 ahead of the results. Targets range from $11.03 (Morgan Stanley) to $19.20 (Deutsche Bank).
 

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