Cardno’s Sharp Downgrade Disturbs Brokers

This story features CARDNO LIMITED. For more info SHARE ANALYSIS: CDD

-Confidence hit by downgrade
-Work backlog increases
-Heightened M&A potential?
 

By Eva Brocklehurst

Engineering contractor and project manager Cardno ((CDD)) has warned that first half operating profit will be weak, down around 25% at the mid point of latest guidance, compared with the first half of FY14. The major reason for the downgrade stems from the rolling off of resources work which, as yet, has not been countered by an expected ramp-up in infrastructure spending. Moreover, starting dates for new projects in the Americas have been delayed and costs to integrate new businesses, notably PPI, have been higher. On the infrastructure side, management remains confident that increased spending will assist the bottom line in the second half.  Most brokers are inclined to wait and see just how much assistance that does provide.

Reductions in capital investment in mining and, more recently, oil & gas, in Australia mean the company's materials testing and electrical engineering divisions will underscore the weak outlook. This exposure has hurt both revenue and margins. Macquarie notes margins have been hit particularly hard. The broker lacks confidence in the underlying fundamentals, particularly given the magnitude and timing of the guidance and downgrades to Underperform from Neutral, lowering its target to $3.52 from $6.30.

UBS also downgrades the stock, to Neutral from Buy, and lowers its target to $3.70 from $6.75. Despite the material decline in the share price the broker can envisage no catalysts for the share price to outperform over the next 12 months. Relentless declines in commodity prices, particularly iron ore and oil, suggest headwinds remain strong regardless of the size of Cardno's order book. UBS considers the discount to global engineering peers – around 33% based on forecast FY15 price/earnings multiples – is appropriate.

JP Morgan sticks with a Neutral rating and highlights the fact the company is now trading at a meaningful discount to international peers in an industry which continues to consolidate, and where there has been an uptick in corporate activity over the last 12 months. Goldman Sachs is also Neutral, pointing to the fact that AGM commentary only in October was signalling a return to positive earnings growth and now the company is expecting a decline in the first half. There is value in the stock but the broker is concerned by the sharpness of the deterioration in such a short time. This concern is echoed by Deutsche Bank, which suggests visibility remains poor.

Morgan Stanley is more inclined to believe guidance is signalling a bottoming of the market while the backlog and infrastructure-led recovery should pave the way for a return to growth. The gap between resources and infrastructure spending may have expanded, as Australian business declines and projects in the Americas are slower to start, but as the work backlog is at a record level of $939m, Cardno should be one of the first, and more significant, beneficiaries of infrastructure spending increases. The broker lowers its target by 27% to $5.50 but retains an Overweight rating.

While confidence has obviously been affected, Morgans considers sector M&A activity and a cyclically low valuation may attract value investors. An Add rating is retained, although the broker concedes a fair amount of risk tolerance and patience is required. The order book has been progressively growing for some time and Morgans observes this is typically a leading indicator of future revenue, with lags by around 6-12 months. This suggests revenue growth will occur in the second half and in FY16. The broker cites a number of contract and preferred tender awards in recent weeks including Sydney's light rail, Westconnex and Commonwealth Games work. Longer term, Morgans considers the company will benefit from ever-increasing environmental regulation.

Opinion on Cardno's outlook is varied. On FNArena's database there are two Buy ratings, three Hold and one Sell. Targets range from $3.52 to $5.50. The consensus target is $4.39, suggesting 25.6% upside to the last share price, and compares with $6.80 ahead of the downgrade. The dividend yield on FY15 forecasts is 7.5% and 8.5% on FY16.
 

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