Subdued 2016 Ahead For Contractors

This story features WORLEY LIMITED, and other companies. For more info SHARE ANALYSIS: WOR

-WorleyParsons heavily hit
-Positives in civil infrastructure
-M&A activity heats up
 

By Eva Brocklehurst

The down-draft for commodity prices that kicked off 2016 is not just problematic for miners, but has signalled further hard going for those providing services to the sector. These companies build the mine infrastructure, oil platforms and provide the machinery and expertise that extracts, transports and analyses material.

Goldman Sachs expects pressure on mining and oil & gas capital expenditure will remain depressed this year. This signals a persistent headwind for contractors as the risk of project delays and deferrals increases.

The broker expects a further 16% fall in 2016 capital expenditure globally, following the 23% decline in 2015. The “lower for longer” outlook for oil prices is also expected the be a major obstacle for those servicing the oil industry.

WorleyParsons ((WOR)) is one such engineer & contractor (E&C) business which is facing a tough year of project delays and possible cancellations. Goldman Sachs has lowered forecasts for WorleyParsons by 6% and 17% for FY16 and FY17 respectively. The broker retains a Sell rating, cutting its target by 36% to $4.00, while noting 75% of the company's sales are exposed to the hydrocarbons industry.

Deutsche Bank has downgraded the stock to Sell from Hold and cleaved the target price to $3.09 from $9.55. The broker forecasts earnings to halve in FY16. There are also risks to the dividend, Deutsche Bank maintains, with the board expected to reduce the pay-out ratio below the typical 60-70%.

The broker also envisages downside risk to Downer EDI's ((DOW)) FY16 guidance, on the back of mining division weakness. The company is a diversified contractor but there is the potential loss of mining contracts amid uncertainty over rail project outcomes.

Some support for Downer is envisaged from power distribution work being outsourced and work on the NBN roll out. Still, Ord Minnett, also bearish on the E&C outlook, notes the company stands out as on of the few that are yet to downgrade is outlook. FY16 guidance at the AGM signalled conditions were challenging and the broker suspects the outlook has since deteriorated.

Previously Ords assumed contract wins in rail would act as catalysts for the stock but these appear to have been delayed. Meanwhile, Downer EDI has exposure to contract mining, which is at risk of being lost. Downer has the equivalent of $95m in revenue per annum from Gindalbie Metals ((GBG)), with the possibility, the broker maintains, that company could go into administration

Moreover, Downer could lose the Christmas Creek contract which expires in September this year and currently delivers an estimated 9.0% of earnings. Ord Minnett downgrades its rating to Lighten from Accumulate.

Cimic ((CIM)) is sustaining a reduction in resources construction and contract mining and, while there is a strong balance sheet which could allow for capital management or acquisitions, there is the potential for a further writing off of work-in-progress. Deutsche Bank is cautious about the margins embedded in Cimic's portfolio.

UGL ((UGL)) has a relatively more positive outlook as it has secured a strong exposure to infrastructure opportunities outside mining, with a $5bn order book. Still, it is working on the Ichthys power plant and, while construction has been progressing, there are risks of over-runs in costs an it remains only 50% complete.

Monadelphous ((MND)) is another E&C contractor which is facing a challenging outlook as mining and oil & gas companies limit capex. While the company is taking steps to diversify Deutsche Bank does not believe the growth in new markets will offset the decline in resource construction and forecasts multi-year earnings declines.

Goldman Sachs has lowered FY16 and FY17 earnings forecasts for Monadelphous by 10% and 16% respectively, retaining a Neutral rating and cutting the target by 18% to $6.77. This latest downgrade reflects the broker's weaker iron ore and metallurgical coal price forecasts.

Ord Minnett expects most of the E&C stocks will underperform at the upcoming results with the market cap of small contracts down 29.4% already in FY16, and most of the fall caused by downgrades to earnings estimates.

The two significant positives for contractors are takeover activity, which is at its highest for a decade, and the fact that contract wins announced in 2015 were up 19% on 2014. Still, even that good news is countered by the likely margin pressure on those contracts.

Not all contractors are equally subdued, brokers acknowledge, as there are differing end-market exposures and balance sheet resilience varies. Ord Minnett believes the market has shorted the sector and this should pay off for diversified contractors Service Stream ((SSM)), Millennium ((MIL)) and Mineral Resources ((MIN)). The broker has Buy recommendations on those stocks.

The broker has upgraded forecasts for Service Stream, as it has won an additional NBN contract, while forecasts for Mineral Resources are downgraded to account for a lower iron ore price and less engineering construction work. Ord Minnett's forecasts for RCR Tomlinson ((RCR)) are also downgraded as some work where the company is the preferred contractor is likely to be delayed.

In regard to more resilient divisions, Deutsche Bank has a positive outlook for the life sciences division of ALS ((ALQ)) but remains cautious about its oil & gas and minerals division. The broker expects Australian E&C companies could be acquisition targets as offshore companies seek to take advantage of depressed valuation and the benefit of a weak Australian dollar.

This is recently evidenced by the second bid for Broadspectrum ((BRS)) by Ferrovial recently. E&C stocks considered more likely to make acquisitions in 2016 are Cimic, Downer and ALS. Cimic and Downer both have share buy-backs in place and if suitable targets are not identified, Deutsche Bank believes another buy-back could be implemented.
 

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