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Cimic Bid For UGL Unmasks Uncertainties

Australia | Oct 11 2016

This story features CIMIC GROUP LIMITED. For more info SHARE ANALYSIS: CIM

Contractor Cimic has made a takeover offer for engineering services company, UGL. Brokers are lukewarm about the prospect, suggesting areas of uncertainty exist.

-Ongoing uncertainty with UGL's Ichthys liabilities
-Less compelling strategically for Cimic, Morgan Stanley believes
-Downside risks still exist for Cimic as well


By Eva Brocklehurst

Infrastructure and mining contractor Cimic ((CIM)) has made a takeover offer for engineering services company, UGL ((UGL)), believing the acquisition will complement its own business or enhance capabilities in new areas.

Cimic has acquired a 13.84% stake in UGL, via its subsidiary CG12, and made an offer for the remainder at $3.15 cash per share. The company, if successful, intends to conduct a strategic review of the UGL business. The two companies have worked jointly on the Airportlink project and Cimic's John Holland and UGL are partners in Metro Trains Melbourne.

Deutsche Bank calculates the transaction would be 8-13% accretive to earnings per share in FY17-20 but neutral to cash flow because of the costs associated with the Ichthys project, noting the bid price implies $150m in Ichthys cost claims are recovered. The broker believes UGL offers attractive end market exposure with 71% of revenue recurring and 68% in non-resources business.

There is little overlap currently between the two competencies, although UGL has previously acted as a sub-contractor to Cimic in electricals and signals and there may be cost savings for Cimic by not having to pay sub-contractor margins in future work of this nature.

At the time of writing the broker notes UGL was trading above the offer price which implies the market is attributing some probability to a competitive bid. Deutsche Bank considers a counter bid by a trade player unlikely, although private equity could offer up to $3.78 and still generate a reasonable internal rate of return (19%).

At the current offer price Deutsche Bank calculates an IRR of 22% based on current UGL forecasts but is inclined to make no changes until the UGL board responds to the offer. Meanwhile, the risks for Cimic are considered to the upside with strong growth in Australian infrastructure.

The transaction looks accretive for Cimic on Citi's calculations. The broker finds it curious that given the well documented issues regarding the troubles with the Ichthys project, the bidder's statement from Cimic indicated it has not had access to the UGL records, or other internal resources, and therefore no due diligence has been undertaken, despite the offer being made unconditionally. Given the large premium in the bid and ongoing uncertainty regarding Ichthys the broker believes it highly uncertain whether the board could obtain a higher offer.

Morgan Stanley calculates that ignoring any underlying cash generation in the second half, the transaction would move Cimic to a net debt position of $400m as of 2016. If successful, the broker estimates the acquisition would be neutral to slightly accretive to FY16 earnings per share for Cimic and, potentially, mid to high single digit accretive in FY17. While in terms of accretion the proposed transaction could be attractive the broker does not find the bid so compelling strategically for Cimic.

The broker would have expected that Cimic is capable of moving into at least some of the areas in which UGL operates without having to take over the business. Moreover, UGL has material exposure to passenger rail manufacture in which Cimic has no experience.

The other issue is the potentially uncapped liability for the CCPP (combined cycle power plant) and SMP (structural, mechanical and piping) contracts that UGL holds at Ichthys, for which $375m in provisions have already been taken. Morgan Stanley observes so far UGL has failed in its efforts to contain these costs, which may signal further downside risk to the earnings profile and cash flow.

For Cimic, Morgan Stanley assigns the smallest weight to its bull case, given the significant downside risks envisaged, including unresolved legacy issues and non-sustainable components of reported earnings as well as the capital structure.

FNArena's database has three Sell ratings on Cimic, with a consensus target of $18.44 that suggests 32.8% in downside to the last share price. Targets range from $12.40 (Morgan Stanley) to $23.20 (Deutsche Bank). For UGL, the database has one Buy (Deutsche Bank), two Hold and one Sell (Ord Minnett, yet to comment on the bid). The consensus target is $2.38, suggesting 26.0% downside to the last share price. Targets range from $1.94 (Ord Minnett) to $3.15 (Citi).

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