Recovery Now Distant For Lend Lease

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The market has slapped Lend Lease down, after a significant write-down for its engineering division, and confidence is expected to take a long time returning.

-Size of the provision a shock, no certainty this is the end of provisioning
-Brokers ponder sale or spin-off of engineering division
-Stock likely to be under pressure until problem contracts are completed
 

By Eva Brocklehurst

Lend Lease ((LLC)) has delivered a major blow to market confidence and will undertake a review of its Australian engineering & services business to reassess risk appetite as well as the bidding process for future transport infrastructure projects.

In announcing a further provision of $350m in its Australian engineering & services business for the first half, the CEO Steve McCann has suggested "nothing is off the table" and all alternatives are being evaluated. An update will be provided at the first half result in February and, in light of the underperforming division, Lend Lease has abandoned a bond issue worth $500m.

The provision and subsequent write-down are related to further deterioration in a small number of projects that were previously flagged by management. This includes NorthConnex, which has lower productivity in the post-tunnelling phases. Deterioration in other projects has been blamed on wet weather, access issues and remediation of defective designs.

The provision amounts to a write-down of around -$500m at the operating earnings (EBITDA) level, which is in addition to a -$280m loss reported in the prior first half. From this, Credit Suisse calculates a total operating earnings loss on problem projects of around -$700m versus project revenue of around $1.9bn.

Shaw and Partners struggles to find the levers that can be pulled to offset the the impairment in FY19. The company has indicated measures are being undertaken to mitigate anticipated losses, including alliances with third parties. The broker's earnings estimates and target price are now under review. Shaw and Partners, not one of the eight brokers monitored daily on the FNArena database, has a Buy rating.

The strategic review appears to Wilsons to be a belated response, given the pressures that have mounted for some time in the engineering business. The broker is shocked by the magnitude of the write-down and empathises with investors who have struck the share price down by around -18%.

Nevertheless, the broker considers this is an overreaction. From a group perspective the engineering division is the smallest contributor to earnings, at just 10% and represents around 5% of the broker's valuation. Meanwhile, the core business is in a strong position to win further major projects.

UBS suspects, given the abrupt nature of the announcement, the stock is likely to trade sideways until troublesome projects are completed, circa 2020. The broker estimates the current price implies no value for the Australian construction or the development business, and the market is expected to price the stock at a material discount until confidence returns.

Implications For Engineering

While current provisioning for problem projects is a best estimate, there is no certainty it will be sufficient.  Citi suspects the worst may not be past and lowers FY19 estimates for earnings per share by -40% and FY20 by -14%. The broker calls the company's track record in engineering abysmal and questions how the division can get back on track as “it has not been on track in the first place”.

Yet, Morgan Stanley finds reasons to be cheerful, while also downgrading FY19 estimates for earnings per share by -40%. Even with a downwardly revised FY20 estimate the stock trades well below its 15-year average and the broker considers this compelling, given the ongoing momentum in the real asset business.

There is increased project momentum which diversifies development profits over a large number of projects and reduces risk and the company is also increasing its capture of development product via funds under management.

The broker acknowledges the quantum, timing and frequency of the engineering provisions could weigh on investor sentiment but maintains an Overweight rating. In contrast, Citi reiterates a view that engineering should be spun off, if possible, and any path to recovery in the share price is dependent on a divestment, downgrading to Neutral from Buy.

Credit Suisse agrees the shares are oversold and the catalysts to restore the business are a long way off. The broker downgrades to Neutral from Outperform. The quickest solution to the engineering problem is likely to be a sale of the division but the broker concedes this may not maximise shareholder value. If the business is retained it will take a long time for a significant improvement in profitability and for investors to ascribe much value.

Margins of 3-4% are not considered sufficient and, in the broker's opinion, there are no synergies between the engineering business and the other attractive divisions. At the AGM on November 16, Credit Suisse suggests investors will be looking for the board to commit to significant change in order to address the challenges.

UBS points out integrated engineering expertise is a key differentiator for Lend Lease when bidding on future project and, given around $4bn of revenue backlog remains from existing projects amid a lack of disclosure, more impairments remain of concern.

Credit Review

The implications extend beyond FY19, in Ord Minnett's view, and include the likely sale of the engineering division and the dilution to earnings and dividends associated with an exit. This has put pressure on gearing and, potentially, one or more of the company's credit ratings may be revised down.

The broker suggests the business has limited capacity to absorb another major impairment without affecting available capital for development. As Lend Lease is trading below its valuation, the broker suggests the cost of capital to hold the stock is high, given the risks that remain.

Moody's Investor Service has placed the company's credit rating (Baa3) on negative outlook, albeit not negative watch. Hence, Macquarie reviews the company's debt position, noting gearing allows for around $1.5bn in headroom.

The company has spent around $140m on buybacks and, taking this into account, gearing moves to 9.2%, from 8.2% as of June 2018. Therefore, Macquarie assesses the balance sheet capacity as reasonable, absent further unexpected shocks. There is flexibility, if conditions were to deteriorate, as Lend Lease can discontinue to buy back stock or sell stakes in key assets.

FNArena's database shows five Hold ratings and one Buy (Morgan Stanley). The consensus target is $15.92, suggesting 22.3% upside to the last share price. This compares with $21.04 ahead of the announcement. The dividend yield on FY19 and FY20 forecasts is 3.8% and 5.7% respectively.

See also, Lend Lease A Winner In Global Development on August 8, 2018.

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