Treasure Chest: CIMIC View Still Constructive

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FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. CIMIC Group has been hampered by soft activity in Hong Kong and timing of Australian projects.

-Group margins are at high levels so revenue remains the key profit driver
-Cash conversion weak in the first half
-Potential support for the stock from reactivating the buyback
 

By Eva Brocklehurst

Significant weakness in construction-related business put a dampener on the first half result for CIMIC Group ((CIM)) and the stock suffered as a result. Poor cash flow resulted, as pre-tax profit from construction fell -15% on a -7% decline in revenue. This was affected by weaker activity in Hong Kong and the timing of Australian projects and, as Macquarie notes, group margins are at high levels so revenue is the key profit growth driver.

CIMIC is the dominant operator in the Australian infrastructure construction market and UBS assesses the stock provides a high level of leverage to the prospect of increasing investment in major infrastructure.

Still, the broker applies a -10% discount to the ASX 200 industrials ex financials, believing this is appropriate at the current point in time, where any outperformance is more skewed to the successful execution of work in hand.

First half cash conversion was only 52%, versus Macquarie's forecasts for 88%, affected by a change in mix towards alliance-style contracts and growth in mining construction business.

These have a more even cash-flow profile versus the large up-front flows in the case of fixed-price development and construction contracts. The change in mix towards alliance-style contracts lowers the risk profile going forward as well.

Cash Conversion

Credit Suisse expects a lower level of cash conversion to persist, compared to the elevated level of recent years. Hence, the broker suggests the weak cash conversion and slowing growth do not support a multiple that is higher than the historical average.

The main upside risk to the broker's target ($35) comes if management acts on the share buyback. Credit Suisse downgraded in the wake of the results to Underperform, cutting the 2019 net profit forecast by -8% to $761m, below management's guidance of $790-840m.

Macquarie has now decided to upgrade to Neutral, given the extent of the fall in the share price in the wake of the first half results, and because of the potential near-term support from a buyback. The company has reactivated its buyback, which can commence at the beginning of August.

If the Hochtief stake moves to 75% from the current 72.7%, Macquarie understands CIMIC would probably be removed from the ASX indices, with the result being 7.5m of potential index-related selling.

Beyond the buyback, a return to positive construction growth is required to support a more favourable fundamental view. Macquarie estimates a drop of -3% in pre-tax profit from construction in the second half and an increase of 4% in 2020.

Construction Outlook

Nevertheless, the broker still believes the broad outlook for Australian construction is positive, with work in hand stable at $36.8bn at the end of June. Recent concerns in the sector strengthen the company's competitive position, in the broker's view. Of note, competitor Lendlease's ((LLC)) engineering business is now considered non-core.

Macquarie suspects, over time, more rational bidding for projects is likely, along with a better share of risks. Cross River Rail in Queensland was the company's largest win in the first half. Construction work in hand was $14.7bn and stable at the end of June, while mining construction work in hand was $10.8bn, down on the levels recorded in March but higher versus the prior corresponding period.

One aspect Macquarie notes in the result was receivable and payable factoring, a tool used to manage working capital, cash and risk. While slightly higher in the first half, factoring did not rise to the same extent as over 2018.

Still, the company propped up cash flow in the first half by increasing the days payable to 159 from 135 in the second half of 2018. Without this, Credit Suisse assesses, there would have been a net cash outflow of around -$700m from operations.

There are two Hold ratings and one Sell (Credit Suisse) on FNArena's database. The consensus target is $40.33, signalling 9.9% upside to the last share price. The dividend yield on 2019 and 2020 forecasts is 4.2% and 4.4% respectively.

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