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Lendlease’s Earnings Visibility Shrouded

Australia | Jul 07 2021

This story features LENDLEASE GROUP. For more info SHARE ANALYSIS: LLC

Successful cost reductions and divestments could provide desperately needed visibility to Lendlease’s value following last week’s profit warning, but brokers want greater clarity over future earnings drivers

-Brokers suspect there’s more negative news ahead for Lendlease
-Clarity needed on future operational performance
-Review expected to target major cost savings
-Potential for re-rating over medium term

By Mark Story

Given that Lendlease Group’s ((LLC)) first half to December 2020 core $205m net profit after tax was below consensus expectations of $213m, the global property developer’s profit warning issued on 1st July shouldn’t have been too much of a shock for the market.

Lendlease's guidance to FY21 core operating profit after tax of $375-410m, -16% below consensus forecasts, revealed that the pandemic is weighing more heavily on near-term development earnings than brokers previously expected. Lendlease also flagged delays with International Quarter London (IQL) as a contributing factor to not hitting consensus.

Much of the profit cut relates to cities going in and out of lockdown during the past financial year which halted work across numerous office, retail and residential projects.

Recently appointed CEO Tony Lombardo highlighted that covid weighed heavily on operating conditions, with London being one of the hardest hit. As a case in point, slower lease-up and/or weaker rents at the first two residential for rent buildings at Elephant Park are expected to reduce profits from the level previously recognised, hence impacting FY21 earnings.

Lombardo also flagged claims relating to historical projects completed prior to the sale of the engineering business could see Lendlease incur an additional provision in the range of -$90m to -$175m after tax in fiscal 2021. While the impact to the business remains uncertain in timing and magnitude, the group expects FY21 profit after tax of $200-320m.

New business model evolving

Reflecting lower development earnings in the near term and a slower ramp-up in activity, Citi has reduced its FY22 earnings forecasts to $578m which is -8% below consensus. But having concluded that the drivers of Lendlease’s profit announcement are predominantly one-off or timing-related, the broker’s longer-term forecasts remain largely intact.

Taking some comfort from development progress in Sydney, Melbourne and Milan, Citi retains a Buy recommendation but lowers its target price to $15.97 to reflect lower forecast earnings.

Overall, the broker continues to see scope for a multi-year re-rating for Lendlease as the business model evolves. Based on the $112bn development pipeline, Citi also sees the potential for the stock to re-rate over the medium term, especially once the non-core business is exited.

Citi expects the wide-ranging review of the business being undertaken by Lombardo to lead to cost savings and sees the continued simplification of Lendlease as a positive. The broker expects to see an increased focus on the group’s $110bn development pipeline and scope to grow the $38bn funds management platform.

While Macquarie concedes a medium-term focus on key business priorities would be positive, the broker suspects this could result in near-term earnings dilution. The broker notes every -1% reduction in costs could be a 3.4% benefit to earnings per share (EPS) in FY22.

Investment strategy: Urban regeneration & funds management

While Morgan Stanley’s mid longer-term thesis for Lendlease’s urbanisation pipeline has not changed, the broker’s near-term conviction remains subdued, and is forecasting FY21 core net profit of $392.5m.

An update on Lombardo’s wide-ranging review will come on 16 August at the company's FY21 result release. Morgan Stanley, which has an Equal-weight rating and $13.00 target price, also suspects a material cost savings target is likely to be announced.

Ord Minnett suspects Lombardo’s restructure could result in annualised cost savings of $50m per annum. The broker maintains a Hold recommendation on Lendlease, but its target price increases to $13.00 from $12.80 due to an increase in the broker’s net asset value estimate.

While Ord Minnett expects the development pipeline to drive materially higher stabilised earnings, earnings recovery is in the broker’s view a FY23-plus story.

Meanwhile, Citi believes Lendlease's growing global urban regeneration pipeline and the funds management business should drive medium-term earnings growth for the company, with earnings visibility increasing over time.

Including profit at Milan Innovation District, profits at Tower 2, One Sydney Harbour, and Melbourne Quarter this results in around $250m from urban regeneration.

The broker also notes the improvement in the group’s liquidity and capital position post the April 2020 equity raising helps secure capital needed to fund the development pipeline, while also taking advantage of other near-term opportunities.

Macquarie notes there are 12 projects which Lendlease may execute on in FY22 versus five in FY21. However, given the smaller nature of these projects, the broker concludes the group’s ability to achieve significant growth in EPS appears difficult.

Like Citi, the broker also suspects Lendlease’s review of the short to medium-term impacts of the pandemic on its operations may result in a delay in achieving production, work in progress and project commencements.

Macquarie, which has a Neutral rating and $11.47 price target, reminds investors the group’s reliance on these profit items to achieve targeted returns has risen, hence reducing earnings visibility. To reflect lower development profits, the broker’s core EPS forecasts for FY21, FY22, and FY23 have been lowered by -10.1%, -5.5%, and -6.5% respectively.

While Macquarie admits normalised EPS value appears to be emerging, the broker wants to see negative earnings momentum cease and greater earnings visibility to give confidence targeted return hurdles can be met.

From Macquarie’s perspective, growth needs to be driven by the development business unit. Given a gradual recovery in communities and a reduction in apartment settlements in FY21, the broker wants to see growth in the urban regeneration book.

While Lendlease has provided little clarity around FY22 profit drivers, given substantial deals still closed in FY21, UBS believes the trajectory remains positive. Based on future growth potential, UBS maintains a Buy rating and target price of $13.00.

The broker sees a three-year net profit compound annual growth rate of 12% from the base of the broker’s revised FY22 profit forecast. Longer term, UBS sees the $100bn development pipeline as supportive of Lendlease with governments keen to support projects/planning/partnerships to drive a post-covid economic recovery.

Risks

With an update on the business review to come, Macquarie also suspects there could be more negative news before the market can focus on the medium-term growth outlook. As a result, post the business update the broker reduced FY22 operating earnings expectations by -5%, -13% below prior consensus.

In short, Macquarie doubts construction and investments are enough to drive the financials (profit & loss) in FY22 towards consensus expectations.

The broker admits there are positive aspects to the financials in FY22, including the absence of Elephant Park write-downs, a recovery in communities and funds/asset management earnings, plus a recovery in co-investment earnings.

However, the broker believes headwinds remain, including the absence of a $30m development fee in military housing, and a full year impact of the sale of a 25% stake in the group’s retirement book.

Macquarie’s bottom-up approach highlights potentially $481m of sell-down opportunities in FY22. But given risks to delays, an 80% risk factor weighting results in $385m of earnings in the broker’s forecasts.

Near term, Citi believes virus-related slowdown in activity remains a major risk. Other key risks to achieving forecasts and target price flagged by the broker include an inability to attract third party co-investment, a wave of settlement defaults, and material cost overruns on fixed price construction contracts.

The FNArena database shows three Buy and three Hold or equivalent broker ratings. The consensus target price is $13.23, suggesting 17.6% upside.

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