As part of a market update, Lend Lease advised fiscal 2013 net profit after tax would be in line with analyst consensus estimates of AUD 540 to AUD 547 million. However, guidance for the 2013 tax rate reduced from low to midteens to an unusually low 4% to 8% range. This update is effectively an earnings downgrade, given the lower tax rate adds AUD 40 to AUD 60 million to earnings. Key areas of weakness are the U.K. construction market, which is suffering ‘unsustainable margins’ and Australia, where engineering volumes and margins are deteriorating.
Declines in commodities have led to numerous miners pulling back on capital expenditure programs. Consequently, engineering firms in the mining sector will try to secure work in civil engineering, which makes up the bulk of Lend Lease’s engineering and construction operations. Higher competition and a lower overall capital investment pool will weigh on margins and volumes of work won. In Australia, we now forecast negligible revenue growth in fiscal 2014 and 2015, cut earnings before interest and taxes (EBIT) margin forecasts for fiscal 2014 and fiscal 2015 from 5.4% to 4.3%, and reduce long-term EBIT margins from 5.1% to 4.6%. In the U.K., updated commentary and a 9% decline in the number of permit applications for commercial property developments, leads us to trim revenue and margin forecasts for the U.K. construction division. Despite efforts by the U.K. government to stimulate growth, we believe the private sector will continue to maintain a conservative stance on capital expenditure commitments.
Around 25% of Lend Lease’s EBIT is annuity-style, derived from funds management, commercial rents and ownership of low-yield retirement units. The parts of the business that continually need to secure work are engineering, construction, project management, commercial development and residential development. While Lend Lease has scale in these activities and will derive some benefits from being vertical integrated, we do not consider it to have a sustainable competitive advantage. With 75% of EBIT coming from these commoditised activities, we do not consider Lend Lease to have a moat. Following cuts to our forecasts for Australia and the U.K., our fair value estimate declines from AUD 10.00 to AUD 9.00.
Lend Lease also disposed of its 25% stake in Jem (Singapore’s third-largest mall) for AUD 189 million. The sale was above December book value of AUD 134 million, but the asset was still under development at the time. We expect a minor profit on the sale will be largely offset by restructuring costs, including redundancies for the Australian and U.K. engineering and construction operations. The bulk of the restructuring costs will be taken in fiscal 2013 (roughly AUD 20 million), with further costs to be incurred in fiscal 2014.
We forecast earnings to decline in fiscal 2014, but this could turn to growth if the 30% share in Bluewater is sold, which would attract a post-tax profit in excess of AUD 150 million. Overall, we see little downside risk to construction work on the two initial Barangaroo office towers and the AUD 1 billion Sydney International Convention, Exhibition and Entertainment Precinct (SICEEP) as these projects already have tenant pre-commitments. Other major projects where work is unlikely to be deferred relate to government work for hospitals (Gold Coast, Melbourne Children’s, Mackay, Queensland Children’s, Cairns, Sunshine Coast), prisons, sporting facilities and government buildings. We forecast that following completion of major works on significant projects (three major Barangaroo towers, Brisbane Showgrounds and the major hospitals), that Australian construction revenues decline 40% during the two years ending June 2017.
Our major concern relates to the Australian office sector. Significant new supply has either been added or is scheduled to be added in Australia’s major cities. We see the combination of this, and headcount reductions from a slowing Australian economy, will result in a sharp contraction in private sector demand for civil and project management services for new office towers.
Subsidiary Abigroup specialises in the construction of buildings and roadways. We believe investment in road infrastructure is likely to remain stable, but the rate of work won and margins are both expected to decline due to increased competition. Subsidiary Baulderstone has expertise in major civil projects (water, bridges, power and defence) and commercial building. Growth for this division will be challenged over the medium term given there is unlikely to be material step-up in funding for defence, water and ports in the foreseeable future.
Lend Lease’s Australian construction business comprises the legacy Bovis Lend Lease operations of project management and construction (high rise residential, office and retail buildings, healthcare and telecommunications) and the Australian businesses acquired as part of the AUD 960 million Valemus acquisition, which comprise Abigroup, Baulderstone and Conneq (engineering asset management and maintenance).
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