More important than why this has happened, is how we can seek to profit from it for our clients. In the dust left behind all this momentum-driven euphoria are a number of companies we consider to be cheap and have excellent prospects.
Worley Limited is one such company, which our Portfolio Manager, Dr Suhas Nayak, discusses below.
Worley LimitedWorley is an engineering services provider that primarily services the global resources and energy sectors. Graph 2 shows the geographic and sector spread of the company’s revenue.Graph 2: Geographic and sector spread of Worley’s revenueSource: Worley FY21 results presentationWorley’s engineers are typically billed out to clients (doing ‘reimbursable work’, to use industry jargon), with very little done on a lump-sum or fixed-cost basis. As a result, the company will do well if they maintain a high level of utilisation of its staff and a high level of revenue. A lot of Worley’s revenue is ‘booked and burned’ (i.e. projects are won and executed) within the year, which makes visibility of future revenue quite difficult. However, activity levels in the resources and energy sectors do influence the company’s overall revenues. Higher capital expenditure programs in both sectors will typically mean higher revenues for Worley, and, if utilisation is kept high, then that will lead to higher profits for shareholders of the company.What went wrong? In 2018, Worley made its biggest acquisition to date, the Energy, Chemicals and Resources (ECR) segment of Jacobs Engineering, which just about doubled the size of the company on most metrics. The share price weakened after this large acquisition, probably as a result of the change in business mix and the large issue of new shares used to fund it. While integration of the two businesses has appeared to have gone well, the aftermath of COVID-19 created significant share price weakness. COVID-19 led to the company’s major customers deferring capital expenditure and projects, which led to a sudden reduction in revenue for Worley. While many of the underlying commodity prices have bounced back to pre-COVID-19 (or higher!) levels, capital expenditure by Worley’s clients has not kept pace. Worley’s revenue growth has therefore lagged the underlying commodities’ price growth. Despite cost-outs that came with integration, and further cost-savings the company has made since, the lower revenues have led to a material reduction in profits as can be seen in Graph 3, which shows Worley’s pro-forma (hypothetical) financials for financial year (FY)18 (which combines ECR and Worley as if the acquisition had happened in FY18) and financials for FY20 and FY21. This has been accompanied by a sharp drop in personnel, from 57,600 in FY18 to 47,700 at the end of FY21. Please note that there is no data available for FY19. Graph 3:Worley's profits are lowerSource: Worley Company announcementsA mix of old and newIn the past, and certainly before the ECR acquisition, Worley’s share price was highly correlated with the price of oil. This probably reflected the company’s exposure to capital expenditure by major oil and gas companies around the world. That level of correlation is less justifiable today, as the ECR acquisition diversified the business. More recently, the company has put a much greater focus on sustainability projects, knowing that a more sustainable world is likely to involve very large capital expenditure and some complex engineering problems. While it is possible that oil and gas capital expenditures do not grow much from the low levels of 2021, Worley’s future revenue growth may not be hindered by that one sector. The company recently flagged its aspiration for 75% of its revenue to be generated from sustainability-related business within five years.What is priced in and what isn’t?Worley’s current market capitalisation is $5.6b. Together with net debt of $1.5b, the company’s enterprise value is around $7.1b. This means the company currently trades at 15 times FY21 underlying earnings before interest, taxes, and amortisation (EBITA), in line with the broader market. However, we think future EBITA is likely to be significantly higher because:Oil and gas capital expenditure was very depressed over FY21. Low oil prices caused project deferrals across the oil and gas space.Work could not be done easily at many sites due to COVID-related restrictions. This reduced the work that Worley could do, especially in the maintenance part of the business.Despite some cost-saving measures (that were going to happen with or without the pandemic-induced reduction in revenues), Worley did not reduce its employee base directly in line with revenue reductions. It chose to look through the cycle and preserve critical capabilities so it could take advantage of any upturn in demand. If that demand does not come through, it is likely further cost-saving measures would be possible, thereby boosting EBITA even if revenues remained flat.Referring back to Graph 3, from FY20 to FY21 revenue was down around $2.5b. Without their achieved cost-saving measures, EBITA would have fallen by approximately $500m. This means gross margins on work done might be around 20%, which also gives a sense of the leverage to increased revenues.If revenues returned to FY20 levels, then we could expect Worley to earn over $950m of EBITA. The Worley share price suggests that the market assigns a very low probability of that increased revenue occurring. But it certainly seems possible: commodity prices were lower through FY20 than they are now, and the tilt towards projects that help the world transition from fossil fuels suggests that there may even be incremental project revenue available in the future.The impact of trendingWhile the upside for Worley looks promising, it is worth commenting on how the company is priced relative to others. After three years of poor share price performance, and two years of a difficult business environment for Worley, we see quite a divergence in valuation between it and some of the favoured stocks in the market. Take, for example, IDP Education Limited, which provides English language testing services for students who want to study abroad, as well as student placement services where it acts as an agent for foreign students. IDP is valued at $9.6b at an enterprise level, compared to $7.1b for Worley. In FY22, IDP is expected to earn approximately $150m in EBIT (up about 100% from three to four years ago), compared to Worley’s $540m in EBIT. Investors pay 35% more for IDP, which earns less than one third what Worley does. The value investors place on IDP’s growth is extraordinary. For it to be on the same earnings multiple, earnings would need to increase five times from 2022’s forecast earnings. Even if earnings grew at 25% p.a. consistently, it would take another seven years to reach a similar earnings multiple to Worley after having already doubled earnings in the previous three to four years. This would be a truly extraordinary outcome and would place IDP amongst Australia’s greatest ever earnings compounders. Only five listed companies in Australia have achieved per share earnings growth of 25% p.a. over 10 years and then sustained those profits beyond that: CSL, Computershare, TechnologyOne, Fisher & Paykel Healthcare and ResMed. In the meantime, Worley is paying a healthy dividend and we believe it is quite likely Worley’s earnings will grow, given it also has a very large and growing addressable market of renewable projects.After a difficult two years, and with such low long-term expectations, an investment in Worley appears to offer a good risk-reward opportunity relative to the broader market and especially relative to the cohort of recent winners.
WOR Price at posting:
$11.42 Sentiment: Hold Disclosure: Held
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