Latest recommendation report Valuation: Not investment grade Last updated: 13/04/11 Unresolved issues Investment rating
HST provides essential building services in Australasia, the UK/Ireland and the Middle East. Operations include commercial air-conditioning, refrigeration, electrical, fire and communication services. The underlying industry is mature and cyclical - primarily dependent on the non-residential building cycle. HST is not investment grade given it is a low margin contractor exposed to weak sectors and carrying too much debt. Dividends are frozen until the precarious financial position improves. Banks are effectively in control but have agreed to a standstill until 1 August 2011 to allow an equity raising. Event
* HST resumed trading after almost two months suspension as it unsuccessfully tried to raise equity to avoid breaching debt covenants. In the end, lenders agreed to a standstill until 1 August 2011 to give more time to fix the balance sheet.
* But the near-term trading outlook remains challenging and it will be difficult to raise enough equity to put a serious dent in net debt of $210m given market cap is now just $60m.
* FY11 EBIT guidance is $50m, 32% below prior guidance and 38% below original guidance given at the FY10 result. Management expects margins to remain at current levels over the next year before improving in FY13. NPAT will be hit by higher interest costs under the new lending agreement.
Impact
* Our fair value estimate is removed due to material uncertainty regarding capital structure, operating conditions and support from lenders. Additionally, financial uncertainty will make building partners nervous and could hurt HST?s ability to win work, a vicious circle.
* The current attractive PE is irrelevant as a big equity raising is needed. Depending on the issue size and price, we estimate an adjusted PE ratio of 9-11x.
Recommendation impact (last updated: 13/04/2011)
No change to our Avoid recommendation as HST is not investment grade. Event analysis
HST resumed trading after almost two months suspension as it unsuccessfully tried to raise equity to avoid breaching debt covenants. In the end, lenders agreed to a standstill until 1 August 2011 to give more time to fix the balance sheet. But the near-term trading outlook remains challenging and it will be difficult to raise enough equity to put a serious dent in net debt of $210m given market cap is now just $60m.
FY11 EBIT guidance is $50m, 32% below prior guidance and 38% below original guidance given at the FY10 result. Management expects margins to remain at current levels over the next year before improving in FY13. NPAT will be hit by higher interest costs under the new lending agreement which involves upfront fees, interest margins rising to 3% and bank guarantee fees rising to 3.25% ? making it more difficult to reduce debt organically.
Our fair value estimate is removed due to material uncertainty regarding capital structure, operating conditions and support from lenders. Additionally, financial uncertainty will make building partners nervous and could hurt HST?s ability to win work, a vicious circle.
We recommend Avoid as HST is not investment grade. The current attractive PE is irrelevant as a big equity raising is needed. Management confirmed it hopes to raise over $100m and press speculation suggests $130m. Depending on the issue price, we estimate an adjusted PE ratio of 9-11x.
Background
Earnings initially held up through the GFC as the company worked through existing projects but underlying conditions deteriorated and soon resulted in significant margin contraction. Management was far too optimistic, leading to a string of earnings downgrades hurting credibility. The real damage was caused by not raising equity before the situation got out of control and continuing dividends until recently. Dividends totalling $45m since mid 2008 could have reduced net debt by over 20%.
Management must take most of the blame for the demise for overextending at the peak of the cycle with the Rotary acquisition, failing to recognise how badly underlying conditions were deteriorating and using far too much gearing for a low margin contractor operating in weak sectors. We expect changes if and when the company stabilises.
1H11 Result
1H11 revenue increased 11% to $900.5m on acquisitions but EBIT fell 43% to $22.9m, a margin of just 2.5%. Net loss was $94.3m after bad debt provisions and write-downs to the value of Rotary. Adjusted NPAT was $6.2m. Dividends are suspended until financial position improves.
The Mechanical Installations division performed poorly with EBIT falling 55% to $12.9m as EBIT margin collapsed from 5.4% to 2.4%. The poor performance relates to ongoing project delays, work-through of low margin contracts won during the GFC, increasing competition and losses in the Plumbing business.
Services EBIT fell 2% to $4.8m on lower discretionary maintenance spend. The acquisition of Spectrum from administration helped revenue jump 63% to $153.9m but didn?t add to EBIT.
Rotary in the UK/Ireland continues to struggle with subdued economic conditions and margin pressure. The strong A$ hurts earnings on translation. Revenue fell 17% to $122.1m and EBIT fell 41% to $3.0m, a margin of 2.5%. Ireland was hardest hit, reporting a loss of $0.8m.
The Middle East division grew revenue 113% to $82.8m and EBIT 71% to $2.2m. But accounting figures are meaningless if customers don?t pay their bills. Most of 1H11?s $33.5m bad debt provision relates to the Middle East, dwarfing paltry EBIT. At current profit levels it would take over seven years for this division to offset bad debts, during which time more could be incurred.
HST Price at posting:
24.4¢ Sentiment: None Disclosure: Held
