what would camden value worley at?, page-6

MM,

Valuing WOR is not easy, although it is not “un-valuable”, which is what many other engineering construction companies are, because frankly, it is impossible to value them because it is impossible to forecast their cash flows.

But WOR does, indeed, generate Free Cash Flow through the cycle. Like most “neck-up” businesses, WOR's capital consumption is not high, and the company has sufficient scale with sufficient levels of customer and project granularity that no individual service contract can end up in the undoing of the business in its entirety.

That’s not to say that bad contracts cannot impact earnings significantly enough for it to matter (or delayed contracts, as is ostensibly the situation currently).

In other words, since it is quite topical, I’ll say that WOR is no FGE: When FGE gets a few jobs wrong it ends up in the demise of the company, but if WOR gets a few wrong it ends up in a 10% earnings downgrade.

One of WOR’s redeeming attributes is that it has significant global scale, and with that scale comes sufficient diversity of customer, service-type, geography and economic sector.

Put another way, I think WOR is to FGE what BHP is to PDN... the larger ones are probably OK businesses, but they will always survive (not that survival should ever be a sole reason to invest) but the smaller ones are pure, unadulterated crap that are just one, left-field torpedo away from death and therefore you should never contemplate owning any of them (although I see that you do, strangely enough).

But let’s focus on WOR.

To value WOR, we need to first “define” the business; not simply in terms of what it does (that is easily observable by looking at the latest investor presentation... incidentally, in my cynical view, in the overwhelming majority of cases, investor presentations are little more than promotional claptrap and really do little to truly inform the investment thesis), but what its “financial pedigree” is.

One really needs to view WOR from 2007, when it made the transformative acquisitions of the COLT Group (about $1.2bn, if my memory serves) and the Parsons Group (circa $350m).

Since then WOR has generated cumulative OCF of some $2.4 bn, and has consumed about $800 m in total capex, so total, cumulative Free Cash Flow over that 7-year period of some $1.6 bn.

In no single year was FCF a negative number.

Following the COLT and Parsons purchases, WOR has spent a further $700m on numerous other smaller acquisitions, exclusively using cash.

WOR’s share count has been remarkably stable since the COLT acquisition (which was partly scrip based):

Shares on issue in 2007 = 240.6 m
Shares on issue today = 246.5m

I like that sort of conservative stewardship of issued equity.

Additionally, $1.3bn has been returned to shareholders in the form of dividends.


Not bad at all.

Make no mistake about it, that’s a real business.

And the balance sheet is in decent shape, with Net Debt-to-EBITDA for FY14 expected to be around 1.2x, which is conservative for a highly cash-generative business like this.

Trouble is, it’s not a business that can grow organically, despite what anyone cares to argue.

It needs to acquire.

Take the period since the COLT and Parsons deals. Operating Profits have not changed materially at all:


EBIT:

2008 = $582 m
2009 = $642 m
2010 = $460 m (GFC impact)
2011 = $540 m
2012 = $601 m
2013 = $592 m

And remember, that’s despite some $700 m having been spent in that period on acquisitions, implying the core business went backwards over that time.

So that’s something I really don’t like about the business, its an acquisition roll-up story and it is why I rate it merely as an “OK” – and not a “good” – business.

Which means I believe investors should never be willing to pay a premium multiple for the stock.... which for some reason they always have done, and which they continue to do, although the premium is deflating thanks to five downgrades in a little over 12 months.

That’s the problem that I have with the stock on a medium- to longer-term structural viewpoint.

But I also have a big problem in relation to the short-term: put simply, I don’t understand the most recent guidance, and I think the company’s management risks having to revise guidance for the FY14 period down again sometime in the new year.

The simple maths behind my reservation goes something like this:

Current management guidance is for FY14 NPAT of $280m (the mid-point of guidance), with a DH13:JH14 split of $100m:$180m.

That’s a big leap in JH14 vs DH13, but management claims it’s because there has been a delay of some projects that will now not make any profit contribution in the current half, and will spill over into the next half.

Trouble is, they also tell us that the Australian business (around 20% of Revenue and EBIT) will be weaker in JH14 versus DH13.

Also, there are to restructuring charges that will be booked in both halves, but likely to be higher in JH14 than DH13.

So what this then means is that, in order to get to that $180m figure in JH14, the non-Australian businesses, i.e., representing 80% of the company’s earnings, will need to grow by more than 80% in order to overcome the drag in JH14 that will come from the lower Australian business performance, as well as the higher restructuring charge impost.

Arithmetically, it looks to me like the 80% of the business outside of Australia will have to double in earnings compared to DH13, or something in that order.

It feels like a huge ask to me, even if the weaker A$ continues to help the offshore cause.

But let’s give the company the benefit of the doubt and take that guidance at face value.

$280m of NPAT equates to EPS of $1.10, leaving the stock trading on a P/E multiple around 15x.

While this is indeed lower than the stock’s historical multiple closer to 17 or even 18 times, I think that the market was simply negligent in affording such a generous historical rating.

Yes, WOR is not a vanilla engineering contractor; and yes, it has some real technical intellectual property and smarts; and yes, it adds value to its impressive global customer base (probably not as much value as its glossy presentations suggest, but probably some value).... but it is not a business that warrants a multiple in line with the broader stock market, which is where it currently trades.

I reckon a 13x P/E – maybe 14.0x once the earnings revision cycle is out of the way – is an appropriate multiple that more fairly values the company in my mind.

So, I think that $14.00 is a more realistic valuation that might provide some downside protection for investors from that level.

Of course, if full-year FY14 EPS ends up being $1.00/share, which I think it could, so for some form of prudential buffer, $13.00 is the price target at which I think the stock is fairly valued.

Not overly scientific, I concede, but then again often 80% of the answer is found in 20% of the time.

This one is not for me, I’m afraid.

(But thanks for inviting an opinion. Let me know if you ever want my opinion on PDN!)


Cam