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Engineers & Contractors
RoIC drives relative value
Sameer Chopra
Research Analyst
(61) 2 82581336
sameer.chopra@db.com
Craig WongPan
Research Associate
(612) 8258 2848
craig.wongpan@db.com
Fundamental, Industry, Thematic, Thought Leading
Deutsche Bank Company Research's Investment Policy Committee has deemed
this work F.I.T.T for investors seeking differentiated ideas. We recommend
investors seek those companies which have a high RoIC premia to cost of capital
accompanied by above average earnings growth.
Deutsche Bank AG/Sydney
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from
local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies.
Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should
be aware that the firm may have a conflict of interest that could affect the objectivity of this report.
Investors should consider this report as only a single factor in making their investment decision.
Independent, third-party research (IR) on certain companies covered by DBSI's research is available to customers of
DBSI in the United States at no cost. Customers can access this IR at http://gm.db.com, or call 1-877-208-6300 to
request that a copy of the IR be sent to them.
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1
FITT Research
Top picks
Leighton Holdings Ltd (LEI.AX),AUD53.30 Buy
WorleyParsons (WOR.AX),AUD37.70 Hold
United Group Ltd (UGL.AX),AUD13.24 Sell
Companies featured
Leighton Holdings Ltd (LEI.AX),AUD53.30 Buy
2007A 2008E 2009E
P/E (x) 16.5 25.8 19.1
Div yield (%) 4.1 2.7 3.4
Price/book (x) 8.5 9.3 7.8
WorleyParsons (WOR.AX),AUD37.70 Hold
2007A 2008E 2009E
P/E (x) 24.2 25.8 20.9
Div yield (%) 2.7 2.7 3.3
Price/book (x) 5.9 5.7 5.3
United Group Ltd (UGL.AX),AUD13.24 Sell
2007A 2008E 2009E
P/E (x) 21.2 16.1 14.6
Div yield (%) 3.4 4.2 4.7
Price/book (x) 3.8 2.1 2.0
Price/price relative
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08
LEI WOR UGL TSE DOW XTI
Return on Invested Capital
-10%
0%
10%
20%
30%
40%
50%
2002 2003 2004 2005 2006 2007 2008f 2009f 2010f
LEI WOR UGL TSE DOW
Fundamental: Substantial differences in RoIC performance across peers
In FY08, we project leading sector performers should enjoy RoIC 4-12% above
peers: LEI 25%, WOR 17%, UGL 12%, TSE 12% and DOW 13%. We explain the
drivers of this substantial difference at a company operating level through our
DuPont breakdown of both RoIC and ROE.
Industry: Buoyant sector conditions contributing to rising returns
Margins have expanded by 90 bps over past 2 years, driving returns. With demand
exceeding supply, increased use of cost plus contracts, expansion into higher
margin geographies and offshore sourcing, we expect margins to expand by
another 60 bps over next 2 yrs. This should extend RoIC premia to cost of capital,
providing positive shareholder returns.
Thematic: RoIC and EPS growth are key drivers of shareholder returns
RoIC premia to cost of capital and EPS growth should drive relative share price
performance and P/E multiples. While acquisitions have provided EPS momentum,
high acquisition prices/low returns from target companies have typically resulted in
significant lowering of RoIC. Our analysis of the 8 largest deals suggests that only
half of these will be RoIC accretive after 3 yrs.
Thought leading: Detailed DuPont analysis highlights return drivers
Our detailed DuPont analysis has identified sharp differences in the factors driving
RoIC (margins, turnover, leverage and tax). This is explicitly evident in working
capital management practices where LEI, best RoIC performer, has funded sales
growth through working capital management while WOR and UGL have required
more expensive debt/equity funding. Also, offshore expansion into lower tax
Middle East offers better returns than higher tax US.
Conclusion: Buy LEI, Hold WOR, Sell UGL - supported by RoIC analysis
In our view, LEI and WOR offer investors superior RoIC premia to cost of capital
and medium term EPS growth compared to peers which in our view should deliver
share price outperformance: LEI and WOR RoIC exceeds cost of capital by 12%
and 6% and is increasing over next 2 years. The earnings for these 2 companies
should grow at 10-15% higher rates than peers. Conversely, UGL has lower RoIC
(and declining) and lower EPS growth outlook than peers which could result in
relative weakness. Analysis in the report has supported downgrading UGL to Sell
(from Hold).
Table of Contents
Overview ............................................................................................ 3
RoIC’s influence on share price and P/E ...................................................................................5
Buoyant conditions driving sector margins ...............................................................................6
Acquisitions provide growth but are not always value accretive ..............................................7
Capital management .................................................................................................................8
Stock specific findings ..............................................................................................................9
Leighton Holdings ........................................................................... 11
RoIC and RoE..........................................................................................................................12
EBIT margins..........................................................................................................................13
Asset turnover ........................................................................................................................13
Leverage ................................................................................................................................14
Tax rate ..................................................................................................................................16
WorleyParsons................................................................................. 18
RoIC and RoE..........................................................................................................................19
EBIT margin............................................................................................................................20
Asset turnover ........................................................................................................................21
Leverage ................................................................................................................................22
Tax rate ..................................................................................................................................23
United Group ................................................................................... 25
RoIC and RoE..........................................................................................................................26
EBIT margin............................................................................................................................27
Asset turnover ........................................................................................................................28
Leverage ................................................................................................................................29
Tax rate ..................................................................................................................................30
Overview
In this research note, we examine the relative Return on Invested Capital (RoIC) performance
for five Australian Engineering & Contracting companies over an eight year period. These
companies are Leighton Holdings (LEI.AX, Buy, TP=$60.00), WorleyParsons (WOR.AX, Hold,
TP$=40.80), United Group (UGL.AX, Sell, TP=$11.00), Transfield Services (TSE.AX, not rated)
and Downer EDI (DOW.AX, not rated). The advantage of using RoIC, alongside other
measures such as margins, P/E and EPS growth is that it highlights the effectiveness of a
company in generating returns for equity and debt holders. Our methodology for RoIC is
defined in Appendix A. In line with common practice, we have adjusted returns and invested
capital for off-balance sheet financing and R&D expenditure, and excluded low-yielding cash
returns from the operating returns of the business.
Additionally, we have used DuPont analysis to assess the drivers of RoIC: EBIT margin, asset
turnover, leverage and tax retention. The nominal value of RoIC drivers will vary to traditional
reported RoE metrics because of the adjustments outlined in Appendix A:
EBIT margins – We have added operating lease expense and R&D costs to reported
EBIT but subtracted a notional charge for depreciation of leased operating assets
(straight line depreciation over a 5 year asset life) and amortization of R&D assets
(amortized over a 10 year period).
Asset turnover – In our calculation of total assets we have included the present value of
operating lease commitments and the net capitalized value of R&D costs, but have
subtracted cash and current liabilities.
Leverage – The leverage ratio is calculated as total assets, as defined in the asset
turnover section above, divided by invested capital. This compares to total assets divided
by equity under the traditional RoE DuPont analysis.
Tax retention – There is no difference between RoIC and RoE tax retention rates.
However, with the exception of leverage, most RoIC drivers will follow a similar trend to
reported RoE metrics.
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