Description

We are recommending a long position in the stub assets of Hochtief (HOT GR) net of its 54% ownership of Leighton Holdings (LEI AU), requiring approximately 2.2 short shares of Leighton for every 1.0 long share of Hochtief. By synthetically creating this stub position, investors have the opportunity to pay essentially nothing for businesses that we believe have a conservative net asset value of at least €2 billion and generate over €10 billion of revenue annually. Hochtief is among the world’s largest commercial construction contracting businesses (minimal to no residential exposure) with a formidable presence in virtually every region of the world, including Turner Construction, which is among the largest in the U.S.  One of Hochtief’s most attractive attributes is its strong presence in the growing global infrastructure construction market, where in recent years the Company has begun to take sizeable equity positions in infrastructure products such as airports and toll roads, diversifying away from the pure contracting operating model.

At today’s price, Hochtief’s 54% ownership in Leighton Holdings is worth €5.2 billion, over 90% of the market value of Hochtief’s equity value, and with additional adjusted net cash of approximately €600 million, the stub has a negative implied enterprise value. Leighton has leading market share in the booming Asian and Australian commercial and infrastructure contracting markets. Over the past 5 years, Leighton has more than doubled its revenue and nearly tripled its operating profit, and the market has rewarded the Company with a 600% total return over the five year time period and 185% total return YTD. For the purposes of our analysis, we will not delve into much more detail on Leighton as it is not part of the stub value, and trades at rather high growth multiples of 14.2x TTM EBITDA, 12.1x price to tangible book value, and 1.3x EV/revenue. Before walking through our valuation of the various businesses included in the stub, the chart below shows the implied valuation of the stub at today’s prices.

In recent years, Hochtief has established itself as one of the leading airport managers in the growing market for airport privatizations. Hochtief’s current portfolio consists of interests in 6 airports, including the recently acquired 75.0% interest in Budapest International Airport, 8.1% interest in Sydney, 26.7% interest in Athens, 20.0% interest in Dusseldorf, 34.8% interest in Hamburg, and 47.0% interest in Tirana. These investments are extremely attractive in that they represent regional monopolies with high returns on invested capital and EBITDA margins that often exceed 50%. The businesses generate revenue on a fee per passenger basis, and therefore passenger traffic is the primary driver of growth for the segment. In 1H 07, passenger traffic grew by 6.6% over the whole portfolio, led by strong increases of over 10% at Athens and 20% at Tirana. Given the predictable nature of their free cash flow coupled with the long duration of their concession contracts, interests in privatized airports are typically valued on a net present value basis, which tends to value these investments at relatively high trailing cash flow multiples. Hochtief provides their internal estimates of NPV for their entire portfolio quarterly with what the Company claims to be relatively conservative projections and a 13% discount rate. In the 2Q 07 report, management’s internal net present value of future cash flows from this segment was €1.24 billion. It’s worth pointing out that if the Company were to use a 10% discount rate then the value of the portfolio would increase by approximately €500 million to approximately €1.73 billion. The Company’s NPV valuation methodology has been more than validated by recent industry transactions, and therefore we are valuing this segment at the NPV provided by the Company of €1.24 billion.

Hochtief’s Development segment designs, builds and operates other infrastructure projects (non airport) through its PPP (public-private partnership) Solutions group, including positions in a handful of toll roads, schools, and hospitals, among other investments. The PPP Solutions projects can be valued on an NPV basis similar to the airport portfolio. The 2Q 07 report estimates that the NPV of the portfolio was €260.7 million as of June 30, 2007. €214 million of the total is attributable to the Company’s toll road portfolio, which is discounted at a rate of 12.1%. This value is expected to grow by over €200 million as the Company takes over two toll road contracts in Greece that it recently won. The Development segment also includes a facilities management group that provides a full range of technical, commercial and infrastructure services for buildings and properties, and also takes direct development positions and indirect position through an asset management arm in various real estate holdings. Though the numbers are difficult to accurately back out given the diversification within the segment and various one time items, our math suggests that the non PPP portion of the development segment generated at least €40 million of EBIT on a trailing twelve month basis. At 8x this number, we ascribe €320 million of value to these businesses, which is less than the value ascribed by most of the sell side analysts. In total, we value the development segment at approximately €580 million.

Hochtief’s Construction Services Americas segment has leading market share in the construction and infrastructure markets in the U.S. and Brazil through its wholly owned subsidiaries Turner construction and Hochtief de Brazil. This segment has experienced high single digit percentage revenue growth in recent years, generating nearly €7 billion of revenue over the trailing twelve months. Yet with only 1.2% EBIT margins this segment generated roughly €83 million of EBIT over the trailing twelve months. The Company expects this segment to continue to grow at similar levels, and is forecasting improved margins in the coming quarters. We believe that a multiple of 8x trailing EBIT is fair if not conservative, implying a value of approximately €650 million for this segment.

Hochtief’s Construction Services Europe is the Company’s oldest legacy contracting business, providing building construction, civil and structural engineering services to select European countries, including Germany, which represents slightly more than half of this segment’s revenue, and the Czech Republic, Poland, and Russia, which comprise the majority of remaining revenue. Over the trailing twelve months, this segment has generated in excess of €2 billion in revenue, but has seen its margins turn negative from a very difficult operating environment in Germany, where they’ve had to write down nearly €100 million of contracts year to date in the face of rising construction costs and a difficult market for hiring subcontractors. Business in the Eastern European countries is growing rapidly and accounts for much of the segments 28% yoy increase in new orders. EBIT margins in Eastern Europe have remained healthy at 2.3%, but this has obviously been offset by the problems in Germany. The Company is forecasting a return to profitability in this segment by 2008 as it eliminates most fixed price contracts, and hopes to return to a more normalized 2% EBIT margin long term. Given the low multiples typically ascribed to contracting businesses coupled with the negative earnings experienced by this segment in recent quarters, we ascribe zero value to this segment to be conservative.

The chart below provides a summary of our valuation of each of these segments, and subtracts corporate overhead at an 8x multiple:

Summary of Thesis:

At a negative implied enterprise value of the stub relative to billions of euros of actual underlying value, we believe the opportunity is extremely compelling. We believe our stub valuation of just under €2 billion is well on the conservative side, and in fact think the value could be as much as twice our valuation estimates. We are also confident that the underlying value of the stub assets will continue to grow, and are particularly optimistic about the Company’s growing capital allocation to the infrastructure sector. We are confident that this value will eventually be at least somewhat reflected in the respective share prices. Additionally, though there is no guarantee that the implied stub value cannot fall further, there is clearly considerable downside protection at the current implied negative stub value. At current pricing, the enterprise value of the stub is negative for the first time in over three years, and in the meantime, the underlying economic value of the stub has grown considerably, primarily due to the value created by the infrastructure investments.

Catalysts:

Though the stub arbitrage is not likely to be fully unlocked by asset monetization or spin offs in the near term (for reasons mentioned below), it is highly likely that the sell side analysts that follow the name will continue to revise their target prices on Hochtief upward to reflect the recent increase in Leighton’s price. The sum of the parts valuation methodology used by sell side analysts for Hochtief value the Leighton component based on Leighton’s stock price, but they also don’t update their models/reports all that frequently, so after big moves in Leighton’s stock price, there is typically a lag in target price adjustments. Some of the sell side reports that we’ve seen even use a weighted average price over a certain time period, so the lagged effect is even greater. UBS, for example, prices Leighton’s value at an average price over the previous four months, and as of their latest report on August 22^nd, this price was just north of $40 (AUD) per share. At today’s price of over $55 AUD per share, this 35%+ price difference alone would imply an incremental value of approximately €21 per share in Hochtief’s value. We believe the weighted average methodology is inherently flawed, particularly when you can currently short Leighton at a much higher price than what is reflected in this methodology (in the upward pricing environment for Leighton). It’s also worth noting that Hochtief’s 54% ownership should theoretically get a premium to minority shares traded in the market, as was the case when Custodia sold its 25% ownership interest in Hochtief for a  5% premium to the stock price at the time, and this wasn’t even a controlling majority position.

Over the long term, we believe that some component of this arbitrage will eventually be monetized or spun off, but in the meantime, we believe the growing investment appetite for the privatized infrastructure segment will eventually drive the stub value. Hochtief has strategically positioned itself as a pioneer in this category, and will continue to build on one of the of the most valuable infrastructure portfolios  in the world.

Risks/Negatives:

As can be seen above, there is little doubt that the stub is being considerably underpriced by the market. Although this value is near historical lows at a negative adjusted enterprise value, it appears that the stub has rarely if ever been fairly valued. Furthermore, though certainly never out of the question, it doesn’t appear that the Company is working toward unlocking this value in the near term. There is fairly strong demand for their infrastructure assets in both the private and public markets, so a spin off or sale of those assets could be easily completed. This appeared more likely when Custodia auctioned off their 25% ownership in Hochtief at €72 per share in March of 2007. At the time, there was considerable anticipation that the winning bidder would use its acquired influence to break up parts of the Company to unlock the stub value, but this was followed by disappointment when the winning bidder was a Spanish based contracting business (ACS) that was apparently looking to expand its geographical footprint in the contracting business rather than unlock the underlying value of its infrastructure assets. Macquarie was thought to be interested in the shares, and given their global presence in infrastructure assets (most notably MAP AU airport assets), the rumor mill was suggesting they would spin off the infrastructure assets. Unfortunately, this did not come to fruition.

As the ratio of Hochtief value divided by Leighton value has decreased over time, the holding cost of entering the stub trade has become increasingly more burdensome. As an example, at the beginning of 2007, the trade required just over €2 of Hochtief for every €1 of Leighton to create the synthetic position of over €1, but this ratio has now declined to roughly 1.11, and therefore €1.11 of Hochtief is required for every €1 short of Leighton to create just an €0.11 position in the stub. It’s also worth pointing out that with the increased total capital required to enter the trade, the investment is subject to greater short term price fluctuations in the underlying positions. The stocks never trade at the same time, and although the daily correlation has been 0.91 over the trailing twelve months, there are days when the relative performance of the two diverges quite a bit.

Catalyst