Description

Short Hochtief at €50.

Summary investment thesis

We’ll keep this write up short since the idea is relatively simple and, in our opinion, timely. We recommend shorting Hochtief at €50. The thesis is predicated upon the following 3 legs which we’ll elaborate below:

a)      Its key asset, Leighton, faces massive macro challenges

b)      Hochtief was able to hide these headwinds, and others, by means of aggressive accounting. We think this could be soon exposed by substantial write down of receivables happening at upcoming quarterly results

c)       Company’s objective to de-lever through disposals will be detrimental in the long term as the best assets are being sold and the remaining business will be very low margin / low ROIC and will attract a low valuation

Brief group overview

Hochtief reports under 3 geographic divisions: Hochtief Americas, Hochtief Europe and Hochtief Asia Pacific. The latter is basically represented by the full consolidation of Leighton, which we’ll describe below. Hochtief Pacific is by far the most important value driver for Hochtief representing c. 60% of sales but c. 80% of EBITA of the group, all based on 2012 numbers.

The DNA of Hochtief is in infrastructure and construction projects. Hochtief is currently 50% owned by ACS, which is a Spanish listed engineering and contracting company. ACS is partially owned and controlled by Florentino Perez, the Chairman of Real Madrid. ACS basically controls Hochtief and has major influence on Leighton as well. The relationship between Leighton and the “Spaniards” has been tense. At the beginning of 2013, 3 independent directors from Leighton resigned due to unduly interference from their major shareholders. Overall management rotation is high and it’s certainly a red flag. In the last 2 years, Hochtief changed 2 CEOs and 1 CFO; Leighton changed the CEO in 2012. HLG (Leighton properties, 45% owned by Leighton) also changed management in 2012. It appears there are some management issues in the group.

Hochtief Americas, through its key subsidiary Turner, operates as a general building player in the US for civil projects such as hospitals, schools etc. This is a no growth business that rarely covered its cost of capital in the past. The division represents c. 30% of group sales and c. 10% of 2012 EBITA.

Finally, Hochtief Europe includes a number of businesses, some of them in the process of being disposed. The division includes Construction Solutions (which is the traditional infrastructure and engineering business), Real Estate solutions, Service Solutions which is in the process of being disposed of, Airports which has been recently sold and it’s currently in non-continuing operations until the transaction closes in Q3, and finally PPP Solutions, what’s arguably the only good business in the segment. Overall, Europe contributed to c. 11% of group sales and about the same in terms of EBITA contribution in 2012. Hochtief Europe traditionally showed low, volatile margins consistently below its cost of capital.

All in all, Hochtief is a badly managed construction business that rarely managed to cover its cost of capital. Whilst based on 2012 seems to screen cheaply on 3.3x EV / EBITA, this metric is very misleading as we’ll explain below. A better metric would be either P/E (22x on 2012 numbers and 15x on 2013) or FCF yield (negative). In the 5 years 2008-12, Hochtief had cumulative free cash flow of negative €1.1bn, against a current market capitalisation of €3.5bn.

A – Leighton

Hochtief owns c. 53% of Leighton, an Australian publicly listed company. The company services include building and infrastructure construction, raw materials extraction and concessions, project development, plus maintenance and services. In the last decade, Leighton benefitted immensely from the mining-related capex boom in Australia. Largest customers include the likes of BHP and Fortescue. Leighton grew its revenues in the last decade from little over AUS$2bn in 2003 to $19bn in 2012. The bonanza is about to end. Irrespective of one’s view on China, it’s probably safe to say that the outlook for miners in Australia is probably grim. Virtually all miners are significantly reducing their capital expansion programme which is going to impact the likes of Leighton both on top line (less projects = less revenues) and bottom line (less projects in the market, more sellers than buyers of mining services, more competitive contract tenders). Leighton share price is down c. 12% this year, clearly reflecting some of those macro challenges. However, we think there is quite some complacency in the sell side on Leighton numbers. The company reaffirmed its full year targets as of Q1 2013 and the market happily went along with that. Bloomberg EBIT consensus on Jan 1^st was for $985m of EBIT in 2013. Today consensus stands at $950m, a mere 3% reduction. We believe this does not reflect the reality that conditions in the market in Australia dramatically changed. Let’s not forget that 40% of Leighton business comes directly from resources and indirectly, it’s likely to be more than 50%. It’s interesting that Leighton, which should be the bell-weather for the industry in Australia being the biggest, has been able to far to dodge the trend when most competitors / peers had to come out with substantial downgrades / profit warning since Q1:

• Calibrem an engineering services company came out in April 2013 revising downwards its earnings guidance for FY13 following “recent client responses to challenging market conditions, including delays in capital investment decisions and on-going cost management affecting asset maintenance activity."
• Emeco, an earthmoving equipment company, did the same 5 days later citing "Australia has experienced delays in the awarding of work and a competitive environment which has impacted margins”
• Transfield Services Ltd. and Boart Longyear Ltd on May 21^st 2013 added to the number of contractors in the sector to warn that profits would be weaker than anticipated and to announce sweeping job losses as they adjust to a coming peak in mining investment
• BHP's new chief executive, Andrew Mackenzie, pledged in May to put the brakes on investment over the next few years
• Another peer, Coffey International, warned in May that market conditions are very tough and that "We have had to respond to deteriorating Australian market conditions and resultant project delays" through cutbacks including 150 redundancies. Coffey International is a specialised geotechnical and engineering company, not directly competing with Hochtief but active in the same industry and driven by same CAPEX decision of large commodities companies
• WorleyParsons, a large service contractor in Australia active in chemicals, resources and refining, issued a profit warning in May
• Similarly, UGL (an Australian engineering and construction company) as well as smaller peer Sedgman, all issued profit warning due to material market headwinds
• The list of companies having to come out with profit warnings includes names like Ausdrill, Bradken and Imdex

All or most of these names currently sit at multi-year share price lows. Leighton is down only 11% this year because of its perceived resilience in a tough market. We don’t dispute Leighton could be seen as the best in class in a challenged sector; we just think it’s like sitting at the back of a crashing plane – you are just delaying the inevitable. We also think that Leighton resilience has a lot to do with Hochtief and Leighton aggressive accounting, which we shall explain below.

B – Aggressive Accounting

Approximately 90% of Hochtief revenues are based on POC (Per cent of Completion) accounting. Most of the VIC community probably knows what this means. For those that don’t, it basically means that revenues are recognised not as final services are delivered to the customers, and the customers get billed for it, but as the service is being only partially delivered and the quantum of the revenue is based on the estimated per cent completion of the project. If the whole project is valued at €100 and in Hochtief estimates, 50% of it is being completed; Hochtief would recognise €50m in turnover. The problem with this is obvious: if there are cost overruns, you are recognising in your P&L revenues when you have no idea whether the customer will agree to pay you back. You incur the cost up front but you still need to bill the customer and hope the customer will accept your cost overruns. One can be even be tempted to cheat and recognise revenues aggressively. We believe Leighton is caught between 2 macro factors affecting their real profitability but are not yet reflected in the numbers. On the one hand, Leighton is currently working on projects won in 2010-12, what we would call “bull market” projects where cost inflation used to be a constant, chronic issue. It’s a well-established reality that mining companies under-estimated their capex costs and so did their supplier / contractors. On those older projects, a mine that was supposed to cost, say, €100 for a 10% margin ends up costing €150. To keep their 10% margin, Leighton would need to convince, say, BHP to pay €165, or at least €160 to make €10 margin. This leads us to the second macro factor: everyone is cutting down on capex and has become dead focused on cost reductions. It would be incredibly hard to convince BHP to pay Leighton €160 when the original cost was €110. Leighton is currently recognising higher revenues but not being paid for this. How do we know this? The company (Hochtief) gave us 2 strong clues:

1. Receivable days are rising considerably. DSOs in Q1 2013 stood at 93 days, 15 days above Q1 2012 and 24 days above Q4 2012. In the last 5 quarters, Hochtief burned €1.6bn cumulatively from changes in working capital. The vast majority is due to ballooning receivables. On an annual basis the company discloses POC unbilled receivables, which are clearly the most “at risk” and these are the ones that showed the biggest increase
2. The company (Leighton) clearly acknowledges that there are some issues in the collection of receivables. The company stated in its recent Q1 conference call: “seasonal deterioration in working capital. It also reflects an increased level of net project under claims (unbilled receivables) from both scope growth and contract variations”. They further added on their conference call that “as we stand today, we think we have given at our best position, but we’ve got to go through the negotiation phase with the client now and I’m loath to talk anymore about it, because I don’t want any clients anticipating that they’ve got us over a barrel”. In other words, the company needs to have major discussions with clients. To write off those receivables now would mean to considerably reduce the likelihood that these receivables will ever be recovered as the client will know they have been written off already. However, the company knows it has a hard task ahead in terms of discussion with clients.

We therefore believe there is a high likelihood of massive receivables write down in Q2 or Q3 2013.

There are other elements of aggressive accounting but they are less material. For example, they consolidate 100% of their JVs but in their slides, used by all analysts for the calculation of net debt, they don’t consolidated JVs debt, effectively understating real Net Debt / EBITDA. Moreover, they consolidate 100% of Leighton and allocate some central and corporate costs to the Asia Pacific division, effectively inflating Hochtief Europe and Hochtief Americas earnings. Arguably, this is not material because, net-net, you take costs from one division and give them to another. However, the market typically values Hochtief on a SOTP and uses Leighton market cap for its Asia Pacific division and then applies a multiple to the rest of the group earnings. Inflating those earnings gets you a higher overall valuation.

C – Valuation

Hochtief remains very expensive. The best way to value Hochtief is probably via Sum of the Part valuation. The most simplistic way, as described just above, is to take Hochtief stake in Leighton at current market price, apply some sort of holding discount and then apply a multiple to the rest of the business. In order to be generous to the company, we assume Net Debt is equal to zero. It’s important to realise that this is an incredibly generous assumption given that as of Q1 2013, Net Debt was €2.2bn. However, we assume that the company will be able to get to zero net debt by the end of the year (in line with company guidance) because of its successful disposal of the Airport business (€1.1bn), Service division disposal assumed (€170m), reversal in working capital and disposal of real estate assets in Germany.

Assuming a 15% holding discount, Hochtief ex-Leighton implied market value is c. €2.2bn. What do investors get for €2.2bn?

• The US business, which according to management should to €80-100m of PBT this year, in line with historical average.
• The European business which we assume will do €80 of PBT in 2013. However, it’s important to realise the following. First of all, it averaged only €40m in the 2008-12 period, so €80m is arguably very optimistic. Most importantly, €80m includes the real estate as well as the services solutions which are planned for disposal and contributed c. €56m in PBT in 2012. Therefore, excluding those assets that will be disposed, Europe will probably generate some €25-30m of PBT going forward. Assuming a restructuring of this segment is successful, we could potential imagine normalised PBT of €50m

Summing it all together, for €2.2bn an investor buys 2 low margin, low ROIC businesses that generate some €150m in normalised PBT or some €100m in normalised after tax earnings. Investors are asked to pay 22x normalised earnings for a business that in normal times should not fetch more than 10-12x times.

Looking at Hochtief on a consolidated basis, the stock is trading at an estimated 15x 2013 earnings. It’s noteworthy that this is a highly capital intensive business that managed to generate positive free cash flow only twice in the last 5 years and on average it generated negative €220m a year in free cash flow against a market capitalisation of €3.7bn.

Note for the above figures we have assumed management hits its targets, so even absent profit warnings / downgrades, Hochtief remains a very expensive stock.

Catalyst