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Morningstar | Cimic Reports a Run of New Contracts, but This Is Needed in Support of Our Unchanged Thesis

We retain our fair value estimate for no-moat Cimic at AUD 29 per share, despite a recent uptick in awarding of new contracts, which we view as supportive of our thesis, rather than additive. Cimic has announced just over AUD 3.0 billion in new contracts since our previous note in mid-July, including NZD 750 million for Waikeria prison in New Zealand, and several mining contract extensions for Thiess, including AUD 420 million Centinela in Chile, AUD 480 million QCoal in Queensland, and AUD 225 million BHP Nickel West, among others. For now, we exclude AUD 1.0 billion in Metro Tunnel Works, for which Cimic is the preferred contractor, which would take new contracts awarded to over AUD 4.0 billion since mid-July. The market has been buoyed by these awards, with shares jumping 20% since mid-July, including a very favourable reaction to the release of the first-half 2018 earnings results, which we have previously discussed. But at the current share price of AUD 51, we think Cimic shares remain materially overvalued.

Our fair value estimate equates to an unchanged 2022 enterprise value/EBITDA multiple of 6.8, assuming a five-year EBITDA CAGR of 1.6% to AUD 1.6 billion by fiscal 2022. At our 11.8% midcycle EBITDA margin assumption, Cimic needs to add approximately AUD 3.5 billion in new contracts per quarter just to stand still in revenue terms. We estimate the AUD 51 share price implies the market anticipates an 11.1% five-year EBITDA CAGR to AUD 2.6 billion by 2022. That would require approximately AUD 5.5 billion in new contracts per quarter, to support the revenue required if EBITDA margins are unchanged at approximately 12%. Cimic has individually reported an average of AUD 2.0 billion in new contracts per quarter this year, and on average, individually reported contracts generally account for about two thirds of the total actually achieved. We still see little reason to become aggressively more bullish in our outlook at this stage.

Awards of contracts are notoriously lumpy, and the uptick in the past few months follows a prior quiet period for the six months to June, which saw work-in-hand levels at AUD 34.8 billion, down marginally on December 2017’s AUD 36.0 billion print.

Also pleasing from the perspective of our outlook is a lessening in average contract duration from new awards. This may sound counterintuitive, but over the past few years, there have been several very large contracts that boosted work-in-hand levels materially, but for which contract life was 25-30 years, meaning the impact in any given year was limited. So far, the weighted average contract duration of new individually announced contracts in 2018 is just 3.5 years, down from averages of 4.0-plus years in 2016 and 2017, and 8.0-plus years in 2014. This reflects various renewed mining contracts for Thiess, which will support revenue in the near term and on approximately 20% EBITDA margins, which are typically more than double those of other segments. Our group 2018 and 2019 EPS forecasts are unchanged at AUD 2.34 and AUD 2.45, respectively, equating to healthy annual increases of 8% and 4.4%.

The current AUD 51 share price, anticipating an approximate 11.1% five-year EBITDA CAGR, would represent an extraordinarily impressive feat, requiring growth in work-in-hand that at least for now remains nonevident. The share price is well above 2010’s AUD 39 mining boom highs, yet work-in-hand of AUD 107 per share is more than 20% lower and more skewed to lower-margin work versus 2010. However, these arguments remain with the share price, not the underlying company performance, which remains impressive. We project net operating cash flow to remain above AUD 1.2 billion per year and growing, and for Cimic to sustain growing net cash, including maintenance of a 60% payout ratio. This may facilitate payment of special dividends or initiation of buybacks at some stage in the future. The trick is for management to maintain discipline to avoid repeating past mistakes of too aggressively chasing work when pools shrink by underpricing for the risk.