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Morningstar | Steady WIH and Reduced Construction Earnings Spook Market. We Increase Cimic FVE to AUD 35.

We increase our fair value estimate for no-moat Cimic to AUD 35.00 from AUD 34.50, due to the time value of money. Cimic reported steady first-half 2019 NPAT of AUD 367 million, below our AUD 400 million expectations. We read no long-term implications into our first-half earnings overcall, with company NPAT guidance for the full year remaining AUD 790-840 million. But given the weaker than anticipated first half, we reduce our 2019 NPAT forecast by 5% to AUD 798 million, now toward the lower end of guidance. Our full-year DPS forecast declines marginally to AUD 1.51 from AUD 1.55, equating to a moderate fully franked 4.1% yield at the current AUD 36.95 share price.

Cimic shares pulled back by around 20% on the result and now trade near fair value. We have long thought the market was pricing in unrealistic growth. Our fair value equates to a 2023 EV/EBITDA multiple of 5.5, assuming a 4.8% five-year EBITDA CAGR forecast to AUD 2.3 billion by 2023. These multiples have shifted since our last note, but only due to AASB 16 accounting changes bringing some leases on balance sheet, reducing operating costs but increasing depreciation and interest. In real terms there is little change. At 0.29, Cimic’s reduced EV relative to its work-in-hand,or WIH, now places it nearer to the 25-year average of 0.27, albeit still higher than the 10-year average of 0.24.

First-half WIH was steady versus December 2018 at AUD 36.8 billion. The bullish market apparently didn’t like this. And the break-down reveals an 18% increase in Services work-in-hand to AUD 8.8 billion, offsetting 3% declines in construction and mining to AUD 14.7 billion and AUD 10.8 billion, respectively, and an 11% decline in corporate to AUD 2.6 billion. Margins for services are lower than for other segments. While not reading too much into a short-term development, the WIH trend is nevertheless in keeping with our thesis for the benefit from public infrastructure spending slowing.

The decline in construction WIH is particularly noteworthy given first-half revenue from the segment declined 7% to a less than expected AUD 3.6 billion.

Second-half group EBITDA margin overall improved to 14.7% from 12.6%, courtesy of mining. But we don’t think the mining contribution should be relied upon either to meet bullish market expectations. Our more hawkish outlook is still for sharp pull-backs in bulk commodity prices from unsustainable levels well above producers’ costs. Our midcycle iron ore price forecast for example is USD 41 per tonne versus USD 120 spot. Our midcycle group EBITDA margin forecast is 13.5%, anticipating comparatively stronger contributions from lower margin segments.

First-half services EBITDA increased 5% to AUD 104 million, broadly in line with expectations. But mining EBITDA exploded by 42% to a better than anticipated AUD 585 million, the margin increasing from 23%. This offset construction EBITDA falling 7% to a below expectations AUD 390 million on softer revenue at steady margin. First-half 2019 EBITDA margin for services was 8.3%, well below that for Mining at 28.4% and even for construction at 10.7%.

Cimic’s balance sheet remains a stand-out positive, despite net cash of AUD 1.3 billion being down on December’s AASB 16 restated AUD 1.6 billion. First-half net operating cash flow halved to AUD 300 million due to inventory build, and free cash flow consequently turned negative. We project the net cash position to recommence its modest build going forward, and for even the modest net debt position including operating leases as debt, to turn positive by as soon as 2020. We estimate the capitalised operating lease position nearly halved to AUD 1.5 billion following accounting changes.