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Morningstar | Lendlease Dozes at Digger as Engineering Impairments Skyrocket. FVE Cut to AUD 17.20

A year ago, Lendlease flagged AUD 200 million of post-tax losses in relation to problems on what is believed to be four Australian engineering projects. These losses have now increased by a further AUD 350 million, pointing to inadequate systems over project management, risk management, and quality control. The additional post-tax losses equate to AUD 0.62 per share and an estimated AUD 0.82 per share on a pretax basis. Adjusting for these and an anticipated pull back in the level of engineering work the firm undertakes going forward in Australia reduces our fair value estimate to AUD 17.20 from AUD 18.50. The losses on the engineering projects are definitely negative news for Lendlease, but we think the market has over-reacted, shaving approximately 20% or AUD 1.8 billion off Lendlease's market capitalisation.

When a firm has had such a strong earnings run as Lendlease, the investment community has a propensity to ascribe a high price earnings multiple. The risk is whenever there is a major stumble--as is the case at present--the share price gets severely punished. With Lendlease trading for much of today in the range of AUD 14.00 to AUD 14.40, the stock screens as undervalued. This is the first time we have viewed the firm as undervalued in at least three years.

A downside risk is Lendlease has recently secured a series of large engineering projects, including Westconnex 3A and Melbourne Metro. Given Lendlease's engineering, estimating and bidding teams have made very costly errors in projects underway, it is quite possible similar issues could rear their heads in the upcoming projects. In regard to this risk, Lendlease’s CEO advised these other projects are different and are in the very early stages, so it is not possible to make a reliable assessment as to whether the costly problems will reoccur.

Following the losses, Lendlease flagged it will undertake a comprehensive review of the engineering and services business. More bearish members of the investment community could be expecting a full divestment of the engineering business. We think this quite unlikely as many of the activities that occur in this division carry modest to low risk, particularly those related to maintenance services.

Lendlease didn’t delve into specifics as much as we would have liked. Losses were attributed to a plethora of issues that include lower productivity in the post tunnelling phase of NorthConnex (a 9 kilometre motorway tunnel in Sydney), excessive wet weather, access issues and remedial work arising from defective design on other projects. These types of issues point to the firm undertaking complicated and high risk projects (tunnelling is notorious for cost over-runs) which is why we think the review of the engineering division will result in a substantial or near complete exit from higher risk activities. We have accounted for this by cutting our revenue growth expectations from positive 2% for the coming four years to negative 2%. Despite numerous packages of engineering work being put to tender across Australia, we expect having had its fingers well and truly burnt, Lendlease will be bidding on and securing far less complicated engineering work than it has in recent years.

One would have thought the impairments of these same engineering projects a year ago would have seen these projects subject to extraordinary management and financial oversight at least on a monthly basis, perhaps even on a weekly basis. So this announcement of a massive spike in engineering costs (AUD 350 million post-tax or an estimated AUD 466 million pretax) for projects that should be under the microscope, means the firm need to improve the monitoring and managing costs, tracking project progress and identifying and managing risk. Lendlease highlighted it has previously taken steps to improve the leadership team, appointing Hans Dekker as group head of building and engineering in May 2018. But it would seem a far more fundamental change is required, particularly around upfront planning, contingencies, bidding margin hurdles, and risk transfer between client and contractor.