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Morningstar | Lendlease Makes Extremely Costly Exit From Engineering and Services; FVE Falls to AUD 15.20. See Updated Analyst Note from 25 Feb 2019

Lend lease reported first-half fiscal 2019 earnings of AUD 16 million, down from AUD 426 million in the prior corresponding period due to foreshadowed AUD 500 million of anticipated losses on multiple engineering projects. Leading on from this, Lendlease has decided to exit its engineering and services businesses and over the next six months work out the optimal approach to sell or separate engineering from the broader business. This is quite a back flip, as the firm had previously flagged its engineering business benefited from competitive advantages and was essential to its integrated model.

Management’s indicative pretax separation costs of AUD 450 million-AUD 550 million are materially above what we would have expected. We estimate only AUD 100 million of this relates to ordinary separation costs related to staff, technology, and bankers. We speculate the balance of AUD 350 million-AUD 450 million relates to "concluding customer contracts," a euphemism for warranties Lendlease will need to provide on further underperforming or high risk projects.

We’ve adjusted our forecasts to assume the Australian engineering and services business is exited in June 2020. The high separation costs of AUD 450 million-AUD 550 million, net outflows of AUD 500 million to complete previously impaired projects, and an estimated AUD 300 million reduction in net working capital underpin our view of a net loss on exiting the business. We also cut our growth assumptions in Australian development but raise growth expectations for development in the U.S. and U.K. to reflect recently secured large and long-tailed urban regeneration projects in the U.K. and escalation in development activity in the U.S. We also slightly reduce the firm's weighted average cost of capital to 9.2% from 9.4% to account for a slightly lower level of risk going forward. Our fair value estimate for no-moat Lendlease declines to AUD 15.20. At current levels it continues to screen as undervalued.

We continue to view the fund management operations as the most attractive part of the broader business. External assets under management were up by over 20% over the past year to AUD 34 billion. Further strong growth (albeit at a slower rate) is assured, underpinned by a commercial pipeline that will see AUD 6.1 billion of office building complete over the 3.5 years to June 2022 in Melbourne, Sydney, and Singapore.

A major positive of the business is urban regeneration, where contracts Lendlease agrees with councils support an attractive return on equity and modest risk. Moving to preferred status on multiple large and long-duration urban renewal projects (AUD 14.5 billion Thamesmead Waterfront project in London and the AUD 2.7 billion Birmingham Smithfield project) support long-term development earnings. It would appear Lendlease currently has an edge over peers in securing urban regeneration projects. However, the high returns the firm is achieving on invested capital could attract more competitors to the space, moderating development margins in outer years.

Lendlease continues to benefit from rising asset values, booking AUD 106 million of non-cash revaluation gains during the half, down on the AUD 201 million in the prior corresponding period. Our outer year forecasts assume the firm will continue to benefit from revaluation gains over the longer term but at a far lower rate as the values can’t keep getting boosted by falling bond yields.