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Morningstar | Lendlease's Fund Management Business to Fuel Earnings Growth. FVE Increased to AUD 18.50

Lendlease Group reported fiscal 2018 earnings of AUD 792 million, or AUD 137 cents per security, or cps, up 1.3% and marginally above our forecast of AUD 135 cps. The result was messy, with construction EBITDA falling AUD 260 million due to engineering related impairments, but largely offset by significant uplift in noncash revaluations of investments by AUD 228 million to AUD 305 million. We forecast fiscal 2019 earnings grow 2% to AUD 140 cps, with a strong recovery in construction earnings, but a higher tax rate of 27% and lower revaluation gains.

Our fair value estimate increases 6% to AUD 18.50 per security from AUD 17.50 on a more upbeat outlook for assets under management, or AUM, growth and higher recurring fee income. Historically build-to-sell apartments made up a large proportion of completions, generating high margins due to strong price growth in residential. Going forward, this will decline, shifting towards build-to-rent apartments, telecom towers, retirement living villages, and office towers. Margins on these will be lower, but most of the completed product will be lapped up by associated entities on Lendlease's investment management platform. We've raised growth expectations for AUM, and associated fee income. This is a positive in two ways: first, it enables Lendlease to grow earnings with less of its own capital; and second, earnings volatility and business risk reduce as income from fund management activities is more annuity-style.

Growth in AUM was the key positive from the result, up by 15% or AUD 3.8 billion over the year to AUD 29.6 billion. There are a series of factors supporting a faster growth rate going forward. First, Lendlease is making good progress sourcing capital from wholesale investors, announcing a new USD 1 billion fund with First State Superannuation to develop build-to-rent apartments in North America. This follows the GBP 1.5 billion fund with CPPIB developing affordable housing in the U.K. Second, the telecom towers investment initiative with Softbank is still in its early stages. The forthcoming implementation of 5G towers in North America is likely to see an explosion in work done and an acceleration in funds under management.

The recent troubles in the Australian engineering business look largely in the rear-view mirror, but it does mean a lot of work done by the Australian construction division will not contribute to earnings for the next two years as the impaired projects complete. Lendlease continues to target a 5% margin for its Australian construction business. It seems likely to get there in a few years due to a bottleneck in engineering that is pushing up bid margins on upcoming government work packages.

However, we don't see the firm's Australian engineering and construction margins anywhere near 5% over the longer term. Our view is premised on the highly competitive nature of the engineering and construction industries. The fact that contracts are often awarded to the firm with the lowest tendered price, means contracts awarded will naturally skew towards firms that that have taken the most aggressive stance on delivery costs. Unless we see evidence of a reason why the major players will be systemically more rational in bidding we continue to forecast long-term construction margins in Australia of 3.4%. However, if we were to assume margins in Australian engineering rise and stay at 5%, this adds AUD 1.80 to our fair value and gets us to the current Lendlease share price of AUD 20.30.

Initiatives being progressed by the Australian Constructors Association Forum seem to be positive for the industry and long overdue. The forum comprises the state governments of New South Wales and Victoria (the Queensland and South Australian governments are passive participants) and the 20 major construction firms. The objective is to agree on approaches to better manage large project risk, which could herald a step up in margins. It is too early to assess if proposed changes to contracting will provide enduring benefits to industry participants as evidence of future sustainable margins around 5% could attract more competition to the sector, particularly overseas entrants, and result in margins being bid down.