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Morningstar | Corporate Action: WorleyParsons in Value-Accretive Purchase of Jacobs ECR. FVE Upgraded to AUD 9.00.

We applaud WorleyParsons’ monetising healthy priced scrip in a proposed AUD 4.6 billion acquisition of Jacobs Engineering Group’s energy, chemicals and resources divisions, or Jacobs ECR. However, we don’t recommend shareholders take up the 1-for-1.47 entitlements in an associated AUD 2.9 billion capital raising, as the AUD 15.62 offer price is well above even our upgraded AUD 9.00 fair value estimate. Further, the entitlements are unfavourably nonrenounceable and trading of shares issued under the Institutional offer unfairly begins on Oct. 31, a full two weeks before the Nov. 16 window available for retail shareholders. We continue to marvel at the inequity allowed by such a circumstance. Equal treatment for all shareholders is core to good stewardship of capital and the retail side is being let down in this regard.

WorleyParsons’ proposed acquisition of Jacobs ECR is sound. It brings world-class chemicals, downstream hydrocarbons, maintenance, modifications and operations, or MMO, and mining and minerals capabilities. There are strategic benefits in combining two complementary organisations and estimated run-rate cost synergies of AUD 130 million per year which we credit in our upgraded fair value. The combination doubles Worley’s earnings. Jacobs ECR also delivers enhanced earnings diversification and more consistent earnings with less cyclical capital expenditure, particularly from chemicals. These benefits lead us to reduce our estimated cost of equity, or COE, assumption for WorleyParsons to 11.0% from 13.5%, alone accounting for AUD 1.75 of the fair value uplift. They also move our fair value uncertainty rating to high from very high.

However, there is even greater gain in raising equity at a significant premium to fair value. WorleyParsons is raising AUD 2.9 billion at AUD 15.62 per share. The magnitude and price premium to our prior AUD 6.30 fair value drives AUD 3.75 of fair value uplift.

But we also think Worley is overpaying for Jacobs based on our DCF, a view which tempers our upgraded fair value estimate to AUD 9.00 per share, all said and done. We value Jacobs ECR at AUD 3.7 billion including synergies, 20% below the AUD 4.6 billion face-value purchase price which in our opinion represents a too-high pro forma fiscal 2018 EV/EBITDA multiple of 11.5, before synergies. But given AUD 985 million or 21% of the purchase cost is to be satisfied by the issue of 58.2 million WorleyParsons shares to Jacobs Engineering Group, at the AUD 16.92 theoretical ex-rights price of the capital raising, two thirds of the overvaluation is effectively a moot point. The balance of the acquisition cost will be funded via AUD 895 million in incremental debt. We project fiscal 2019 net debt/EBITDA of 2.2, little changed from fiscal 2018, and anticipate a fall to a comfortable around 1.0 by as soon as fiscal 2022, excluding operating leases.
Our upgraded fair value equates to a higher 2023 EV/EBITDA multiple of 7.8 on the expanded group, versus our prior 6.1 estimate. Much of the change rests the lower COE assumption. At the announcement of AUD 17.84 price for the combined group, we think the shares imply an unrealistic 14.3% midcycle EBITDA margin if assuming a five-year revenue CAGR of 4% normalised for Jacobs, nearly double our 8.7% margin forecast. On our forecasts, the market values Worley on a 2023 P/E of 25 and a price/cashflow multiple of 24, discounted at WACC. We think this too high, the implied 2.4% yield underwhelms, implying anticipation of very strong growth we just don’t see.
Completion of the Jacobs ECR takeover is expected within four to six months’ time, subject to regulatory approvals for which we don’t anticipate any issues. A regulatory knock-back, however, would perhaps counter-intuitively lift our fair value estimate even further, by around 10% to AUD 10.00, with the full accretionary benefit of above-fair value entitlement offer undiluted by a somewhat over-priced acquisition at face value. The institutional entitlement offer closes on Oct. 23, while the retail offer opens on Oct. 29 and closes on Nov. 7.
Worley anticipates Jacobs ECR generating 20% EPS accretion on a fiscal 2018 pro forma basis, increasing to 50% including full run-rate cost synergies. Our model credits less, just over 16% EPS accretion on average from fiscal 2020, when full synergies are expected to accrue. The merged company will balance revenue contribution from Worley’s upstream hydrocarbon segment to 39% from the current 62%. Downstream will grow to 20% from 13% and chemicals to 23% from just 6% now. Chemicals in particular is a favourably less cyclical segment driven by population and GDP growth. The merged company will also more than double the U.S. revenue contribution to 33% from 13%, while reducing Europe to 21% from 29%, and ANZ to 10% from 17%.