Salini Impregilo : Still the best in class?

>Credit opinion: Stable // Recommendation: Neutral 2021, Reduce 2024 - From its inaugural 2013 bond issuance, Salini Impregilo has emerged from a troubled construction backdrop. As a number of peers ran into default (Abengoa, Isolux Corsan, Carillion), whilst others coped with difficulties (Astaldi, OHL), Salini Impregilo did more than resist. It managed until 2016 to combine strong expansion with stable margins and, most importantly, positive cash flow. On the back of improved ratings, it could constantly obtain better terms on bond markets, a momentum which culminated with the issue in October of a seven-year € 500m bond at 1.75%. However, as the market turned more bearish from the beginning of the year, some of the group's weaknesses also became more blatant:- High project concentration, resulting in volatile cash generation and vulnerability to specific issues on individual contracts.- Relatively high exposure to high-risk countries, which caused the group to book impairments on its Venezuelan exposure and currency losses along with a substantial working capital outflow in 2017- Low cash conversion rate, as decent margins in 2017 came along with a surge in net debt. Over a long-term period, the record of cash generation remains subdued.We think the group’s strategy and execution remain satisfactory, and we appreciate the commitment to continue de-risking the business. However, we also see limited room for improvement in credit metrics given a sluggish backdrop in Italy and emerging countries. Meanwhile, the transition of Lane towards a more sophisticated model will take time and is not devoid of risks. Lastly and perhaps most importantly, a number of previous contracts (Panama) or existing ones (Ethiopia and Tajikistan) create risks of large deviations.The 2024 € 500m bond currently yields 3.2%, which is above most comparable ‘BB’ or ‘BB-’ rated bonds. The 2021 € 600m bond also trades at a premium to equivalent bonds, although the gap is in this case much tighter. Short-term pressure on ratings is limited (beyond the anticipated one-notch downgrade by S&P) and liquidity remains good, which lands weight to our Neutral recommendation on the 2021 bond. Conversely, we adopt a Reduce recommendation on the 2024 bond. We reckon that longer-term, a low-BB rating would be more commensurate given some weaknesses in the business profile (project concentration and exposure to high-risk countries) and low cash generation ability. The yield should also include in our view a higher spread premium related to the construction sector. This would put the fair valuation of the 2024 bond at around 4%, higher than the current 3.2%. Support factors - - Worldwide leadership in dams and water projects and good positions in metros- Relatively cautious contract selection and geographic expansion since 2013- Good access to markets. In case of deterioration, the group could raise equity without necessarily putting at risk the main shareholder's control given an ownership rate of 66.9%- Modest exposure to concessions, which limits the need for equity injectionsPoints to watch - - Project concentration is fairly high as top ten projects account for 55% of the backlog- Despite a growing exposure to low-risk geographies (mainly the US), exposure to riskier emerging countries is still material at around one-quarter of revenues in 2017- Strong vulnerability to currency fluctuations as most of the debt is denominated in euros, while the vast majority of its sales and cash is in dollars or emerging currencies- High potential exposure to the Panama Canal project (max. € 600m on our estimate)