Tecnicas Reunidas: Cash And Risk Focus To Compete

Tecnicas Reunidas, leading the bid for Aramco Gas ProjectsTécnicas Reunidas' refinery in Saudi Arabia

BARCLAYS | While in large parts descriptive, Tecnicas’s recent analyst day highlighted the controls that the company has in place, the shock to the system as proved to be sub-optimal in Canada and the efforts put in place to ensure that these don’t repeat. Importantly, the market is tougher, but largely in that the cash fluidity of a contract is less. Hence cash is now firmly at the heart of the business and the balance sheet of Tecnicas should become a competitive advantage. The company has migrated from a small Engineering & Construction (E&C) company at IPO 10 years ago, into a global player in the construction of the critical elements of refineries, a market segment which appears to be relatively robust. As such, the company’s backlog of EUR12bn, representing over 2.6 years of 2016F revenues, should differentiate it from the wider oil services universe. Tecnicas trades on sub 6x EV:EBITDA, is cash positive and has nearly half of its EV in contracted cashflow. Yes, the increased tax rate has eaten up growth of recent years and the company has had its hiccups in performance terms, but the stock stands out as inexpensive in our view, and with over 40% upside potential to our unchanged EUR38/share price target, we rate the stock OW.

When tough isn’t tough:  As the oil price has rebound stocks with early cycle exposure to the commodity price have rebounded sharply. However they still largely face tough times, the rally in share price based on a theory, not a reality. In the mean time, the onshore construction related names retain strong backlogs, which despite a slow 1H16, remain near all-time highs. The message from all of them is similar, including from Tecnicas – the market is tough. However, “tough” for Onshore construction, is not the same “tough” for the wider oil services universe. “Tough” for Tecnicas involves short term delays to projects. “Tough” for Tecnicas involves lower prepayments and later milestones. It does not include asset base and headcount reductions of up to 40%, nor imminent covenant breaches, as other parts of the oil services world do. In relative terms, the Onshore construction business is in rude health. As such, the fears of a market slowdown and competition pressures, we feel are somewhat overdone. Tecnicas has reduced its margin expectations to 4% at the EBIT level, largely in our view to build a buffer to smooth earnings as it has in the past (Buffer, the margin Slayer 7 February 2016). As such we expect to see continued steady growth and as contracts arrive later in the year, backlog to remain stable and then return to growth. This dynamic, we feel is not reflected in current investor thinking. Indeed we believe that rising oil prices will also benefit the onshore business as the financial constraints on the markets in Tecnicas’s core regions are reduced.

Making the roller coaster steeper: The cash basis lump sum E&C model has long been consistent. A prepayment is received. Cash is worked down at a pre-determined milestones, more cash is advanced. At the end any variation orders are settled and contingences released, leaving profit. Indeed, the final profit is not known until the end of a project (for full details of a typical project cash profile see Working through the working capital 27 April 2016). The profile of cash is often referred to as a roller coaster function. However, in the current oil price downturn the company was keen to point out that cash advances are now typically coming in at an early milestone, rather than upon signature, the initial engineering and early procurement activities carried out on the company’s clock (ca6-9% of the contract), probably understandable as this is activity that the E&C contractor conducts with in-house resources. In essence, the company’s own early work is invoiced rather than prepaid. Thereafter milestones have moved later and are subject to client acceptance, that can be fickle. Furthermore, variation orders that could once be accepted and paid during a contract are now typically only paid at the end, even if approved earlier. As such cash will often lag booked profitability, whereas it was only behind for a short period of time under historical payment terms. Hence, the company will have to use its balance sheet more, a strength of Tecnicas which could prove to be an advantage over time. Below we show indicative cash profiles of projects as once was and today, assuming the same size project (US$1bn) and a 10% margin. As can be seen there is a more volatile cash profile under current contracts.

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Cash is king, but can be volatile: The company appears to have upped its focus on cash. As the terms and conditions of contracts have become tighter, so is the requirement to pay more attention to it. Until 2015, the company essentially had no debt, being asset light. At 1Q16, it had EUR147mn of debt, offset by EUR668mn of cash. This is more than comfortable, in our opinion, but the company does invoice and collect caEUR360mn of cash every month. As milestones become later and bigger, the short-term swings can become more significant for investors, while ironically, having little significance for the business, if the project goes to plan. At the analyst day, the CFO highlighted an invoice payment for caEUR160mn late in June, which if it had arrived a few days later would have significantly changed the quarter end net debt position. Over time, as the project terms take effect, non-invoiced receivables and payables should grow. There is likely to be a reduction in the net positive cash position of the company and the financial facilities of the company are likely to grow to cover future eventualities. However, this does not necessarily imply the construction risk is going up and it is construction where the profits and equity growth are generated. Indeed, the company highlighted that it has put increased emphasis on ensuring that the contingencies applied in bidding cover the necessary risks. It is this risk management which we feel could once again endear the company to investors, if delivery stabilises. As the CFO said “we are a family run company, conservative company, with four to five main projects controlled by its top management.”

Lessons learnt from Canada: Canada was the company’s first major headache in terms of project. The good news is that the project is essentially complete, with handover in mid-July. Welding is completed and there is some small cable pulling activity remaining as well as finalization of the insulation. As such we expect no further deterioration of the project. Elsewhere, the in-depth rundown of the major projects under execution highlighted that things are going to schedule and as such, we feel that it is likely that the execution on the current generation of projects is better than on the last. Importantly, when discussing the future and potential new areas, the CEO appeared very reticent, to us, to take on any construction risk in the US, should the company be successful in wining workload there, a more conservative position than we had previously believed.

Market outlook resilient: As order inflow in the Onshore E&C space has been lower than previous periods in 1H16, we have noted investor sentiment that this reflects a material shift in the market outlook. Tecnicas, as its peers have done, pointed out only short-term headwinds in awards, in Abu Dhabi for example, but a picture which is still constructive. Indeed, the CEO indicated that he expects to see backlog improve and grow into 2017F. His statement that he was more worried about the order outlook at the start of 2014 than today should comfort investors. Indeed he described both the 2016F and 2017F outlook as “decent” as he sees too many large projects bidding, for the company to not see some awards, with upstream gas, petrochemicals and refining new build/upgrades still driving the market.

Outlook not reflected in valuation: The financial risks on a projects are increasing, but it is clear from the company that execution risk, the key driver of profitability, is being dealt with as before. Over the two days we got no impression of aggressive bidding on projects within the industry and the margin sacrifices that were made by some players in 2010. Indeed, the later payments on contracts and negotiations over variation orders that have been in place for the past year or so, could be argued to be a barrier to aggressive bidding, with no competitors being likely to bid low and hoping to make it up in late-life negotiations in future. The stricter payment terms, however, should not be a significant concern to investors. Firstly, execution excepting, the company has one of the strongest balance sheets amongst its peers, an ever increasing valuable asset. Secondly, we believe that any increased risks are already baked into the 4% margin assumption that the company has given for the medium-term guidance. As such, our DCF-based price target of EUR38/share offers attractive upside potential. Current backlog of EUR12bn at a 4.5% EBITDA margin could deliver ca EUR430mn of post tax cashflow, versus an enterprise value (EV), adjusted for working capital, of EUR1.2bn. If the company is correct in that backlog can grow by the end of 2017F, then at least a further EUR290mn potential can be added, implying over 60% of the EV of the company would already have been covered with indentified cash flow by then. Given the medium-term outlook for further gas, refining and petrochemical expansion near the production bases, then we see the future as Tecnicas as overly discounted and as such we remain OW. Indeed, at a book:bill of just 1, behind company expectations, at the current revenue rate, the company will have executed enough and have enough in backlog to cover the entirety of today’s EV within five years, a proposition comparable to that of the asset heavy oil service industries in the peak times of the last decade.

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