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Leighton – Under Construction

Avoiding exposure to Leighton (LEI) has been a smart move so far this year. However has the stock become so disliked that the market is ignoring fundamental improvements in its outlook?  It does seem so.  Sure, Leighton has suffered some horrendous blow-outs during its major projects and there is still residual risk in its order book. But there are clearly identifiable reasons why Leighton got itself into such trouble and equally, visible reasons why the company’s future performance is likely to be much improved. Valuing the company on a backward looking basis, as the market is currently doing, may not be the correct approach.

A poor corporate culture emanating right from the top was the main driver of Leighton’s poor performance at the likes of Brisbane’s Airport Link, the Victorian Desalination Plant and in the Middle East. Former CEO Wal King may well have done great things for Leighton in the earlier phase of his career. But as he became more interested in long bike rides and serious mountain climbing it seems he stayed too long in the role and his strategy for the company suffered as a result. In his last few years at Leighton he focussed almost entirely on top line growth, actively encouraging the various operating companies to compete against each other to achieve this aim.

His approach worked in as much as Leighton managed to hugely expand its order book, winning multi-billion dollar contracts such as those mentioned above. But the singular focus on simply winning contracts meant that there was little consideration of project risk. A poorly considered billion dollar Design and Construct contract can all too easily become a billion dollar liability if it is mispriced. Vic Desal is an excellent example. Thiess won the contract at the expense of John Holland, despite the fact that John Holland had previous experience with desalination plants while Theiss had none.

Airport Link, another well-publicised disaster for Leighton, was undertaken with insufficient knowledge of the extent of the work involved. This resulted in a design that needed to be significantly reworked at great cost. The company’s push into the Middle East was similarly ill-considered. Leighton’s obviously lacked understanding of the different attitude Middle Eastern clients have towards the payment of variation expenses. Such expenses are often considered for payment on completion in the Arab world, as opposed to the Western approach of regular milestone payments. This left Leighton essentially funding the working capital requirements of its major clients and they are still trying to get paid.

The bottom line is that any major contract won during the Wal King era is at risk. However, the capacity of these projects to inflict further pain on Leighton has greatly reduced. Airport Link is finished and open to traffic, the Victorian Desalination plant is in the commissioning phase and the financial impact of further delays through liquidated damages is capped. The jetty project at Gorgon was widely speculated to be the next major blow-up, but this has proven not to be the case with Chevron accepting responsibility for cost over-runs. Over in the Middle East, the two problem projects are nearing completion and a resolution to the outstanding payment issue should be achieved in the next 12mths.

But it isn’t just the fact that problem projects are finishing up. CEO Hamish Tyrwhitt has implemented a much improved culture and approach to risk management across the business, which goes all the way up to board level. The operating companies can no longer compete for contracts and Leighton proactively monitors the risk profile across its order book when new business is being considered.

If Leighton can avoid any further negative announcements at next month’s 1H12 results then we may begin to see investor negativity towards the stock begin to thaw. At any rate, given the current valuation of around 8X FY13 and a forecast FY12 yield of 5.4%, rising to more than 7% in FY13, downside risks appear overly priced in. While this isn’t a stock for the faint hearted, making money in the contractors is all about picking them up after the major blow-ups when things still feel uncomfortable, not beforehand when everything seems to be going swimmingly.

It has been quite some time since I have had a look at anything in the building game. This looks like a reasonable place to start.

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