Cromwell Property Group (CMW.ASX)
Given the headwinds faced by Australian office demand, in many ways catalysed or at least accelerated by the pandemic, it may sound surprising that we would consider this particular business. However, given the current valuation, this may prove to be a surprisingly solid investment proposition. First though, a little context around the business.
Listed in 1998, Cromwell tells the story of a great Australian success. Currently operating in fifteen countries and managing a total of $11.8bn in AUM. The core strategy has been to avoid highly priced office assets in CBD markets, opting instead for more reasonably priced and higher yielding secondary markets. Many of you may be more familiar with the business for all the wrong reasons though, with FIRB (Foreign Investment Review Board) stepping in to block a takeover and the CEO Paul Weightman retiring (rather conveniently) after 22 years in the business. A situation not helped by headwinds resulting from Covid and a downgrade in distribution guidance. A rather unloved proposition by the market with the share price trading at 88c at the time writing (from a pre-covid high of $1.23).
So why does this make a reasonable proposition?
Author: Sid Ruttala
Firstly, the valuation. We feel that the risks associated with the fall in office space may be a touch overdone. While it is true that bargaining power is much more to the advantage of the renters, with an NTA per share sitting around the $1.00 AUD mark, even the worst case scenario associated with rental income cannot substantiate the current valuation (remember the 88c share price, for a market cap of about $2.3bn). It is the profile of the tenants that we feel the market is not properly considering, with 40% accounted for (in terms of income) by the government and a further 15% accounted for by Qantas, who are on a 15 year lease).
Secondly, we feel that the downside risks to office space are currently overdone. It is true that there is an increased tendency to go towards flexible work or at least office hours and part-time work but there still remains a space for the traditional office environment. One could, for example, argue that in the 1990s (during the initial stages of the dotcom era) office space would have faced substantially higher headwinds given the move towards part time work and higher structural unemployment. This time around we feel that the nature of the fall in demand and unemployment (i.e. Covid-related) is more transitory and the economy will see a faster recovery in employment (and thus demand for office space) than in the past. Something which we, again, feel the market is discounting in its valuation.
Thirdly, we arrive at the management and boardroom drama. The business has refreshed its board and management ranks over the course of the last financial year. Included among the fresh faces are a new CEO in Jonathan Callaghan (former head of Investa) and Gary Weiss (of great pedigree having served on the boards of Westfield and Premier).
With that, to the numbers. Statutory profit was up 73.5% to $308m, while underlying operating profit was down by 13.1% to $192.2m. Rather messy numbers on face value but one also has to strip out one-off items, including the sale of Northpoint. Adjusting for this, the business’ operating profit was up 140bps.
So, why does it make sense now?
Quite simply, the current price. Despite the potential for continued lockdowns across her major markets, with NTA at 1.00 AUD, this seems like a good investment proposition. This, along with a seeming turnaround as a result of the change in management and the opening up (though it may not feel like it in the short-run for many of you living in lockdowns) of the economies, makes for an interesting proposition when the dividend is also considered.
Red Flags & Risks: Put simply, debt on the balance sheet. With an average weighted maturity of 3.2 years and 42% gearing, this component remains the biggest risk on the balance sheet. We would ideally like to see management locking in longer duration, even at the risk of higher debt-servicing costs.
Dividend: 8% dividend yield. Expecting this to grow by 10% in 2023.
Worley Ltd (WOR.ASX)
Coming to the last stock of the series, we look at Worley Ltd. Another engineering and services business (we have previously spoken about CIMIC and SSM). Another unloved business that we feel that the market may be wrong about.
For those that are less familiar with the company, a little context. Simply, Worley provides engineering and professional services to the oil, gas, utilities, mining and infrastructure sectors. Most Australian investors (if you have had previous experience with the company) would see it as driven primarily by hydrocarbons given that 75% of the businesses revenues used to come from that segment. Indeed, we feel that this may be the reason why, like much of the energy sector in general, the market continues to discount the business. However, WOR’s rather smart acquisitions, including Jacobs ESR, recently have seen this reliance come down significantly. Hydrocarbons now accounting for 52% and chemicals (previously accounting for 6%) increasing to 23%.
In addition, the business has global scale. Operating in over fifty countries gives WOR a scale that is difficult to replicate. Moreover, given that most of the contracts are of a cost-plus nature, the risk from project delays and cost overruns (which are the most significant risks to the sector) remain minimised.
So, why does this make a reasonable proposition?
Again, returning to our commodities thesis, we stand firm that we are at the infancy stages of a multi-decade secular bull cycle in commodities. However, for the more conservative investor that wants to take advantage as well as gain exposure to thematics such as the transition to green energy, we feel businesses like Worley may be a more reasonable option (as opposed to paying egregious valuations for end producers). For the more impatient, one metric that is of particular importance is that the backlog in work is $14.5bn AUD as of March 2021 (a notable increase from $13.5bn at the end of December). In other words, we know the business has significant and sustainable cash flows from its traditional footprint over the short-to-medium term. This is important while WOR focuses and uses it to advance its longer-term ambitions, including sustainability and green energy in particular. One other metric that might be of interest is the fact that the global market for sustainable design is approximately $4.5tn USD, of which WOR’s addressable market share is 10-20% (or $900bn USD). For decarbonisation, this is around $1.5tn USD with an addressable market share of 3-5%. To put this in a little more context, the current revenues for Worley are $10bn AUD.
With that, numbers! EBITDA was down 25% to $649m, operating cash flow down 24% to $533m AUD. These may seem like rather lacklustre numbers but context is key here. We feel that this is a one off (importantly, revenues remained rather stable) with Covid related impacts the main driver and, accounting for the work backlogs, we should see this return to historic levels (assuming normalisation) within FY 2022. Moreover, the business has been deleveraging with Net Debt/EBITDA coming down to 1.9x.
Red Flags & Risks: Covid continues to be the biggest threat to the business with the situation in China and the Delta Variant creating broad risks.
Dividend: 4.7%, expecting double digit growth over the next 24 months.
