Don't rush into buying Lendlease

Lendlease Group (ASX:LLC) recently announced aggressive growth medium-to-longer term targets for its Development and Investment divisions. While these have the potential to materially lift earnings over the same timeframe, we recently reviewed the Company’s fundamentals to assess whether there were any catalysts for either an improvement in earnings over the shorter-term or for the share price in general.

About Lendlease Group

LendLease Group (LLC) is a leading international property and infrastructure group with operations in Australia, Asia, UK, Europe, the Middle East and North America. The Company has three operating divisions:

i. The Development division is involved in the development of communities, inner-city mixed-use developments, apartments, retirement, commercial assets and infrastructure. Earnings are generated via development margins, development management fees received from external co-investors and origination fees for the facilitation of infrastructure projects.

ii. The Investments division includes a leading wholesale investment management platform and also includes the Company’s ownership interests in property and infrastructure co-investments, Retirement Living and US Military Housing.

iii. The Construction division provides project management, design and construction services, predominantly in the infrastructure, defence, mixed use, commercial and residential sectors. The Company generates an income via project management and construction management fees, in addition to construction margin.

Key Fundamental Drivers

Management’s Main Focus is Increasing Completions

The Company intends to increase production (completions) from $3.8b in FY21 to >$8b from FY24. To achieve the latter target, LLC needs to move $16b of projects into production in the next 24 months: 74% of this relates to apartments and commercial (mostly office) where the outlook is still subject to end market demand. While the latter is largely outside management’s control, the Company noted that production on four of the six projects recently secured will commence within 24 months.

Communities Settlements to Remain Below Target

A key contributor to earnings within the Development division is the Communities business. There are a total of 49 development projects, of which there are 17 communities projects (16 in Australia and one in the US). The balance comprises a total of 32 urbanisation projects. Of LLC’s $113.6b development pipeline, $13.2b sits in its Australian Communities business.

In each year from FY19-21, settlement volumes have been well below the target range of 3,000 to 4,000 settlements per annum. There were 2,433 settlements in FY21 and settlements are expected to remain below the target range in FY22.

The level of pre-sales has also been in decline, down by 17% in FY21 in comparison to FY20 and -37% in comparison to FY19. The decline in both volumes and pre-sales compares negatively to other Master Planned Community (MPC)-developer peers, who have recently reported strong sales due to stimulus packages such as HomeBuilder as well as a strong underlying residential market. In particular, Stockland (ASX: SGP) and Mirvac Group (ASX: MGR) achieved sales that were in line with their record years.

The Communities business is being repositioned under new leadership and the Company expects to return to targeted settlements of 3,000 to 4,000 settlements per annum in FY23.

Cost Savings Identified – But Targets Remain Unchanged

LLC is targeting annualised savings of >$160m, including >20% from corporate costs and nearly half from downsizing following the sale of the Engineering & Services businesses. The rest of the cost savings are expected to be generating from consolidating the Australian operating platform. The bulk of the expected saving (70%) are in staff costs with a further 20% from occupancy costs.

Importantly, LLC chose to keep its Return on Equity (ROE) target unchanged at 8-11%, with the Company noting that the cost savings target helps to achieve these targets and is not necessarily additive. We struggle to see the logic here; and suspect that returns to equity holders across the broader business have been reset lower (at least in the near term) in part driven by the delays to the development pipeline and or a change of contract structure may have impacted the timing of projects.

Increased Funding Requirements are Placing Balance Sheet Under Pressure

At present, LLC’s gearing level of 5% is well below its target of 10-20%. Over the medium term, LLC’s strategy requires ~$4b of additional capital (~$1b for developments and ~$3b for investments). Not all this amount can be funded from retained earnings and there is heavy demand on the balance sheet from items such as:

Potential cash outflow from the non-core business. ow will occur in FY22-25;
An additional $1.5b to ramp up Development Invested Capital from ~$4.5b to ~$6.0b; and
An additional cash requirement for LLC’s investment business given its drive to lift FUM to $70b by FY26. Over the next two years, it is not inconceivable that LLC may have to contribute to owning stakes in new assets/acquisitions.

As such, the remainder of the additional capital would need to be funded by debt, although to aid funding, LLC may reduce capital in other areas of the business (i.e. retirement, military housing and communities). If the remaining portion is funded by debt, gearing would move towards the top end of 10-20% gearing target. As a result, in the near term, it is likely that LLC will focus on the deployment of development capital, with more incremental increases in investments. While this lowers the funding requirements it also delays the transition of earnings towards more predictable investments.

Fundamental View

We continue to see LLC as a long-term earnings recovery play and as such struggle to see any real catalysts over the short term. The ROE target of 8-11% implies core earnings of $600-800m in FY24. While this represents a significant uplift from the $377m reported in FY21, a declining earnings profile for FY22 and a recovery in earnings for FY23 indicate that the Company’s more immediate focus is on lifting Development WIP from ~$15b to >$20b in order to achieve the completions target of >$8b from FY24. Furthermore, LLC’s revised profit structuring approach also means that any outperformance on pipeline progression won’t likely result in profits until after FY24.

The Company’s intention to generate a greater portion of earnings from Investment Management (LLC is targeting 35-45% from 30% as at FY21) improves earnings quality as it becomes more recurring. But this strategy is also a long-dated one and achieving the FUM target of $70b by FY26 has a downside risk – as achieving the target relies heavily on development completions. Further, the FUM growth profile from FY21-26 (12% CAGR) is not materially different to the FUM growth of 11% CAGR achieved over the last five years (FY16-21).

Charting View

LLC has been in a downtrend for the last couple of years. Risk is therefore still to the downside for now. There may be support near the 2020 lows at around $9.50. Investors can therefore wait to see if support kicks in down at those levels which will provide a cheaper entry price.