Over the last six months, shares in Worley Limited (ASX:WOR) have ebbed and flowed. Investor focus has swung between, on the one hand, earnings uncertainty over the short-term and on the other hand, the potential leverage to a global economic re-opening, increased energy CAPEX in FY23/24, and the high-growth sustainability opportunity.
The shares have recovered from their December 2021 lows. A key reason for this is the higher oil price and expectations for oil prices to remain high. Oil demand is set to rise above pre-pandemic levels by the end of calendar year 2022, as supply remains tight. With this in mind, we recently researched WOR to assess whether there are any fundamental drivers, in addition to macro factors, that can provide further upside in the shares.
Worley is a provider of global engineering, advisory and project management services to the oil, gas, mining, power and infrastructure sectors. Key customers include most of the world’s largest oil and gas, mining, chemical and petrochemical companies. The Company provides engineering services across the entire project lifecycle, i.e. planning (design, engineering, feasibility), development (procurement, construction management), operations (maintenance, modifications) and ultimately project de-commissioning.
Key Fundamental Drivers
Earnings Growth Highly Dependent on Cost Savings Program
While earnings for the full year to 30 June 2021 (FY21) declined significantly, a key highlight from the FY21 result was an improvement in earnings in 2H21. The improvement was largely driven by the benefits from Worley’s cost-out/synergy program,. The Company is on track to deliver $350m of cost savings by June 2022. WOR has a strong track record in achieving cost savings targets. To this end, the $190m synergy target from the Jacobs ECR acquisition has been completely actioned.
The achieved cost savings enabled the EBITA margin in 2H21 to improve by 150 basis points to 6.1%. This is despite the ongoing adverse business mix (more construction & fabrication work relative to professional services in comparison to the prior corresponding period). In context, EBITA margin prior to COVID-19 was mid 6%.
The adverse business mix has continued into 1H22, as customers continue to delay some projects with a continued focus on capital discipline. As such, any EBITA margin improvement reported in 1H22 is likely to be mostly driven by the cost savings program.
EBITA margin is likely to show a more meaningful improvement from FY22, as many contract awards to date only ramp up toward end of FY22 and as end markets continue to recover.
Sustainability Projects Offer Long-Term Revenue Growth Potential
The Company recently outlined its sustainability strategy, where it aims to maximise its exposure whilst also growing its traditional business. WOR’s traditional business customers are increasingly planning for the energy transition and decreasing the carbon intensity of their businesses.
WOR expects its sustainability business to grow at a faster rate than its traditional business. It has ambitions to grow sustainability revenues from 32% of aggregated revenue in FY21 to 75% of aggregate revenue by FY26. Projects nominated by Worley as “sustainable” currently comprise 33% of its revenues, 26% of its contract backlogs and 50% of the Company’s factored sales pipeline.
The Company intends to focus its efforts across nine sustainability growth markets. This is where it already has skills, client relationships and project experience. Key emerging sustainability opportunities likely to be targeted are projects that typically generate higher margins due to their increased complexity. These include the Hydrogen, Carbon Capture, Use & Storage (CCUS) and Water markets, where market size is expected to grow annually by 50%, 12% and 8%, respectively, out to 2025.
Balance Sheet Has Significant Capacity
WOR has a solid balance sheet, with gearing of 2.0x (on a net debt to EBITDA basis). While the reduction in earnings pushed the gearing level higher relative to FY20 (1.8x), it remains at the top end of the target range of 1.5x – 2.0x. Importantly, the current level of gearing is below that for some of its global peers. For example, Wood Group has a gearing ratio of 2.9x. In addition, WOR’s balance sheet capacity places the Company in a strong position to pursue likely Merger & Acquisition activity in the sector.
WOR is currently trading on a 1-year forward P/E multiple of ~18.5x. This is above the 5-year average of ~16x, as the market is starting to price in factors such as:
i. An earlier-than-expected recovery in energy CAPEX, especially considering the stronger oil price to which WOR shares have somewhat of a correlation, and to a lesser extent,
ii. The growth opportunity from the transition towards sustainability.
However, at current levels, we remain cautious on WOR’s fundamentals given that the traditional business continues to face both revenue and margin headwinds from ongoing project deferrals and competitive pressure. In turn, this increases the risk for: i) 1H22/FY22 earnings to fall short of consensus estimates (1H22 results release due on 23 February), and ii) For the expected earnings recovery in FY23 (where consensus estimates are factoring in +40% EPS growth) to be pushed out.
Whilst the fundamentals look challenging, the technicals look a bit more promising – at least in the short term. WOR put in a double bottom at the end of last year (circled). Then in the last couple of weeks, it has managed to push through a major trendline. It now looks as though WOR is going to push higher from here during the next several weeks and attempt to retest the recent peak near $14.
Michael Gable is managing director of Fairmont Equities.
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