Our media and its favoured economists may exist in a netherworld of unicorns and rainbows but a few investment banks at least do not. Morgan Stanley is out today with a new note on the Engineering and Construction sectors and it makes scary reading:
A severe and prolonged decline in Australian E&C activity appears to be the most likely outcome Australian E&C activity has grown continuously for twelve years with activity in 2012 some 598% above that of 2001. The Golden run is over – our forecasts now suggest we are entering a period of double digit declines in activity driven by declining E&C capex, an event that is unprecedented in the 27 years of data we hold. Although early opex driven salvos have been fired, we think the real downturn is only now about to begin.
The decline could become disorderly
As activity declines significant excess capacity will need to be expelled placing considerable pressure on the industry. The prospect of irrational behaviour emerging through this period is high. Margins are likely to be competed lower, cash flows will come under pressure and broad scale restructuring will be required. We see the greatest risk in capital heavy segments of the market such as civil and contract mining where equipment values may have already fallen by ~40% with DOW and LEI most exposed. With reported profits potentially a lagging indicator, we believe investors should increasingly focus on cash earnings as an early indicator of distress.
We cut our forecasts but this may not be the last time
After such a sustained period of growth, it is extremely difficult to determine where activity may settle, however, with the industry order book already down 21% from the March 2012 peak, a significant downward trajectory is clear. We have lowered our FY14-FY15 forecasts by 6-28% across the sector.
We see the most challenging outlook for LEI and MND both of which have the greatest exposure to E&C capex. See our eleven challenges on pg 5 for the potential drivers of downside. Despite this outlook, E&C shares have staged a strong recovery from their June lows. We remain Underweight all stocks in the industry with the exception of WOR for which we see a divergent growth outlook. Although we remain Cautious on the industry and see substantial share price downside for most stocks, we expect the August reporting season may not act as the key downside driver for the industry. Instead we expect this is more likely to come in February 2014 when the extent of the downturn is likely to be much clearer.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific's leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
