AusGroup Ltd: Stronger but external risks remain

Revenue down 23.5% QoQ. AusGroup Ltd posted a 23.5% QoQ decline in 3Q09 revenue to A$99.6m. Despite a higher gross margin of 15.2% (11.8% in 2Q09) due to timing effects, net profit fell 17.1% QoQ to A$4.1m. On a YoY basis, both net profit and revenue (up 28.3% YoY) compared favorably with a net loss of A$3.4m recorded a year ago. The company's results were better than expected as our estimates had provided for revenue drop through additional contract cancellations.

Tough external environment. Financing difficulties and a steep decline in commodity prices have impacted the mineral resources sector's capital expenditure programs. This is also true, to a lesser extent, in the oil & gas sector. The size and availability of future projects is a question mark. Our view is that select blue chips like BHP Billiton will continue to spend and replacement capex should pick up slowly. But the size of the pie appears to have shrunk compared to last year's levels. Additionally, AusGroup's margins may be at risk due to 1) increased competitive pressure and 2) negative operating leverage - a fixed cost/falling volume effect.

But reaping rewards from overhaul of execution capabilities. Over the past year, management has been working on improving AusGroup's tendering process in facets such as selection of opportunities, costing, and ensuring tighter terms and conditions. It has also been focused on improving management oversight on projects and implementing a more robust risk management process. This overhaul is clearly a long-term work in progress but is already producing visible results. We see three key indicators: 1) a more realistic revenue booking process; 2) an impressive decline in receivable days from 103 days to about 50 days over 9M09 (our estimate); and 3) the pay down of A$24.3m in debt in 9M09, taking the company to a net cash position.

Valuation. AusGroup's current order book stands at A$230m, up 37% QoQ. We have adjusted our earnings estimates upwards and now estimate revenues of A$80m in 4Q09F (down 20% QoQ) and A$380m in FY10F (down 13.6% YoY). This implies AusGroup winning another A$230m of orders over the next 14 months. 4Q09 will be a better benchmark of both operating conditions and AusGroup's ability to sustain this improvement in internal processes, in our opinion. AusGroup is up 186% YTD. Recommend HOLD with S$0.55 fair value (previously under review). This pegs AusGroup at 13x FY10F earnings - at a slight discount to ASX-listed competitor Monadelphous.

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