Hochtief: Take A Long-Term View And Enjoy The 5% Dividend

Summary

• Hochtief subsidiary CIMIC incurred significant one-off costs in both 2019 and 2020.
• To avoid a loss in 2020, a 50% stake in cash cow Thiess was sold.
• Hochtief actively managed the risk profile and expects to grow operational net profit in 2021.
• The stock price more than halved since 2017, but traded sideways for the past year indicating it has bottomed out.
• The current price of €77 generates an 5% dividend yield and offers an attractive entry point for the long-term investor.

Photo by Joern Pollex/Getty Images News via Getty Images

Investment thesis

Hochtief (OTCPK:HOCFF) posted disappointing numbers for the second year in a row. On the back of this performance, the share price more than halved since it hit a high of €172.20 in June 2017. In spite of the stock price gradually decreasing, the dividends increased at a compound annual growth rate of 29% prior a dividend cut in 2020. Currently, investors seem to focus on the negative news only and are missing the long-term prospects. At the current price, this company provides a 5% dividend yield while management streamlines the business to return to dividend growth in 2022.

Company overview

Hochtief is an infrastructure group with activities in all major developed markets around the world. Originally starting as a pure construction business, overtime it has developed into a holding company with interests in many notable construction companies. Fields of expertise are construction and engineering but also public-private partnerships and mining. The business is divided into three main divisions which are based on geographic areas:

• Americas
• Asia Pacific
• Europe

Each of these divisions is made up of different companies either fully or partially owned by Hochtief. The Americas division consists of the subsidiaries Turner, Flatiron, E.E. Cruz, and Clark Builders. These subsidiaries can complement one another or operate independently. Clark builders, for example, is a large Canadian general contractor whereas Turner holds the same position in the U.S. Flatiron and E.E. Cruz, on the other hand, operate in the fields of infrastructure, bridges, and water treatment.

The Asia Pacific division is formed by four different companies operating under the umbrella of CIMIC (OTCPK:LGTHF). CPB Contractors and Leighton Asia both are construction companies. Thiess and Sedgman operate in the mining business providing mining and mineral processing services.

In Europe, the main branches are formed by Infrastructure, Engineering, and PPP Solutions. PPP stands for Public Private Partnership, a cooperation between a government agency and a private company, in this case, Hochtief. Besides these three operating subsidiaries, there is a range of dedicated companies per country such as Hochtief UK.

Results under pressure

A summary of the Hochtief results for FY 2020 is given in Table 1. To focus on the performance per division, the impact of HQ results is omitted from this table.

Table 1 - Hochtief 2020 results (values in million €).

A quick glance shows the Americas and Europe divisions performed in line with the year 2019. Both divisions also managed to increase EBIT which is a welcome result for a year in which the world faced a health crisis.

In spite of this performance, the real difference is made in the division Asia Pacific. Although this division posted the highest EBIT of all in 2019, a €526 million net loss was reported. In contrast to this result, the division booked a €230 million net profit for the year 2020.

To understand what happened in this division an overview of the cash flow is presented in figure 1.

Figure 1 - Development of cash position in 2020

The net cash position after operations for FY 2020 increased by €91 million to an amount of €1.62B. This cash position has been used to distribute dividends, perform share buybacks and increase the stake in CIMIC. Excluding the non-operational effects, this led to a cash position of €772 million for FY 2020.

The non-operational expenses however show quite some big numbers which draw attention. The items BICC Cash out and Thiess divestment both originate from Hochtief subsidiary CIMIC.

CIMIC

In 1983 Australian contractor Leighton Holdings bought Thiess Contractors. At the time of this transaction, the majority shareholder of Thiess was Hochtief, which now became the majority shareholder of Leighton Holdings. In 2014 Hochtief expanded the position in Leighton to 74.23 percent of the shares and the following year rebranded the company to CIMIC.

In 2019, CIMIC management reviewed operations, and as a result, decided to exit the Middle East. This decision resulted in the sale of a non-controlling interest in BIC Contracting (BICC). The pre-tax impact was $2,724.7 million, which reduced to $1,840.2 million after taxes, see figure 2.

Figure 2 – CIMIC P&L statement for 2019 (results in AUD)

With this impairment covered, 2020 should have been the year to return to profitability. Needless to say, the pandemic had an adverse effect on the performance. The company had to incur costs due to the COVID crisis, but it also used this pandemic as an opportunity to make settlements, provisions, and impairments. Combined this resulted in a negative position of $613.3 million.

As if the environment was not challenging enough already, CIMIC received the news they had lost an arbitration case against Chevron (CVX). The dispute had to do with cost overruns at the Gorgon natural gas project. Losing this arbitration resulted in a one-off after-tax impairment of $805.3 million.

To avoid a loss for the second consecutive year, a 50% stake in Thiess was sold to Elliot Advisors Ltd. According to the 2020 annual report, this divestment led to a one-off after-tax gain of $1,438.2 million, conveniently annulling the Gorgon and FY2020 one-off items, see figure 3.

Figure 3 - CIMIC financial performance 2020 (results in AUD)

It is worrisome the company had after-tax cash outflows exceeding $3B over a two-year timespan and partially plugged the hole by selling a 50% stake in a well-performing part of the business. That said, the exit from the Middle East has been a strategic choice and management willfully decided to incur the resulting impairment. The same goes for the settlements and provisions booked in the wake of the corona pandemic. This leaves the problem with the Gorgon project; revenues were booked at a time when it was not certain these would be recognized. On the other hand, however, management acted decisively when the arbitration case came to a close by selling the Thiess stake to ensure profitability.

Risks

The risk profile of Hochtief is elevated mainly due to:

• Asymmetric risk in construction business
• Leighton legacy

The profit margins for each division, and by extension for Hochtief as a whole, are slim. This is not just the case for Hochtief, rather low margins are characteristic for the construction industry. Low margins are not necessarily an issue as long as volumes and turnover of the goods sold are high. One could for example think of the fast-moving consumer goods business. In this environment it simply does not matter if an item goes on sale or perishes, it is just a small part of the volume.

Construction business however is anything but fast and it does not come in large volumes either. Surely the size of the projects can be huge, but typically projects are tailored to the needs of customers. Per project, the degree of tailoring may differ as a highway is more standardized than a subway station for example, but unfortunately, standardization does not automatically translate into the absence of risk in the construction business.

The challenge is to manage risks of bespoke mega-projects while working with small profit margins on a multitude of other projects. If a large project such as Gorgon starts losing money, it will take many (low margin) profitable projects to offset such a loss. Essentially the risk profile for a company like Hochtief is asymmetric.

One might ask why the Asia Pacific division is struggling whereas the other divisions show constant performance. My take is the current owners are still dealing with the Leighton legacy. In 2012 allegations of bribery and corruption surfaced against Leighton which would eventually become known as the Unaoil Bribery Scandal. Although the investigation is still ongoing, the details are not of importance for this article. What is important is that Leighton was headed by a management team with the wrong focus. In this context, it may be interesting to note the Gorgon project was originally awarded to Leighton in the year 2009.

Since Hochtief increased its stake in Leighton, Hochtief CEO Marcelino Fernández Verdes was placed on the board and the name was changed to CIMIC. The exit from the Middle East and wrap up of the Gorgon project were other necessary steps to break with the past. These steps were visible and measurable in terms of money, it will be more difficult however to transform company culture.

In spite of necessary actions being taken, the real question for Hochtief shareholders is if they are willing to accept elevated risk in the Asia Pacific division and which income they require in return.

Shareholder return

The investment of Hochtief in CIMIC is clearly one with focus on the long term. This is supported by the fact Hochtief expanded its shareholding in CIMIC over the course of 2020. Surely the divestment of the 50% stake in cash cow Thiess was not desired, but as a consequence, an otherwise potential loss for the year 2020 was avoided. Interestingly one of the details of the divestment transaction involved the ‘option for Elliott to sell its interest in Thiess to CIMIC between three and six years from completion of the transaction’. This option means management is taking a long-term view while generating cash at a moment when it was needed.

The share price performance since 2017 did not follow the general uptrend of the broader market. Actually, the share price moved inversely showing a prolonged decline. The past year it moved sideways in a bandwidth between €60 to €90 with the current price hovering around €77. Although more bad news was presented during last year, it seems the stock price bottomed out. The dividend at this price translates into a yield of about 5%. This relatively high yield is justified as the company has shown to struggle with the Leighton legacy.

This yield is rather high, even though the dividend was reduced in 2020 from €5.80 to €3.93 as seen in figure 4. This shows management remains committed to the distribution of dividends. In addition, Hochtief reduced the number of shares outstanding as it executed share buybacks for the sum of €168 million. Total shareholder return for 2020 amounted to a total of €574 million. This indicates management is willing to address difficulties pro-actively and maintain a long-term view while simultaneously showing commitment to shareholders, though not at all cost.

Figure 4 - Hochtief dividends and share price

The question remains if Hochtief will be able to significantly increase the dividend or share price. Based on the guidance given by the company this is not likely in the short term. Figure 5 presents the operational net profit guidance. In this figure, the effect of the Thiess divestment is specifically mentioned. The 2020 operational net profit is affected to the extent that it drops from €477 to €368 million due to the partial sale of Thiess. The high end of forecasted growth (25%) means operational profit for FY 2021 will be less than the amount booked in 2020. This guidance implies the current dividend can be sustained during 2021, but an increase will likely not happen before 2022.

Figure 5 – Hochtief operational net profit guidance

Another consideration is how available cash will be distributed between dividends, share buybacks, and the extension of the shareholding in CIMIC. Based on the information available, it may be expected Hochtief, through CIMIC, will want to regain full ownership of Thiess. If so, extension of the position in CIMIC will have priority.

Since 2012 one of the priorities has been shareholder returns in the form of dividends. Extrapolating this trend into the future indicates the second priority is dividend and third share buybacks. This supports the thesis the dividend will be kept at a constant level until the moment net profit has substantially increased.

Conclusion

Hochtief incurred significant costs in 2019 and 2020. Although management acted decisively and remained committed to shareholder returns, the short-term outlook remains subdued with respect to gains in dividend and share price. According to the guidance for operational profit, 2021 will be the year in which profitability levels need to return to the level prior the Thiess divestment. This means growth of net operational profit relative to 2020 levels will not materialize before 2022.

The colorless outlook makes Hochtief one of the lesser appreciated stocks at the moment. This, combined with the fact the business has been streamlined, makes the current stock price an attractive entry point. At the current share price of €77, this company provides a substantial 5% dividend yield for the long-term investor, with dividend growth expected after 2021.

Analyst’s Disclosure: I am/we are long HOCFF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.