Australian equity fund manager DNR Capital had its faith in one of its core holdings, the multinational construction and property company Lendlease Group, tested over the past year. It has decided to stick with the company and in its latest investor report it explains its decision.
Lendlease is one of the top 10 holdings in DNR’s Australian Equities High Conviction Fund, with a 5 per cent weighting in the portfolio.
Lendlease’s share price peaked at $20.72 in August last year, after a steady climb up from around $13 in 2016 and 2017. By January it had fallen to $11.89 – a five year low. Since then it has come back to its current level of around $15.
DNR says that given the issues Lendlease has had in its engineering business in recent years, the stock attracts many differing views, “and some criticism is warranted”.
Lendlease revealed the hefty provision and review of engineering and services in November, citing issues with Sydney’s NorthConnex tunnel, excessive wet weather and remedial work due to defective design on some projects. It took a $350 million write-down of the troubled unit in the December half.
“Cost blowouts on infrastructure projects raise serious questions on why it has an engineering business at all.
“That said, we are a little surprised at just how singularly focused the market has become on a division that, even at peak valuations, represented well under 10 per cent of the company.”
Lendlease suffered a $6 billion fall in value in the second half of last year. “The share price reaction to the engineering business problems implies that the business is worthless, which is probably fair, but also implies cost blowouts of somewhere between $2 billion and $5 billion,” DNR says.
“This is for a business that had already provisioned for underperforming projects, which were well advanced, and has only won one material contract for $1.8 billion in the last two years, which reduces the risk of future blowouts.”
The other 90 per cent of the business continues to trade strongly, with cash flows coming from the settlement of the Darling Square project and the continued build in the development pipeline.
Lendlease now has more than $80 billion in urban regeneration projects, which provide 10-plus years of development activity and a material source of future investment product for the funds management platform that already manages over $30 billion.
Highlighting the success that it has had in this area was the recent announcement of a $20 billion development project in the San Francisco Bay area. This project leverages its experience developing mixed use communities with affordable housing in Australia and the United Kingdom.
“Significantly a large proportion of the apartments will be build-to-rent, which will grow Lendlease’s funds under management,” DNR says.
“This analysis, simple as it is, highlights a situation where the share price reaction is not reflecting the fundamentals.
“While we cannot ignore the issues in engineering, the company is in the process of exiting that business and the remaining operations now have a long-dated pipeline of projects, along with very high-quality funds management platform that looks set to grow materially.
“By staying true to our process, focusing on the fundamentals and taking a longer term approach, we see material upside in Lendlease. The current focus on engineering has provided a contrarian opportunity to buy a strong underlying business with material valuation support.”
The DNR Capital Australian Equities High Conviction Fund has lagged the S&P/ASX 200 index over the past couple of years but in recent months performance has picked up.
Over the 12 months to the end of July, the fund returned 6.55 per cent, compared with the 13.3 per cent return of the S&P/ASX 200 Accumulation Index.
Over the past six months the fund is up 16.4 per cent, compared with an 18.7 per cent market return.
Other core holdings in the fund include NAB, Treasury Wine Estates, James Hardie Industries, Seek, REA Group, WorleyParsons, Brambles and Macquarie Group.
DNR says it is currently overweight de-rated quality stocks where it believes the market has overcooked concerns. Apart from Lendlease, stocks include James Hardies and Treasury Wine Estates.
It is also overweight “a basket of names with defensive characteristics”, such as Brambles, Aurizon and Tabcorp.