Middle East – The Comeback King

Two years on from the property crash in Dubai, could now be the time to invest in a potential infrastructure boom across the Middle East?

The bursting of the Dubai property bubble in 2009 and fall in the oil price led to significant reductions in both revenues and profits for UK stocks with exposure to this market, plus in some cases serious bad debt write-offs. As we outline in this article, we see significant investment upside from a recovery in the Middle East funded by an oil price that appears to be sustainable at above $100 per barrel and driven by an investment focus on infrastructure, in parts perhaps to appease political unrest, instead of speculative property projects.

We are now nearly two years on from the problems in Dubai, which were fuelled by investment excess on property projects that were not backed by a sustainable plan for future development. The end result was Abu Dhabi bailing out Dubai and a debt restructuring of Dubai real estate developer Nakheel, which is still ongoing today. This negatively impacted demand for services from UK engineering consultancies, construction firms operating in joint venture with partners across the Gulf, and equipment rental firms.

However, the outlook appears to be improving rapidly, and the growth this time should be more sustainable. This time the focus of growth is not on Dubai but instead on a broader region, which has a significant need for infrastructure investment. Areas include Abu Dhabi, Oman, Qatar and Saudi Arabia are expected to rapidly increase their investment in infrastructure over the next few years.

What these regions have which Dubai does not have is the backing of significant oil reserves – budgets are balanced in the region at between $40 and $90 a barrel of oil. The oil price (currently at $111 per barrel) has rebounded even following recent International Energy Agency action to release additional supply into the market, adding further support to the widely held view that the price should be sustainable over the long term at a level above those used in budget planning processes, therefore generating significant budgetary surpluses to fund investment.

Planning ahead
Abu Dhabi has a plan of where it wishes to be by 2030, which is both highly ambitious and impressive. The targets are vast – to nearly quadruple industry space from four million square metres in 2007 to 15 million square metres in 2030, nearly treble the number of schools from 236 to 650, nearly quadruple the number of hospital beds from 2,800 to 10,000 and to support a planned increase in the population from 900,000 to 3.1 million residents. The investment required to build the infrastructure to support this population growth is significant (c. £1,000 billion) and will need to draw upon the engineering and construction expertise of numerous companies listed on the London Stock Exchange.

Qatar has similar plans to Abu Dhabi and has also recently won the bid to host the 2022 Football World Cup, which will provide additional opportunities across the infrastructure spectrum as rail, roads, airports and
water facilities will need to be further invested in to cope with demand.

Infrastructure investment is also serving as a mechanism to appease political unrest in the region. While stocks in the UK have had little exposure to Bahrain, Egypt and Libya, they are benefiting from other countries such as Saudi Arabia accelerating social infrastructure spend in areas such as schools and hospitals to appease potential political unrest.

According to data provided by Middle East-listed contractor Drake & Scull, forecast construction, infrastructure, power and water contract awards on non-oil projects over the period 2011-15 for the Middle East excluding Iraq and Iran are estimated to total $1,019 billion. This compares with the 2006-10 period, when $627 billion of contracts were awarded. The largest markets are expected to be Saudi Arabia ($250 billion plus), followed by the UAE, Qatar and Kuwait.

How UK investors can participate
The early-stage players are the engineering and environmental consultants who provide front-end design for projects. At the time of the bursting of the Dubai bubble, nearly every listed UK consultant had operations in the region. Those who entered the Middle East more recently, such as Mouchel and WSP, have now significantly downsized or are in the process of exiting the region following significant bad debt write-offs caused by working for clients such as Nakheel.

Consultants that had a longer history in the Middle East performed much better, and avoided significant bad debt write-offs by being more selective in the client and projects taken on. Two prominent UK consultants who performed better during the downturn and continued to collect cash were Atkins, which is the number one consultant in the region (£140.9 million of revenue in 2011) and Hyder Consulting, which is the fourth-largest consultant in the region (£65.5 million of revenue in 2011). For Atkins, cash collections have exceeded the written-down balances in the group’s balance sheet, contributing to forecast upgrades in the group’s recent financial results.

There are very tangible signs that the Middle East is recovering, as evidenced by recent contract awards, such as Atkins being awarded the role of lead designer and programme manager for a new 30 million per annum terminal at Jeddah Airport. Atkins’ outlook for 2012 from its recent 2011 results statement noted, ‘Overall market sentiment is improving, although the timing of work remains unpredictable, making resource planning challenging’, while Hyder reported ‘there are signs that liquidity is improving in the region as a whole’. The recovery is at an early stage but is one that we are very excited about.

Companies have also made a point of diversifying away from Dubai, in anticipation that this market could be weak for some time, but feel that infrastructure investment in oil-backed locations was likely to be much stronger. For Hyder, historically Dubai was over 50 per cent of Middle East revenue but this has now reduced to around 30 per cent.

Hyder’s attractions
Hyder, in our view, could be an attractive and geared play on recovery in the Middle East, with roughly one third of group earnings coming from the region. Its management team, which was installed just before the recession hit, has navigated the recession well by downsizing the group’s UK and Middle East operations to cope with reductions in demand while at the same time continuing to deliver sector-leading earnings growth by successfully growing its activities in Australia.

Hyder’s balance sheet has a strong cash pile from which to fund organic growth in the Middle East. Hyder also has the potential to make earnings-enhancing acquisitions to add further capability to its portfolio. We estimate that by spending its net cash pile and modestly gearing the balance sheet to around 1x Net Debt/EBITDA at sensible acquisition multiples, earnings could advance to 15% to 20% above our current March 2013 forecast.

Overall, we feel that Hyder could be an attractive investment story, which should deliver upgrades to forecasts over the next year. We view the current valuation of 10x p/e, 6.6x EV/EBITDA (adjusted for pension deficit) and 6 per cent  FCF yield as attractive.

Looking beyond the consultants, there are a number of UK contractors involved in the construction phase of projects in the Middle East. Balfour Beatty, Carillion and Interserve all have operations in the region. These operations are typically structured as joint ventures with local construction companies. The UK company will either own 49 or 50 per cent of the equity and bring their expertise of operating in the UK and other territories to the Middle East, while the local partner brings local relationships.

Carillion’s focus historically has been on the UAE, with some operations in Oman and Egypt, while Interserve has focused its operations on Qatar and Abu Dhabi. Carillion also recently entered Qatar but is yet to announce a sizeable contract win there. In terms of geographical exposure, we prefer exposure to Qatar, Abu Dhabi and Saudi Arabia as the most attractive markets.

Carillion has a target over the next three to five years to grow its Middle East business to £1 billion of revenue from £493 million in 2010, again highlighting the growth potential in this market.

Higher margins
For construction companies, the Middle East operating margins are significantly ahead of those in the UK, principally reflecting lower labour rates. In 2010, Carillion and Interserve reported operating margins of 9.6 per cent and 10.7 per cent respectively in their overseas operations, versus 1.9 per cent and 3 per cent in the UK. Both companies expect margins to reduce over time, but margins are likely to remain well in excess of what can be achieved in the UK, making the region very attractive for construction companies.

All three companies are currently lowly rated, reflecting concerns over the UK construction and public sectors, but growth in the Middle East could provide some mitigation and all three stocks offer attractive dividend yields.

Equipment rental is a market that is significantly less well developed in the Middle East than in the UK. Speedy Hire is attempting to build a business in the UAE from a base contract with Carillion to support Carillion’s construction activities. Success to date has been limited but the venture has significant potential if management can get it right.

One potential way to play equipment rental in the Middle East could be through Lavendon, a specialist provider of powered access solutions across Europe and the Middle East. It is the market-leading business in the region providing such equipment to large infrastructure projects. Lavendon will pick up demand at a later stage in the cycle than the consultants and is experiencing tough trading conditions at present, but we see potential for the Middle East to have a significant positive impact on overall group earnings on a 12- to 18-month view given that the Middle East business generates margins that are more than double the group average.

In addition to the Middle East upgrade potential at Lavendon, there is upside from a £5 million operational efficiency programme which is yet to enter analysts’ forecast models for 2012 and 2013. We think the shares offer good value even on current forecasts, which are cyclically depressed, on 12 times 2011 earnings and 3.8x EV/EBITDA.

In summary, we believe that the Middle East infrastructure investment theme is fundamentally attractive from a UK investor’s point of view, with little upside yet priced into share prices. Two companies that we think could warrant further analysis include Hyder Consulting and Lavendon.

Michael Parkinson (head of research), Mark Fleetwood (research analyst), James Woodrow (research analyst) and Sandy Fraser (managing director, corporate finance) make up the Brewin Dolphin Support Services team.

The opinions expressed in this document are not the views held throughout Brewin Dolphin Ltd. No director, representative or employee of Brewin Dolphin Ltd accepts liability for any direct or consequential loss arising from the use of this article.