I was doing some quick lunch time reading of the various Leighton’s (LEI) press releases that have hit the market recently. For those who have been living on Mars inside a cave, LEI announced a $700M+ turnaround in profit for FY11 – to come in at a forecasted loss of $427M. Ouch.
The horrible result was attributed to three major projects:
- The Brisbane Airport Link
- A Desalination plant in Victoria
- Their Middle Eastern venture Habtoor Leighton
It was the desal plant numbers which caught my attention because they reveal some potentially serious engineering and risk management issues at Leighton.
What happened in Victoria?
Below is a snap shot from the investor presentation put out to explain the write downs. This particular shot is from the “Materials” section of the desal plant.
As you can see, they severely underestimated the most crucial quantities on the job. In fact the use of the word “severely” is an underestimate in itself – sort of like saying World War 2 was a minor scuffle.
Keep this in mind – a 226% increase means if you budgeted to use 100 tonnes of something, you actually end up using 326 tonnes. That’s more than a 3 fold increase in quantity.
Now, your author has experience in design and construction and I know a few things about how these estimates are typically put together. I also know what constitutes a bad estimate because I’ve read post-mortem results that compare design quantities to as-built quantities. Yet I have very rarely heard of a job where steel, concrete and earthworks quantities are all out by more than 100%. In fact, any one quantity that is out by 50% or more is considered a disaster and is likely to precipitate the ending of careers.
So I’ll let you draw your own conclusions where the desal plant may sit on a scale of “Awesome Job” to “Complete and Unmitigated Disaster”.
Looking to the Future
Leighton’s has reacted to the news with a capital raising – which is apt given current debt levels and the reduction in equity the write down will create. I think the market re-pricing them to $25.00 (after the trading halt ended) is about right if you believe the forecasted return to NPAT of $600M for FY12. However, the very cause of the write down means one has to question this belief.
Leightons (and their subsidiaries) seems to have some serious issues with their engineering and estimating processes. To fall that far short on quantities most likely means they didn’t have the right information about the site or if they did, the engineers and estimators screwed up royally. Either way it’s not a good look for an engineering company.
In addition to the engineering concerns, the risk management processes of LEI must also be called into question. I would be surprised if a job this size went from the engineer’s desk straight to tender. There would be several studies to consider all options and several risk reviews to ensure that the job lined up with expected construction metrics ($/m of road, tonnes of steel per cubic volume of structure etc). Past jobs would be reviewed as benchmarks and several senior people would be signing off on the tender. All these toll gates (which are bureaucratic nightmares for engineers) exist to ensure these sorts of under estimates don’t happen.
Yet it still did.
Increased Risk
At Empire Investing we’ll be looking at Leighton’s with a much higher risk profile than we did a month ago. We believe the value of the company is closer to $20 because estimating disasters of this size usually beget more errors. I would think some of the people responsible for the mess are still there, because a clean sweep of personnel in the middle of a project is just not feasible – who would replace them and how would they get up to speed on the works?
LEI will need a few years of blemish-free operation before I start to believe the decks have been cleared and processes have been improved. Until then, we’ll be very wary.
Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has no interest in any business mentioned in this article. The article is not to be taken as investment advice and the views expressed are opinions only. Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.