This company is firing on all cylinders

Worley is a contracting firm that provides engineering expertise to clients around the world. We initiated a new position in Worley during the quarter due to our view that end-market demand and an improved competitive environment will enable Worley to grow earnings materially over the next three years. We outline our thinking below.

Worley’s end markets are firing

Worley is one of the three largest global engineering firms. It generates annualised revenue of over A$10 billion, predominantly earned in the US and EMEA.

Figure 1 & 2: Worley 1H 2023 revenue by region and sector

Worley’s revenue is tied to capex investments made by its key customers in the oil & gas, chemicals and mining sectors. After a decade of declines, customers are starting to spend again. Figure 3 shows the aggregate capital expenditure across 40 large, listed companies from Worley’s key client segments. Capex appears set to recover to an 8-year high in 2023. This is still well below previous peaks.

Figure 3: Capital expenditure is starting to rebound (aggregate spend across 40 large, listed companies from Worley’s key client segments)

The mix of investment spend is changing. Currently, 40% of Worley’s revenues and backlog are derived from projects related to sustainability. For example, carbon capture and battery materials. Worley is targeting 75% of group revenues to be derived from sustainability projects by 2026, which is supported by a pipeline skewed to sustainability projects as shown in Figure 4.

Figure 4: Worley’s mix of projects is shifting towards a higher proportion of sustainability-related projects.

The outlook for spend on energy transition projects is understandably very strong. Investment spend on clean energy projects needs to step up materially to accelerate the transition away from fossil fuels. BloombergNEF estimates that the level of investment in energy transition projects needs to lift three times its current levels from 2023-2030 to set us on a path to hit net zero targets.

Figure 5: Annual energy transition investments need to grow at 3x the current pace from 2023-2030 to achieve Net Zero targets

At the same time, investment in traditional energy sources is needed to continue to support world’s overall energy needs. Over the past 30-40 years, global electricity production has grown by more than 2% p.a. and is expected to continue growing at over 1% p.a. into the future.

Figure 6: Total energy production will continue to grow. Investment in tradition energy sources is needed to support this

With regards to investment in traditional energy, it is not enough to just maintain historic levels of spend. Investment needs to be accelerated to account for:

1. A historic underinvestment in energy over the past decade; and
2. The loss of Russian pipeline gas, which accounted for ~25% of the global natural gas market.

On the second point, Worley has already been a direct beneficiary. The company has been awarded a 20mtpa LNG project being run by Venture Global. We estimate the project will generate US$2-3 billion of revenue over the next three years.

We expect the abovementioned dynamics in sustainability and traditional sectors will drive a continued increase in global capex spending. As a result, we forecast Worley’s revenues to grow 14% in FY2023 and ~10% p.a. in FY2024 and FY2025. We believe these estimates could prove conservative if current trends continue.

Figure 7: We forecast organic revenue growth of 14% for FY2023 and ~10% p.a. for FY24-25 but believe these estimates could prove conservative

Competitive environment has improved markedly

We acknowledge that the contracting industry is typified by low barriers to entry. A small number of loss-making contracts can lead to value destruction. However, we believe medium-term conditions in Worley’s major markets are conducive to sustainable, profitable growth.

Worley (ASX: WOR) is one of only three truly global engineering firms that have the expertise to take on many of the projects that are currently coming to market. The other two are Wood Group and Fluor. Despite revenues of US$5 billion and US$14 billion respectively, both Wood and Fluor have generated minimal or negative cash flows over recent years due to problem projects. Worley has fared better, generally due to a lower risk tolerance when selecting projects.

Figure 8: Wood Group Free Cash Flow (£ millions)

Figure 9: Fluor Free Cash Flow (US$ millions)

Figure 10: Worley Free Cash Flow (AUD millions)

The good news for Wood, Fluor, and Worley is that the volume of work they are being asked to tender for at the moment is allowing them to:

1. Be selective about the projects they compete for;
2. Write more “reimbursable” contracts, which pass a lot of cost risk onto the client; and
3. Lift prices across the board.

Comments from the CEOs of each of the major contractors over the past few months suggests they are taking advantage of these supportive conditions.

• Worley: “in 25 years, I have never seen conditions so buoyant across all our lines of business. We're no longer willing to take low margin work, because we don't have to.”
• Wood: “the work we are currently bidding, we see the opportunity to increase pricing.”
• Fluor: “margins on new awards have been at or above plan for the last five quarters.”

Margin improvement could surprise to the upside

In February 2023, Worley guided to 7.5%+ EBITA margins in FY2024. We believe this medium-term guidance underpins the confidence Worley has in its current backlog which has been signed up on favourable pricing terms.

We forecast higher EBITA margins than consensus estimates in FY2024 and beyond. Our assumptions drive a forecasted >20% p.a. earnings growth rate over FY2023-FY2026, underpinning substantial upside based on our three-year P/E-relative valuation framework.

Figure 11: Firetrail forecasts higher EBITA margins than consensus estimates for FY2024 and beyond

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