Engineering Group - Call Me Maybe? - Model Update
All,
Please find our updated analysis of Engineering Group here.
Note: Beta testers can check Engineering Group on the portal here.
Incoming proceeds from the sale of parts of the business to Accenture will likely shape the capital structure going forward. We believe a new capital structure could finally make the business generate FCF, but it won't fix everything. Questions remain regarding the underlying fundamentals, and the company will need to prove that it cannot only grow but grow profitably. We are waiting for some proof points on the business performance while all eyes are on the rightsizing of the capital structure, which might create some interesting risk-adjusted opportunities helped by the call schedule of the outstanding notes.
Investment Rationale
We are not taking a position at the moment as the 28 SSNs seem to be trading close to what we believe is fair value; however, given the probability we put on an early refi of the 2030 SSNs and FRNs, we might consider parking some idle cash in one of these instruments to benefit from the call protection - resulting in decent YTC - and clip some coupons along the way.
We welcome the company's plans to use the M&A proceeds to repay expensive debt as it will improve both leverage and FCCR - the latter being our main concern.
However, the company still has to prove its ability to create sustainable FCF and manage the seasonal WC swings and seasonality in the public administration business.
The other proof point the company needs to deliver is on achieving profitable growth; the sharpened focus on AI has yet to show its positive impact on profitability, which sits at a lower level post the divestments to Accenture.
Once these proof points show up in the results, we expect a sale of the business is on the table given the PE owners have been invested for a while; however, it might take too long for the AI story to fully play out for Engineering and to receive a full multiple in a sale.
Key Conclusions
Engineering needs to fight on several fronts: FCF and profitable growth require proof points which the company has yet to deliver.
We expect FCF generation to improve as a result of putting the M&A proceeds from the Accenture transaction to use; management earmarked the proceeds to pay down its most expensive debt; we believe this might trigger a full reset of the capital structure, thereby reducing both leverage and interest expense.
Demand growth will need to show resilience post the expiration of the Italian PNRR spending program; we believe some of the spending will spill over into 2027 and there will be some recurring demand created; however, the quantum of this recurring demand and how it translates into revenues for Engineering is uncertain at this point and is certainly a key item to watch in the next quarters.
The company's sharpened focus on AI while continuing to operate in the more commoditised system integration business (which provides operating leverage) has yet to prove to be the right one and to show up in the results.
Engineering's proprietary software capabilities are set up to provide recurring revenue streams but also need to prove their resilience vs. potential AI disruption.
The company seems to be set up appropriately post the divestments, with execution on the strategic plan and demand volatility being the key to watch.
Miscellaneous
Business performance remains an item to watch, with system integration as the most commoditised part of the business most at risk from AI disruption.
With continued seasonality in the business and significant working capital swings, cash management will continue to be critical.
Heavy exposure to the Italian market creates macro, political and budget risk.
Here to discuss the name with you,
Martin Hoelzl