Construction. Good entry point. Sector Report. 27/2014/SR (141) September 9, 2014

Transcription

1 Sector Report 27/2014/SR (141) September 9, 2014 Construction Good entry point Analyst: Andrzej Bernatowicz, +48 (22)

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3 Sector Report 27/2014/SR (141) September 9, 2014 Analyst: Andrzej Bernatowicz +48 (22) Construction Good entry point We see good prospects for Polish construction industry in which, coupled with recent declines of WSElisted builders market share prices, makes an attractive entry point for investors, in our view. aawe think that the industry is in an unique point where noncyclical infrastructural (power, roads, railroads) investments will go hand in hand with cyclical residential/industry outlays. That should provide volume expansion in , with a minor slowdown in We expect a positive earnings momentum for all observed companies in , and all but railway builders in aathe industry has been hit hard by the crisis most aggressive players went bankrupt and the companies we cover seem to take a rather conservative approach towards contract budgeting. We think that the excessive risk taking will not repeat in this cycle. aaafter recent market share price declines valuations in the sector become undemanding, with handful of companies trading at single-digit forward P/E ratios. aawe raise our LT fundamental recommendations for Budimex (Buy + Overweight; 12M EFV of PLN per share) and Trakcja (Buy + Overweight; 12M EFV of PLN 1.37 per share). The companies should be the main beneficiaries of EU-funds inflow for roads and railroads, respectively. Out of these two most liquid exposures we prefer Budimex, since Trakcja s results may slightly suffer if the railroad investment gap in 2016 materializes. aawe like also the middle-sized cubature exposures with Unibep (Buy + Neutral; 12M EFV of PLN 10.2 per share) being cheaper than Erbud (Buy + Overweight; 12M EFV of PLN 34.0 per share). Among smaller railway construction exposures ZUE (not covered) looks like a reasonable (although risky) play whereas Torpol (not covered) requires rather an option approach, in our view. Elektrobudowa (Hold + Underweight; 12M EFV of PLN 86.8 per share) may be an interesting bottomfishing investment case, yet we see too many risks lurking around to become positive on the stock. Construction; Recommendations Market Cap (PLN m) LT recommendation ST bias Last price (PLN) 12M EFV (PLN) Upside (downside) Budimex 3,060 Buy ( ) Overweight ( ) ( ) 19% Trakcja PRKiL 432 Buy ( ) Overweight ( ) ( ) 28% Elektrobudowa 356 Hold (-) Underweight (-) (-) 17% Erbud 316 Buy ( ) Overweight ( ) ( ) 40% Unibep 245 Buy (-) Neutral (-) (-) 44% Torpol 189 Not covered Not covered 8.73 n.a. n.a. ZUE 161 Not covered Not covered 6.35 n.a. n.a. Source: WSE, DM BOŚ SA Construction; Multiples P/E EV/EBITDA 2014E 2015E 2016E 2014E 2015E 2016E Budimex* Elektrobudowa Trakcja PRKiL Erbud Unibep Torpol ZUE *Cash-adjusted P/E Source: Bloomberg, DM BOŚ SA Construction; Key drivers/catalysts Company Catalysts Risks Budimex - earnings momentum - lowering of tender hit ratio - increasing backlog=>rising cash - best exposure for road story; Trakcja PRKiL - earnings momentum - empty backlog for claims recovery - best exposure for railway story Elektrobudowa - earnings momentum - bottom fishing' idea - conservative guidance - share in Russian Vector, export - lawsuit in Finland - Tychy, grid contracts Erbud Unibep - earnings momentum - improving results in power - lawsuit against Bank Millenium - earnings momentum (light construction) - strong housing market - Eastern fears exaggerated Torpol - guidance delivery (superb earnings momentum) - contracts in Norway - new contracts (fat backlog=> cherry-picking) ZUE - earnings momentum - foreign contracts - bottom fishing' idea Source: DM BOŚ SA - new contracts in power - Modlin - weak commercial real estate market - troubles with Eastern contracts - Łódź Fabryczna risk - Rail Baltica risk - Norway (entry risk) - grid contract aapolish construction companies are relatively small, undiversified and high-risk, so we advise diversifying the risks away by building a broad sector exposure.

4 Contents Contents Position in the cycle = good prospects Unique point in the cycle Cycle model How will current cycle be different? Costs may rise slightly Road construction cycle bottom reached Volumes will recover Competitive pressure eases marginally Cooperation with GDDKiA improves marginally, yet remains very difficult Margins to improve slightly Financial results Railroad construction good times are coming Strong 2014E-2015E weak 2016E and bright future Road scenario not repeated, so far Not an easy market, yet better than roads General construction cyclical revival Good volume perspectives No-frills in margins Financial results Power construction eventually kicked off Polish Utilities Polish Grid Operator Key success factors Contract management NWC management Operating leverage - share of own forces Financial leverage Size & diversification Expansion abroad PPP...22 Company section...23 Budimex...24 Elektrobudowa...30 Erbud Torpol...40 Trakcja PRKiL...44 Unibep...49 ZUE...54

5 1. Position in the cycle = good prospects We think that a strong cycle started in Polish construction, involving combined growth in cyclical, infrastructural and power construction. We expect market growth in , interrupted by slightly weaker Compared to the past, current cycle should be smoother in volume distribution and characterized by a more risk-conscious behavior of market participants. We are not afraid of the threat of rising material prices since it is only an unexpected rise of cost that poses a risk to general contractors margins. We expect a positive margin momentum in , with dynamics for subcontractors/suppliers better than for general contractors Unique point in the cycle Volumes up in all segments, construction segment seems a good place to be in was a year of volume collapse in Polish construction industry. Unlike two recent cycle peaks, current revival should have the unique feature of combining growth in all significant segments: a acyclical, GDP-driven advance in housing construction and industrial construction; a aeu-funds (new perspective) fuelled growth in road and railroad construction; a astate-driven investments in power infrastructure (power plants and grid investments). Our forecast, based on a bottom-up model is depicted below. For 2014 we expect 8.0% yoy construction production growth, which is slightly more conservative that 9.8% yoy growth in 1H14 reported by CSO (which might have been however upward biased by mild winter). For the next years it seems that the volume distribution in time should change much smoother than in previous cycle. The cycle may end with a harsh crisis around 2020 when EU funds will be exhausted and next perspective most likely to be far less generous for Poland. Fig. 1 Poland; Construction production Residential (LHS) Infrastructural (LHS) Non-residential (LHS) GDP growth yoy Good times Crisis starts? 8% 7% 6% 80 5% 60 4% 40 3% 2% 20 1% E 2015E 2016E 2017E 2018E 2019E 2020E 0% Cyclical Counter-cyclical Balanced Source: CSO (GUS); DM BOŚ SA 1.2. Cycle model Margins of construction companies fluctuate with demand, subcontractor/suppliers margins are more volatile than GC s.???????????????????????? 5

6 Cycle models implies that we are in the mid of contractor market aainvestor market. Volumes go down, GC s are forced to downsize and compete with price. Low demand exerts pressure on material and labour price. Nevertheless, margins deteriorate and least efficient companies go bankrupt. aacontractor market. Volumes go up and so do the margins with companies becoming more picky about contracts. At the beginning, the margin is split more in favour of GC since subcontractors/suppliers operate below full capacities. When the boom develops GCs are able to improve their margins, but the bulk of additional profits goes to subcontractors/suppliers who become a scarce resource. Local price bubbles (e.g. aggregates in 2011) may be formed. Fig. 2 Construction; Theoretical cycle model We are here Smoother cycle => decline in 2016 should be less severe Subcontractor/ supplier margin GC margin E 2016E Investor market Contractor market GC SC/Supplier Investor market Source: DM BOŚ SA Empirical data show that the aggregate sector margin moves along with output. SC margins are more volatile than GC and dependent on volume growth Macro data confirms that prices growth with demand Historical data, although limited, suggests that the subcontractor/supplier margins are far more volatile than GC s and depend mostly on increase/decrease of construction production (not the activity level itself). Therefore 2012, which was the peak activity year in the cycle, showed margin declines. Since we expect current cycle to be smoother, without large output hikes, we think that the subcontractor s margins will not recur to previous cycle levels. Consequently, we think that the expected investor market in 2016, driven by minor output decline, will be mild and result in only a slight margin deterioration (nothing comparable with disastrous 2013). The company-level observations are confirmed by the macro data that show that construction prices growth dynamics moves along with output growth. Fig. 3 Construction; Production vs. prices Fig. 4 Polish construction; Margins vs. change in construction production 30.0% 25.0% 20.0% Construction production prices yoy Construction production yoy 25% 20% GC EBIT margin (LHS) SC EBIT margin (LHS) Construction production yoy chng (RHS) 30% 25% 20% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% % 10% 5% 0% E 2015E 15% 10% 5% 0% -5% -10% -15% Source: CSO (GUS) SC EBIT margin based on median from Herkules, Lafrage, Cemex, Peri, Streif, Ulma, Elektrobudowa GC EBiT margin based on sales-weighted average of Budimex, Strabag, Bilfinger Berger, Warbud, Trakcja, Erbud, Skanska, Unibep, Eurovia Source: CSO (GUS), Companies, DM BOŚ SA 6????????????????????????

7 1.3. How will current cycle be different? Current cycle: smoother volumes, lower margins, caution Every cycle has its distinct features. That s what we expect for the current one: aasmoother volumes. GDP-driven component should peak in 2015, infrastructural in 2017 (with less concentrated works than in ), power construction - in That should result in smoother output increase. As a result, margins will not boost like in the previous cycle, but we also do not expect cost-driven wave of bankruptcies. aalower margins. There should be no margin explosion neither for subcontractors/suppliers nor for general contractors because of (i) smoother volumes, (ii) high competition (depending partially on the external factors i.e. overcapacities in Europe). aacaution. After spectacular bankruptcies of PBG, Polimex (in fact), Radko, Poldim, DSS etc. most players will remain more cautious, at least in the current cycle (after wave of bankruptcies/ problems in early 00 s enough to mention PIA Piasecki, Exbud builders remained conservative for nearly a decade). Companies that made large losses made changes in management boards (e.g. Strabag, Eurovia, Polimex-Mostostal). State financing may become a problem at some point, but it is not a story for today One issue that makes us a little uneasy about the current cycle is state financing. Since the typical equity share in EU-co-financed projects is c. 50%, Poland will need to spend PLN billion on road and railroad infrastructure only to broadly meet plans (and our forecasts), which implies PLN billion fund requirement annually. To put this number in a perspective, it is more than twice the annual dividend Treasury is getting from its holdings. This may become a problem, although not a concern for equity investors now Costs may rise slightly Costs mat rise slightly, but GC s margins should improve nevertheless The most important cost factors are materials and labour, with materials being the key driver, in our view. Reasonably acting general contractors try to hedge most of the cost before inking the contract, but some risks remain unhedged: (i) there is a few months between filing the bid and signing the contract, (ii) contracts with large numbers of small subcontractors (most profitable) have difficult hedging, (iii) infrastructural contracts (especially design & build) are typically long, which makes hedging of some risks impossible. We think that delicate cost pressures may be observed, and they will likely intensify as construction production volumes increase. Nevertheless, we do not expect the Eldorado for material suppliers/subcontractors from the previous cycle to repeat. Fig. 5 Poland-based subcontractors/suppliers; Financial results (PLN m) Spółka Cemex Sales ,113 1,193 1, ,298 1,125 n.a. EBIT margin -8.8% 1.1% 16.4% 14.8% 2.4% -1.5% -1.6% 10.9% -0.9% n.a. Elektrobudowa Sales , EBIT margin 3.8% 3.8% 5.0% 6.5% 8.8% 9.8% 6.7% 5.2% 2.2% 2.7% Lafarge Sales n.a. n.a. EBIT margin 7.4% 10.2% 8.8% 18.0% 14.5% 8.2% 6.4% 5.3% n.a. n.a. Peri Sales n.a. EBIT margin 37.5% 35.0% 36.6% 36.2% 24.0% 3.9% 12.2% 28.6% 26.7% n.a. Ulma Sales EBIT margin 15.4% 25.7% 29.8% 29.9% 17.0% 2.3% 12.7% 24.6% 12.6% 1.9% Herkules S.A. Sales EBIT margin -17.1% 15.2% 21.1% 32.5% 35.7% 7.4% 12.3% 18.4% 6.7% 14.0% Atrem Sales n.a EBIT margin n.a. 6.2% 7.9% 9.6% 12.1% 9.5% 9.7% 4.6% -10.3% 2.5% Streif Sales n.a. EBIT margin -2.3% 2.1% 8.4% 10.9% 15.4% 10.2% 0.8% 5.1% -4.4% n.a. Source: Companies, DM BOŚ SA???????????????????????? 7

8 aaasphalt important in roads, driven mainly by oil prices. Duopoly of Orlen and Lotos. Budimex s agreements with Lotos and Orlen comprise roughly 6-7% of its road construction cost, according to our calculations. Contracts are mostly annual, so there is a risk exposure to oil prices. A nearly 30% increase in asphalt prices brought many GC s on their knees in Fig. 6 Construction; Asphalt prices (1Q10=100) Source: Budimex aaaggregates comprise c. 5-8% of road construction cost, which is the main driver for demand in Poland. The cost is strongly affected by transport (oil price). Aggregates are typically used in later phases of road construction. In aggregates prices rose inflationary at the production site and the remaining growth is due to transportation cost. We estimate that the prices in 2011 might have increased by 20-30%. In 2013, aggregates prices decreased by 15-20%, PZPK informs. The segment still rates overcapacities and we would not expect a noticeable cost pressure by aalabour construction is labour intensive. We think that pure labour is c. 20% of construction cost. We observe that labour cost growth is correlated with demand growth (construction production and level of employment) and average wage level growth in the enterprise sector. General contractors typically subcontract a lot (eg. payroll is only 4% ex-sg&a in Budimex S.A.), so the wage cost rise is initially taken by subcontractors. Fig. 7 Poland; Aggregates production vs. road outlays Fig. 8 Cemex; Aggregates Aggregates production (LHS) GDDKiA + PKP PLK outlays (RHS) % 60% Volume yoy Price (PLN yoy) % (mln t) (PLN bn) 20% 0% % % E 0-60% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q E Source: GDDKiA, CEMEX, PZPK Source: Cemex 8????????????????????????

9 Fig. 9 20% 15% Construction; Drivers for wages (yoy dynamics) Average wage construction Average wage enterprise sector Construction production Average employment construction 10% 5% 0% % -10% -15% Source: CSO (GUS) aasteel important in general and infrastructural construction (bridges, building construction) and railroads (rails). Global trends in steel prices are the most important driver. Fig. 10 Reinforcement steel prices (1Q10=100) Source: Budimex aaconcrete, cement - Concrete and cement are needed for all construction activities. Concrete is a composite material composed typically of water, aggregates and cement, thus influenced by the two latter. The price of cement will be dependent on electricity since the production in energyintensive (carbon permits are an issue). The rebound of volumes in 1Q14 is partially because of better weather, but the Polish Association of Ready Mix Concrete producers forecast a FY increase as well. We think that with the overcapacities a significant increase of prices should not be observed by aamachinery highly dependent on demand, which is clearly visible in volatility of results of Herkules and Streif. Investment in construction machinery typically increases with rising construction production volumes, encouraged by rising lease prices. When the cycle ends prices decline helping GC. aasubcontractors comprise the majority of costs for most GC. Obviously, subcontractor prices vary depending on labour cost, material cost and, most importantly (as depicted below), demand. This cost factor is hard to quantify because it mostly depends on degree of work specialization and policy of GC towards subcontractors. Most of GCs maintain good relations with subcontractors, which results in relatively higher costs in times of market downturn and lower costs in times of boom. The only exception may be road construction where it is easier to exploit subcontractors and suppliers since the construction sites move along entire country and one may never need the service of a subcontractor again.???????????????????????? 9

10 Fig. 11 Concrete prices (1Q10=100) Source: Budimex Fig. 12 Concrete; Polish market size Fig. 13 Cement; Polish market size (m3 million) (million t) E E 2015E Source: Polish Association of Ready Mix Concrete Producers (SPBT) Source: IBnR, DM BOŚ Fig. 14 Cemex; Ready mix concrete 80% Volume yoy Price (PLN yoy) 70% 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q E Source: Cemex Fig. 15 Cemex; Domestic gray cement 60% Volume yoy Price (PLN yoy) 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q E Source: Cemex 10????????????????????????

11 Fig. 16 Construction machinery outlays vs. construction production Fig. 17 Subcontractor profitability vs. growth in construction production 50.0% Machinery outlays growth yoy Construction production growth yoy 20% Construction production yoy (LHS) SC/Supplier median EBIT margin (RHS) 30% 40.0% 18% 25% 30.0% 20.0% 10.0% 0.0% -10.0% 16% 14% 12% 10% 8% 6% 20% 15% 10% 5% 0% -20.0% 4% -5% -30.0% 2% -10% -40.0% -50.0% Source: CSO (GUS) 0% SC EBIT margin based on median from Herkules, Lafrage, Cemex, Peri, Streif, Ulma, Atrem, Elektrobudowa Source: Companies, CSO (GUS), DM BOŚ -15%???????????????????????? 11

12 2. Road construction cycle bottom reached In terms of volumes road construction segment should show improvement from the current bottom by 2017 on the wave of EU-funds momentum. We expect a margin recovery, but with fierce competition and difficult cooperation with GDDKiA no rapid growth in margins should be assumed. Nevertheless, the industry should face 2-3 years of rising profits Volumes will recover We expect PLN 110 bn to be spent in by GDDKiA only Fig. 18 GDDKiA; Outlays Slow contracting in resulted in a work accumulation for , followed by a volume collapse since the means from current EU perspective were utilized. With improved efficiency of GDDKiA s tender preparation, we expect that in perspective things will look differently we expect high volumes for the next few years and a collapse thereafter (when all means will be utilized). In terms of total funds allocated it seems that the magnitude of infrastructure flows in will be similar to , but directed more to railroads, with roads showing slight decline, in our view. Fig. 19 Cost of 1 km road built (PLN bn) E 2015E 2016E 2017E 2018E 2019E 2020E Source: Budimex, GDDKiA, DM BOŚ SA (EUR m) The Netherlands Norway Austria Hungary Source: GDDKiA, PWC Ireland Poland EU - average The Czech Republic Germany Slovenia Spain Denmark 4.0 Lithuania 2.2. Competitive pressure eases marginally Polish road sector is highly competive which we do not expect to change Polish road sector is highly competitive because the market is open for international players and shows a very good dynamics compared to other EU states, which encourages further entrants. We think that this situation will not change dramatically. aadespite failures of many foreign companies, we expect that they will mostly continue fight for a chunk in the Polish market, which is confirmed by high number of admission requests/bids in new tenders (in 2014 we see a median of 17). There are also new entrants like Italian Salini. aawe see no political will to create entry barriers, since the current situation allows for a relatively cheap road build - please notice that high margins before construction boom in Poland were driven by elevated prices and likely price fixing. GDDKiA informs that compared to 2008 the cost of building 1 km of motorway and expressway declined by -36% and -39%, respectively. aacurrently, the cost of building 1km of motorway is at EUR 9.4 million, in line with European average (which includes mountainous countries as well), 17% more expensive than in Germany, 8% more expensive than in Czech Republic. Example of numerous profitable road builders (Budimex, Skanska, Strabag most of the time) shows that with good risk management decent margins can be achieved on road contracts. The jeremiad and lobbying by industry s representatives are understandable, yet should not mislead investors about the real prospects of the segment. 12????????????????????????

13 although some relief may be observed However, we see that recently the competitive pressure tends to weaken slightly. This is may be attributed mainly to the bankruptcies/heavy losses of the most aggressive players and troubles of some companies to secure bid bonds and performance bonds Cooperation with GDDKiA improves marginally, yet remains very difficult GDDKiA is a difficult partner for construction companies GDDKiA is by far the most important investor in road construction nearly all contracts exceeding PLN 100 million worth are granted by this agency. This monopolistic position has created a difficult playground for general contractors. aarepresentatives of construction industry complain that stripped FIDIC agreements transfer most risks (material prices, project mistakes) to general contractor. This is especially apparent in design & build and optimize & build contracts (rarely seen on other markets) where the large geologic and material price risks (long time of execution) are transferred to general contractor. aacontracts tend to be split into smaller pieces, reducing risk for investor, but increasing competition (smaller contracts = higher competition). aait is difficult to get supplementary works paid without a lawsuit. aachanges in projects are rarely allowed. aalowest price is the sole criterion in the tender. aaproject bureaus are chosen in the lowest price regime as well, which means that the projects are frequently of poor quality causing problems for GC. Fig. 20 Euroconstruct; Expected construction output dynamics Source: Euroconstruct???????????????????????? 13

14 Fig. 21 Road construction; Tender competitiveness measures 8 Median no. of bidders Median deviation from budget Median deviation from median bid 7 6 0% -5% -10% Fig. 22 Road construction; Median deviation of lowest bid from median bid vs. budget of the contract (smaller contract higher competition) 1,600 1,400 Median: -9.8% 1, % 4-20% 3-25% 2-30% 1-35% Jan Dec 2013 Jan 2014-July 2014 Source: DM BOŚ SA Median: -13.1% % -35% -30% -25% -20% -15% -10% -5% 0% Source: DM BOŚ SA aaprice indexation is not practiced, which is a risk especially with long-lasting contracts where hedging is hard to perform. 1,000 PLN m (gross) aanewest regulation assumes that GC need to pay down subcontractors before being paid by GDDKiA, which may adversely affect their NWC. yet some easing may be observed On the other hand, in the recent tenders there were some minor evolutionary changes going in the direction desired by general contractors. aa5-10% prepayments. aasome price indexation may be allowed (we would not assume substantial changes in contract budget, though). aaprice gets 90% weight, with 10% depending on more qualitative factors. We remind also that Mr Lech Witecki, heavily criticized by the construction industry General Director for National Roads and Motorways, was substituted by Ms Ewa Tomala Borucka. Claims are no risk for future investments Another issue are claims against GDDKiA, mainly for the contracts realized in According to the press coverage, they may exceed PLN 11 billion, out of this PLN 5 billion have been already filed to court. GDDKiA stated that they may be even 10x lower since part of them is totally unjustified and many contractors file multiple claims for the same subject. The claims are mainly by contractors that failed to execute signed contracts (Alpine PLN 1.9 billion, SIAC PLN 1.8 billion, SRB PLN 2 billion). Contractors that manage to make money like Budimex or Strabag have nearly no claims. All in all, we think that the claims pose no significant risk to the future financing of GDDKiA s projects Margins to improve slightly All in all, we expect some improvement in margins We think that aforementioned competitive pressures and difficult cooperation with GDDKiA will prevent road construction gross profit on sales margins from reaching their pre-crisis double-digit levels. We do expect some recovery to continue in At the end of 2015 though, in line with our cycle model, price pressures in materials and subcontractors (labour cost) should start to rise and prevent a strong margin rise, in our view. All in all, we think that we may observe c. 4% GC EBIT margin in the peak of the current cycle, not 7%, as it was in the previous cycle Financial results Road exposure worse margins Financial results of Budimex, Skanska, Strabag, Bilfinger and Eurovia show that the company with significant road exposure may show no worse profitability than general construction peers (Erbud, Unibep). 14????????????????????????

15 Some companies had bad years (like Strabag or Eurovia), but they underwent a management change, which should translate into more conservative offering in the future. Fig. 23 Poland-based GC (infrastructure/general construction); Financial results (PLN m) Company E Budimex* Sales 3,043 3,076 3,350 3,290 4,430 5,516 6,078 4,749 4,776 EBIT margin 0.3% 0.9% 3.3% 6.1% 7.5% 6.3% 3.0% 3.6% 4.5% Strabag Sales 1,964 2,183 2,193 3,143 4,019 5,027 4,301 3,210 EBIT margin -0.6% 2.1% 6.0% 12.1% 8.1% 6.3% -2.7% 1.5% Skanska* Sales n.a. 3,015 2,590 2,830 3,804 4,615 4,282 4,200 n.a. EBIT margin n.a. 3.5% 4.6% 3.7% 7.7% 8.6% 4.4% 4.0% n.a. Warbud Sales 1,006 1,645 1,621 1,538 1,330 1,394 1,347 1,115 n.a. EBIT margin 1.2% 2.3% 1.9% 5.1% 5.2% 3.5% 2.2% 2.8% n.a. Eurovia Sales ,694 1, n.a. EBIT margin 10.4% 0.7% 0.6% 2.5% 2.3% 3.6% -13.9% -24.5% n.a. Erbud Sales , ,104 1,528 1,384 1,224 1,496 EBIT margin 5.9% 3.8% 2.4% 2.7% 2.3% 1.7% 1.8% 2.1% 2.8% Bilfinger Sales , n.a. n.a. EBIT margin 6.0% 2.4% 0.2% 7.5% 4.8% 3.5% -6.0% n.a. n.a. Unibep* Sales ,137 EBIT margin 1.7% 4.0% 6.3% 6.6% 4.6% 3.6% 2.4% 3.1% 3.3% *Includes significant developer activities Source: Companies, DM BOŚ SA???????????????????????? 15

16 3. Railroad construction good times are coming Prospects of Polish railroad construction look promising and 2015 will be record-high years in terms of volumes may be weaker, but taken into account expected fund inflow from new EU-perspective we have a fairly optimistic LT outlook for the sector. The competition remains intense, but higher entry barriers (players without machinery needs to subcontract) results in better margins than in road construction. Additionally, despite peaking volumes we see no cost pressures, so far Strong 2014E-2015E 2014E-2015E: record-high rail expenditures Railroad construction companies are enjoying record-high backlogs and, even assuming typical underdelivery of PKP PLK s budget targets, it seems that 2014E-2015E will be record-high in the history of Polish railway investments. PKP PLK needs to reconcile means from current perspective by end of 2015, so there will be pressure for contract acceleration weak 2016E and bright future 2016E may be weaker, but beginning from 2017E volumes should rise again There may be some volume decline in PKP PLK promises tenders for PLN 5 billion to be launched in 2H14, but we would not be surprised by a delay (reconciling previous perspective will be the priority). If this happens to be the case, 1H16 may see a gap in the volumes. Nevertheless, taken into account (i) attribution of means from new EU perspective (similar funds for infrastructure like in with greater share of rail vs. road), (ii) heavy underinvestment of Polish railway infrastructure, and (iii) improving efficiency of PKP PLK driven by organizational changes, we see bright prospects for the industry for Road scenario not repeated, so far Crisis in rails has been milder than in roads Similarly like with road construction, in the last years the railroad market experienced intense competition (low barriers to entry). Financial statements of road builders confirm that it resulted in pressures on margins, but has not led to a wave of bankruptcies of general contractors (abstaining from PNI s case). Additionally, we do not see a material rise in material/subcontractor prices in 2014, despite record-high volumes. Fig. 24 PKP PLK; Investment outlays Fig. 25 Railway construction; Median deviation of lowest bid from median bid vs.budget of the contract 9 8 Execution Plan 100% Unsatisfactory Satisfactory Good 7 90% 6 80% (PLN bn) % 60% 3 50% 2 40% E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E 2028E 2029E 2030E 2014E outlays based on Ministry of Infrastructure and Development 2014E-2020E outlays based on PKP PLK s National Railroad Plan (Krajowy Plan Kolejowy). 2021E-2030E outlays based on Polish Railroad Transport Masterplan (Masterplan dla Transportu Kolejowego w Polsce do 2030 roku). Uniform outlays distribution assumed. Source: PKP PLK, Ministerstwo Infrastruktury, Torpol 30% 20% 10% 0% Source: DM BOŚ SA 16????????????????????????

17 Fig. 26 Polish railway builders; Financial results (PLN m) Company E Torpol Sales EBIT margin 3.5% 1.7% 3.3% 4.7% 5.1% 6.3% 2.3% 2.6% 3.7% Trakcja PRKiL* Sales ,042 1,428 EBIT margin 3.3% 4.6% 6.7% 10.8% 9.0% -0.6% -1.3% 3.0% 3.4% ZUE Sales n.a EBIT margin n.a. 15.5% 18.1% 8.4% 8.3% 5.5% 0.7% 1.7% 2.9% PNUIK Sales n.a. n.a. EBIT margin -7.7% 3.3% 3.6% 0.9% 5.1% 4.4% 1.9% 1.9% n.a. *Including consortium partners to ensure historical comparability. Rail segment only. Source: Companies, DM BOŚ SA Research 3.4. Not an easy market, yet better than roads Intense competition, but more specialization makes the situation better than in the road segment Competition in railroad construction is intense, but the number of tender participants is lower than in roads. Railroad contracts have a significantly different characteristics than road contracts - specialist machinery is needed to perform the construction works. This is owned by only few (mostly Polish, besides Strabag) companies, so even if a foreign aggressive bidder wins a contract, he needs to subcontract to one of the Polish players. Obviously in such a case they get a lower margin, but filling backlog is not a nightmare for railroad builders CEOs (unlike for their road peers). All in all, we see the competition slightly easing in recent tenders, it is also apparent that larger contracts are less competitive. Fig. 27 Railway construction; Tender competitiveness measures 9 8 0% -2% Fig. 28 Railway construction; Median deviation of lowest bid from median bid vs. budget of the contract (smaller contract higher competition) % -6% Median = -7.9% % -10% -12% PLN m (gross) Source: DM BOŚ SA Median number of bidders (LHS) Median deviation of lowest bid from budget (RHS) Median deviation of lowest bid from median offer (RHS) Jan Jul 2013 Aug Jan 2014 Feb Aug % -16% -18% Median = -10.2% 0-30% -25% -20% -15% -10% -5% 0% Source: DM BOŚ SA???????????????????????? 17

18 4. General construction cyclical revival We expect cyclical revival in general construction driven by rebound in residential construction and industrial construction Good volume perspectives Good prospects in residential & industrial, stagnation in commerce Residential construction is early cyclical and has already rebound, following low interest rates. Commercial projects are a more difficult story because of growing saturation of commercial space and pressure on rent rates. We see a potential rebound in industrial production (e.g. revival in storage space investments), which corresponds with positive trend in GDP No-frills in margins Strong competition will prevent margin expansion Since general construction works require limited expertise the competition is strong. On the bright side, the tenders are mostly private and therefore quality matters sometimes there are even no tenders, but negotiations between investor and selected builder. All in all, the margins should be somewhere inbetween road and railroad construction, in our view Financial results The table below depicts sales and profitability of Polish general contractors that are active in general and infrastructural construction. Fig. 29 Poland-based GC (infrastructure/general construction); Financial results (PLN m) Company E Budimex* Sales 3,043 3,076 3,350 3,290 4,430 5,516 6,078 4,749 4,776 EBIT margin 0.3% 0.9% 3.3% 6.1% 7.5% 6.3% 3.0% 3.6% 4.5% Strabag Sales 1,964 2,183 2,193 3,143 4,019 5,027 4,301 3,210 EBIT margin -0.6% 2.1% 6.0% 12.1% 8.1% 6.3% -2.7% 1.5% Skanska* Sales n.a. 3,015 2,590 2,830 3,804 4,615 4,282 4,200 n.a. EBIT margin n.a. 3.5% 4.6% 3.7% 7.7% 8.6% 4.4% 4.0% n.a. Warbud Sales 1,006 1,645 1,621 1,538 1,330 1,394 1,347 1,115 n.a. EBIT margin 1.2% 2.3% 1.9% 5.1% 5.2% 3.5% 2.2% 2.8% n.a. Eurovia Sales ,694 1, n.a. EBIT margin 10.4% 0.7% 0.6% 2.5% 2.3% 3.6% -13.9% -24.5% n.a. Erbud Sales , ,104 1,528 1,384 1,224 1,496 EBIT margin 5.9% 3.8% 2.4% 2.7% 2.3% 1.7% 1.8% 2.1% 2.8% Bilfinger Sales , n.a. n.a. EBIT margin 6.0% 2.4% 0.2% 7.5% 4.8% 3.5% -6.0% n.a. n.a. Unibep* Sales ,137 EBIT margin 1.7% 4.0% 6.3% 6.6% 4.6% 3.6% 2.4% 3.1% 3.3% *Includes significant developer activities Source: Companies, DM BOŚ SA 18????????????????????????

19 5. Power construction eventually kicked off Power investments have been a story for Polish construction for a long time, yet failed to materialize. It is happening now with Kozienice, Opole and Jaworzno power plants, high outlays for grid and renewables. It should be however remembered that power plant construction is a high-tech business, so the contribution of Polish builders will be limited (yet still significant) Polish Utilities Polish utilities started intensive CAPEX programs in distribution and generation. In we expect Polish utilities to spend PLN 130 bn in distribution, generation and renewables aadistribution. We expect stable, high CAPEX since the companies are remunerated for their increased RAB (regulatory asset base) by ERO. There is a risk of curbing the investments if in 2016 ERO switches to quality tariffs and neglects infrastructure development. We do not assume this as a base scenario since the medium and low-voltage grid is mature and will still require significant outlays. aageneration. CAPEX should surge in since Kozienice (in progress) will be followed by Opole, Turow and Jaworzno projects (which have secured financing and contractors). The main risk is on contractors side since Polish companies have neither financial capacity nor experience in this kind of projects and everything is in hands of Hitachi and Alstom (which are also likely to reap the lion s share of margin). On the other hand, there will be a lot of work for subcontractors like listed Elektrobudowa (i.e. power evacuation), Erbud (general construction), Ulma (formworks and scaffholdings) or Herkules (cranes). Larger companies may try to make smaller projects on their own (Elektrobudowa - Tychy CHP) or with experienced partners (Budimex s 25% stake in Turów contract). aarenewables. Meeting the requirement of >15% electricity consumption from renewable sources by 2020 implies addition of at least 3,000 MW new renewable capacity till Taking PLN 6 million per MW (which is the cheapest wind energy) yields total CAPEX of PLN 18 billion. We think that there will be a small culmination of investments in 2015, before the introduction of auction system (installations launched before will have an optionality of green certificates/auction). Companies exposed for this trend are, i.e. Erbud (windfarms are high-margin part of road & engineering segment) and Herkules Polish Grid Operator PSE plans PLN 9 billion CAPEX in According to Mr Cezary Szwed, member of Transmission System Operator (PSE) management board, the operator wants to spend PLN 23 billion on grid construction and modernization in , out of this PLN 9 billion in (over PLN 5.5 billion were contracted so far). aabest price is the only criterion in the tender. Fig. 30 Electricity generation; Investment outlays by Polish biggest utilities Fig. 31 Electricity distribution; Outlays by Polish biggest utilities 10.0 PGE Tauron Enea Energa 7.0 PGE Tauron Enea Energa (PLN bn) (PLN bn) E 2015E 2016E 2017E 2018E 2019E 2020E E 2015E 2016E 2017E 2018E 2019E 2020E Projections nuclear plant exclusive Source: Companies, DM BOŚ SA Source: Companies, DM BOŚ SA???????????????????????? 19

20 Fig. 32 PSE (Polish Grid Operator); Investment outlays 1,800 1,600 1,400 1,200 1, (PLN m) E 2015E 2016E 2017E 2018E 2019E 2020E Forecast based on PSE s investment plan (downwards adjusted since the realization for fell short of budget Source: TSO (PSE), DM BOŚ SA aacompetition is much lower than in infrastructure, but it increased after PSE encouraged foreign bidders (like Piggao). aacontracts are quite complicated. aacompanies that have been present on this market for a long time (Elbud Gdańsk, Elbud Warszawa, Elbud Kraków etc.) are generally inefficient since they were spoiled by low competition and undemanding investor. Therefore, they started to have problems a few years ago. aain the past, contracts tended to be NWC-intensive. Recently PSE makes prepayments which improves cash flow, but also decreases margin (lower capital entry barriers => higher competition). Fig tender competitiveness in transmission contracts vs. roads and railroads Transmission network Roads Railroads Median deviation from budget -6% -29% -11% Median deviation from median bid -10% -13% -10% Median no. of bidders Source: DM BOŚ SA 20????????????????????????

21 6. Key success factors Among key factors that determine GC s success and failures are contract and risk management, NWC management, operating and financial leverage and size & diversification Contract management Theoretically GC should have a hedged margin. In practice it is impossible, but the margins should not be volatile Ideally, model world general contractor should calculate offer basing on binding bids from subcontractors/ suppliers and hedge all costs as soon as possible after winning the contract. In such a case the GC s margin would be fixed. The reality is more complex since not all costs may be hedged, especially with contracts longer than 1 year. We observe also that after recent spectacular problems of the industry the companies become increasingly risk-conscious (e.g. Budimex, recently also Trakcja and Elektrobudowa) NWC management Negative NWC is an enormous value driver, yet not many companies manage to drive it down Again, in an ideal, model world GC should get the prepayments from investor and pay subcontractors/ suppliers later, maintaining a negative NWC. This is however the case only with large, cubature/roads GC s like Budimex and Strabag. It seems that the negative working capital is not achievable for railroad builders, mostly due to the fact that they realize a significant part of the contracts with own forces. Anyways, improvement in NWC is an enormous value driver for construction companies Operating leverage - share of own forces Higher own forces provide operational leverage The companies differ in respect of using own forces or subcontracting. Typical general contractors have little own forces, relaying on subcontractors. This kind of structure is easier to upscale/downsize and has a better NWC profile. However, when the market is in an upswing and subcontractor prices rise, own forces and materials strongly improve margins. Railway builders are typically characterized by a higher share of own forces since they hold equipment and therefore rely less on subcontractors Financial leverage The construction industry is high-risk (highly volatile sector, plenty off-balance sheet liabilities) and the companies need good standing to have access to necessary financial instruments (performance bonds, bid bonds). Therefore, renowned GC have typically a strong balance sheet with no net debt at best. The exceptions are restructuring cases like Trakcja and PORR. Mirbud is a conspicuous and high-risk stock in this context. Fig. 34 Construction companies; NWC as % of FY sales Fig. 35 Construction companies; % of contract realization with own forces 30% 25% 70% 65% 20% 60% 10% 11% 7% 7% 7% 6% 50% 50% 45% 0% 3% 2% 1% 0% -9% -12% -14% -15% -31% 40% -10% -20% -30% ZUE PORR Poland Trakcja PRKIL Strabag AG Hochtief AG Erbud S.A. Unibep S.A. Torpol Warbud PORR Implenia Strabag Poland Hochtief Poland Eurovia Poland Budimex S.A. 30% 20% 10% 15% 10% 5% 5% -40% Last available FY used. Please notice that the NWC is eoy so it is likely understated (due to cash flow seasonality). NWC adjusted for developer inventories/prepayments. Source: Companies, DM BOŚ SA 0% ZUE Torpol Strabag AG Erbud S.A. Mirbud Budimex S.A. Unibep S.A. Source: Companies, DM BOŚ SA???????????????????????? 21

22 Fig. 36 Construction companies; Net debt/ebitda Mirbud PORR Trakcja Hichtief Strabag AG Unibep Erbud Vinci Construction Implenia Strabag Poland Budimex Warbud -10 Last available FY used. Please notice that the net debt is eoy so it is likely understated (due to cash flow seasonality). Source: Companies, DM BOŚ SA 6.5. Size & diversification The construction business is a risky one, and with smaller companies a single troubled contract may impact the whole year. This was the case of Erbud (Silesia, Modlin) and Trakcja (Poldim s A1 stretch). This was not the case of Budimex although the Company had same contracts that made heavy losses. Size matters therefore. Obviously, size will not help when the whole company is mismanaged, which the examples of PBG and Polimex clearly confirm. Besides Budimex, WSE-listed builders are small-cap, so to achieve a proper diversification we recommend investing in a handful of construction companies Expansion abroad Expansion abroad is a necessity in the LT, failures are certain Taking into account likely crisis of Polish construction after 2020 the attempts to gain foothold on foreign markets are a strategically sound. They are undertaken by ZUE (RTI Germany), Erbud (GWI), Unibep (Unihouse in Norway, general construction in Eastern markets and Germany) and Torpol (Norway). Budimex also announced its willingness to go abroad, Trakcja is already present in Lithuania and eyes Nordic markets. These efforts are necessary and strategically sound, but also involve high risks - we are sure that one of aforementioned companies will fail in this attempt PPP PPP is another necessity in the LT With exhaustion of EU funds after 2020 PPP will become another necessity to finance investment needs (that will still be significant, in our view). That will require mental shift on the public side. PPP requires strong balance sheet, and as for today it seems that only Budimex will be capable of fully benefiting from the trend. 22????????????????????????

23 Company section

24 Analyst: Andrzej Bernatowicz +48 (22) Budimex Key points aaleader of the rebounding market. With weaker competition and good track record Budimex is well-positioned to benefit from the next wave of EU-funds for the road infrastructure. Additionally, with positive earnings and cash momentum the Company s shareholders may hope for hefty and regular dividend payments. Valuation-wise, the Company does not look expensive, although the adjustment for its large excess cash position is necessary to catch proper perspective. We raise our LT fundamental recommendation to Buy (from Sell), our ST market-relative bias to Overweight (from Neutral) and our 12M EFV to PLN per share (from PLN previously). aathe only exposure to road infrastructure. Budimex is the only WSE-listed road builder, which makes it an attractive and unique exposure for a heavily growing market. aastrong contract intake Budimex s 1H14 eop backlog at PLN 3.9 billion was down -9% yoy and should be considered a weak figure. However, the Company has PLN 2.8 billion best offers pending. The intake in GC is also strong and will be enhanced by large Czyżyny project (developed by Budimex Nieruchomości). Moreover, in August road tenders for c. PLN 10 billion were announced, which may bring Budimex c billion additional orders by the end of the year. All in all, we think that Budimex eoy backlog + best offers may even exceed PLN 7 billion (up 60% yoy). a a should help margins Since many of the contracts will be long term (design & build in roads, Turów), we do not expect a strong sales increase in GC for However, securing important future revenues will allow Budimex to be more picky in the new contract acquisition, resulting in better margins. a a and cash. Budimex operates at a negative NWC, so the rising backlog and revenues should result in improving net cash position and allow for hefty dividend payouts. Sector: Construction Market Cap.: US$ 989 m Fundamental rating: Buy ( ) Bloomberg code: BDX PW Equity Market relative: Overweight ( ) Av. daily turnover: US$ 0.40 m Price: PLN Free float: 41% 12M EFV: PLN ( ) 12M range: PLN Guide to adjusted profits 2013 EBIT and NI adjusted for (i) PLN 200 million expected gain on Danwood disposal and (ii) PLN -40 million loss on land revaluation, with tax implications taken into consideration. Key data IFRS consolidated E 2015E 2016E Sales PLN m 4, , , ,213.6 EBITDA PLN m Adj EBITDA PLN m EBIT PLN m Adj EBIT PLN m Net profit PLN m Adj net profit PLN m EPS PLN EPS yoy chng % Net debt PLN m -1, , , ,897.5 Mid-year net debt PLN m ,423.3 P/E x Adj P/E* x P/CE x Adj P/CE* x EV/EBITDA x EV/EBIT x DPS PLN Gross dividend yield % 3.5% 10.2% 5.3% 6.2% No. of shares (eop) m * Multiples based on mid-year net debt since it is the best proxy for excess cash Stock performance 150 WIG 140 Budimex Volume (m) Source: Bloomberg 1. Release of 3Q14 results: October 29, Upcoming events aabold move in the developer segment. The Company decided to utilize its large plot in Czyżyny by pushing through a lowmargin fast-selling project for 3,500 flats in 2-3 years. It is a good move that should allow for unfreezing cash and acquiring new plots. Generally, with a favourable market momentum Budimex s developer arm shows good sales results and strongly contributes to the Company s valuation. Catalysts 1. Expected backlog improvement 2. Exposure to road construction 3. Strong NWC management 4. Track record of positive surprises 5 Cheap cash-adjusted valuation Risk factors 1. Worsening of contract intake hit ratio 2. Contract risk (well-diversified, though) 3. Additional investments in PNI aamultiples need to be adjusted for cash. With bottoming interest rates, cash produces tiny income, which elevates P/E ratios for cash-rich companies. When adjusted for the excess 24 cash in the numerator and financial income in the denominator, Budimex s P/E does not look rich any more (especially compared to Strabag that is the best peer, in our view).????????????????????????