Upside For Downer

This story features DOWNER EDI LIMITED, and other companies. For more info SHARE ANALYSIS: DOW

By Greg Peel

FNArena has made note in the past that if all ten brokers and researchers in the FNArena database line up with Buy ratings on a particular stock then warning bells should ring. Unfortunately this tends to imply a contrarian sell-signal.

We can thus perhaps be grateful to RBS for maintaining a Hold rating on Downer EDI ((DOW)) to give the stock a 9/1/0 Buy/Hold/Sell ratio in the database, rather than a perfect score. But RBS has not updated its recommendation on Downer since the company's interim result was released in February.

Downer EDI consists of a group of companies that specialise in the engineering, construction, telecommunications, mining and resource sectors in the Asia Pacific region. Between Australia's government-sponsored infrastructure plans and the rebound in resource sector projects across the country, one would suspect Downer would be a highly sought after stock at present. But it's not. Indeed its shares are trading at around a 30% valuation discount to rival engineering services company United Group ((UGL)) and a 20% discount to the ASX Industrials index, notes JP Morgan.

As the chart below shows, Downer has also quite simply underperformed the broad market for the past six months.

The major downer for Downer has been its 49% stake in UK engineering company Reliance Rail. Reliance recently had its credit rating downgraded and that was not well-received by a market generally nervous about credit, despite analysts pointing out Downer had no obligation to inject more capital. But perhaps the main reason investors have stayed away has been Reliance's public-private partnership (PPP) with the NSW government to supply the new Waratah commuter trains.

One can understand why any investor would run for the hills at the mere mention of any of “NSW government”, “PPP” or “Sydney trains”. Mention them all in the one sentence and investors would quite simply flee. Past experience tells us (1) that this NSW government could not organise a booze-up in a brewery, and would likely flip-flop several times on location, cost, and whether or not the booze-up should go ahead (See: Rozelle Metro); (2) that the letters PPP have spelt little more than disaster in recent years (See: Cross-City, Lane Cove tunnels); (3) and that the last time a new Sydney train was delivered on time it had a coal tender (It's 2010 and we're still waiting for the “Millennium Train”).

Investors have thus become very train-focused, and this has weighed on perceptions of Downer despite the company's exposure to infrastructure contracts elsewhere, including the booming resource sector (albeit the RSPT has thrown a cloud over that industry as well).

However, as we spend another session watching the ASX 200 sink slowly into the west, investors might be encouraged to note that the new Waratah train built by Reliance Rail is now undergoing testing on the Sydney network late at night as a precursor to its impending roll-out. And moreover, Downer has just won the biggest mining service contract in Australian history.

The contract is subject to final negotiations, but Downer is now preferred tenderer on a six-year, $500m per annum contract to establish project infrastructure and deliver drilling, blasting and overburden handling services for Fortescue Metals' ((FMG)) new Christmas Creek iron ore project. The negotiations are set to be finalised in June, with work commencing in July. UBS notes that a typical “large” mining service contract in Australia involves around $1bn over 4-5 years, so $3bn over six years is believed to be the largest contract of its kind in history, by some margin.

Analysts have responded by increasing their earnings forecasts for Downer by 2-7% from FY12 on. They do note, however, that to service this contract would require around $500m of capital expenditure plus working capital. However, it is agreed that taking into account Downer will undoubtedly subcontract a lot of the work, and the current state of the company's balance sheet, that a capital raising will not be necessary. However, Citi points out that further contract wins and a possible top-up of the rail PPP might force a capital raising some time from FY12 if Downer is to maintain its target gearing limits.

And analysts also agree that the scale of the contract not only implies significant revenue potential, but also significant ramp-up risk. In short, risk increases proportionally with reward. The contract will also require a level of “front-loading” of capex, meaning brokers have actually revised down their FY11 valuations on the stock ahead of benefits accruing thereafter.

On a company-wide risk basis however, there is an element of geographical diversification offered by the Fortescue deal. Currently Downer's business is only 20% exposed to WA, Macquarie notes, while being 22% exposed to NSW and 50% exposed to Queensland.

Macquarie also recently hosted Downer at its equity conference at which management noted that 70% of targeted FY11 contract revenue and 50% of FY12 was already “sold”. This latest deal, says Macquarie, “reinforces an increasingly positive outlook in FY11-12 and beyond”.

No one disagrees.

At the time of writing, Downer shares are trading at $6.73 on what is broadly a very weak day for the market. As noted, the brokers in the FNArena database have a 9/1/0 rating ratio on Downer and the average target is $9.12, indicating 34.3% upside. The range of targets, if we don't count the now dated forecast from RBS, is a tight $9.00-$9.79 suggesting little volatility in analyst calculations.

FNArena's Stock Analysis shows Downer trading (as at yesterday's close) on a PE of 11.7x on FY10 forecasts dropping to 10.4x on FY11, and a dividend yield of 4.4% rising to 4.9%.

For the longer term investor, and not withstanding immediate market fears, Downer is offering attractive valuation.

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