Downer Faces The Music

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

By Greg Peel

On Tuesday engineering contractor Downer EDI ((DOW)) announced the out of the blue provisioning of $290m against potential losses on the Waratah train contract for the Sydney rail network (See Rail Disaster). The implication was that information flow within the group was negligent. The analyst response was that risk management was clearly inadequate.

Yesterday Downer management was obliged to face the pitchfork-brandishing mob at its scheduled Investor Day. While there was little more management could add to what had been a shock announcement, there was some outlook confirmation.

Downer reaffirmed 5% earnings growth guidance for FY10 and suggested stronger growth in FY11.

It was noted work in hand of $16bn is a record and the company held preferred tender status on another $4bn. The pipeline for further work is strong as well with, as an example, $7bn worth of tenders being held in the mining division alone.

CEO Geoff Knox reiterated his target to double the company in five years, which GSJB Were suggests will take double-digit growth over the next three years.

Most importantly, management suggested it had enough capital on the balance sheet to fund its record work in hand despite the Waratah provisions, and that includes the recently announced $3bn Fortescue Metals ((FMG)) project. But…and this is the but that matters…management suggested more capital will be needed were the company to win any sizable new contracts in the coming months.

Having calmed down somewhat after Tuesday's announcement, analysts present were prepared to take comfort that the provisioning Downer has made against Waratah is conservative. They were also pleased to hear further reiteration that UK train builder Reliance Rail had no recourse to Downer beyond that which is minimal, although given Downer has been down this treacherous path before, one or two would still rather assume some damage in their forecasts.

But Macquarie echoed the general opinion in suggesting market focus has swung away now from Reliance and firmly towards ultimate delivery of the Waratah trains. With 70% of contract progress yet to go, analysts are unsurprisingly nervous even if provisioning is generous.

In short, there was little disagreement that Downer would still be looking like great value, had it not been for the train debacle. That was certainly the opinion of analysts before they learned about the provisions. There was also little disagreement that the 27% knock-down in share price puts Downer in the “potentially oversold” basket.

However, all agree Downer is now trading under a cloud of uncertainty, and will do so for some time. Credit Suisse points out Downer's implicit price/earnings is now a full 50% below the broader sector. But CS also notes that last time Downer incurred a project write-off, an average 45% discount remained in place for a year.

Analysts are also assuming there will be a capital raising eventually. To not require further capital would imply no further big contract wins, so its a bit of a lose-lose either way.

Downer remains at a 6/4/0 Buy/Hold/Sell ratio in the FNArena database with an average target price of $6.40 from the ten brokers. RBS Australia must still be shell-shocked as no post-announcement review has been forthcoming as yet. RBS was the only broker without a Buy rating previously, and its $8.04 target is slightly distorting the average.

Those retaining Buy are doing so with caution, unable to dismiss the big drop in share price. Those now on Hold simply cannot bring themselves to recommend Buy now that good old-fashioned Downer uncertainty has reared its ugly head once more.

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