Downer Reveals Value in Diversification

This story features DOWNER EDI LIMITED. For more info SHARE ANALYSIS: DOW

-Road maintenance, infrastructure key to growth
-Electrical, Instrumentation prospects in LNG
-Waratah train contract could be extended
-No problems so why are shares sold off?
 

By Eva Brocklehurst

Diversified engineering services provider, Downer EDI ((DOW)), shows just how valuable being "diversified" is in the current economic climate. Often conglomerate companies encounter difficulties in good times, spreading too thinly trying to take advantage of many opportunities. Now, with some areas of the economy sustaining soft conditions, Downer still has plenty of work.

Road maintenance and infrastructure are the stand out categories for growth that Citi has identified. NSW and Queensland are outsourcing more road maintenance and these two states account for 60% of the market. At this stage, they outsource just 20%. Citi views this as a $2 billion per annum revenue opportunity for Downer if these two states raise outsourcing to the level of Victoria and Western Australia (70%). Downer has a 30% market share in this area. Citi acknowledges that NSW and Queensland have talked about outsourcing more road maintenance for some time but suspects that fiscal pressure, and new hands on the tiller, may now provoke the required action.

Downer's Infrastructure Australia should be able to increase earnings margins to 5% by FY15 against the 4.4% sustained in the first half of FY13, according to Citi. This should reflect the benefits from the full integration of engineering and works, cost savings and the rolling off of loss-making projects. On the resources side of things, Downer's earnings should be supported by involvement in the most active segment – LNG. JP Morgan concurs, finding Downer's leading position in electrical and instrumentation (E&I) should help the company pick up more work in LNG as projects approach this phase of construction. The broker also flags Downer's success on the NBN and the broader opportunities in telecommunications and renewable energy that can provide work in the E&I area.

There are risks of course, as contract mining is under pressure and there are margin pressures with rail. Miners are cutting operating costs by reducing overburden removal and strip ratios and cutting ancillary services. Citi notes this has resulted in margin pressure for Downer. In response, Downer is improving plant utilisation and cutting its own overheads. JP Morgan also thinks the exposure to iron ore and coal mining, despite the slowing in Chinese economic growth, will still prove supportive to Downer. The development of the Roy Hill iron ore mine, for which Downer EDI is bidding on earthworks and E&I, should provide a $1.2 billion opportunity, in Citi's opinion. 

JP Morgan recently upgraded Downer to a Buy, citing the fact the company had made progress in stabilising its business, particularly the Waratah train project. Train delivery schedules are on track and, based on current production in Cardiff and in China, JP Morgan expects Downer can deliver all 78 sets required by mid 2014. There is potential upside here. Under the terms of the original contract between Reliance Rail and the NSW government there is an option for extending delivery by 20 trains. This option expires this month. JP Morgan believes the government may choose to extend the delivery outside of Reliance Rail (the public/private participation vehicle). As Downer EDI has been able to solve the problems with manufacturing and design that weighed on the Waratah project originally, the broker believes any extension order could provide earnings upside.

More positives? There has also been a significant improvement in profitability and a return to headline revenue growth for Downer New Zealand, reflecting momentum on Christchurch rebuilding and new work in major telecommunications. Both brokers see a valuation gap emerging, with JP Morgan observing that, since the beginning of March, the share price has fallen 17%, in line with peers. Downer returned to paying dividends in the first half, with a 10c interim payment, partly franked. This was substantially more than JP Morgan had expected and the broker sees no impediment to regular dividends with some level of franking.

On Citi's number crunching, Downer has capacity for $250-400m in bolt-on acquisitions by FY14, based on gearing around 25-30%. The stock may have a poor history of returns but the broker still thinks the return on investment and return on equity should increase to 13.7% and 12.9% respectively in FY14. Downer's performance historically has been clouded by problematic contracts but the problems with Waratah trains and Curragh coal no longer present. Also, Citi hails the better risk management that's now in place. So why should Downer be cast in the shade along with sector peer Leighton Holdings ((LEI))? JP Morgan believes there are no stock-specific issues at present for Downer, while Leighton is facing corporate governance concerns. It must all be to do with blanket downgrading of the sector.

Citi and JP Morgan are wholeheartedly in the Buy camp, along with five others on the FNArena database. The only other recommendation is a Hold from Credit Suisse. The range of price targets is $5.55 to $6.40 with the consensus target of $5.88 suggesting 21% upside to the last traded share price. Dividend yield is 4.7% based on consensus FY13 estimates and rises to 5% for FY14.
 

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