Downer’s Strength Lies In Cash Flow But Risks Remain

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

-Question of pay-out ratio arises
-Potential catalysts in upcoming contracts
-Margin pressure intensifies from competition
-Downer better relative to others in sector
 

By Eva Brocklehurst

Downer EDI ((DOW)) is consistent. Macquarie finds the mining services and infrastructure company hard to fault when it comes to maintaining cash flow. When FNArena reviewed the stock six months ago the company was confident that it could offset declining mining revenue from other sources. This has largely worked… so far. Macquarie observes the improved cash flow is a result of better collection systems and processes and fewer legacy problem projects. Hence the company is increasingly under-geared. Macquarie forecasts a near halving of gearing to 9% in FY15. This brings up the subject of capital management and/or acquisitions. The company is reticent about pursuing acquisitions in the current environment so capital management is foremost in brokers' minds.

Macquarie observes there are also plenty of potential catalysts from contracts, with bidding opportunities in Sydney light rail, engineering on the Ichthys project, contract mining and the oil & gas sector in eastern Australia. JP Morgan is also confident in management's ability to respond to the mix of challenges and opportunities, noting the pull back in resources capex took its toll on Downer Australia and on rail but strong execution in both mining and Downer New Zealand compensated as costs were taken out.

BA-Merrill Lynch sums up the results as a beat in mining revenue expectations offsetting a miss in infrastructure. Mining margin was a record 8.8%, delivered by cost control, the cessation of lower-margin contracts and the switch to finance leases from operating leases in some projects. Downer Australia's (infrastructure) revenue declined 18%, materially more than Merrills expected and largely because of major project work rolling off more sharply. Still, the broker notes work in hand has increased for the first time since FY12 and the infrastructure division should return to growth in FY15 and FY16.

The company's improved operations were the highlight for CIMB Securities. The broker thinks the business is improving significantly in the midst of a deteriorating operating environment. Okay, so investors prefer revenue-driven growth to cost-driven growth, but in the current environment the cost cutting is an important tool which CIMB thinks will stand the company in good stead. Downer EDI is the exception to the rule when it comes to owning contractor stocks in the current environment. CIMB expects a 20% return over the next 12 months, driven by some upgrades to earnings expectations, balance sheet improvement and a 5% dividend yield, which becomes fully franked in the next reporting period.

Now for a more negative stance. This comes from Morgan Stanley. The broker agrees that the company is outperforming its peers but thinks investors may be underestimating the underlying risks. The broker notes construction revenue is at multi-year highs and rail under structural pressure. The contract mining industry could be about to follow, in the broker's opinion. This adds up to earnings challenges which drives a risk to forecasts. The risk in mining lies with the scaling back of resources and with mining companies electing to cut costs by bringing work in house. Morgan Stanley estimates this has resulted in $1.2bn of surplus mining equipment in the Australian contract industry. As contract mining contributed 49% of earnings in the first half, the broker thinks the exposure is being underestimated. Moreover, as the engineering and contracting capex activity declines over the next two years, Morgan Stanley thinks the company will find it increasingly difficult to replace the work given intense competition for new contracts and falling bidding margins.

In summary, it's all about relativity. Downer is just a better bet relative to Leighton Holdings ((LEI)), Transfield ((TSE)) and UGL ((UGL)), which are struggling to maintain cash flow. Morgan Stanley has an Underweight rating. On the FNArena database there are seven Buy ratings and one Neutral – Credit Suisse. Credit Suisse comes closest to Morgan Stanley's view in emphasising a tough market, while considering the stock is fair value. The broker believes the earnings base is defensive against the broader sector, based on the progress in cost savings and productivity gains, but there is limited upside amid significant headwinds that have become more apparent from this result. The infrastructure tender market remains highly competitive and there's pressure on margins.

Locomotive maintenance services face severe headwinds as customers defer fleet maintenance and major overhauls. The extent of weakness in this area took Citi by surprise and, while some of the deferred spending is likely to return, the broker notes the timing is uncertain. Citi also questions the sustainability of mining margins and suspects these benefited from abnormally dry weather in the first half. The company expects to maintain mining margins in the second half and thinks these will trend towards 7-8% in the longer term. Citi considers the ramp up of Roy Hill a big contract that will help support mining revenue in FY15.

UBS believes Downer remains compelling value at current multiples and the anticipated balance sheet strength poses upside risk to the dividend pay-out ratio. This is the key re-rating catalyst in the broker's view. UBS assumes the 45% pay-out will rise to 50% in FY15 and to 60% in FY16. Deutsche Bank is disappointed that a capital return is not planned within the next 12 months but thinks the stock has a balance sheet that will see it through the current cycle. Moreover, the company has shown how it can grow with cost reductions. The valuation remains attractive to the broker and a Buy rating is maintained.

The FNArena database reveals a consensus target price of $5.78, suggesting 20.4% upside to the last share price. The dividend yield is 4.9% on FY14 forecasts and 5.7% on FY15. Price targets range from $5.20 (Credit Suisse) to $6.14 (JP Morgan).
 

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