Can Diversity Save Downer?

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

-FY16 drop in profit forecast
-Rail projects key catalysts
-Could stock be a target?
 

By Eva Brocklehurst

The upcoming twelve months were always going to be a challenge for Downer EDI ((DOW)) but brokers are of the opinion it may be even worse than previously surmised.

The company may have the ammunition to withstand the onslaught better than its broader peer group but as Morgan Stanley argues, this is not that compelling. The scope for further cost reductions is limited and acquisition capacity increasingly constrained. The remaining advantage the company has, diversity, may not be enough.

Downer’s guidance for FY16 suggests a 10% fall in net profit and Citi maintains, given the uncertainties, the company has been prudent. The broker points to a quality management team which has a track record of only communicating what it believes is achievable. Increased visibility as FY16 gets underway should enhance confidence in guidance.

What the guidance signals to Morgan Stanley is that the decline in engineering and construction capex is unprecedented. The broker is optimistic the company can derive significant growth from utilities and rail segments, should it be successful in securing its share of the upcoming work on offer.

Still, these opportunities are long dated and unlikely to contribute until FY18. Meanwhile, substantial LNG work will roll off in FY17-18. Morgan Stanley observes, with the exception of the Wheatstone contract, most of the construction work currently on the order book is small-scale.

This may change if the company wins the $800m passenger rail tender in NSW or a similar sized bid in Victoria. Nonetheless, this then brings to the fore memories of the bungled Waratah train project. The scale of these projects could stretch the company’s resources too far in the event it secures more than one of the contracts on offer, Morgan Stanley warns.

Citi is inclined to the view the benefits of diversification should help soften the blow from the resources and energy industry slowdown, which is having a worse impact on the company’s peers. In any case, a robust balance sheet and strategic alignment to growth projects sets the broker wondering whether the company is a potential target for acquisition.

Citi also believes too much focus on the short term could prove short sighted and upgrades its recommendation to Buy from Neutral. The broker maintains the market is factoring in a view that Downer will be unsuccessful in all the three major rail tenders that are on the table.

Macquarie, too, is upgrading to Outperform from Neutral, suspecting the stock price reaction has been too harsh. The market appears to be ignoring the options in the balance sheet with $400m in capacity to make acquisitions or buy back stock. While FY16 carries a higher than usual degree of earnings risk the company’s track record stands it in good stead, in the broker’s opinion.

The fact that the FY16 outlook implies substantial underlying earnings declines cannot be overlooked and UBS goes the other way, downgrading to Neutral from Buy. The broker remains attracted to the strong balance sheet, with related opportunities such a buy-backs and further accretive acquisitions, but assumes there is little or no earnings growth for the next two years.

There is only so much that can be done to prevail in a deteriorating environment, despite the competence of management, in Deutsche Bank’s opinion, and a Hold rating is considered appropriate at this juncture. This broker also emphasises the power and rail opportunities will be unlikely to contribute until FY17-18.

JP Morgan considers the stock oversold, noting the market ignored the cash flow conversion to earnings of 100%. The result has more implication for stocks leveraged to resources construction and the broker believes Downer’s exposure is less than 10% of revenue. Hence, an upgrade to Overweight from Neutral.

On the resources exposure issue, Credit Suisse is concerned diversification and cost cutting are not progressing quickly enough to mitigate the impact of the mining-exposed end markets. The broker awaits hard evidence of a turnaround before becoming more constructive.

Also, Credit Suisse observes bid costs for the three light rail projects have not been considered in FY16 guidance and the company’s forecasts could be stretched. Longer term, aggressive price tendering or a “win at any cost” is an emerging risk and this may support near-term earnings at the expense of subsequent years.

With four ratings changes in place FNArena’s database now has four Buy ratings, three Hold and one Sell (Morgan Stanley). The consensus target is $4.45, signalling 10.2% upside to the last share price and compares with $4.75 before the results. The dividend yield on FY16 and FY17 estimates is 5.9% and 5.8% respectively.
 

Find out why FNArena subscribers like the service so much: “Your Feedback (Thank You)” – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms