Rail Disaster

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

By Greg Peel

“Downer management has seemingly not learned the lessons from recent history,” notes a terse Credit Suisse. “The new management team has now been at the helm for over two years. This should have provided ample opportunity to assess the risks (both financial and execution) of the Rail PPP contract. Importantly, the quality of its order book and contract execution has again proven inferior to its peers”.

Yesterday Downer EDI ((DOW)) dumped an announcement on an unsuspecting market that saw its share price trashed by 27%. For the most part, this hammering represented a complete evaporation of confidence in a company that had recently begun a slow road back to market faith.

Downer announced that $190m has been shifted on the balance sheet to a provision representing the expected loss on the Waratah public/private partnership (PPP) rail project with the NSW government, and another $70m asset impairment charge has been taken against assets held for sale, customer contracts and goodwill. Of the $190m, $40m is included for additional contingencies, which suggests to Macquarie at least some conservatism is being used.

Downer management attempted to put a brave face on it, suggesting provisions would be taken out of working capital and thus will not impact cash earnings, that debt covenants are not under threat, and that otherwise there was no material change to its 5% FY10 earnings growth guidance. But at the same time, it was noted Downer's Rail CEO would leave the business on July 1.

The announcement shocked analysts, as it appeared the previously troubled Downer had finally turned the corner. It was only two weeks ago the company announced the biggest mining service contract in Australia's history at Fortescue Metals' ((FMG)) new Christmas Creek iron ore project. Analysts noted the stock was then trading at a 30% discount to rival United Group ((UGL)) and a 20% discount to the All Industrials, despite having already “sold” 70% of its contract capacity for FY11 and 50% for FY12. It was enough for nine out of ten FNArena database brokers to rate Downer a Buy. It was enough for a now chastened journalist to write Upside For Downer.

Moreover, management has continued to inform the market that the Waratah train project was “on track”. On the announcement of the Fortescue contract, analysts noted the Waratah trains were now undergoing late-night testing on the Sydney network, suggesting a “roll out” was not too far off. But now this.

GSJB Were notes the trigger for the provisioning was a project review which is typically taken around this time of year and prompted by the project having reached 30% completion. That said, this was no minor adjustment.

The announcement “comes as a surprise,” says Macquarie, “given that existing design/delay issues were understood to be already factored into prior allowances and contingencies”. It “goes against previous management assurances,” notes BA Merrill Lynch. And “After repeated confirmation from Downer management that the PPP contract was tracking to revised time and budget, extreme investor disappointment was evident”.

Indeed – 27% of it.

Citi went on to note the provisions relate to design and procurement cost overruns, and “highlights Downer's inability in pricing risk. While this is a legacy contract and Downer has since approved its risk management, the limited visibility Downer had of the cost overruns calls into question the adequacy of its risk management systems”.

In short, it was up to group CEO Geoff Knox to admit yesterday that a detailed external review found the cost position on the PPP is far worse than Rail CEO Guy Wannop had previously suggested, JP Morgan notes.

Prior to yesterday, nine of ten FNArena database brokers had a Buy rating on Downer, with RBS on Hold. Seven brokers have reviewed their positions this morning, but only three have downgraded so far. Downer's average target price has nevertheless been slashed from $9.23 from ten brokers to $6.21 from seven brokers this morning.

The reasons for the target slash are largely an across the board downgrade of forecast earnings (brokers are not completely buying the “no risk to guidance” story) and a significant sentiment slash to apply a confidence discount. It will be a long while before the market recovers from this one.

The reason only three brokers downgraded from their Buy ratings is the 27% drop – overdone in most opinions, if not understandable. At $6.21 there is still significant upside from the current share price around $4.70. But there are two problems analysts remain wary about.

One is that Downer was already approaching the topside of its gearing target, and although covenants may not be threatened that target should now be breached. This comes at a time when analysts had just noted the big Fortescue contract was capital intensive, but that a capital raising was probably not necessary given the strong state of Downer's balance sheet. It ain't strong no more. And yesterday management would not rule out a capital raising in light of the new provisions.

Secondly, the Waratah PPP is only 30% complete. What else is going to happen from here? Even if this is the last of the cost bombshells, shattered investors will be too scared to take the risk.

For Downer, all credibility is shot. As Merrills suggests, Downer is now “value for the brave”.

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