Downer On A Firm Road

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

-Progress on reducing risk, fixing problems
-Limited exposure to mining capex downturn
-Biggest opportunity in Qld, NSW road work
-Potential for acquisitions
 

By Eva Brocklehurst

Downer EDI ((DOW)) has impressed brokers with progress on improving risk management, fixing problems with project execution and solidifying the balance sheet. The engineering services provider updated brokers in a briefing recently and reaffirmed FY13 earnings guidance of $370 million. Most tweaked earnings expectations to the downside for FY13 and FY14, citing the challenging conditions in contract mining and lack of certainty in infrastructure markets. Despite the current climate, brokers were confident that Downer was one of the best placed contractors, with limited exposure to the impending decline in large-scale mining and energy capital expenditure while in line for the opportunities in government outsourcing.

The company has re-established its investment grade status for BA-Merrill Lynch and is now the broker's top pick in the sector. Merrills thinks combining the Australian and New Zealand infrastructure business units should allow for more cross-selling opportunities and efficiencies in a division that has historically underperformed peers. For Merrills the risks now lie with contract mining and freight rail. These are are the most exposed to a reduction in bulk capital expenditure and cost reduction strategies. Management has revealed a diminishing contract mining tender book and lower sales for locomotives, which is consistent with the broker's view.

Despite the downturn, management believes the contract mining business is strong. The order book still has in excess of $6 billion and an expected earnings margin of 7-8%. Brokers see this as the benefit of three years of a strategy to be more diverse in exposure while remaining cost competitive. Citi notes Downer has had no contract terminations, other than Peabody which was at end of life, and the renegotiation of the BHP Billiton ((BHP))/Mitsubishi alliance contracts are expected to be completed shortly. Revenue growth in FY14 is expected to be challenging but the broker flags the fact Downer is tendering for contracts worth $400m per annum, which supports a return to growth in FY15 earnings forecasts.

Management believes the biggest near term opportunity is the Queensland and NSW road work. Combined, this represents around $35 million per annum in potential revenue. Contracts are to start being awarded in 2014. Citi highlighted the growth potential in road maintenance, viewing it as a $2 billion per annum revenue opportunity if NSW and Queensland increase outsourcing in line with Victoria and Western Australia. Merrills has flagged the benefit, discussed by management, of operating asphalt recycling. Producing recycled asphalt is cheaper than using virgin material. Taking a cost perspective, 50% of road maintenance cost is asphalt and Downer captures 10% of cost savings by using a recycling plant. As well, Downer will receive green grants on building a recycling plant, reducing capital costs. This should give the company a competitive advantage over incumbent peers.

JP Morgan observed management is considering acquisitions, given the financial position the company is now in. This won't come easy, as the focus is on securing financial as well as competitive advantage. Management is intent on broadening capability rather than bulking up in core markets. Moreover, the company wants to avoid buying bad contracts and remarked on the low level of transparency in the accounts of potential targets.

JP Morgan flags the opportunity and desire to grow offshore revenue to 20% of group revenue, although management acknowledges entry into Asia is difficult. Goldman Sachs, noting CEO Grant Fenn said there were capability gaps he'd lie to fill, thinks the company could be considering increasing the geographic footprint internationally, as well as more scale in industrial maintenance. Macquarie found this bit interesting as well, seeing potential in expansion of the tyre management business from Latin America/Africa.

Credit Suisse came away more positive and upgraded the rating on the stock to Buy from Hold. The broker found the hard work over several years has paid off, although concedes there are no new major contracts to act as catalysts. Nevertheless, Credit Suisse believes Downer is now one of the better positioned in the contracting area and has limited exposure to the pending decline in large-scale resources and energy capex. Additionally, it is now among the largest asset maintenance companies in Australia, with over 70% of revenue from recurring activities. Rail and infrastructure legacy issue have been rectified and the broker now finds the company has a compelling valuation as a de-risked business with a 5% dividend yield.

FNArena's database reveals seven Buy recommendations and one Hold (Macquarie). Macquarie replaced Credit Suisse's former Hold position on the database, downgrading the stock to Hold from Buy. While acknowledging the company is navigating the current environment well, Macquarie finds FY14 a bit uncertain. The broker is forecasting a 2.2% revenue decline in FY14, resulting in a flatter earnings profile, and believes upside to FY13 guidance is unlikely. Macquarie believes Downer has a number of near-term contract opportunities, such as electrical work on Wheatstone and Ichthys, NBN work and $1.5bn in mining work under bid but most of this is likely to be of benefit in FY15 rather than FY14.

The consensus target price is $5.77, suggesting 23.9% upside from the last share price. The dividend yield based on consensus FY13 forecasts is 4.8% and rises to 5.3% for FY14.

See also, Downer Reveals Value In Diversification on April 9 2013.
 

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