Downer Well Placed To Tough Out FY14

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

-Balance sheet now an asset
-Capital management options in view
-Potential in government outsourcing
-Valuation discount unwarranted
 

By Eva Brocklehurst

Downer EDI ((DOW)) has some pretty nasty headwinds. The company's mining services businesses have felt the chill from a substantial reduction in resource sector investment. In delivering the FY13 results the company pointed to a stable FY14, quietly confident that the losses in mining related revenue can be offset from other sources.

What stands out for Macquarie is that Downer has shown in the past that guidance is realistic. That does not mean there aren't risks but the company is seen delivering and the management team hard to fault. The Fit 4 Business program, with a focus on site productivity and equipment optimisation, has delivered $250m in cost savings and another $125m is targeted for FY14. This is required to offset the impact of declining revenue. It's tough though. Not only are there reductions in mining capital works but also budgetary constraints for government expenditure on road and rail. The company is aided by its diversity and high level of recurring earnings. The under geared balance sheet is also a big turnaround from a few years ago.

BA-Merrill Lynch thinks the balance sheet has moved to be an asset from being a burden. Gearing is expected to reduce rapidly and the company should be in a net cash position by FY15. This then places Downer in a position to reduce the interest rate burden, financing with cheaper debt, and capitalise on value accretive mergers and acquisitions where they present. What is also a positive is the company has repaired problem projects and instilled greater risk discipline, which had previously weighed on profitability. Macquarie also sees upcoming options vis-a-vis capital management. Downer has said the focus on asset management is increasing and has mentioned selective offshore expansion in existing business areas.

The company's confidence in being able offset the loss of $200-300m in mining revenue in FY14 may be optimistic, according to Citi. Herein lies the greatest risk to FY14 earnings. The infrastructure division may be taking the helm from mining but, as Macquarie points out, this business has an inherent mid to late cycle bias in terms of electrical engineering. Rail earnings are under pressure, as evidenced by FY13 underlying rail earnings being down 20% year on year. Nevertheless, this could be the trough in Citi's view. Lower heavy haul locomotive earnings should be partially offset by increased freight maintenance and increased earnings from Telstra ((TLS)) infrastructure spending.

Where are the opportunities? Citi thinks the Wheatstone and Ichthys electrical and instrumentation engineering and possible iron ore mining at Roy Hill could support resource project earnings in FY15-16. Offsetting the decline in resources business should be government outsourcing, particularly in NSW and Queensland. There is a big opportunity in road maintenance from FY15. NSW and Queensland are expected to outsource around $300m of road maintenance from the fourth quarter this year. Catalysts for brokers include an update on NSW roads outsourcing contracts in September-October this year.The company also has diversified end markets which should help withstand the domestic downturn in civil and resources capex. Here, the 40% of services related work in hand, largely recurring, should provide the buffer.

The valuation discount that Downer trades at relative to peers is unwarranted in most broker views. The price/earnings ratio on FY14 estimates of 7.9 times means Downer is trading at a 12% discount to the sector. Credit Suisse lists several reasons why this should not be so. Earnings are expected to be more resilient owing to the company's weighted exposure to recurring work at around 70% of earnings. The business has been de-risked over the past 18 months and there is balance sheet flexibility, unlike many peers, with gearing below the targeted 25-35% range. From a valuation perspective Macquarie thinks the Australia/NZ business is a higher multiple than mining given the higher returns and less capital intensity. This transition to infrastructure earnings emphasis from mining could be positive in terms of the multiple the market is prepared to pay for Downer.

On the FNArena database the stock has eight Buy ratings. That's it folks. No Hold. No Sell. The consensus target price is $5.20, suggesting 35.4% upside to the last share price. The average target has fallen from $5.37 prior to the results. Price targets range from $4.65 to $5.63. The dividend yield on FY14 consensus forecasts is 5.9% and for FY15 it's 6.4%.

Is there a dark side? Morgan Stanley is not that confident the stock will ride out the storm. This broker believes, as conditions continue to deteriorate, that Downer shares will continue to trade lower as FY14 will be characterised by a reduction in resources capex and budgetary constraints from government. Moreover, the commentary suggested 30% of revenue is still be secured in FY14. Morgan Stanley is 5% below guidance in FY14-15 forecasts and remains Underweight on the stock, as the company faces the repercussions of excess industry capacity across its businesses. Having said all that, the stock is still preferred relative to domestic peers.
 

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