Treasure Chest: Downer EDI Set To Re-Rate

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

-Earnings outlook is robust
-Net cash seen late 2014
 

By Eva Brocklehurst

Downer EDI ((DOW)) may have strengthened recently but CIMB thinks there's more upside to come. The broker thinks the move off the lows related to the problems in the past with the Waratah train construction does not capture the near-term outlook. The company boasts a robust balance sheet, improved operations and recurring work that's higher than peer averages. The stock is primed for re-rating in CIMB's opinion.

It adds up to potential for further share price appreciation over coming months. CIMB expects Downer to reach the FY14 profit guidance of $215m but thinks estimates for FY15 are too low. Upgrades for FY15 should drive the re-rating. Downer's operating cash flow has contributed strongly to the balance sheet metrics in the past two years and this will be helped by the release of working capital on completion of the Waratah project. After August, CIMB expects a net cash position and this improvement in the balance sheet is worth 9% to the equity value, without any consideration of what the capital will be used for. Between the Waratah working capital release and strong operating cash flow the FY15 net interest expense is expected to fall around $20m. The broker does not think this is being captured in many forecasts. The reduction in net interest expense is worth $14m to net profit, on the broker's estimates.

Even if the resource capex reduction cycle has another 18 months to run, which the broker believes it might, Downer is well placed to grow earnings. The company has won a range of jobs which should add around $520m to incremental revenue in FY15. The CEO has stated work-in-hand has increased to $19.6bn. Restructuring costs have primarily been in rail and mining and CIMB does not expect these to be repeated in FY15. Eliminating such costs should add $30m to earnings in FY15. The broker does not think there will be a significant benefit to the mining divisions performance from the cuts to costs, given the higher-than-expected margin in first half result.

However, rail should demonstrate an improved performance as a result of cost cutting so far. Employee numbers are down 300 in this division and the broker expects another 100 will go. The reduction in costs of employment is expected to add up to around $20m, equating to  $14m in profit. In aggregate, such benefits would total 30% growth in profit but the broker is not expecting all this will fall to the bottom line. Negative offsets are the mining margin, expected to fall 1.2 percentage points, and some allowance for completion of jobs. Reflecting the assumptions the broker forecasts FY15 profit of $220m and total shareholder return of more than 20%. The numbers may not line up exactly, but the broker thinks the strength of the factors at play will contribute to profit growth in FY15 that will reveal current consensus forecasts are too low.

The company's cash conversion has steadily improved and CIMB thinks this is a function of both strong cash management and client approval of the company's work, reducing net debt and interest expense. In sum, the broker considers, with the company trading on forecast enterprise value/earnings multiple for FY15 of 5.85 times an upgrade to earnings forecasts for FY15 will result in a re-rating. The catalysts to drive this outcome should appear in the third quarter of 2014. The risks to the forecasts include a shift by larger miners to more in-house operations, downsizing or cancellation of projects in both the private and public sectors and offshore players entering the market providing increased competition.

Macquarie also recently reiterated a positive view. The broker considers Downer stands out from its peers in that earnings are less skewed to the second half and there are strong cash flows and balance sheet, with gearing to fall to 10% in FY15. This all adds up to potential capital management and/or acquisitions. Macquarie notes rail remains the toughest division for Downer but the company has diverse business to offset this. The broker observed some lag in revenue as WA resources work fell away and new work in oil & gas and other parts took over. Still, the company has picked up what Macquarie thinks is a good share of available work in the last six months, including $400m at Wheatstone, $100m in Sydney road maintenance, $80m at Burrup and $100m at the Whitehaven ((WHC)) coal handling plant.

There are seven Buy ratings on the FNArena database and one Hold (Credit Suisse). The consensus target is $5.81, suggesting 16.1% upside to the last share price. Targets range from $5.20 to $6.20. The consensus dividend yield on FY14 forecasts is 4.7% and on FY15 forecasts is 5.5%.
 

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