Downer Under Pressure But Cashed Up

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

-Signals more owner-operator mining
-Pressure on mining earnings continues
-But opportunities for acquisitions
-And buy-back potential
 

By Eva Brocklehurst

Downer EDI ((DOW)) may be able to withstand the headwinds when sentiment turns sour but there are few places to hide. The stock received a drubbing after the company announced the contract for overburden removal and pre-stripping at Goonyella Riverside open cut coal mine, Queensland, has been terminated early by the BHP Billiton ((BHP)) Mitsubishi Alliance. Work was originally scheduled for completion in June 2016. Downer indicated the revenue impact on work-in-hand would be $360m, split between FY15 and FY16.

The reaction from brokers took in all angles. To Morgan Stanley the news is a signal the shift to owner-operator mining is beginning. The broker has calculated that with attractive equipment funding options it may be significantly more cost effective for miners to convert to an owner-operator model than to use contract miners. In the broker's survey, 70% of respondents indicated they would consider bringing contract mining in-house, with the remainder having already done so.

UBS estimates that coal mining operations represent 20% of Downer EDI's group earnings and, while the broker's forecasts had already assumed a 22% decline in mining earnings in FY15, they are lowered further to incorporate the loss of Goonyella Riverside. The company may be executing strongly, and oofer opportunities arising from a strengthening balance sheet such as earnings-accretive buy-backs and/or value-accretive acquisitions, but the pressure on mining revenue is mounting. This pressure is coming from miners taking work in-house and also reductions in the scope of works. UBS downgrades to Neutral from Buy.

Credit Suisse takes the same view, downgrading to Underperform from Neutral. In the absence of a material recovery in coal prices the trend to owner-operators is likely to continue more broadly and this implies a greater risk for contract mining earnings, says CS. The broker thinks the remaining BMA contract at Blackwater is likely to meet a similar fate prior to the FY16 renewal date and this loss would make future renegotiations problematic, particularly in the face of a commodity cycle which has passed its peak and excessive divisional returns. Negative earnings momentum means the potential for merger and/or acquisition is likely to be a focus point, in the broker's opinion.

Citi joins the downgraders camp, to Neutral from Buy. The broker thinks the mining industry has further to go with structural cost adjustments and has taken the opportunity to adjust long-range forecasts for Downer EDI's mining division to account for the risks that are inherent in a multi-year down cycle. That's not to say the broker is not positive about the prospects long term, as the company has a robust financial position and will be net cash in FY15. This should provide the means to supplement the growth profile at an opportune time. Still, the broker expects the share price will reflect the mining risks for the time being.

The news did not justify a downgrade, in BA-Merrill Lynch's opinion. The broker retains a Buy rating. Despite the difficult operating conditions in the coal market in Australia, Merrills only envisages minimal further downside risk from Downer's remaining coal exposure. Analysis of the company's order book shows only an additional $120m in contracted revenue – Blackwater – that the broker would assess as being at substantial risk of early termination over the next two years. On the other side of the balance sheet, the company's infrastructure pipeline is growing and Merrills believes this should offset near-term revenue pressure in mining. The broker considers the drop in the share price overdone.

CIMB is of the same opinion, believing the impact of sentiment on the stock is much greater than the actual financial impact. The broker made no cuts to forecasts, having built a buffer of 15 percentage points into revenue forecasts to allow for contract losses or termination. CIMB also observes that Blackwater is the only mine contract left in place with BMA in FY15. While it may sound glib to state the fall in the share price is a buying opportunity, CIMB believes it is just that.

JP Morgan also sticks with an Overweight rating. The company has a diverse order book and that is what matters, says JPM. Other work has recently been won and the broker cites opportunities such as the Adani contract, for which Downer EDI is bidding. Moreover, management has taken steps to stabilise the business and has the capacity to respond positively to the mix of risks and prospects. The broker believes the current discount to its $5.90/share valuation factors in potential near-term risks, without reflecting the stock's competitive advantages. Macquarie also highlights the prospects with Adani and lists some catalysts, such as reasonable FY15 earnings guidance, acquisitions and the buy-back potential.

On FNArena's database Downer EDI has five Buy ratings (compared to seven previously), two Hold (one) and one Sell (none). The consensus target price is $5.43, which compares to $5.87 ahead of the news and signals 15.8% upside to the last share price. The stock offers a 5.0% dividend yield on FY14 forecasts and 5.6% on FY15.
 

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