Is Downer’s Valuation Becoming Stretched?

This story features DOWNER EDI LIMITED. For more info SHARE ANALYSIS: DOW

Infrastructure, engineering and mining contractor, Downer EDI, has won a major contract for Sydney trains. Brokers mull over the growth potential ahead.

-Rail projects likely to drive a positive outlook for earnings in FY18
-Over 55% of revenue now generated from servicing public infrastructure
-Yet several brokers consider the stock's valuation is stretched

By Eva Brocklehurst

Infrastructure, engineering and mining contractor, Downer EDI ((DOW)), has won a second major contract out of the three large Australian public sector projects recently up for grabs. The Sydney growth trains contract is worth $1.7bn and follows the contractual close of the Victorian government's $2bn high capacity metro project, with Downer part of the Evolution Rail consortium.

The Sydney growth trains contract includes an order of 24 double-deck trains with options for up to 45 additional sets and maintenance of the trains for an initial period of 25 years, plus two optional five-year extensions.

Macquarie believes rail will drive a positive outlook for Downer's earnings in FY18 and the long-term maintenance business from this latest contract is the main prize. Macquarie estimates $30-40m in potential maintenance revenue per annum once the trains are built. The broker believes this latest win fits well with the company's previous win in Victoria and the Newcastle light rail, providing a solid foundation for growth in the rail business going forward.

The broker also envisages this latest contract with Sydney trains has a much lower risk than the prior troubled Waratah contract. Macquarie considers the sale of the power asset, Ausgrid, provides an opportunity for Downer from the potential outsourcing of power/utilities maintenance in NSW. The broker retains an Outperform rating.

Credit Suisse takes the opportunity to review assumptions and notes the company has positioned itself well for a move away from the challenged mining and engineering, construction & maintenance sectors.

Over 55% of revenue is now generated from servicing public infrastructure customers in Australasia and this should increase as more government spending is directed towards infrastructure. The company maintains strong cash flows and this should contribute to a further strengthening of the balance sheet, leaving plenty of head room for capital management and further M&A.

Yet, quantifying the earnings turnaround is difficult, the broker asserts. Arguably, recurring public infrastructure and maintenance work should warrant a higher multiple, but with a 44% lift in the share price after the FY16 result, and the stock trading at around 16 times forward consensus earnings per share, Credit Suisse believes there is more risk to the downside. The broker considers, despite a strong balance sheet and capacity for growth, the valuation is stretched.

That said, Credit Suisse does not discount the leverage the new contract wins provide for continued expansion of trading multiples. For example, if the Adani Carmichael mine is developed with Downer as a contractor, this could add up to $0.50 per share to valuation.

The broker remains reasonably confident in the sustainability of earnings, yet given the material re-rating post the FY16 result, downgrades the stock to Underperform from Neutral. Credit Suisse contends that the business still needs to prove the earnings multiple inherent in FY19 forecasts.

Deutsche Bank notes the manufacturing of the trains is being sub-contracted to CRRC and Downer will not generate much income from that part of the contract. The broker estimates project management will provide $50m revenue per annum for two years and the maintenance work will provide around $30m in revenue per annum once all trains have been delivered.

Delivery of Australian passenger trains has usually suffered significant cost increases and been unprofitable for the contractor but the broker suspects this one is probably lower risk, given it will be based off the last recently-delivered passenger train. Deutsche Bank adds around 1% to earnings per share forecasts for FY17-21. The broker considered the risk/reward is balanced and retains a Hold rating.

Morgan Stanley envisages the project is relatively low risk for Downer, as JV partner CRRC is accountable for train construction and Downer is assuming a project management and maintenance role. Still, the contract means little in the way of a short-term uplift for earnings.

The broker is also inclined to the view that with the stock now trading on its highest price/earnings ratio ever (16x) and with no known significant catalysts for upside ahead, there is risk to the downside. Morgan Stanley retains a Equal-weight rating.

FNArena's database shows two Buy ratings, three Hold and one Sell (Credit Suisse). The consensus target is $5.42, suggesting 9.3% downside to the last share price. Targets range from $4.01 (Morgan Stanley) to $6.40 (Macquarie).
 

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