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Downer A Sector Stand-Out

Australia | Sep 19 2012

 – BA-Merrill Lynch reinstates coverage on Downer with a Buy
 – Attracted to improved balance sheet and exposure to diverse markets
 – Brokers assess the sector

By Chris Shaw

Having not covered engineering company Downer EDI ((DOW)) for some months, BA Merrill Lynch has re-instated coverage on the company with a Buy rating and $4.70 price target. This brings to seven the total number of Buy ratings on Downer EDI from brokers in the FNArena database, compared to a single Hold rating courtesy of UBS.

For BA-ML, part of the attraction of Downer at current levels is a strengthened balance sheet, as a combination of asset sales, solid execution and working capital management has left debt ratios well below covenant levels. As BA-ML notes, even allowing for the capital intensive nature of Downer's business, the improved balance sheet opens up scope for the resumption of dividends in FY14.

As well, Downer is moving beyond some legacy contract issues, something BA-ML expects will help boost returns going forward. A recent site visit gives greater confidence in this regard, as Deutsche Bank noted Downer has achieved some improvement in both production and quality at its Cardiff rail facility. This improvement led Credit Suisse to suggest there was potential for some new contract wins with the likes of Railcorp.

The other attraction for BA-ML is that Downer has a strong level of work in hand and operates in diverse end-markets. This means exposure to any one sector of the economy is limited. A particular advantage in Downer's case is there is less exposure to leveraged resources capex.

As BA-ML notes, only around 20% of Downer's work in hand is based on resouces capex, the remainder being split across contract mining at about 35% and and civil services and construction at around 45% of current work in hand.

Given Downer has had some issues with respect to project completion in recent years, which BA-ML notes prompted some changes to senior management positions in FY10, the consolidation of operating companies and a greater focus on risk management is comforting.

Execution remains a key variable for earnings, as BA-ML notes a 1% improvement in margins adds around 5% in return on equity terms. Such an improvement would lift Downer's returns to near the top of its peers on the numbers of BA-ML.

To adopt a conservative stance BA-ML has set its forecasts at the lower end of Downer's long-term averages. In earnings per share (EPS) terms the broker is forecasting 47c for FY13 and 53c for FY14, which compares to consensus EPS estimates according to the FNArena database of 47.5c and 52.5c respectively.

For Citi, a potential major downside risk to earnings for Downer EDI comes from the Australian construction sector. Developers and contractors have increased exposure to non-residential and engineering work in recent years, but these markets appear to be headed lower over the short to medium-term.

While in FY12 non-residential and engineering markets represented 75% of total construction work done, Citi's expectation is this market is likely to fall by at least 10% in FY13. Through FY15, engineering and construction spending growth ex-resources is expected to remain relatively flat, reflecting a winding down of government stimulus and a lack of private sector appetite for major projects at present.

This softer outlook in infrastructure and non-residential markets has seen Citi trim earnings forecasts in coming years for the likes of Downer, Leighton Holdings ((LEI)) and Lend Lease ((LLC)), with price targets also being reduced accordingly.

Citi's target for Downer has come down to $4.44 from $4.48, which is below BA-ML's $4.70 price target. The consensus target for Downer according to the FNArena database is $4.47, targets ranging from UBS at $3.85 to $5.02 for RBS Australia.

For BA-ML the stock offers value at current levels, as the broker's earnings estimates imply earnings multiples for the stock of 7.7 times in FY13 and 6.8 times in FY14. Other in the market agree, as in the view of RBS Australia balance sheet concerns for Downer are overdone, meaning the market is undervaluing the stock.

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