Brokers Query Downer’s Push On Spotless

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Infrastructure and engineering services contractor Downer EDI has made a play for facilities manager Spotless Group and several brokers are unconvinced about the move.

-Likely to take time to turn Spotless around and integration risks high
-Brokers question the raising of capital, lack of due diligence as a pre-condition
-Downer may re-visit the sale of the Spotless laundry division
 

By Eva Brocklehurst

Infrastructure and engineering services contractor Downer EDI ((DOW)) has confirmed its interest in taking over facilities manager Spotless Group ((SPO)). Brokers appear unconvinced about this fork in the company's expansion strategy.

Deutsche Bank is wary of the proposed acquisition, given weak operations at Spotless and deteriorating market conditions. Moreover, no due diligence will be undertaken by Downer and the integration risks and cost synergies look high.

While Downer's management has had reasonable success in achieving cost reductions in other acquisitions, the broker notes Spotless has already been through a significant cost cutting exercise and, therefore, the potential for further reductions is low. From the Spotless perspective, Deutsche Bank considers the $1.15 cash offer an attractive exit price.

Credit Suisse also finds it hard to come to grips with the rationale for acquiring Spotless, as Downer acknowledges the acquisition is about growth rather than synergies, although $20-40m in cost synergies will be targeted over time. The broker is sceptical about growth for growth's sake and also questions the large premium in the bid, the lack of due diligence as a pre-condition and the raising of such a large amount of capital for the deal.

There are material and numerous risks in the broker's view, despite the conditions Downer has set for the deal to progress. The broker acknowledges an argument that management is moving on Spotless at a time when all bad news maybe incorporated into the price and there is a decent chance of turning the business around.

Yet, final judgement on whether the deal was right may only be forthcoming in years from now. Credit Suisse concludes it is fair to give management a chance to prove a difficult investment story can be turned around but remains less than enthusiastic. Hence, the broker sticks with an Underperform rating for Downer.

Downer's Intentions

The company intends to diversify into services and recurring revenue areas such as catering and facilities management and away from construction. Macquarie observes Downer has already started on this journey via its 2014 acquisition of Tenix. The move also enhances the company's government/public exposure and broadens services to existing government customers.

Macquarie downgrades to Neutral from Outperform as this looks to be an opportunistic diversification and the deal size is larger than expected. There is reasonable accretion for earnings per share and the acquisition is consistent with a increased emphasis on services, but the broker believes this needs to be balanced against the higher gearing and the execution risk regarding the turnaround of Spotless.

Macquarie acknowledges Downer has an excellent base business and good record of integrating acquisitions. Nevertheless, Spotless is larger in size and broader in scope and the uplift in earnings per share is expected to be accompanied by a de-rating for the combined business.

The main focus for the near term will be gaining comfort on the Spotless acquisition. Macquarie suspects Downer considers Spotless as a lower-risk play with a stretched balance sheet and little or no revenue growth. The broker envisages relatively low risk of another bidder emerging but believes it will take time to turn Spotless around.

Laundries

Spotless ran an indicative process to sell its laundry business last year but no sale eventuated. Laundries have been a deterrent to potential buyers from offshore and Macquarie suspects Downer is likely to revisit a potential sale of that division.

Business development investment is unlikely to bear fruit until FY18 and revenue remains under pressure in the near term, the broker suggests. The company has identified underperforming or low margin contracts but an exit is expected to take up to 2-3 years as contracts mature.

Macquarie downgrades Spotless to Underperform, after the share price rallied 49% in one day. The broker recommends investors sell into the bid, which is subject to conditions and has a relatively low risk of another bidder emerging.

In the wake of the bid, Ord Minnett upgrades Spotless to Hold from Lighten. Although the potential for higher bids is limited, the broker considers the current transaction has a good probability of proceeding. The main threat is any downgrade to Spotless' net profit guidance, the maintenance of which is a condition of the deal.

The Deal

Downer now owns 19.99% of Spotless, with 15% recently acquired at $1.15 per share. The company has made an all-cash offer to acquire 100% of the company at $1.15 per share, which is a 59% premium to the pre-bid closing price.

This is conditional on 90% minimum acceptance and no reduction in the Spotless FY17 earnings guidance of $80-90m. Spotless recommends shareholders take no action in relation to the bid at this stage. A definitive recommendation will be provided in due course.

Downer has also announced a fully underwritten $1bn equity raising to fund its potential acquisition. The renounceable entitlement offer has a price of $5.95 per share, around a 20% discount to the closing price on March 20.

There are two Hold ratings and one Sell rating on FNArena's database for Spotless. The consensus target is $0.89, which signals -15.2% in downside to the last share price. This compares with $0.74 ahead of the announcement. Targets range from $0.63 (Deutsche Bank) to $1.10 (Macquarie).

For Downer there are four Hold ratings and one Sell rating. The consensus target is $6.04, suggesting -18.6% in downside to the last share price. This compares with $6.33 ahead of the announcement. Targets range from $4.01 (Morgan Stanley, yet to comment on the bid) to $7.70 (Citi, also yet to comment on the bid).
 

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