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Downer A Sector Stand-Out
FNArena News - September 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.

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