Further Re-Rating For Downer?

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

Several rail contracts are about to be awarded and success on any or all of the tenders could be a catalyst for re-rating Downer EDI, brokers note.

-Quality of DOW's FY16 result bodes well for FY17
-M&A opportunities and capital management potential
-Still facing decline in mining & construction earnings
-Expanding role in the defence supply chain

By Eva Brocklehurst

The outlook for Downer EDI ((DOW)) is firmly planted in the award of several large rail contracts, which promise to underpin a re-rating of the stock if won.  The company is a front runner on three rail contracts, likely to be awarded in the first half.

The strong second half of FY16 was supported by cash flow, which suggests to Ord Minnett the quality of the result is high and bodes well for FY17. The stock closed 8% higher after the report and the broker believes, given it is still trading at a discount to peers of 23% on FY17 multiples, there is room to run further.

Ord Minnett acknowledges a back flip in its recommendation, upgrading the stock to Buy from Lighten. The broker estimates Downer EDI could spend around $550m on acquisitions and still keep gearing below 20%.

The main risk to broker viewpoints is the fact the company is still facing a decline in mining and construction earnings, with LNG construction finishing up a year’s time. Ord Minnett forecasts earnings in FY18 to dip as well – FY17 is expected to be lower – before the company starts to grow again. With a declining earnings profile investors are not expected to rush back into the stock but the broker asserts the multiples appear too low, relative to peers.

Credit Suisse concurs, expecting further diversification should drive a re-rating of the stock. Yet, while envisaging value in the medium term, the broker suspects investors may prefer to wait for a bottoming of contract mining earnings before appropriately recognising the value.

Over 55% of the company’s revenue is generated from servicing public infrastructure in Australia and New Zealand. This percentage is expected to increase as the business emphasis moves to transport, utilities and communications and away from mining. Credit Suisse also suggest recurring public infrastructure and maintenance work should warrant a higher multiple.

The broker believes FY16 results suggest the bear case scenario is unlikely to materialise and, besides contract mining, all divisions should deliver a modest improvement in FY17. The broker expects tight cost controls and strong operating cash flow will allow the balance sheet to return to a net cash position over the next 12 months. This will provide the opportunity for capital management and/or mergers & acquisitions, both potential catalysts.

The company is still not in the clear, Morgan Stanley contends. Mining and engineering represented around 48% of earnings in FY16 and the broker expects this segment to continue to pressure the earnings profile. Earnings from Fortescue Metals ((FMG)) will cease from September this year and margin pressure in contract mining is expected to increase. Work on Gorgon rolls off in FY18 and Wheatstone finishes in FY18-19.

The broker also maintains that should Downer fail to win the three rail projects, it could result in $25m in bid costs being expensed in FY17. Still, the outlook is better than Morgan Stanley previously perceived and the margin continues to surprise modestly to the upside. The broker’s base case is for a flat earnings outlook through to FY19 but the next six months is expected to be the litmus test for earnings, given the bidding profile.

The results confirmed for Macquarie that the company is the best in its sector. The guidance suggests the transition from resources to more infrastructure and services is bottoming out. For this to convert to growth now depends on the outcomes of the rail contracts.

The broker believes Downer EDI is best placed on the Sydney rail contracts, with $2bn in NSW InterCity contract awards expected in the September quarter and the $1bn suburban rail passenger contract to be known in November. The $3bn Victorian rail contract outcome is also expected this month.

Macquarie also notes Downer is seeking to expand its role in the defence supply chain and the company is one of the few Australian owned ASX100 engineering services which can play a significant role in delivering the investment in facilities planned by the Australian government.

Deutsche Bank likes the management team, the diversity of earnings, high cash conversion and strong balance sheet. While there are challenges in the resources sector the broker envisages growth opportunities in renewables, telecommunications and utilities.

Citi, too, is of the view that the exposure to public infrastructure investment means that the company is in a robust position in the medium term, notwithstanding the risks in the rail contracts and the large oil & gas projects. The broker contends the 20% jump in the share since late June has anticipated this outlook to some extent but the stock remains one of the best placed options in the sector.

FNArena’s database shows four Buy ratings and two Hold. The consensus target is $4.67, suggesting 0.6% upside to the last share price. This compares with $3.66 ahead of the results. The dividend yield on FY17 and FY18 forecasts is 5.1% and 5.0% respectively.
 

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