Downer Downgrades, Again. More To Come?

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

Downer EDI has warned profit will be lower in FY20 than previously assumed and brokers wonder whether this will be the last of the downgrades.

-Investor confidence may take time to recover following Downer EDI's profit warning
-Company's focus on urban services should provide more sustainable earnings base
-Progressing planned sale of laundries and mining businesses
 

By Eva Brocklehurst

Cost over-runs, reduced construction activity and delays to mining projects have sent Downer EDI ((DOW)) back to the drawing board for FY20 guidance, with a resultant downgrade to net profit forecasts.

The company has lowered FY20 net profit guidance to $300m from $365m, representing an -18% reduction.The downgrade stems from the ECM (electrical, construction and maintenance) and mining businesses.

A small number of loss-making ECM construction contracts and lower forecast revenue have combined with a delay in the commencement of two mining projects; all contributed to the downgrade.

ECM is the largest driver, with a -$43m pre-tax impact from underperforming projects. There is also a -$20m impact from lower revenue in construction because of a smaller pipeline of work and a -$10m impact from redundancies.

The question brokers ask is whether there is more to come, given there have been two downgrades from the company in less than a year. This is particularly vexatious, Citi asserts, as problem contracts were meant to have been identified and provisioned for at the last result.

Management has historically taken pride in its record of meeting guidance and Credit Suisse suspects the downgrade will be viewed poorly by investors and, while a material recovery is likely beyond FY20, it may take time for confidence to recover.

Despite the sell off, the broker's rating is downgraded to Underperform from Neutral. Management has reiterated cash conversion will be lower in comparison to recent years.

Citi, albeit disappointed, does not believe confidence has been destroyed. The broker expects most of the issues will be contained to FY20 and, while contracting is inherently risky, Citi analsts believe the re-positioning of the business away from fixed-price construction will reduce risk in FY21 and beyond.

Setbacks

UBS agrees the latest underperformance in construction is likely to add to concerns around the company's position vis-a-vis ECM projects going forward. Over the past 12-18 months Downer EDI has suffered setbacks on the Clare solar project, the Murra Warra wind farm and two additional undisclosed ECM projects.

This is in addition to the cost over-runs incurred on the Carrapateena copper-gold project and the Orbost gas plant upgrade. Nevertheless, Citi considers further downside to FY20 is limited as some of the problem projects are nearly complete. Macquarie finds consolation in this as well. Orbost is being de-mobilised and Carrapateena will de-mobilise in a few weeks, while the Murra Warra wind farm is nearing completion.

Restructure

The company has decided to restructure the ECM division, which brokers expect will create a lower overall risk profile. UBS assesses the corporate strategy is moving towards a capital-light, urban services model which has a more sustainable earnings base.

While re-positioning ECM to long-term service related contracts, execution has clearly fallen short, in Macquarie's view, suggesting a greater focus on operations is required. A narrowing of the portfolio via asset sales should assist, the broker acknowledges. Meanwhile, Downer EDI is making progress on the planned sale of the laundries and mining businesses and a more detailed update is expected at the first half result on February 12.

FNArena's database has three Buy ratings, one Hold (UBS) and one Sell (Credit Suisse). The consensus target is $8.01, signalling 5.4% upside to the last share price. Targets range from $7.00 (Credit Suisse) to $9.50 (Ord Minnett, yet to comment on the negative market update).

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