Australia | Oct 08 2020
The infrastructure splurge in the latest federal budget augurs well for Downer EDI, Australia's largest road construction and maintenance provider, and Morgan Stanley upgrades to Overweight.
-Budget emphasis on infrastructure positive for Downer EDI's urban strategy
-Potential re-rating once divestment of mining, laundries occurs
-Exposure to economic recovery should allow margins to improve
By Eva Brocklehurst
A renewed focus on infrastructure in the federal budget puts transport contractor/engineer Downer EDI ((DOW)) in the front seat going into 2021, with around $14bn allocated for new and accelerated infrastructure projects along with road safety funding.
Downer is Australia's largest operator in terms of road construction and maintenance, and included in the allocation is $7.5bn for new road and rail links as well as upgrades to highways.
Around 80% of the company's earnings come from Australian infrastructure development, operations and maintenance. Hence, UBS points out, any increase in the overall size of the infrastructure asset base provides for a positive earnings outlook.
Moreover, water infrastructure has also been given a $2bn impetus over 10 years which should also help the utilities division. Downer also provides maintenance services to Australia's power stations and its customers supply 60% of the national energy market.
The earnings fillip for the company's new urban services division will come from ongoing public sector investment and, so far, federal and state governments have accelerated job-intensive projects worth around $8bn from existing budgets.
Further stimulus programs targeting defence, social housing, education or road maintenance should also provide benefits. Moreover, Morgan Stanley assesses the enlarged federal budget deficit will be an opportunity for more private/public partnerships.
The company currently has future work in hand for transport of $3.5bn for FY21 and $3.2bn in FY22, and the broker suspects the latest "use it or lose it" direction for funding from the federal government to the states will mean activity is front-loaded and, importantly, carry a higher degree of labour intensity.
The budget emphasis on infrastructure is also a positive catalyst for the move to an urban strategy. The core urban services division will include transport, utilities, facilities management and asset services.
These operations are less capital intensive than mining and provide more predictable revenue. The outcome will be better visibility, brokers assert, and an even stronger skew to government clients.
All up, Morgan Stanley suspects a more reliable earnings stream will enable the stock to re-rate higher, hence the broker upgrades to Overweight from Equal-weight. Downer trades at a -5% discount to its long-term average and the broker considers it possible a multiple re-rating will occur if a successful exit of mining occurs.
UBS suspects the volatility related to the pandemic has slowed the company's process of divestment of both its laundries and mining businesses. With respect to the latter, the broker also surmises Downer may want to break up operations to facilitate an orderly exit, such as the separation of mining from drill & blast operations. Downer Mining is Australia's second largest contract miner.
A restructure bodes well for a re-rating, and UBS recently upgraded to Buy, modelling a restructured portfolio of urban services that could deliver $350m in free cash flow, which compares with the recent average of $200m.
The broker also points out the share price has declined -45% over the year to date, significantly underperforming the -12% fall in the ASX200. This has been underscored by concerns regarding the balance sheet which have now been addressed following an equity raising.
The restructured business will be less cyclical and capital intensive, and also relatively lower risk as the company winds down "problematic" construction operations. Underperforming construction contracts have been largely resolved, Macquarie notes, such as the wind farm at Clare and solar farm at Murra Warra as well as the Orbost gas plant upgrade.
The stock is cheap, the broker asserts, given its exposure to a recovery post the pandemic and a solid customer base. Margins should also recover somewhat in FY21. Group earnings (EBITA) margins fell to 3.1% in FY20, from 4.2%, which reflected the impact of the pandemic on productivity and efficiency as well as the shutdown in New Zealand.
Downer does not expect a drop off in utilities demand will occur even after the NBN construction winds down, anticipating ongoing maintenance and demand in telecommunications.
FNArena's database shows five Buy ratings and one Hold (Ord Minnett). The consensus target is $5.10, suggesting 7.9% upside to the last share price. The dividend yield on FY21 forecasts is 3.1% and on FY22 forecasts, 5.0%.
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