Diversified engineering & construction conglomerate, Downer EDI, is expertly managing the move to infrastructure from resources but brokers believe this is largely reflected in the share price.
-Large potential in balance sheet for acquisitions and/or buy-backs
-Large amount of upside now factored into share price
-Citi: one of the best-placed options in the infrastructure sector
By Eva Brocklehurst
Engineering & construction conglomerate, Downer EDI ((DOW)), is moving with the times, countering the mining investment downturn with new business in infrastructure and ongoing work on the National Broadband Network. Net profit in the first half of $78m beat many broker forecasts, while FY17 net profit guidance has been raised by 7% to $175m.
The results beat Macquarie's estimates in four out of the six divisions, with the main surprise in technology & communications services, driven by a ramp-up in the NBN and Telstra ((TLS)) work. The broker expects these two should remain healthy contributors to Downer's income for the next 2-3 years, which highlights the benefits of the company's diversified nature.
The company has over $400m in potential capacity on the balance sheet for acquisitions and/or buy-backs, in Macquarie's calculations, and the earnings recovery for Downer has started earlier than expected, with 8.6% growth in prospect for FY18.
Soft Result In Utilities & Mining
The broker notes the completion of a major gas project and lower-than-expected profit from the Ararat wind farm muted the results in utility services in the half year. Moreover, the completion of the Christmas Creek contract contributed to a soft result in mining earnings, where EBIT declined 34%.
A $25m reduction in depreciation flattened the first half result, but as this relates to mining and the sale of some equipment, Macquarie does not believe it detracts from the services result, which was better-than-expected.
The company remains reasonably confident that the Adani Queensland coal project will proceed, having a letter of intent for both contract mining and the coal handling plant. However, Macquarie does not factor this into its forecast, nor has the company factored it into guidance.
While there is potential to exceed provides guidance and a high level of recurring revenues with low debt, Deutsche Bank is of the view that this is largely reflected in the share price, maintaining a Hold rating. Credit Suisse is even less enthusiastic, although concedes there was no hiding the strength of the result.
While it was hard to find an area that was disappointing the broker believes the outcome is reflected in the share price response. Credit Suisse upgrades its earnings base for FY17, assuming a similar, but now higher, earnings trajectory.
Record Work In Hand
Work in hand was a record $21.1m, reflective of recent wins in rail and around 58% of revenue being generated from public infrastructure clients. The growth outlook for transport, utilities and rail is strong while there are some headwinds across mining and engineering, construction & maintenance. Credit Suisse believes the business is exiting the high capex mining cycle in good shape, but this is reflected in the multiple.
The broker struggles to get its valuation close to the share price. Hence, an Underperform rating is retained. Nevertheless, Credit Suisse suspects this will be unlikely to compel holders of the shares to sell, particularly if they feel further earnings surprises can be delivered.
Morgan Stanley also suspects, despite the upgraded guidance, that downgrades to consensus EBITDA forecasts for FY17 are likely. The broker estimates that whilst FY17 net profit guidance implies around a 9% uplift to consensus, it is in fact a -7% downgrade to consensus EBITDA. The broker acknowledges the flexibility on the balance sheet and that a possible lifting of the final dividend has been flagged, but suspects the company's ability to fully frank this would be somewhat limited.
Citi notes management has taken definitive steps to restructure and appears to be managing the downturn in resources, shifting the portfolio towards the growing infrastructure and utility sectors. The broker is of the view that the exposure to public infrastructure investment puts it in a robust position for the medium term. While the 50% jump in the share price since the FY16 result has anticipated this to some extent, the broker still believes the stock is one of the best placed options in the sector.
FNArena's database shows one Buy (Macquarie) rating, three Hold and one Sell (Credit Suisse). The consensus target is $6.25, signalling -9.9% downside to the last share price. This compares with a target of $5.54 ahead of the results targets range from $4.01 (Morgan Stanley) to $7.45 (Macquarie).
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