|Summary: Engineering contractor Downer EDI shares jumped last week after the company reported a better-than-expected increase in net profit, together with a higher dividend. While mining services activity has slowed, the company has a solid pipeline of infrastructure work to underpin earnings. A majority of stockbrokers are now rating the company to outperform, and that its share price will head back to where it was earlier in the year.|
|Key take-out: Downer’s investment appeal includes its balanced schedule of infrastructure work, low gearing, the potential for a less severe-than-expected correction in mining contracts, and the potential for continued share-price recovery.|
|Key beneficiaries: General investors. Category: Shares.|
|Recommendation: Outperform (under review).|
Down 44% in four months; up 18% in five days. If ever a stock qualified for the description of “wild ride”, it’s Downer EDI, a contract engineering and services company caught, and then freed, from fear of being damaged by the slowdown in the resources sector.
Continued recovery in the Downer share price can be expected, and it remains a buy as investors reflect on the over-reaction during the panic selling and the discovery that the business remains handsomely profitable and that the mining downturn might not be as severe as forecast.
Most investment bank analysts who follow Downer have it on an outperform rating, even after the recovery which started last week with the release of a better-than-expected earnings result for the year to June 30, and a forecast of a steady result in the current financial year.
The cause of the sell-off, which drove Downer shares down from $5.66 in mid-February to $3.16 in mid-June, was a failure to understand that the company is not solely reliant on servicing the mining sector. It also has a big infrastructure arm and a smaller railway rolling-stock business.
Mining services have slowed, and will probably slow further in the current year, but infrastructure services in Australia and New Zealand are expected to account for 49% of the $19 billion worth of work in hand, rail 21%, and mining 30%.
It is the diverse nature of the Downer business which was always going to protect a large proportion of its profit, a fact which the market overlooked.
There is also now the potential for the mining services business to perform better than even Downer management expects, thanks to signs that the Chinese economy is stabilising, boosting demand for commodities.
From being over-sold and under-appreciated between February and June, Downer’s recovery moved into over-drive on August 6 when chief executive, Grant Fern, reported a 10.3% increase in net profit to $215.4 million, an 11c a share final dividend, and a forecast of a repeat performance this year.
The final payout comes on top of an interim 10c a share, marking a return to rewards for shareholders after a two-year dividend holiday, perhaps the best indication of confidence that the company has overcome a series of problems in its rail and contracting business units.
Fern was careful to not overrate the strength of the recovery, warning of tighter margins in the resources sector as mining companies optimised the volume of production, and government infrastructure work was affected by budget pressure.
“As a result there is a higher level of uncertainty for the 2014 financial year than in the prior year,” Fern said. “The company’s short-term focus is on securing our revenue base for the 2014 year and continuing to drive down costs.”
The target for the current year is to repeat last year’s net profit of $215 million, which might not sound ambitious but is likely to be better than Downer’s competitors – a point Fern made when commenting on last year’s result.
“We are one of the few companies in the sector to deliver on guidance,” he said. “Our operating cash performance was particularly strong, with due credit to the rigorous focus on cash and working capital management.”
The Downer business is divided into three main business units: infrastructure, mining and rail.
Last year, it was infrastructure which led the way with a 13.1% increase in revenue to $5.2 billion, and a 33.3% increase in pre-tax earnings to $230.3 million.
The mining division, despite fears of a crash, lifted revenue by 3.7% to $2.55 billion and pre-tax profit by a marginal 0.4% to $174.2 million.
Rail revenue rose by 4% to $1.33 billion, while pre-tax profit fell by 22.7% to $59 million, a drop caused partially by the company’s decision to quit the locomotive building business.
Four factors add to Downer’s investment appeal.
- It has a balanced schedule of infrastructure work, which will underpin earnings.
- Low gearing at 12%, or 20.8% when off-balance sheet debt is added.
- The potential for a less severe-than-expected correction in mining contracts, and
- The potential for continued share-price recovery after the over-reaction earlier in the year.
Of the nine analysts who cover the stock, eight rate it a buy/outperform and one has a neutral rating.
The odd man out is Goldman Sachs, which acknowledged the solid profit result in the latest year but downgraded its outlook for Downer because of its “re-basing of our mining forecasts in light of lower mining activity”.
China’s surprise economic rebound and the recent rise in mineral prices could cause a degree of re-thinking about the extent of the downturn in the Australian mining industry, with companies such as Downer early beneficiaries of a faster-than-expected recovery.
But even without a mining rally, there is enough strength in Downer’s infrastructure division to believe the steady $215 million profit projection and to expect a modestly higher dividend payout this year.
The consensus view of analysts is that Downer’s share price is heading for $5.20, or back to roughly where it was earlier in the year, which is 90c or 21% higher than its latest price of $4.30.
Goldman Sachs, despite its neutral investment rating, sees Downer’s share price rising to $4.80, a level shared with Macquarie Equities, which rates the stock a buy.
UBS, which also has a buy recommendation, sees $4.70 as the price target, while other brokers have more optimistic price tips. Deutsche Bank has $5.93, which would be a three-year high, and BA Merrill Lynch has $5.70, a price forecast which comes with a warning that the stock deserves a high-risk rating.
All analysts complimented Downer management for a strong result in tough conditions, with Macquarie telling clients that while it was difficult to find a management team in the contracting sector that continues to deliver the Downer team “has now delivered for three years in a row”.