|Summary: Downer EDI’s share price was hit hard mid last year as the engineering group was caught up in the general fears over contracting services companies exposed to the mining sector. But Downer has been climbing ever since, with the market taking into account the company’s broader operational brief that also includes civil construction and rail infrastructure.|
|Key take-out: Over the next 12 months it is the prospect of a steady financial performance that will set Downer apart from its peers, which is why most investment banks rate the stock as a buy.|
|Key beneficiaries: General investors. Category: Shares.|
|Recommendation: Outperform (under review).|
It is too early to forecast a widespread recovery in the performance of engineering and contracting companies, but it is not too early to see individual stocks outperform. That is what Downer EDI has been doing over the past six months, and should continue to do.
Since crashing with its peers in the first-half of last year, Downer has staged a remarkable recovery to be within sight of its three-year share price high and with forecasts of a higher price to come over the next 12-months.
That means an outperform recommendation on Downer when I last looked at the stock on August 14 (see Downer’s big recovery drive) is retained.
Back then, Downer’s share price had started to climb out of the hole into which all engineering contractors had fallen, trading at $4.30, which was $1.14 (36%) up from the year’s low of $3.16 reached on June 13.
The recovery has continued and has further to run, with the stock climbing back over the $5 level. It’s on track to hit a consensus 12-month price forecast of $5.78, and perhaps higher, with some investment banks showing greater enthusiasm than others.
J.P. Morgan, for example, last week lifted its price target for Downer from $5.90 to $6.39, while Deutsche Bank lifted its target from $5.84 to $6.22. Both banks are well ahead of the lowest price target, which comes from Credit Suisse at $5.40.
Looking back, what happened to Downer in 2013 appears to be a case of throwing the baby out with the bathwater, with investors fearful that all contractors would see their profits decimated by the end of the construction phase of the mining boom.
In most cases that fear was well placed, as companies with excess exposure to the mining and oil industries saw their order books dry up, margins on contracts squeezed and profits fly out the window – along with a large number of staff who lost their jobs.
Downer, however, is different. It has a big mine services business and that will be hurting. But it also has a big infrastructure division that is exposed to civil works, and a big rail division servicing government and private railway operators.
The challenge in assessing an investment in Downer lies in separating it from more troubled engineering and contracting companies such as Monadelphous, which is very heavily exposed to mine construction work, and Leighton Holdings, which is dogged by mining exposure and lingering legal issues and contract disputes.
For all contracting companies there are always three great unknowns that should have investors carefully monitoring their exposure.
They are: (1) uncertainty about the flow of work, (2) uncertainty about whether a bid for work will be profitable because it was priced too low, and (3) uncertainty about the performance of a contract.
A fourth issue that routinely trips contractors is when they have misjudged an acquisition because management did not fully understand the problems in contracts on the books of the takeover target.
Forge Group, which crashed spectacularly late last year, is an example of misjudging the value of an acquisition. A number of power station contracts held by a recent acquisition went sour, with the result that Forge suffered a 96% share price collapse from a high of $6.96 to a low of 28.5c before starting to recover.
Downer has had problem contracts in the past, particularly in its rail division, but it has avoided the sort of near-death experience that gripped Forge before management was able to steady the business by landing fresh contracts and securing the support of its financiers.
A flat outlook
The outlook for Downer is not spectacular, but more a case of being the best performer in a sickly bunch simply by delivering a profit this year that will probably look much like last year.
A glimpse into the company’s trading will be available on February 4, when Downer releases its first-half results. As long as there are no surprises, such as asset-value write-downs, that first-half should set the scene for Downer to post an annual net profit of around $215 million. The consensus forecast from analysts is that management will lift the annual dividend by 2.2c a share to 23.2c. The prospective yield for 2014 at the current share price is 4.6%.
Apart from its civil and rail divisions there is a financial factor that separates Downer from other contractors, which is the strong flow of recurrent earnings.
Over the next 12 months it is the prospect of a steady financial performance that will set Downer apart from its peers, which is why most investment banks rate the stock as a buy.
Deutsche expects a balanced spread of earnings this year from Downer’s different divisions led by infrastructure services in Australia and New Zealand, followed by the mining and rail divisions.
Overall, Deutsche described the outlook for engineers and contractors as cautious, but “not as difficult as last year” as most of the marginal and low-return resource projects were re-scoped or cancelled in 2013.
J.P. Morgan described the engineering sector as being in transition, with the pullback in resources spending weighing on earnings while an expected pick-up in infrastructure spending was yet to have a major effect. It has overweight recommendations on Downer and Lend Lease.