Goldmine of reasons for rate cut
The Reserve Bank might have been coy about its reasons for the latest rate cut but Downer EDI boss Grant Fenn provided some context in his cautious 2014 outlook statement: lower levels of mining investment and budgetary pressure on government expenditure on big ticket infrastructure projects.
While there are still some big mining projects going ahead, including Gina Rinehart's Roy Hill and the liquefied natural gas (LNG) projects, many have been axed or pared back in reaction to a fall in commodity prices on the back of a slowing Chinese economy.
In recent years, total construction activity has been supported by the capital expenditure boom in mining and LNG - to the point where it had become half of all construction activity, versus a historical average of less than 20 per cent.
Put simply, mining has been propping up the economy for the past few years. If it winds back to its historical average of less than 20 per cent, Australia could face billions of dollars being sliced off GDP in the next two years, which would have a big impact on economic growth.
From Downer EDI's perspective, it was able to offer investors the comfort of guidance of a flat net profit in 2014 of $215 million. But it warned that 2014 wouldn't be easy with a greater emphasis by mining companies on costs, which is a polite way of saying the miners will continue to put the squeeze on contractors and service providers.
The squeeze began in earnest a year ago when commodity prices started falling and mining companies started resetting their contracts. Mining services and construction companies got caught in the crossfire with their work cut back and margins squeezed.
It resulted in profit downgrades and a bloodbath on the sharemarket. An insight into the sort of tactics being employed by miners was no better highlighted than the decision by the BHP Billiton Mitsubishi Alliance to terminate a $300 million contract with Leighton Holdings at its Peak Downs coalmine in April. It wasn't so much that Leighton lost the contract but that it was replaced by a smaller operator, HSE Mining.
Besides the loss of the contract stripping Leighton's book by an estimated $260 million, this hardball act was seen by the industry as a portent of things to come.
Downer released its full-year profits for 2013 with the market generally pleased it was able to meet guidance. It was able to do this with the help of a few favourable one-offs as well as approaching clients a year ago to discuss ways to cut costs to ensure they didn't suffer a similar fate that befell Leighton at Peak Downs.
For this reason Downer stands out in sharp contrast to most of its peers in the sector, which have already issued profit downgrades. The latest was the downgrade by the engineering group Ausenco on July 25, which resulted in a 30 per cent smashing in the share price on the day. It follows a dive in Orica's share price the week before, after announcing a 10 per cent earnings downgrade. Others that issued downgrades in May and June include Lend Lease, WorleyParsons, UGL, Coffey, Calibre Group and Transfield Services.
Leighton has stood by its guidance and will release its interim results on August 14 but all eyes will be on its underclaims in Indonesia, Australia and the Middle East.
Leighton's net contract debtor balance at December 31, 2012, stood at just over $2 billion, but it is believed to have increased in the past few months. Some of this can be attributed to late payments, and some relates to disputes.
Ben Brownette, at Commonwealth Bank Equities Research, estimates the sector as a whole will be exposed to 100-200 basis point margin declines in the next 12 to 24 months based on tendering activity from industry contacts, depending on the level of competition and sub-segment.
Downer's shares closed 0.5 per cent lower on a day when investors pushed other stocks with an exposure to mining and infrastructure much lower. For instance, UGL closed 1.3 per cent lower, Leighton lost 2.1 per cent and Emeco was down 2 per cent to 24¢, compared with 82¢ a year ago. Other stocks to suffer included the world's biggest drilling company, Boart Longyear, which dived 4.3 per cent, as investors dumped stock in preparation for the loss of future projects. Not surprisingly, hedge funds have targeted the sector.
But it isn't just listed companies that are struggling with the downturn. This column revealed last week that two companies a day in the construction and building-related sector are collapsing, as late payments from creditors worsen, activity dries up and banks put the squeeze on funding.
It showed that between June 1 and July 18, almost 100 companies in the construction and related industries collapsed, 23 of them in Victoria, 45 in NSW and 15 in Queensland.
It supports the general economic statistics, which showed that in the seasonally adjusted March quarter gross domestic product figures, construction activity fell 2 per cent.
Given construction contributes 14 per cent of Australia's economic output and further evidence of slowing in China, it explains why the Reserve Bank decided to cut the official cash rate to 2.5 per cent.