Downer EDI's credibility, and shares, will take a battering tomorrow when shareholders are hit with another $150 million-plus provision caused by technical hitches relating to the delivery of trains in its $1.9 billion Waratah rail project with the NSW Government.
Delivery will now be delayed even further, beyond this month, and trading in the company's shares were halted on Monday.
As the financial implications are still being assessed, including estimating how many months the trains will be delayed and the size of the provision, shareholders will have to wait until Downer's financial results are made public next month to see whether an equity raising is likely.
Against this backdrop, banks and politics have entered the mix, trying to pressure Downer to put in more money and take on more risk. It is understood the company is working closely with the investment bank UBS to help with this strategy.
An equity issue will hinge on whether the international ratings agency Fitch downgrades Downer's credit rating. Fitch was briefed by senior executives on Monday night, and the company is waiting on its decision. If there is a downgrade, Downer will have little option but to raise capital, probably when its profit results are published.
The company appointed a new senior executive, Ross Spicer, last month to take control of the controversial rail project. He has been working directly with the Downer boss Grant Fenn to sort out the project. He has worked in the rail industry in Britain for more than 20 years in companies including Eurostar and more recently Virgin Trains.
His appointment, and this latest setback, undoubtedly have set the clock ticking for Peter Reichler, who was chief financial officer from 2005 before being appointed chief executive of joint ventures (including the Waratah project) in 2009. Fenn is busy working out the technical issues and the impact these will have not only on the delivery of the first train set - there has been a series of delays - but also the following 77 trains. Provisioning is expected to exceed $150 million, which follows a $190 million provision in June.
On December 7 Fitch put out a note confirming its rating for the engineering and rail group after Downer put out a notice to the ASX warning the first set would be delivered to RailCorp this month, rather than in mid-December. Fitch is now assessing the impact on the group of the latest debacle.
Two analysts with the Commonwealth Bank, Ben Brownette and Steve Shoobert, do not believe Fitch will downgrade Downer. They believe any provisioning would be treated as non-recurring and so Fitch would strip it out of earnings.
Almost needless to say, Brownette and Shoobert believe Fitch has been too generous in its treatment of Downer and note that its method of assessing Downer is being ignored in bond markets based on the bond spreads.
"In our view, this treatment by Fitch is rather generous, as the provision relates to several years of earnings, and the contract has the potential to be costly out until 2043 via the severe revenue abatement regime," they say.
"While our view is that this expense should therefore be considered as an operating item (and we await to learn whether it results in a technical breach of its banking covenants), Fitch has not agreed. Nonetheless, Fitch may indeed adjust this view, which might lead to a ratings downgrade."
The news comes after shareholders suffered a horrible 2010, culminating in a 98 per cent fall in net profit to $3 million, after Downer announced in June that it would suffer $190 million in blowouts on the multibillion-dollar Waratah project and $70 million in other write-downs.
Disappointments, contracts gone bad, profit downgrades, credibility issues and a revolving door for chief executives, directors and senior executives have been recurring
themes for the group, leaving shareholders out of pocket and angry.
The last chief executive to get the bullet was Geoff Knox last year. Before him, the interim chief executive Bruce Waldron left in 2007 and before him Stephen Gillies resigned in August 2006 following huge company profit downgrades in 2006-07, partly caused by a long-running dispute with Iluka Resources over Downer's $150 million claims in cost overruns in Iluka's mineral sands project.
Since Fenn took the top job in August after a short stint as chief financial officer, he has insisted
the trains would be delivered
on time. He even set part of his salary package on delivery of the trains on time. This has gone up
in smoke.
The setback is very damaging for Fenn's and Downer's credibility.
The company cannot afford any more stuff-ups or delays.
Fenn will need to detail to the market a revised production schedule and project costs -
and this time make sure there are no more issues with a project that has dogged the company since it was signed.
Downer has a 49 per cent stake in the (unfortunately named) Reliance Rail consortium, which has a 40-year contract to build and maintain the 78 trains for Sydney in a public-private partnership with the state government.
When Fenn took the top job he sent signals to the market that he was on a mission to fix Downer. He promised $250 million in cost-cutting to create efficiencies, an overhaul of management reporting lines, a commitment to deliver the first train by December 31 and a focus on risk management procedures. He will need to pull a rabbit out of the hat to fix this mess.
Tomorrow's announcement will signal the end of his honeymoon. He will have to prove his worth
or face a similar fate to his
predecessors.
Frequently Asked Questions about this Article…
What went wrong with Downer and the Waratah rail project that investors should know?
Downer has reported further technical hitches on the $1.9 billion Waratah rail project that have delayed train deliveries beyond the scheduled month. The company expects a fresh provision of more than $150 million related to these issues, trading in Downer shares was halted, and management is still assessing the full financial impact.
How big is the new provision and how does it compare to previous write-downs on the Waratah contract?
The latest provisioning is expected to exceed $150 million. That follows a $190 million provision announced in June and other earlier write-downs that contributed to a 98% fall in net profit to $3 million for 2010, so this is another significant hit for the company.
Could a Fitch credit rating downgrade force Downer to raise capital (equity)?
Yes. The company is waiting on Fitch's assessment after briefing the agency. If Fitch downgrades Downer's credit rating, Downer may have little option but to raise equity when it publishes its profit results next month. Management is working with UBS on potential strategies.
What is Reliance Rail and what is Downer's exposure to that consortium?
Downer holds a 49% stake in the Reliance Rail consortium. Reliance Rail has a 40-year public–private partnership contract to build and maintain 78 Waratah trains for Sydney, so delays and cost issues on this contract directly affect Downer.
What are analysts saying about the likelihood of a ratings downgrade over the Waratah problems?
Two Commonwealth Bank analysts, Ben Brownette and Steve Shoobert, do not believe Fitch will downgrade Downer. They think any provisioning would be treated as non-recurring and stripped out of earnings. However, they also warn the provision relates to several years of earnings and could prompt a reassessment that may lead to a downgrade.
Who is running the Waratah recovery effort and what actions has Downer taken?
Downer appointed Ross Spicer last month to take control of the troubled rail project; he is working directly with CEO Grant Fenn. Fenn has previously promised $250 million of cost cuts, an overhaul of reporting lines and had tied part of his pay to on-time delivery, but the latest delay has damaged credibility and the management team now needs to publish a revised production schedule and project costs.
What immediate steps should shareholders and everyday investors watch for from Downer?
Investors should watch for Downer's upcoming financial results next month (which will quantify the provisioning and potential need for capital), Fitch's rating decision, any announcement of an equity raising, and management's revised production schedule and updated project cost estimates for the Waratah contract.
How could the Waratah delays affect Downer's longer-term financial position and bank covenants?
The article notes the provisioning could be costly over several years and there is uncertainty about whether the expense will be classed as an operating item that might trigger a technical breach of banking covenants. Fitch is assessing the wider group impact, and a downgrade or covenant breach could force Downer to seek additional capital.
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