Digging in at Downer EDI
Recommendation
Lately, though, despite a series of contract wins in May, plus a 44% lift in half-year profit to $20.3m, it hasn't made a difference. In fact the share price is down 36% since our last full review in issue 96/Feb 02 (Long Term Buy - $0.80). So, is it time to bail out or buy more?
Back in 1995, Downer EDI was a pure construction company. Today, 80% of revenue comes from service and maintenance activities in the road, rail, telecom, power and mining industries - much of it under long-term contract.
Contract signings
The EDI rail division is number one in Australian and New Zealand locomotive manufacture and maintenance and in May it and joint venture partner Bombardier Transport, confirmed the signing of a $220m contract with South West Metropolitan Railway in Perth.
EDI Rail is also in the running to pick up other contracts, including stages two and three of Sydney's Millennium Train project. It's a good example of how the company has achieved a leading position in many of its markets.
The infrastructure division is another. It's the market leader in Australian rail truck maintenance and the largest road maintenance operator in New Zealand. It too is placed to win new work as rail authorities outsource more maintenance activities.
The mining division is the market leader in full mine management and runs second in contract mining in Australia, an admittedly low-margin business. It has been particularly successful in generating business lately with the value of work at the Coppabella coal mine in Queensland reaching $600m.
The story just goes on. The engineering and telco maintenance divisions are well placed given that in the telco and power industries much of the maintenance work is done in-house but is likely to be outsourced in the future.
So why is the share price falling and not rising? It's hard to say. The company hasn't suffered a profit warning and isn't being investigated by the authorities. The fall in US markets hasn't helped but what is beyond doubt is that even though the company enjoys strong positions in many markets, it still faces several potential risks.
Cyclical
First, its businesses are cyclical, although the number and magnitude of the long-term contracts the company has secured obviates this risk to an extent, as does its geographic and industry diversification.
Second, it's possible that some contracts have been mispriced and third, that the company has made too many acquisitions too quickly. The full year result, due in September, will give us a better indication of that.
More conservative subscribers may want to wait until then but we're taking a more aggressive position. Downer EDI is trading on an expected PER of 7.2 before goodwill amortisation, which compares very favourably with competitors like Leighton Holdings and Transfield Services.
If the company's target of $3bn plus in revenue per annum can be achieved in the next few years, that should result in a higher use of its asset base and a greater return on assets and equity. That would mean a substantially higher share price. Of course, that doesn't mean the share price won't fall further in the short term. What we can say is that at $0.51, the value argument looks quite compelling. LONG TERM BUY.