Downer EDI (ASX:DOW) releases their results in early February. The chart looks interesting, but challenges remain in the business. Does this mean that the share price will be stuck in a new trading range? We look at both the fundamentals and technicals and determine if its worth investing in for the long term, or does it now become a good trading stock.
About Downer EDI
The Company is an integrated service provider to customers in domestic infrastructure, rail, engineering, contracted mining services and maintenance. Following the acquisition of ASX-listed Spotless Group in 2017, DOW’s business now comprises six divisions. These are Transport, Utilities, Rail, Engineering, Construction and Maintenance (EC&M), Mining and Spotless.
Margin Outlook Remains Challenged
One of the noticeable aspects from the FY18 results was not just lower overall group margins, but the fact that the majority of the DOW businesses experienced margin declines in FY18 relative to FY17. These generally reflect the mix of work but also the (still) competitive nature of the markets in which DOW operates.
We consider that there is downside risk to group margin from tightening labour availability. This is where margin could be impacted either due to cost inflation or lower productivity from less-trained staff.
Potential Changes to Business Portfolio
The Company has moved towards creating a less capital intensive, service oriented recurring revenue business in recent years. This could result in the Company looking to divest the Mining business. To this end, there was media speculation in late 2018 in relation to potential sale of the Mining division.
On the one hand, a sale of the Mining business would be positive. This is from the point of view that, firstly, it would improve the balance sheet. That is, Mining has net assets of $570m, so a sale price around this level could potentially be used for capital management/debt reduction. Secondly, Mining is a highly capital intensive and cyclical business as opposed to the more stable and free-cash flow generative Services business.
However, it is worth noting that the Mining division (while representing only ~10% of forecast group FY19 EBIT) is one of the key earnings growth drivers for FY19. This is due to recent contract wins and solid volume growth. As well, other divisions are face a challenging earnings outlook: Spotless’ underlying EBIT (i.e. excluding expected synergy gains) is expected to be flat. Also, the revenue outlook for EC&M is challenging given that the LBG construction boon has ended.
At present, the extent of the earnings lost from any asset/divisional sales, as well as the extent to which this can be replaced by further acquisitions within the remaining core Downer businesses and/or debt reduction/capital management initiatives presents cannot be assessed at present.
Lack of Progress on Underperforming RAH Contract
After completing a review of all Spotless contracts in November 2017, the Company identified Spotless’ 30-year facility management services agreement with Royal Adelaide Hospital (RAH) as an underperforming contract. This was due to high labour costs, construction delays, and defects. Spotless is now in the second year of its contract term and the RAH contract remains loss-making.
The Company had been hopeful of a resolution by September 2018. However the lack of progress to date provides a risk to FY19 earnings guidance if DOW is not able to renegotiate the contract at favourable terms.
Further New Contract Wins Needed to Underpin Revenue Outlook
In comparison to the ~$3.0b increase in Work in Hand (WIH) reported in FY18, the Company has only secured an additional $986m in new contracts for FY19 to date. Although these do not include maintenance contracts that are likely to be in the hundreds of millions (DOW did not disclose contract values).
Despite Spotless previously bidding for a large number of maintenance services contracts over the course of FY18, Spotless’ WIH (which accounts for ~43% of overall WIH), increased modestly as at 30 June 2018 compared to one year earlier.
Fundamental View of Downer EDI
On balance, we consider that there are limited catalysts for a re-rating in the share price, which are currently trading on a 1-year forward P/E multiple of under 14x, having de-rated from ~17x following the completion of the Spotless acquisition. This means that there any rallies may well be sold into on valuation grounds.
Charting View of Downer EDI
DOW gave us a nice reversal in mid December and it has been trading well every since. For the moment it looks as though the shares will continue to head higher with resistance coming in near $7.65. Any dips before then should be contained above major support which is at $6.50. Unless there a catalyst to do otherwise, DOW is likely to trade bewteen about $6.50 and $7.65. This may present traders with an opportunity to buy the dips and sell the rallies.
Michael Gable is managing director of Fairmont Equities.
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