Share price performance for ASX-listed contractors over the last 12-18 months has been muted. Skilled labour shortages continue, costs are escalating, and ongoing supply chain risks remain. However, recent Company commentary suggest that these pressures may be easing.
With this in mind, we recently researched Downer EDI (ASX:DOW) in The Dynamic Investor to assess whether the risk/reward profile more appealing at current levels.
About Downer EDI
Downer EDI is a services company focusing predominantly on the maintenance of infrastructure, such as roads, railways, telecoms, and utilities. Following a recent restructure, the Company has largely divested its prior mining exposure and is transitioning its core focus to its “Urban Services” infrastructure businesses. The current business comprises three divisions: Transport, Utilities, and Facilities.
Following the restructure, the Company’s client base is significantly skewed towards government entities. Accordingly, the new business model is both less cyclical and capital intensive. In addition, the business model underpins more predictable revenues and cashflows.
A significant portion of DOW’s is derived from the infrastructure end market, reducing exposure to the cyclicality of the mining industry. In turn, this means that DOW has a defensive revenue profile, as well as long-term exposure to de-carbonisation CAPEX tailwinds and infrastructure maintenance requirements.
The main contributor to the revenue and earnings base is the Transport division, which accounted for 55% of FY23 group revenue. The Transport division comprises the Road Services, Rail & Transit Systems, and Projects businesses.
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Key Fundamental Drivers
Mixed Revenue Trends
A trading update issued at the Company’s AGM on 22 November 2023 for the 1st quarter of financial year 2024 (1Q24) highlighted mixed revenue trends across divisions. The Company’s AGM comments largely reiterated previous points about FY24 being a transition year.
There is potential upside from further contract wins. The Company previously noting (at the FY23 results release) that it has a strong pipeline of work from Industrial & Energy customers for decommissioning and de-carbonisation projects. The likelihood of wins is also supported by improving labour availability at a sector level.
Is the Margin Target Achievable?
At the 1H23 results release in February 2023; DOW outlined a group EBITA margin target of 4.5% after the EBITA margin reached an historic low of 2.2% in 1H23. The prior peak in EBITA margin was 4.0% in FY19. Interestingly, the Company highlighted executive Long-Term Incentive remuneration is now aligned with this margin target. Executive management is required to achieve an average 4.5% EBITA margin across FY25/26, and a minimum threshold average of 4.2% for all of FY25.
The key factors expected to drive an improvement in the EBITA towards the target include:
i. Progress on the $100m cost-out target, which is expected to be delivered by end of FY24. A key component of this is a reduction in the number of employees on a full-time equivalent (FTE) basis. The FTE reduction is expected to have been completed by the end of calendar year 2023. Whilst labour is still a headwind in the short term, the Company appears to be managing this issue better than 12 months ago.
ii. A more streamlined operating model. Having already completed significant restructuring activity, the Company’s operating platform is now more focused on its core “Urban Services” infrastructure businesses. Accordingly, DOW’s end market exposure is now more defensive. Not only has the new business model reduced both cyclicality and capital intensity, but it is also relatively lower risk and is meant to provide the Company with more predictable revenues and cashflows.
iii. Reducing the portion of low-margin work. DOW highlighted that it is focused on selective bidding for projects, improving underperforming contracts, and driving a culture of accountability.
iv. Further portfolio optimisation. Regarding asset sales, the key areas of progress to date have been the sale of Transport Projects and 45% stake in Victorian recycler Repurpose It. The Company is looking at further potential divestments of non-core assets.
Gearing Likely to Trend Lower
The level of gearing (on a net debt to EBITDA basis) is at the lower end of the 2.0-2.5x target range. Recent non-core asset sales are likely to lead to a further reduction in gearing.
Further, the Company is targeting refinance of various debt facilities in FY24 to further optimise debt maturity profile and reduce medium-term refinancing risk.
Downer shares are currently trading on a 1-year forward P/E multiple of ~13x, which is broadly in line with both the 2-year and 5-year averages. The current multiple appears attractive in the context of an EPS growth profile of +17% over FY23-26 on a CAGR basis. However, we note two key factors precluding a re-rating from current levels:
i. Additional evidence that the strategies in place to can deliver EBITA margin expansion. To this end, we note that consensus estimates for EBITA margin in FY25 are currently 3.6%; well short of the 4.5% target set by the Company.
ii. The risk of an overly negative share price reaction at the upcoming interim results release due on 14 February. Of particular concerns is whether the underlying profit figure falls short of, or does not exceed, consensus estimates. To this end, it is worth noting that FY24 results contains a larger-than-normal skew in earnings towards the 2nd half due. This is due to: a) A challenging 1H24 period for the Utilities division and b) The timing of realisation of cost-out measures.
Whilst the fundamentals of Downer show some headwinds for the shares to head higher, from a charting perspective, it does look look as though the share price wants to recover from here. In late 2023, we saw DOW break above the downtrend line which had been in place since 2021. It has since retested that line and traded sideways. This indicates that Downer is preparing for a move higher from here. If the shares can hold above $4 after the results on 14 of February, then we can be confident that it will start to trend higher again.
Michael Gable is managing director of Fairmont Equities.
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