Downer EDI (ASX:DOW) has rallied strongly since early April and recently closed at an all-time high. Are current levels justified and is there enough momentum to hold on to the shares?
Downer EDI a leading provider of integrated services in Australia and NZ. Following the acquisition of ASX-listed Spotless Group in 2017, DOW’s business now comprises six divisions: Transport, Utilities, Rail, Engineering, Construction and Maintenance (EC&M), Mining and Spotless.
By way of background, Spotless is a provider of outsourced facility services, catering and laundry services, technical and engineering services, maintenance and asset management services and refrigeration solutions to various industries.
The shares’ 1-year forward P/E multiple has de-rated from ~17x to ~14x following the completion of the Spotless acquisition. We contend that the key reasons for this are:
1. Mixed Performances in the Traditional Downer Businesses
Impressive organic growth in some parts of the traditional businesses (i.e. excluding Spotless) have been offset by either flat or declining margins across the traditional businesses in comparison. Most notable in the Utilities Services and Mining divisions.
Further, there is a mixed outlook for the traditional businesses, with the divisional forecasts out to FY20 indicating that revenue growth is expected to moderate from FY18. EBIT margin is expected to be largely flat for the Transport, Utilities, Rail and EC&M divisions and EBIT margin recovery/expansion only likely in the Mining division and for Spotless. EBIT margin recovery in Spotless is likely to be eroded by a large portion of the expected synergies being re-invested back into the business and/or whittled away through competition.
2. The Inherent Challenges in Spotless Group
DOW is still in the process of integrating the Spotless acquisition. It is now the largest earnings contributor at ~30% of group FY18e EBIT. While additional synergies are expected to be extracted, DOW is faced with the challenge of now having higher employee costs – as the inclusion of the Spotless business has resulted in a more labour-intensive contract base, as well as higher subcontractor costs (which are necessary in order to retain greater cost flexibility in the event that contract activity retracts).
The challenges in managing the operating cost base for Spotless has been borne out in the long-running Royal Adelaide Hospital (RAH) Contract saga. In an update issued to the market in November last year, DOW identified Spotless’ 30-year facility management services agreement with Royal Adelaide Hospital as an underperforming contract. At the time of the market update in November, the contract was cash negative, with the challenges faced by the Company at RAH being a higher number of full-time staff to meet additional scope, as well as construction delays and defects.
While a recent trading update in May indicated that staff numbers (and monthly cash burn) at the RAH have been declining, the contract remains cash negative.
Accordingly, we consider that a rerating in the share price is unlikely over the short-term, based on the company fundamentals. Because of that, we are unlikely to see upside until the Company can demonstrate that it is in a better position to meet the above challenges.
What does the chart say for Downer EDI?
The chart for EDI has been a hard one to read and it is not clear whether it can continue the push forwards. The sharp sell down in early 2017 wasn’t easily recovered and the stock continues to struggle anywhere above $7. Unless we can see a strong push to a new high, we are likely to see the shares ease back again. This means that from a charting point of view, it is hard to justify buying DOW at these levels, and holders might want to consider trimming positions.
Michael Gable is managing director of Fairmont Equities.
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