Downer EDI (ASX:DOW) revealed an unexpected earnings downgrade and revelation of accounting irregularities in early December. This sent the shares plummeting to near 3-year lows. We recently researched DOW in The Dynamic Investor to assess whether the shares were oversold.
Overview of 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. This comprises three divisions (Transport, Utilities, Facilities). Following the restructure, the Company’s client base that is significantly skewed towards government entities. Accordingly, the new business model is both less cyclical and capital intensive, while also relatively lower risk, providing Downer with more predictable revenues and cashflows.
The main contributor to the revenue and earnings base is the Transport division (which accounted for 50% of FY22 group revenue) and comprises the Road Services, Rail & Transit Systems and Projects businesses.
Key Fundamental Drivers
New Business Model Yet to Show Defensive Qualities
Following a restructuring, the Company’s operating platform is now more focused on its core “Urban Services” infrastructure businesses and a client base that is significantly skewed towards government entities. Accordingly, DOW’s end market exposure is defensive, with ~90% of Work In Hand being government-related. Not only has the new business model reduced both cyclicality and capital intensity, but, in theory, it is also relatively lower risk and is meant to provide the Company with more predictable revenues and cashflows.
Having re-affirmed FY23 guidance for 10-20% profit growth at the AGM in November, the Company surprised the market in early December by downgrading profit growth guidance for FY23 to a range of -7% to +2%. At that time of the AGM in November, it was considered that further wet weather posed downside risk to guidance – not only has this materialised, but it has done so to a greater extent than anticipated. Further, a higher cost-to-serve (also foreshadowed at the AGM) was another negative factor.
Downgrade Has Impacted Medium-Term Earnings Growth Profile
With improving weather and an earnings skew towards 2H22, we expect that some of the impacts identified in the recent earnings downgrade may to be mitigated through improved operating conditions in 2H23. However, it is likely that NPATA growth for FY23 will come in at the lower end of the updated guidance range.
Importantly, the impacts have also led to EPS downgrades for FY24/25, however these are somewhat moderate in comparison to FY23, given that deferred work is recovered. Earnings beyond FY25 remain exposed to an expanding infrastructure pipeline and with majority exposure to government projects. However, we suspect that market confidence needs to be restored before the market ascribes any re-rating in the shares on the basis of its longer-term earnings growth potential.
Balance Sheet Position Supported by Improved Cashflow
As at 30 June 2022, gearing (on a net debt to EBITDA basis) was 1.6x and well below the target range of 2.0-2.5x. Given downgrades to EBITDA forecasts for FY23, we envisage gearing as at 30 June 2023 will likely rise slightly (to ~1.8-1.9x), given that:
i. Cash conversion has generally been high and supported by the restructure of the business to a more capital-light, less cyclical and capital intensive and relatively lower risk model.
ii. Recent refinancing activity, hedging and fixed rate debt mix sees DOW well placed to absorb current rate increases in FY23; thus, supporting operating cashflow.
Do Accounting Irregularities Extend to Other Contracts?
The Company recently announced that it had identified certain accounting irregularities in its Australian Utilities business involving historical misreporting of revenue and work in progress on one of DOW’s maintenance contracts. Specifically, service revenues were recognised in advance of those services (and costs) having been performed. This practice is at odds with AASB 15 ‘Revenue from Contracts with Customers’, which states that revenue should be recognised when a customer obtains control of the goods or services.
While the quantum of overstated profits is immaterial (amounting to ~2% of EBIT), an investigation has commenced to ensure that the irregularities do not extend to other contracts. The outcomes from the investigation are expected at or before the February results release.
The de-rating in the shares now sees DOW trading on a 1-year forward P/E multiple of ~11.5x. While acknowledging that this multiple is below the 2-year average (~14x), a re-rating in the shares is unlikely until the Company can: i) Re-establish a track record of more reliable earnings performance and ii) Assuage any market concerns around the extent of any further project or accounting irregularities.
A further investment uncertainty is that the Company is in the process of a leadership transition. On 1 December 2022, DOW announced that Peter Tompkins will be appointed Chief Executive Officer and Managing Director of the Downer Group following the retirement of Grant Fenn in February 2023. Following his retirement in February 2023, Mr Fenn will remain available through calendar 2023 to assist with the transition. Mr Tompkins joined Downer EDI in 2008 and currently the Chief Operating Officer (a position he has held since June 2021).
Downer had already been trending lower over the past year. The gap down in December saw it rally off the lows and then fail to continue falling – which is a positive. However, there is no denying that the stock remains in a downtrend. Even if the lows from several weeks ago end up being the ultimate low, the stock will need to build more of a base here before it can be a buy. For the moment, those looking to buy are advised to remain patient.
Michael Gable is managing director of Fairmont Equities.
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