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Morningstar | Downer Maintains Fiscal 2019 Guidance Despite a Softer Than Anticipated 1H. See Updated Analyst Note from 07 Feb 2019

We make no change to our AUD 5.70 per share fair value estimate for no-moat Downer. That’s despite lowering our underlying fiscal 2019 NPAT forecast by 3% to a guidance-equalling AUD 291 million or AUD 0.49 per share from AUD 0.51; one year’s earnings does not a fair value make. Downer reported a just 2% increase in underlying first-half fiscal 2019 NPAT to AUD 115 million, 14% below our AUD 134 million forecast. But its underlying fiscal 2019 NPAT guidance is unchanged at AUD 291 million, suggesting a significantly stronger second half than we’d envisaged. We simply bring our full-year forecast back in line with guidance. At an AUD 7.30 share price, we think the market credits a too-high midcycle EBITDA margin nearer 9%. That and/or revenue growth we just don’t see. We clearly see less net revenue growth potential in focus areas than the market does. For example, we believe government infrastructure spending is nearing peak.

The company did trumpet a guidance increase for fiscal 2019 net profit after tax and before AUD 44 million in amortisation of acquired intangibles, or NPATA, by 5% to AUD 352 million from AUD 335 million. But this simply adds AUD 17 million fair value gain on the Downer Mouchel joint venture, which our underlying forecast excludes as a noncash one-off, so no real change to the underlying forecast.

Our fair value estimate equates to an unchanged fiscal 2023 EV/EBITDA of 5.0, crediting negligible five-year revenue growth, but improvement in midcycle EBITDA margin to 7.8% from fiscal 2018’s 6.5% mark. Our margin forecast is closer to longer-term historical averages, anticipating improvement from most earnings segments, and including ongoing gains from Spotless as as the acquisition is fully incorporated. Our fair value estimate implies a 2023 P/E of 12, price/cash flow multiple of 4.5 and fully franked dividend yield of 5.0%, all discounted at WACC. Versus today’s fair value estimate, the metrics are 7.6, 2.6, and 7.9%, respectively.

Downer’s strategic focus on services has reduced earnings contribution from construction-related activities to just 17% of group. Urban services businesses of transport, utilities and facilities (Spotless) leverage Downer to population rise, government outsourcing, and technology.

The as-expected interim fiscal 2019 DPS of AUD 0.14 increased by 8% and equates to a moderate annualised fully franked 3.8% yield at the current AUD 7.30 share price. We project DPS to increase at a five-year CAGR of 6.5% to AUD 0.37 by 2023. That would equate to a nominal yield of 5.0% at the current share price, but just 3.2% in real terms and less compelling.

Work-in-hand favourably increased by 3.5% to AUD 43.5 billion versus end December 2018. The gains were substantially in transport services including rail, though visibility is clouded by yet more changes to segment reporting. Chiefly the rail segment is now being included as part of the transport segment, among a number of lesser reshuffles. But as a function of annualised first-half revenue, work-in-hand represents a modest decline to 3.4 years from 3.5 six months ago. First-half fiscal 2019 revenue grew by 9% to AUD 6.3 million. And so far this fiscal year, Downer has announced only AUD 566 million in new contracts, not including a maintenance contract for Chevron at Wheatstone LNG and for BHP at Port Hedland for which contract values were not disclosed but likely in the hundreds of millions. The picture painted is in line with our outlook for negligible five-year revenue growth. Downer generates more than AUD 1.0 billion per month in revenue that must be replaced to maintain work in hand levels. We reiterate our concern that work levels weren’t supporting the high market expectations.

First-half net operating cash flow was solid, up 11% to AUD 340 million, though not sufficiently to stop net debt from climbing marginally to AUD 931 million. While this is still modest leverage of just 7%, net debt/EBITDA of 1.2, or 2.1 if operating leases are included, a company operating in the contracting space probably shouldn’t have any net debt at all given the industry’s vagaries. For instance, Cimic with its net cash position is in a far stronger position. We don’t project Downer to be net debt-free until very late this decade, a legacy of fiscal 2017’s AUD 1.3 billion Spotless acquisition. Weighted average debt duration is relatively short at just 3.8 years.

Our prior fiscal 2019 NPAT forecast had anticipated sooner margin improvement on increased road construction and surfacing from state government investment, growth in renewable energy projects, strong growth in minerals processing, and growth in oil and gas maintenance. This didn’t eventuate as anticipated with group first-half fiscal 2019 EBITDA margin at 6.3% actually down on fiscal 2018’s 6.5%. Lower than anticipated margins were across the board from mining to EC&M and to Spotless. Downer said weighing on margins were increased employee benefits expense due to a more labour-intensive contract base compared with the previous corresponding period.