EUR 850.00 For Business Accounts Only

Morningstar | Downer's Fiscal 2018 Short of our Target, but Not to Detriment of Longer Term. No Change to FVE. See Updated Analyst Note from 16 Aug 2018

We make no change to our AUD 5.40 fair value estimate for no-moat Downer. Underlying fiscal 2018 NPAT of AUD 250 million came in 9% below our AUD 274 million forecast, but without implication for long-term assumptions. Net operating cash flow increased by 32% to AUD 583 million, boosted by the Spotless Group acquisition. But this too was also below our AUD 655 million expectations. The full-year dividend of AUD 0.27 missed our AUD 0.31 target, a 61% payout, but was calculated over the lower-than-anticipated earnings. Downer shares have strengthened 20% from April AUD 6.30 lows, and at AUD 7.50, trade at a substantial premium to our fair value estimate. We continue to think the market credits unrealistic earnings growth, including from high-profile government infrastructure spending. We think disappointment at translation of work-in-hand, or WIH, to cash flows could be a key catalyst for share price to retreat to fair value.

WIH increased by 7.5% to AUD 42 billion in fiscal 2018, the gains substantially in mining and in transport services. But Downer is burning through more than AUD 1.0 billion per month in revenue that must be replaced just to stand still. We have previously expressed concern that work levels weren't supporting the high market expectations. While we recognise there will be volatility in work levels over short time frames and more large contracts will come through, particularly in the public infrastructure arena, these are necessary to replace income in addition to growing it. Current WIH per share levels of AUD 70 are considerably higher than circa AUD 50 fiscal 2010 peaks, but AUD 12.0 billion fiscal 2018 revenue is more than double AUD 5.8 billion fiscal 2010 levels. And many of the newer rail and maintenance contracts are considerably longer-dated than mining and EC&M contracts traditionally dominating; less revenue per year but accruing over a longer period.

Our fair value estimate equates to a fiscal 2023 EV/EBITDA of 5.0, crediting negligible five-year revenue growth, but improvement in midcycle EBITDA margin to 8.0% from fiscal 2018's 6.5% mark. Our margin forecast is closer to longer-term averages, anticipating improvement from most earnings segments, and including ongoing gains from Spotless as it is bedded-down. Our fair value estimate implies a 2023 P/E of 12.2, price/cash flow multiple of 4.4, and fully franked dividend yield of 4.9%, all discounted at WACC. Versus today's fair value estimate, the metrics are 7.7, 2.8, and 7.7%, respectively. At an AUD 7.50 share price, we think the market pencils in an unrealistic midcycle EBITDA margin near 10%.
Downer has provided guidance for 16% improvement in fiscal 2019 NPAT, including AUD 44 million in goodwill amortisation, to AUD 291 million. We sharply lower our fiscal 2019 NPAT forecast to AUD 294 million, now just marginally above guidance. We achieve this by slowing the rate of anticipated margin improvement from fiscal 2018's low mark to midcycle levels.
Downer's fiscal 2019 guidance anticipates 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. We expect similar from a revenue perspective, and our slightly more bullish profit outlook rests on considerable margin improvement. We forecast group fiscal 2019 EBITDA margins to increase by 130 basis points to 7.8%. Much will rest on eking further margin gains from transport, utilities and EC&M.

Underlying fiscal 2018 NPAT excludes a net negative AUD 178.6 million in significant items, including on an aftertax basis, AUD 41 million loss on divestment of freight rail and AUD 17.5 million Auburn Rail claim, AUD 76.4 million mining goodwill impairment, and AUD 40 million in Spotless-related acquisition costs.