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Morningstar | No-Moat Downer FVE Increased to AUD 5.70 on Time Value of Money

We increase our fair value estimate for no-moat Downer to AUD 5.70 per share from AUD 5.40 due to the time value of money. Our fair value estimate equates to a fiscal 2023 enterprise value/EBITDA of 5.0, crediting negligible five-year revenue growth, but improvement in midcycle EBITDA margin to 7.6% from fiscal 2018’s 6.5%. Our margin forecast is closer to longer-term historical averages, anticipating improvement from most earnings segments, and includes ongoing gains from Spotless as it is bedded down. Our fair value estimate implies a 2023 price/earnings of 12.2, price/cash flow multiple of 4.4, and fully franked dividend yield of 4.9%, all discounted at the weighted average cost of capital. Versus today’s fair value estimate, the metrics are 7.7, 2.8, and 7.7%, respectively. At a share price of AUD 6.40, we think the market credits a slightly higher midcycle EBITDA margin near 8%.

Our fiscal 2019 and fiscal 2020 EPS forecasts are little changed at AUD 0.51 and AUD 0.59, respectively. Downer provided guidance for 16% improvement in fiscal 2019 net profit after tax to AUD 291 million, or AUD 0.49 per share, along with its fiscal 2018 results announcement in August. Our slightly more bullish outlook anticipates better margin improvement aided by 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. These represent structurally higher investment levels that will level off. Earnings from minerals in particular are higher margin than the group average. At its annual general meeting in November, Downer said it was performing in line with EPS expectations for the first few months of the 2019 financial year.

Work in hand increased 7.5% to AUD 42 billion in fiscal 2018, with the gains substantially in mining and in transport services. But so far this fiscal year, Downer has announced only AUD 566 million in new contracts. This doesn't include 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.

Downer generates more than AUD 1.0 billion per month in revenue that must be replaced to maintain work in hand, or WIH, levels. While announcements only include just a portion of the largest contracts won, we still keep an eye on them. Between fiscal 2015 and fiscal 2018, announced contracts constituted around a third of contracts ultimately added. At that ratio, recent contracts would not be sufficient to sustain WIH levels. We have previously expressed concern that work levels weren’t supporting the high market expectations. 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. But these are necessary to replace income in addition to growing it. Failure to sustain WIH levels could be a key catalyst for share price convergence to fair value.

Current WIH per share levels of AUD 70 are considerably higher than circa AUD 50 in fiscal 2010, but revenue levels in excess of AUD 12.0 billion are 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, with less revenue per year but accruing over a longer period.

Downer says the integration of Spotless following its acquisition just over a year ago is going well. While the competitive landscape remains tough, growth in road construction benefits the surfacing and bitumen products businesses. It also expects telecommunications to stay relatively buoyant over the next few years and for growth in utilities to be driven by wind and solar projects in Australia, as do we. There is decline in oil and gas construction, as major LNG builds come to an end, but growth in asset servicing is a partial offset--for instance, at Wheatstone, with 25 process trains soon to be in operation around Australia, there are significant opportunities in shutdowns, turnarounds, and general maintenance. On balance, we view these as supportive of existing revenue levels, as per our forecasts, rather than sources for revenue growth as the market seems to anticipate.