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Morningstar | No-Moat Downer Reaffirms Fiscal 2019 Earnings Guidance. We Increase our FVE to AUD 6.00. See Updated Analyst Note from 07 May 2019

We increase our fair value estimate for no-moat Downer to AUD 6.00 per share from AUD 5.70 due to the time value of money. Downer maintains fiscal 2019 guidance for a 23.8% increase in NPATA to AUD 352 million. We retain our essentially guidance-equalling underlying fiscal 2019 NPAT forecast of AUD 292 million, equivalent to AUD 0.49 per share or 17% EPS growth on fiscal 2018. This adds back amortisation of acquired intangibles. In our opinion, the current AUD 7.80 share price equates to a too-high multiple of 15.9 times fiscal 2019 earnings, given our forecast for five-year EPS CAGR of 4.8% to AUD 0.62 by fiscal 2023. 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 4.7% at the current share price.

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 an anticipated fiscal 2018 low of 6.5%. Our margin forecast is closer to longer-term historical averages, anticipating improvement from most earnings segments. 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%.

At an AUD 7.80 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 believe government infrastructure spending for example is nearing peak.

Work-in-hand, or WIH, currently sits at around AUD 43.5 billion, marginally higher than AUD 42.0 billion June 2018 levels, for an unchanged 3.4 years of revenue life. Since Spotless’ inclusion approximately two years ago, WIH has been growing at an annualised 5.6% CAGR, favourably faster than 4.4% normalised revenue CAGR over the same period. But WIH is becoming longer-dated with the average life of announced contracts in recent years tripling to over 15 years versus levels typical prior to fiscal 2017.

This reflects the shift in work to urban services away from engineering construction, including a number of 25-30 year train contracts including support and maintenance. These are good for revenue longevity, but not necessarily near-term growth. Hence our subdued revenue growth projections.

We think the market misprices for this trend, with Downer’s enterprise value/WIH having grown to the current multiple of 0.13 versus sub-0.10 levels prevailing in fiscal 2012 and fiscal 2013. The group EBITDA margin fell following the Spotless acquisition. We think the WIH should be more heavily discounted for the greater delay to revenue realisation, the trade-off for certainty. Downer generates more than AUD 1.0 billion per month in revenue which must be replaced to maintain WIH levels.

Urban services now accounts for 80% of Downer’s EBITDA, including transport infrastructure maintenance and management, asset management of utilities in power, gas and water distribution networks, and facilities management in health, education, defence and other. Mining and engineering construction and maintenance EC&M comprise the 20% EBITDA balance. This limits construction risk in deference to more defensive, long-term and predictable revenue. In the past decade, Downer underperformed as a result of mispricing contract risk, poor project management, and unsatisfactory project execution. The shift makes sense but comes at the expense of material near-term revenue growth in our opinion. Mining and EC&M comprises just 11% of Downer’s current WIH. Including goodwill, we don’t project anticipated sub-8% returns on invested capital to exceed 9.5% WACC.