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Major Downer

Major Downer

Downer Edi Limited (ASX: DOW) just released its annual report for the period ending June 2015. It’s a sobering read for anyone still invested in businesses focused on engineering, infrastructure and contracting.

Downer is a multi-faceted business with operations spanning the entire scope of engineering and infrastructure management services, like Minerals & Metals, Oil & Gas, Power, Transport, Telecommunications, Water and Property. It therefore allows one to get a reasonably quick and dirty feel for how a number of sectors are performing all at once and unfortunately, the view is that business is soft, and is likely to get even softer.

Downer reported a FY15 Net Profit After Tax of $210.2 million, which although was in line with previous guidance of $210 million, it was supported by a lower tax rate and reduced interest expense – what we would consider to be a lower quality outcome.

You may also remember that Downer made a material acquisition in October 2014 of Tenix. A business which in FY14 generated revenue of $791.1 million and Earnings Before Interest and Tax of $29.4 million and in the 2015 result for Downer Edi Limited, likely contributed 8-9 months of trading performance.

Therefore, despite Downer’s earnings being down just 3 per cent on the prior, when Tenix’s contribution is removed, Downer’s core business not only went backwards, but did so at a rate of knots. Unless it can find another large acquisition (and fast), we believe 2016 may be the point where the small decline this year, really does snowball.

It is increasingly apparent that Downer has entered a period of negative momentum which will be very difficult to halt. Management guided towards Net Profit After Tax of $190 million in FY16, which is 10 per cent lower than FY15. Yet even this number may be a tad optimistic when you consider the following caveat:

“Providing guidance for the 2016 financial year has proven more difficult than in the past five years. In this environment, it is difficult to predict the flow of uncontracted revenue, which is slightly higher than at this time last year”.

Whilst we don’t want to kick a well-managed company when it’s down, and Downer has managed the downturn much better than many of its competitors, there’s only so much one can do in a lean environment with very little project work.

Management’s difficulty in predicting “uncontracted revenue or work that isn’t on the books”, makes for some sobering reading, as it means that despite a tough few years in resources and engineering, the next year could be an awful lot harder for the entire sector.

To us, this is a clear warning sign that guesstimating earnings and attempting to value the business is now a dart throwing exercise. So beware of an analyst that comes to you with a solitary ‘valuation’ as a reason why it’s potentially cheap and should be bought on that basis. It might be cheap, it might be wildly expensive, and if your dart skills are anything like mine, they (earnings and hence the share price) could land anywhere on the board but be nowhere near the bullseye.

Russell Muldoon is the Portfolio Manager of The Montgomery [Private] Fund. To invest with Montgomery domestically and globally, find out more.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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2 Comments

  1. Hi Russell, thanks for the update and your article earlier in the week regarding green shoots in the mining space.

    I thought my own anecdotal experience might add to the discussion. I am also highly sceptical of the green shoots theory and wary of the possible effects on the economy as a whole.

    I am a construction electrician and have spent several years working on major projects and FIFO jobs for some of the major contractors such Downer (at Ranger and Gove- both being mothballed), Thiess John Holland, United Group and Fluor on the GLNG project. I am now noticing a severe drying up of work amongst my friends and contacts within the industry. With the QLD LNG finishing up and Coal and Iron Ore almost standing still. There is now only Wheatstone, Gorgon and Inpex that are offering the sort of money that many within the industry have come to expect and have adjusted their lifestyles and debt levels to.

    Many of these workers have no savings and many thousands of dollars of loans for holidays, the usual trady toys and quite a few horrendously overpriced investment properties. I am a bit of a tight arse myself and managed to slot back into regular work in Brisbane when our family expanded around 12 months ago, however I am now hearing of a lot of guys struggling to find ongoing FIFO work and even struggling to get lower money work back in town, as the rush out of mining intensifies. Now many of these workers, who believed they could rely on $150000+ a year for as long as they wanted, are starting to get worried.

    The WA jobs are some consolation, however they will be finishing in the next 18 months with nothing coming on to replace them. I remember the excitement in the industry when Gorgon and Wheatstone were announced, but that was back in 2009 so the lag time to a lot of electricians getting on the fit-out phase is around 4-5 years. I know it is similar with many of the other skilled trades. This means that even if new jobs such as Carmichael coal mine were given the final go ahead tomorrow it would be too late to keep these workers servicing their debts. Maybe it is human nature to be naively optimistic without any evidence, but the reality is the next round of major projects needed to have been announced 2-3 years ago to ensure continuity of work.

    My fear is a continuing lack of any sort of budget reform coupled with a China slowdown could see a lot of these guys dumping their houses, jetskis, V8 utes on the market at the same time with the inevitable price falls and bad debt feedback loop that would accompany it.

    It’s always impossible to know what will happen, but a much harsher downside than anyone is predicting (excluding MIM) is one possible result.

    Regards,
    Guy

    My fear is that

    • Russell Muldoon
      :

      Thank you for sharing those insights Guy. Lots of extremely valuable thoughts that everyone can get value from, thank you again. I agree with you on most points and have been doing work around the exposure for example that the big4 banks have in Ausralia. What is interesting is that despite the boom, most of them have just 1-2% ‘exposure at default’ to the mining and energy sectors. So it appears they are well aware of the industries highly cyclical nature and appear to have managed their risks OK at this point. Still, ANZs trading update this week showed a trend up in resource bad debts so it may just be gathering speed. Worth watching but it appear to be controllable. Their exposure to Australian housing is another kettle of fish…

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