A disastrous 18 months for Downer EDI (DOW) have brought shares in the integrated services firm back near their pandemic lows, but near-term headwinds may be obscuring a brighter long-term outlook, according to Morningstar analyst Mark Taylor.

Shares have all but halved in the last 18 months, significantly underperforming the broader market, and driven down, in part, by declining revenue growth.

graph DOW

The market’s poor sentiment is also likely compounded by lingering concerns after “accounting irregularities” overstated the company’s reported profit by as much as $22 million late last year.

Following the reporting scandal, shares shed more than 20%. Three months later, shares in the company fell a further 20%, after it revealed a 30%-plus decline in earnings in its latest half-year report.

Downer is a major domestic infrastructure, rail, engineering, and maintenance business, with the latest earnings decline attributed to wet weather, labour market tightness, and falling contracts in the company’s utilities business.

Amid the share price turmoil, Downer’s board has undergone a major shake-up, with CEO and managing director Grant Fenn retiring from the top job in January, replaced by former COO Peter Tompkins.

The company’s CFO and chairman also resigned in the proceeding months and the company remains in discussions to replace the recently promoted COO as well as three vacant non-executive board seats.

Near-term issues mask growth potential


Despite the near-term issues facing the company’s earnings potential, however, Taylor says the punishment the stock has seen appears excessive.

“The market is likely unhappy with the top-line trajectory, but we don’t think the gripe with Downer’s revenue growth is justified,” he says.

“The business has fundamentally changed and capital intensity has more than halved with asset divestments, yet share price recognition is lacking.”

Those changes centre on the company’s transformation into a low capital intensity urban services business, but Taylor says those benefits are yet to be credited by the market, which is transfixed by recent missteps.

Taylor notes that if Downer’s management can show these business improvements, then shares will likely rerate.

“A focus on cost-outs and strong underlying demand suggest the odds are in investors' favour. We expect macroeconomic tailwinds, such as the outlook for military and infrastructure spending, and normalisation of 2022's unusually disruptive wet weather, to support profits.”

As evidence for this transformation, Taylor points to the company’s capital expenditure margins, which have fallen from 6% in 2017 to below 2% more recently, following the jettisoning of Downer’s more capital-hungry mining and laundries businesses.

Further, at $3.88 apiece, shares in the company currently trade at a 30% discount toMorningstar’s fair value estimate of $5.60—a valuation that according to Taylor hinges on two things: reasonable revenue growth and steady margin improvement.

Government underpins revenue growth forecast


The company’s recent growth decline may have spooked some investors, but Taylor says government demand in areas like defense, housing and infrastructure should drive improvements in this metric.

“Downer’s revenue growth is largely tied to government-derived demand, a reasonable investor position given the necessary spending in those areas and broader economic concerns.

“The Australian government maintains a strong 10-year $120 billion infrastructure pipeline […] Aging infrastructure, population growth, increasing outsourcing rates, and the energy transition are fair winds.”

Downer should also benefit from the estimated $2 billion of investment into clean energy and infrastructure that’s needed next 10 years to reach net-zero 2050 goals, he says.

While near-term headwinds have hit earnings, Taylor says an easing of labour and supply chain tightness, weather, and improved contract performance are likely to drive margin improvements.

The full report on Downer: Stronger Business, Revenue and Margin Growth Obscured by Transient Headwinds; Shares Cheap, is available to Investor subscribers.