Downer (ASX: DOW) is a major domestic infrastructure, rail, engineering, and maintenance business. The company is chiefly exposed to the domestic rail, water, road, and telecommunications sectors.

The future of Downer is focused on urban services, with mining and high-risk construction businesses sold down. Senior Equity Analyst Mark Taylor does not believe Downer deserves a moat despite position, scale, and strong customer relationships.

“Contracting is a difficult industry in which to establish a moat and Downer in the past decade underperformed from an operational and financial perspective as a result of miscalculating contract risk, poor project management, and unsatisfactory project execution.” Taylor states.

However, Taylor believes Downer is making progress in FY23 results reported on the 10th of August.

Taylor retains his $5.60 fair value estimate for no-moat Downer. Underlying fiscal 2023 net profit after tax for the restyled urban services company declined 22% to AUD 156 million, in line with recent guidance.

The market reaction was negative with the shares down 6.39% on August 10th, despite largely meeting Taylor’s expectations. Downer shares remain materially undervalued in Taylor’s opinion and is trading in 4-star territory. Ongoing contract awards and continued earnings improvement from the disastrous first-half fiscal 2023 are likely key catalysts for an ongoing share price recovery.

Looking ahead, Taylor expects Downer to make solid progress on both revenue and margin improvement. He see strong public-sector demand driving compound annual EBITDA growth of 10% to AUD 772 million by fiscal 2028, supported by EBITDA margin expansion to 5.4% by fiscal 2028, up from 3.8% in fiscal 2023. The strong growth forecast starts from the weather and accounting scandal ravaged base year that was fiscal 2023. We estimate compound EBITDA growth closer to 6.5% on a normalised basis.

Positively, on Downer’s preferred measure of EBITA, or EBIT before amortisation of acquired intangibles, improvement is already registering. Underlying fiscal 2023 EBITA margin fell to 2.6% versus 3.4% in fiscal 2022. But the second-half print of 2.9% bettered the first half’s 2.2% convincingly.

Fiscal 2024 will still be a year of turnaround as areas of underperformance are addressed. But while market conditions are expected to remain challenging, particularly cost escalation, labour availability, and productivity, positive signs are already emerging.

Downer targets continued EBITA margin improvement for fiscal 2024 with the fiscal second half to be stronger than the first. It hasn’t quantified this yet, but remains confident of achieving its $100 million or $0.14 per share pretax in cost outs, with the full run rate to reflect in fiscal 2025.