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Why the Downer EDI Limited share price could rocket higher this week

Credit: Flazingo Photos

On Monday morning, the directors of Spotless Group Holdings Ltd (ASX: SPO) issued an ASX release urging shareholders to reject the hostile $1.27 billion takeover bid from construction and engineering firm Downer EDI Ltd (ASX: DOW).

Takeover rejection

In preparation of Spotless Group issuing a target statement to shareholders by Thursday 27 April, Spotless’ management announced that it recommends investors reject the bid as “it does not reflect Spotless Group’s strong core business”.

In making the recommendation, management indicated that its significant shareholder Coltrane Asset Management has acquired a 10.37% blocking stake in Spotless and intends to reject the takeover offer.

This implies that even if Downer can convince all other Spotless shareholders, it may not receive the required 90% threshold to complete a full takeover. This could result in Downer walking away from the table.

Is it all bad?

In my opinion, a scenario where Downer’s takeover fails could be a blessing in disguise for the $3.4 billion firm.

Whilst I admit that an acquisition of Spotless Group by Downer does make sense given Spotless’ businesses would complement and expand Downer’s operations well, the takeover only makes sense at the right price.

Although a post-takeover scenario would transform Downer EDI into a vertically integrated engineering, construction and maintenance services company which services both the private and public sector, Downer’s $1.27 billion offer for Spotless seems a bit steep.

The offer price of $1.15 for each Spotless share (Downer doesn’t already own) represents a lofty 59% premium to Spotless’ closing share price of 73 cents before the takeover was launched. Whilst such a large premium in hostile takeovers is acceptable, Downer’s offer doesn’t seem to add up based on Spotless’ results.

Spotless Group’s financials

For the half-year ended 31 December 2016, Spotless Group reported that sales revenue shrunk 9.4% to $1.45 billion. Underlying earnings (EBITDA) took a whopping 11.8% hit as the company eked out a $33 million net profit after tax (statutory) – down 31.4% on the prior corresponding period.

Whilst Spotless’ drop in earnings and profitability could be excused if the business was showing some positive signs of growth, the company’s future looks bleak in my opinion. Spotless’ EBITDA margin contracted 0.2% to 8.3%, implying that new work being won is being hit by margin pressures. In my view, this does not bode well for Downer.

Offer too high

Prior to the takeover, Spotless traded on a price-earnings of about 11x which seems reasonable for a company of Spotless’ ilk. However, at an offer price of $1.15 per share, Downer’s takeover offer represents an expensive 17x trailing price-earnings for a company that is still experiencing earnings attrition. Even with post-acquisition synergies of an estimated $20-$40 million per annum, the cost of expanding into new markets by Downer seems too high.

Foolish takeaway

In my view, Downer’s takeover offer for Spotless is expensive and unwarranted at the present time.

Though the takeover represents new business opportunities and opens up the private and government maintenance market for Downer, I believe the offer price leaves no room for error and adds further risk to Downer’s existing business.

Accordingly, in the event Downer decides to walk away from the takeover offer, I believe Downer shares could head higher in the medium-term.

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Motley Fool contributor Rachit Dudhwala has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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