Downer jumps on contract win but there's more to picking winners in the embattled sector

Is Downer EDI Limited (ASX:DOW) an opportunity or too expensive at current prices?

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Engineering contractor Downer EDI Limited (ASX: DOW) has given investors a rare opportunity to cheer when it announced it was about to be awarded contracts worth in excess of $2 billion.

Shares in Downer jumped nearly 2% on the news before giving ground with the rest of the market to finish the day up 0.9% at $4.74.

While the contacts will provide a big lift to its topline, the cash will be spread over seven years to fit the project timeline. This means Downer's revenue is still unlikely to grow in 2014-15 (and could even dip) even though the news that Adani Mining has issued two letters of intent to award Downer the contracts for the Carmichael coal mine in Queensland is encouraging news for the embattled sector.

The good news is that Downer's revenue should start growing again in the next financial year. Consensus estimates is tipping topline growth of 2% to $7.9 billion in 2015-16, which would imply a price-earnings (P/E) multiple of 10 times.

That may sound like pathetic growth, but given what the industry has gone through from the sharp decline in available work, particularly in the coal sector, any growth should be celebrated.

Detractors may also think that Downer is expensive on a 10 times P/E. After all, the rule of thumb when it comes to investing in a contractor is "buy on five and sell on 10".

However, that rule hasn't worked in 2014. Buying civil and mining contractors who looked cheap would have led to big losses. In contrast, investing in those trading at a premium would have yielded a much better result.

Lend Lease Group (ASX: LLC) is one example with the stock trading close to a seven year high. If you applied the rule of thumb on P/E multiples, you wouldn't have ever invested in the stock. Much can be said about Leighton Holdings Limited (ASX: LEI) as well despite its governance issues.

I asked my contacts who are engineers at large construction firms what sets these firms apart, and I was told (no surprises) it's all about processes. Good operators like Leighton have a robust set of procedures managers have to follow and this removes a lot of the project risks. It may sound like common sense but many contractors do not have the same discipline.

This means picking winning contractors is less about the size of their project pipeline and more about whether they have "best practices".

On that note, Downer EDI is also said to have good processes in place. Given that Downer is one of the better performing contractors in my portfolio, I think this theory carries some water.

Motley Fool contributor Brendon Lau owns shares in Downer EDI.

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