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Here’s what you need to know about Downer EDI Limited’s big contract win

Despite tough times throughout the resource and engineering sectors in general, companies like Downer EDI Limited (ASX: DOW) and UGL Limited (ASX: UGL) continue to announce that they’re winning new contracts.

Things can’t be too bad if they’re winning work right?

Wrong.

I’ll go into the less obvious risks of winning contracts in a moment, but first here are the main points from Downer’s newly announced contract with Fortescue Metals Group Limited (ASX: FMG):

  • Fortescue decided to consolidate both Christmas Creek iron ore drill/blast and load/haul contracts into one company – Downer EDI. MacMahon Holdings Limited (ASX: MAH) lost out in this specific instance, ceding its contract for Christmas Creek 2 to Downer EDI.
  • Downer’s contract runs until September 2016 (with the option for an additional year) and is worth approximately $720m in revenue to the company
  • Fortescue will provide the majority of the additional plant and equipment required for the expanded contract

While the contract is arguably a vote of confidence in Downer’s efficiency and competitiveness, there are several hidden downsides.

First is the short contract length, probably imposed as a result of tumultuous resource markets. While this does provide opportunities for renegotiation sooner when business conditions improve, it also allows potential for Downer to be ousted from its position by a more competitive company.

Second is the fact that service companies traditionally quote revenue and not margins when winning contracts.

Unfortunately right now the mining services space is highly competitive and a buyers’ market, which means that margins are continuously being squeezed by corporations fighting for their share of a continuously shrinking pie.

And (as the linked article shows) the pain may not be over yet, with the number of upcoming resource projects at their lowest level in more than a decade.

This suggests to me that there is even more pain coming for shareholders once major iron ore and LNG expansions finish up – because there simply isn’t much work coming through to replace them.

The risks are too great for me, and I’m putting my money into reliable, dividend-paying growth shares that will increase earnings and deliver me some comfortable returns over time.

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Motley Fool contributor Sean O'Neill doesn't own shares in any company mentioned.

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