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Is Downer EDI Limited’s 7.6% yield too good to be true?

Engineering services, construction, and maintenance contractor Downer EDI Limited (ASX: DOW) has surprisingly held up relatively well over the last couple of years. Yes, there’s been capital raised, and yes, net profit has fallen moderately since peaking in 2011, but the share price is only down 2% over the last 12 months and is actually UP 4% over the last five years.

A Poor Investment

Some, possibly most, readers will consider me crazy at this point, however Downer’s exposure to the Australian mining sector could have resulted in a far lower return. Consider that Forge Group is no longer in business, and that the share prices of Worleyparsons Limited (ASX: WOR), Maca Ltd (ASX: MLD) and Cimic Group Ltd (ASX: CIM) are between 20% and 60% lower over the same period.

Regardless, investors will not be pleased with the 5-year return from Downer and now is an important time to consider whether to retain your holding.

The Future

Downer is doing its best to diversify away from the local mining and oil and gas sector, which has typically contributed around 25% of group revenue. Last year’s clever acquisition of Tenix Holdings Australia for $300 million will boost Downer’s exposure to the defensive power, gas and water industries and will provide the company with a greater proportion of recurring income.

This is important as the pending decline in oil and gas capital investment (upon completion of a number of projects in the top half of Australia) is predicted to hurt revenue.

Downer’s Strength

Of Downer’s 5 divisions; engineering, construction and maintenance; infrastructure services; New Zealand; mining; and rail; investors and management would love to see more from infrastructure, particularly government funded road and rail programs- Downer’s bread and butter.

Analysts believe that Downer’s existing relationships with local and state governments will aid the company winning tendered work, however it will rely on an increasing pipeline of projects coming on board, which sounds suspiciously like Downer is waiting on a stimulus program.

Regardless, analysts are expecting little from Downer this financial year. Consensus net profit sits at only $201 million while management is forecasting ‘around $210 million’. A fully-franked 24 cent dividend per share is expected this financial year and 25 cents next year, implying a fully-franked 5.2% yield this year and 5.4% next year, which corresponds to a grossed-up yield of over 7.6%!

Too good to be true?

Only time will tell if Downer will deliver its 7.6% yield next year, however if I was an investor I would keep an eye out for new tender wins- as without new work Downer’s high fixed cost base will quickly eat into profits.

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Motley Fool contributor Andrew Mudie has no position in any stocks mentioned. You can find Andrew on Twitter @andrewmudie

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.