Shares in diversified industrial group Downer EDI Limited (ASX: DOW) have slowly clawed back their losses since announcing their takeover of Spotless in the spring. I believe that investors will reap the benefit of the deal in 2018 as the market starts to rate its earnings more highly.
Although Downer was well spread in areas such as Transport, Utilities, Rail, Mining and Infrastructure, the $1.3 billion Spotless acquisition adds high-quality long-term service revenue in cleaning, catering and workwear.
The market fixated initially on the 59% premium that Downer paid for a business that was struggling at the time, without considering the synergies and benefits that Spotless will bring to the group, including cost savings of $20-$40m.
I believe that those forecast savings could be understated. After all Spotless has revenues of $3 billion and last year it lost money. In the previous year Spotless reported EBITDA north of $300m. The turnaround potential under Downer's 88% ownership is enormous.
In the meantime, all the valuation and business quality metrics that I look at are favourable.
For example, last year, Downer generated operating cashflow of $441m representing 103% conversion of its EBITDA. Over the last five years, Downer has made an impressive average return on invested capital of 19.6% In terms of its forward order book at year end, that was $22.5 billion, which is a healthy 7% up on the previous year.
Foolish takeaway
Downer's review of Spotless should be complete by the end of November, when a full trading update will be provided. It's worth noting that Downer has met guidance for the last seven years running. I back management to continue to deliver, with potential upgrades to forecasts based on Spotless. I expect a healthy re-rating of the group to emerge as we go into 2018.
