The profit results unveiled by Downer EDI Limited (ASX: DOW) shows that the construction and engineering contractor is flying on the tailwinds of the infrastructure boom, but that is probably not the most interesting takeaway from today's announcement.
The stock reacted well to the profit news as it jumped 1.8% to $6.82 as management reported a 79% surge in underlying earnings before interest, tax and amortisation of acquired intangible assets (EBITA) to $222.3 million on the back of a 69.3% jump in group revenue to $6.1 billion.
It's a pleasing result but the it's the lack of operating leverage that is concerning. Operating leverage is when profit increases faster than revenue due to economies of scale.
While underlying EBITA may be up more than sales, the reported earnings are messy as it excludes several one-off items, such as the writedown in the value of goodwill for its mining division and the loss from the sale of its freight business.
What is telling is that expenses are rising faster than revenue. Total expenses increased by as much as 78.5% although management pointed out that this includes a number of individually significant items that have no corresponding revenue.
But even if these were excluded, expenses are still up 74.2% and it shows how labour-intensive Downer's operations are as employee entitlements and subcontractor costs contributed to this blowout.
This is significant because we are supposed to be in a wage growth recession. The increase in manpower costs is probably more to do with Downer taking on extra workers – such as labour costs relating to its majority stake in Spotless Group Holdings Ltd (ASX: SPO) – and not wage rises.
If wage rises were to return to the mean over the coming year or two, Downer will come under increasing margin pressure.
But it's not only human resources that is behind escalating expenses. The cost of consumables and raw materials has nearly doubled too and these are something that management has little control over.
Downer is not the only one complaining about rising costs. BHP Billiton Limited (ASX: BHP) and its offspring South32 Ltd (ASX: S32) are afflicted with the same condition.
I wonder if this is an early tell-tale sign that the era of weak inflation is about to end – but that's a topic for another article.
Coming back to Dower, let's not just focus on the negatives. I'm more a glass half full kind of person anyways.
The fact is, Downer is well placed to benefit from the large pipeline of road, rail and other infrastructure spend. The company's transport, rail and utilities businesses have delivered robust double-digit growth, while its oil and gas project-exposed EC&M division is also achieving similar growth rates.
It's underperforming Mining Services business that was hit by the loss of Fortescue Metals Group Limited's (ASX: FMG) Christmas Creek contract could bounce back as stubbornly high commodity prices are breathing new life into mining projects.
Downer is forecasting a FY18 net profit after tax excluding amortisation of acquired intangible assets (NPATA) of $295 million. This reflects a 58.1% improvement over the previous year.
Shares in Downer have gained less than 5% over the past 12 months, slightly ahead of the 2.6% increase in the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) but significantly lagging other contractors such as Cimic Group Ltd (ASX: CIM) with its 20% increase and Worleyparsons Limited (ASX: WOR) with its 86% rally.
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