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Is the Downer EDI share price in the buy zone?

Shares in the ‘jack of all trades’ engineering contractor Downer EDI Limited (ASX: DOW) are up by 1.27% in morning trade today to $4.79, following the performance of the S&P/ASX200 Index (ASX: XJO) more broadly.

An often forgotten company that features widespread operations across multiple industries, Downer’s share price remains approximately 50% lower than its peak at $8.94 in January.

Let’s break down why the market has fallen out of favour with this blue-chip powerhouse, and why I see the company as a significant buying opportunity for long-term investors.

What are the current headwinds facing Downer EDI?

As one of the largest companies in Australia with some 53,000 employees, Downer has been a profound victim of the COVID-19 pandemic and its restrictive impacts.

One of the biggest laggards on its operations has been the Spotless Group, an integrated services company in which Downer maintains an 88% stake. Spotless has come to a virtual standstill due to its formidable exposure to catering, hospitality and laundry services.

According to a presentation delivered by Downer at the 2020 Macquarie Australia Conference last month, hospitality revenue for Spotless had been slashed to zero and up to 6,000 employees had been stood down without the JobKeeper stimulus due to the pandemic. This revenue hole was further expanded by the news Spotless was dealing with vastly reduced volumes of laundry from private hospitals due to the decline of elective surgeries.

Apart from the Spotless shortfall, the presentation also revealed that the Downer brand was facing a mine closure in South Africa, and a 70% reduction in productivity spurred by severe lockdowns for New Zealand activities.

Overall, it appears as though the impressive breadth of the company’s operations across several industries has been deeply challenged by the unprecedented COVID-19 pandemic, forcing the share price to bottom out at $2.58 in March. This would have been an agonising period for existing shareholders, who were also hit with the news of Downer deferring its dividend until September this year.

Future outlook – what I like about Downer EDI  

Notwithstanding these challenges, I remain optimistic about the company’s financial performance in FY21 and beyond. Firstly, its balance sheet is bursting at the seams. This has been aided by its financing of a $500 million syndicated bank facility, adding to the already half billion in cash and $1.14 billion of undrawn debt the company held at the end of 2019.

Secondly, coupled with its supreme liquidity, Downer’s longstanding government customer base also ensures it is a likely beneficiary of government stimulus and new infrastructure projects under the JobMaker program. The expertise of the company to deliver high-level transport projects and general urban services likely puts them in good stead to benefit from new government contracts under JobMaker and beyond.

Thirdly, the company’s earnings hit in FY20 will likely be short-lived. Spotless will likely revive its capacity at some point in the coming months, albeit under the caveat of greater social-distancing and hygiene restrictions, and the incidence of elective surgeries already appears to be recovering.

Notably, Downer announced in May that its relationship with Fortescue Metals Group Limited (ASX: FMG) had been extended through a confirmed $450 million agreement at the Eliwana iron ore mine in Western Australia. This 5-year arrangement is the second transaction between the pair, and represents Downer’s broader strategy of utilising existing contracts to expand on subsequent work for its clients.

The Fortescue deal adds to Downer’s impressive current project portfolio, which includes the delivery of the Auckland City Rail Link, railway vehicles including the Sydney Waratah and Melbourne Metro train fleets, and light-rail projects in Parramatta and the Gold Coast.

With plenty of new and existing work on the horizon and a historical dividend yield of 5.8%, I believe the current Downer share price provides prospective investors with significant upside over the medium to long-term.

Foolish takeaway

This company has been equally helped and harmed by its unique exposure to such a wide array of industries throughout the COVID-19 pandemic. Yet, although its ownership of Spotless continues to be a thorn in Downer’s side, I remain optimistic that the company’s exposure to substantial government and private-sector infrastructure projects bodes well for the continued resurgence of the Downer share price.

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Motley Fool contributor Toby Thomas has no position in any of the stocks mentioned. 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 Scott Phillips.

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