Is Downer EDI a value play or value trap?

For shareholders of Downer EDI (DOW), the last 12 months have been challenging ones to say the least.  Shares of DOW have fallen approximately 52 per cent.

The start of the 2011 hasn’t been much better.  Shares tumbled from $4.50 to as low as $3.66 following news that the company was taking a $A250 million provision of due delays in delivering trains for Sydney’s suburban rail network.  Shortly after this, ligation funder IMF announced that a shareholder class action suit has been launched against the company. CEO Grant Fenn has a tough road ahead to convince shareholders that the future will be rosier.

Downer EDI consists of a group of companies that specialise in the engineering, construction, telecommunications, mining and resource sectors in the Asia Pacific region. Revenue for 2010 was $6.1 billion, operating cash flow of $377 million and liquidity in excess of $800 million ($385 million in cash plus current credit facilities). The Downer Group includes:

1. Downer Consulting – which delivers ‘front-end’ engineering design and consulting capabilities

2. Downer Engineering – which provides engineering services from design and planning through to operation and maintenance with prime activities in contracting, services and projects.

3. Downer Mining – a major provider of mining, mine planning and mine management services.

 4. Downer Rail – a leading provider of passenger and freight rolling stock and associated maintenance services in Australia

5. Downer Works – which provides services for development, asset management and maintenance of public and private infrastructure

With shares currently trading 12 – 15 per cent higher than the recent low, the broking community is starting to question whether now might be the time to get back in. Is all bad news reflected in its share price?

Analyst Carey Smith of Alto Capital, who currently has a Buy recommendation on Downer EDI believes the markets have overreacted to a short-term issue. He thinks the group currently offers top value for the longer-term investor.

Novus Capital analyst Steven Hing recently commented: “Downer EDI suffered a 20 per cent fall in late January after again failing to deliver the new NSW rail carriages (Waratah trains). The company announced it was provisioning a $250 million loss on the project (up from $150 million). Delaying delivery until April has sparked rumours the company may need to consider a capital raising. However, DOW appears to have robust operations in its other divisions, and I feel the price can recover towards $5 levels. I believe the market has overreacted again to the Waratah train issues, and today’s price represents a good buying opportunity.”

When it comes to bargain hunting in shares, one always has to be aware of being snagged in a value trap.  Typical value traps are the following:

1. Ignoring debt.  When we look at Downer, current debt to equity and interest coverage ratios suggests that the current debt is not excessive.

2. The dividend trap. Many times investors are attracted to shares for its dividend. The current dividend yield of 8.00 for DOW is not bad, but it also may not be sustainable.

3. Shares cheap on a historical basis and cheap relative to their high-multiple peers.  Downer‘s current P/E, of 8.7 X, is historically cheap and lower relative its peers.  We need to find out why.

Experience teaches us that shares have a tendency to overreact to news, both good and bad. When companies are trading at low multiples of earnings, cash flow or book value for an extended period of time, they are often doing so for good reason. The reason being, they have little promise and or possibly no future.

Downer EDI, in comparison, has a strong underlying businesses outside of the Waratah rail project, revenue over $6 billion dollars, $385 million in cash and over $800 million in liquidity.  That being said, at its current share price, brokers are thinking that the risks to the downside appear limited.

Bottom Line

Although Downer EDI continues to struggle with the Waratah project, the company’s strong balance sheet, ample liquidity and strong underlying business suggests that the market may be over-reacting. As Baron Rothschild, said ‘The time to buy is when there’s blood in the streets”.