Positioning In Energy Transition And Defense Will Unlock Future Opportunities

Key Takeaways

• Strategic positioning in energy and infrastructure services supports revenue growth, leveraging government contracts and carbon transition opportunities.
  
• Cost-reduction initiatives and operational improvements enhance earnings potential and profitability, especially in defense and infrastructure projects.
  
• Reliance on government contracts poses revenue risk, while costly restructuring and legal issues may impact short-term net margins and profitability.

Catalysts

Operates as an integrated facilities management services provider in Australia and New Zealand.

• Downer's exposure to government outsourcing due to population growth and long-term government-related contracts provides a stable revenue base, with expected future growth in infrastructure services. This is likely to positively impact revenue.
  
• The company's strong positioning in transitional energy requirements and power infrastructure related to a lower carbon economy, highlights significant opportunity for revenue growth by leveraging capabilities in the energy sector.
  
• Downer’s strategic focus on becoming a prime contractor in local industries boosts its ability to secure high-value contracts, especially in the defense sector, likely enhancing earnings growth due to its specialized capabilities.
  
• A robust cost-out strategy with a target to realize significant cost savings by FY '25 is likely to improve net margins and overall earnings.
  
• The ongoing business transformation and streamlining of operations, alongside enhanced governance and risk management, set the foundation for improved project execution, which is anticipated to improve EBITA margins and profitability.

Downer EDI Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Downer EDI's revenue will grow by 5.1% annually over the next 3 years.
• Analysts assume that profit margins will increase from 0.5% today to 2.5% in 3 years time.
• Analysts expect earnings to reach A$323.2 million (and earnings per share of A$0.46) by about February 2028, up from A$56.1 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 14.4x on those 2028 earnings, down from 68.2x today. This future PE is lower than the current PE for the AU Commercial Services industry at 23.2x.
• Analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.29%, as per the Simply Wall St company report.

Downer EDI Future Earnings Per Share Growth

Risks

• Downer's reliance on government-related contracts, making up 90% of its revenue, poses a risk if there is a reduction in government spending or policy changes affecting infrastructure projects, which could negatively impact revenue.
  
• The completion of low-margin contracts and reduction in spending, particularly in key areas like Victoria, may impact transport revenue growth, leading to potential stagnation or decline in earnings from this segment.
  
• Significant restructuring and transformation costs are being incurred to drive cost efficiencies, which, while potentially beneficial long-term, could pressure near-term net margins if not managed within expected budgets.
  
• Ongoing investigations and legal matters, such as the ICAC public inquiry and class action, may incur substantial costs or penalties impacting net income, as well as potentially affecting future revenue through reputational damage.
  
• While improvements in cash flow and debt levels are noted, the ambitious transformation targets may still require further investment, impacting short-term profitability and financial flexibility if savings are not realized swiftly enough.

Valuation

• The analysts have a consensus price target of A$5.612 for Downer EDI based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of A$6.15, and the most bearish reporting a price target of just A$5.0.
  
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be A$12.8 billion, earnings will come to A$323.2 million, and it would be trading on a PE ratio of 14.4x, assuming you use a discount rate of 7.3%.
  
• Given the current share price of A$5.71, the analyst price target of A$5.61 is 1.7% lower. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.