A turnaround play in the macro storm - Downer EDI

Investment headlines are currently dominated by big macro issues such as recession and inflation. While some investors ponder about these big issues, stock specific opportunities are sometimes overlooked. Stocks that typically perform well irrespective of the macro environment are turnaround plays. Downer EDI (DOW) is one such stock that could ride out the macro storm.

DOW’s business model is often described as a both less cyclical and capital intensive than other listed contractors, which makes the company more predictable with a lower risk profile than peers. However, this was put to the test when the company announced two significant earnings downgrades in December 2022 and February 2023. The market’s fickle nature gave up on the notion of predictable cashflows and dumped the stock.

Two central themes that underpin DOW’s downgrades were (i) excessive rain that led to lost shifts and (ii) the tight labour market led to increased use of more expensive outsourced labour. Compounding these issues was the revelation of an accounting irregularity for one of their contracts that led to an overstatement of earnings in prior years.

DOW’s management has since announced asset sales, a $100m cost out program and ultimately aim to double EBITA margins from its current depressed level of 2.2% (1H23) to 4.5% (FY25). Vertium is typically sceptical of hockey stick earnings recoveries as lofty promises often disappoint. However, there are reasons to believe that DOW’s management guidance is achievable (at least directionally).

Firstly, 2022 was an exceptional year when the east coast of Australia recorded its highest rainfall on record, which surpassed previous record readings in 2010. There was more than a decade difference between record rainfall years and, if history is a guide, it is unlikely there will be back-to-back record rainfalls in 2022 and 2023. More importantly, in early 2023 there were signs that the La Nina environment which drove the 2022 heavy rainfall was ending. In fact, El Nino, which leads to dry weather in Australia, was recently declared by various authorities.

Secondly, 2022 was also an extraordinary year regarding the tight labour market and its occurrence is quite rare. The desperation of companies wanting to hire workers in 2022 was nearly on par with extremely tight conditions 15 years ago prior to the 2008 Global Financial Crisis. More importantly, on a forward-looking basis, the labour market has been loosening since early 2023. Thanks to the Reserve Bank of Australia attempting to slow the Australian economy, the tight labour market of 2022 is likely to unwind.

Regarding the accounting issue for one of their contracts, management has assured the market that it was a one-off issue and was not systemic across other contracts. In fact, the problem contract was renegotiated with their customer and is expected to deliver a reasonable profit to the company. We take comfort that DOW has created a new Chief Risk Officer role, aimed at improving the consistency of DOW's risk management framework so that this issue is not repeated.

Despite DOW’s recent rally, the stock still looks cheap. Sentiment remains sour as the stock still suffers from a credibility issue given its double earnings downgrade within a 3-month period. Consensus has not given management the benefit of doubt as the average earnings estimate is towards the bottom end of DOW’s FY23 NPATA guidance range of $170 - $190m. Consensus also does not fully believe in DOW’s turnaround in EBITA margin, which is at 4.0% versus guidance of 4.5% in FY25.

Whether you believe management guidance can be debated but at 4% margin DOW's FY25 EPS is expected to be $0.38. At 14x PE (similar to how the stock traded prior to the COVID pandemic), the stock could trade at $5.32 (more than 20% higher than current share price). If management delivers on its margin guidance of 4.5%, consensus EPS would have to be revised up by 17%, and the stock is likely worth north of $6. 

Investing in turnaround plays such as DOW is one way to cut through the macro volatility. DOW's credibility and its stock price crumbled when they announced back to back earnings downgrades within 3 months. However, the conditions that led to DOW's downgrades is clearing but sentiment is still somewhat bearish. This sets the foundation for DOW to continue to deliver solid risk-adjusted returns.