Extensive wet weather this year has undone Downer’s earnings guidance. To the extent that this is beyond the company’s control, it is forgivable if not frustrating. Unearthing ‘accounting irregularities’ that stretch back to 2020 is very unfortunate and saps investor confidence in the Management. Nothing illegal has occurred, as far as the company can determine, but this is a red flag event that shareholders should not ignore.
Accounting mistakes. DOW revealed accounting irregularities had occurred in its Utilities business across a four year period beginning in September 2019. The irregularities are estimated to amount to $30-40 million of pre-tax earnings. Further work is being done to confirm the full extent of the errors. DOW said misreporting of historical revenue and work in progress in one of the company’s maintenance contracts was the source of the problem.
Guidance downgrade. Separately, the wet weather that has enveloped eastern Australia this year has continued into October and November. DOW had previously caveated its full year guidance of 10-20% net profit growth as being subject to no material weather effects, labour shortages or COVID-19 restrictions. DOW now admits the weather has rendered the guidance unachievable. It now expects underlying FY23 net profit to be $210-230 million, compared to FY22 at $225 million.
Investment View
The accounting irregularities have occurred over a four year period in a single contract suggesting this is perhaps no more than human error, albeit a big one. DOW regularly reviews all its work in progress (approximately $36 billion) but a full body scan may be necessary to ensure the group accounts are squeaky clean.
We would anticipate consequences once the Board has finalised what went wrong and who is responsible. Grant Fenn is in his final months as CEO before handing over to Peter Tompkins in February 2023, so this will be a disappointing end to his tenure and a rocky start for Tompkins.
The earnings downgrade is fixable in the sense that weather-delayed work can be caught up in time. DOW does have a deep pipeline of infrastructure work that can drive earnings and recapture investor confidence in due course. The balance sheet is in good shape and leaves room for acquisition activity before it reaches its target range of 2.0-2.5x net debt to EBITDA.
The view from 30,000 feet on DOW might conclude that neither the accounting mishap nor the weather-induced earnings downgrade is especially egregious. It has exited mining and hospitality businesses to concentrate the portfolio on Urban Infrastructure where 90% of its business is government related. In the context of a group revenue line that is close to $12 billion, does it really matter that a single contract worth an estimated $150 million in annual revenue should cause such consternation for investors? Our answer, frankly, is yes.
Naturally, the company believes the share price, even before the latest kerplunk, did not reflect fair value for the business. But like Lemony Snicket’s series of unfortunate events, DOW seems unable to shake the trail of calamities that has befallen it over the last ten years.
Our change of recommendation pertains to a loss of confidence in an earnings recovery and a question mark over the management.
In DOW’s defence, it is financially solid, and earnings could conceivably recover in FY24f given a decent spell of fair weather.
Consensus earnings forecasts have aligned with the downgraded guidance, but there will be a generous dose of salt to be taken with that. Regardless, a sub-10x FY24f PE ratio, a dividend yield over 7% and net debt to EBITDA at 1.0x has some appeal. On the downgraded forecasts, a valuation on a fully diluted share count could comfortably exceed $5.00 per share. That prospect saves our recommendation change from a worse fate.
Risks to Investment View
Earnings would be dented if the economic infrastructure plan did not play out, or if COVID impacts and prolonged wet weather continued to disrupt operations.
Recommendation
We have reduced our recommendation to HOLD from BUY.
Specific Disclosure: Sandstone Insights analyst holds a position in the subject company.
