panic = opportunity, page-46

Downer on downward spiral over rail doubt
DAVID SYMONS
June 23, 2010

THREE weeks on from Downer EDI's belated confession that all is not well with its Reliance Rail contract, and shares in the company are still spiralling lower.

Downer shares touched a 12-month low of $4.04 yesterday, down from $6.27 immediately before the company recorded a $190 million provision against the rail contract.

Restoring the company's credibility will be nearly impossible so long as operational and financial uncertainty surrounds Reliance Rail, but what could be tackled is increasing expectation that a sizeable capital raising is coming.

It is unlikely that sentiment will improve until the perception that the company needs to raise capital is dealt with.

There are two key drivers for a capital raising. The first is the looming need to contribute more equity to put 49 per cent-owned Reliance Rail on a surer financial footing. The project is now geared to 94 per cent, with $2.3 billion of debt supported by just $137 million of equity.

Of course, Downer chief executive Geoff Knox vehemently denies that Downer is set to contribute to a recapitalisation of Reliance Rail. But there are plenty in the market who reckon failure to participate in a recapitalisation - possibly walking away from the contract - would cause immense damage to Downer's reputation.

This could cripple the company's ability to win future business.

Then there's the problem that Downer's credit metrics are stretched, even without taking a capital recapitalisation of Reliance Rail into account. According to CBA analysis, if Downer were to bring its credit metrics back in line with credit ratings agency requirements for a BBB rating, while continuing to pursue growth opportunities such as a major contract win with Fortescue, an equity raising of between $250 million and $400 million would be required. Downer is rated BBB- by Fitch.

Adding weight to the expectation of an equity raising is the expiry of both a medium-term note and a New Zealand bond in the next three years. Replacing these facilities would be tough if Downer is only rated BBB-.
Elders anxieties

WHILE the severity of Elders' profit downgrade shocked the market yesterday, sending shares plummeting 46 per cent to 44, more disturbing are the questions emerging about management's ability to turn around Elders' rural services operation.

The profit downgrade to a full-year loss that could be as much as $14 million throws into doubt all previous analysis of the sustainable earnings that can be expected from Elders.

That the current agricultural season is the best that much of the country has seen in years only adds to anxieties about the likely profitability of Elders in a drought year.

Also significant is that the company seems to have fallen short of previous profit targets of about $45 million without losing market share.

Analysis released by the Elders camp suggests that in key areas of the chemical, glyphosate and east-coast fertiliser markets, Elders has held its own against key competitor Landmark. Both have had to make trade-offs between volume growth and price in an increasingly competitive market, but there is no indication that Elders has come off worse.

With questions hanging over the Elders cost base, at this stage chief executive Malcolm Jackman is sticking to his guns, predicting an improvement in rural services EBIT margins to at least 5 per cent by 2013, up from current levels of less than 2 per cent.

Jackman also remains confident in the Elders model, while noting that the cost of servicing customers is going to have to be reduced if the company is to deliver on its profit goals. Better procurement and supply chain management won't be enough.

Notably, however, Jackman's goal of removing $45 million of staff costs by Christmas, without incurring a restructuring charge or having much impact at the coalface, will need to be seen to be believed.

This is not the first round of staff reductions to take place since Jackman took the helm 21 months ago. The easy staff cuts have already been undertaken at a regional level (being about 5 per cent of the workforce), and the next cuts are expected to be tough to achieve without affecting market share.