OREANDA-NEWS. Fitch Ratings has affirmed Downer EDI Limited's (Downer) Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB'. The Outlook is Stable.

The rating action applies to all senior unsecured debt issued or guaranteed by Downer, including debt issued by Downer Group Finance Pty Limited. A full list of rating actions follows at the end of this commentary.

Downer's work-in-hand (WIH) remained strong at AUD18.6bn at 30 June 2016 (FY16), as the company benefits from its exposure to infrastructure. Downer's project mix continues to reflect this transition, with WIH increasing in its transport, utilities and technology and communications segments, offsetting declining demand for its mining and other resource sector-based businesses.

Fitch expects Downer's margins to fall due to the shift towards infrastructure projects and long-term maintenance contracts. However, the company is targeting lower-risk, less capital intensive and recurring maintenance-type work, which Fitch expects will lower Downer's business risk and keep its overall business and financial profile consistent with its rating.

KEY RATING DRIVERS

Infrastructure Pipeline Supports Order Book: Downer's WIH remained strong at AUD18.6bn at FY16, despite continued mining-sector weakness. The company's mining segment WIH has declined by 67% to AUD2.5bn since its peak in FY11. Downer's exposure to other sectors, including infrastructure and civil sectors, allowed it to mitigate the fall in mining work, with infrastructure WIH increasing by 55%, to AUD11.4bn, over the same period. Downer announced a number of new projects in 2016, including a 10-year AUD512m supply and maintenance contract with the Public Transport Authority of Western Australia and a two-year extension of the mining services contract at the Meandu Mine in southern-Queensland, worth around AUD250m.

Focus on Government Infrastructure: Downer's project-mix reflects the transition in demand for the company's services away from the resources sector to other parts of the economy. Government-related revenue continues to increase, already representing 56% of Downer's total revenue in FY16. Fitch expects government infrastructure spending, including rail infrastructure and passenger rollingstock upgrades in Australia and New Zealand and privatisation of public assets, to be the primary source of major opportunities for the company over the medium term. Downer also continues to actively target new industries that can utilise its core competencies, including Australia's defence sector.

More Recurring Projects: The industry transition is causing a shift in project composition towards regular lower-risk, less capital intensive and maintenance-type work away from large-scale construction-type contracts. Fitch expects Downer's business risk to lessen as these projects increase as a proportion of WIH, as they are generally less complex and provide greater visibility around long-term cash flow generation. Downer's recurring maintenance project exposure is spread across a large customer base, which the company expects to continue.

Profit Margins Squeezed: Fitch expects Downer's profit margins to deteriorate in the short - to medium-term, as infrastructure projects - which historically yielded the thinnest margins of around 4% - rise as a proportion of its order book. Furthermore, management says customers are increasingly seeking to cut costs leading to some larger contracts being renegotiated at narrower margins in the resources sector or changed to fixed pricing. Previous Australian resource-sector growth enabled Downer to benefit from higher-margin (7%-8%) mining projects.

Robust Project-Risk Oversight: Downer's robust project bidding and execution skills will become increasingly important as competition intensifies. The company's senior management are directly involved in monitoring the bidding and delivery of all major projects to identify potential problems and avoid major cost overruns. Furthermore, bids above AUD30m must be approved by the Tender and Contracts Committee and those larger than AUD250m by Downer's board.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Downer include:

FY17 in line with Downer guidance of net-profit-after-tax of around AUD170m, excluding the effect of bid costs on three major rail projects, which will need to be written-off to the extent these bids are unsuccessful

Above average consolidated revenue growth in FY18, then growth in line with general forecasts for the Australian economy. Growth in the transport, technology & communications and utilities segments and a recovery in the rail segment is expected to offset declines in the mining and engineering, construction and maintenance segments (FY18: 4.5%; FY19: 2.1%; FY20: 1.2%)

Stabilising variable costs due to Downer's efforts to transform it businesses to address demand changes between its segments, with consolidated EBITDA margin of around 7% until FY19 (FY16: 8%)

Project delivery governance to remain in place with no major write-offs

Gross dividends to remain stable at around 24 cents per share per annum

Capex to decline in FY17 to around AUD150m, then increase to around AUD220m from FY18 to FY20.

RATING SENSITIVITIES

Positive: Downer's geographic concentration and scale, as well as the weakening of Australia's macroeconomic environment, constrain its rating at 'BBB'.

Negative: Future developments that could lead to a negative rating action include:

An increase of adjusted net-debt/operating EBITDAR above 2.5x (FY16: 1.6x) or a decline in the EBITDA margin below 7% (FY16: 8%), both on a sustained basis

Changes to its business-risk profile leading to increased exposure to fixed-price construction contracts (total fixed-price contracts, including construction and maintenance: FY16: 34%; FY15: 34%).

FULL LIST OF RATING ACTIONS

Downer EDI Limited

Long-Term IDR affirmed at 'BBB' with Stable Outlook

Senior unsecured debt affirmed at 'BBB'

Downer Group Finance Pty Limited

Senior unsecured debt guaranteed by Downer EDI Limited affirmed at 'BBB'