Fitch Rates Downer's AUD300 Million 2026 MTNs 'BBB'

(The following statement was released by the rating agency) Fitch Ratings-Sydney-April 22: Fitch Ratings has assigned Downer Group Finance Pty Limited's (Downer Finance) AUD300 million 3.70% fixed-rate medium-term notes (MTNs) due April 2026 a rating of 'BBB'. The proceeds will be used to repay bank debt at the Downer EDI Limited (Downer, BBB/Stable) level and diversify its debt portfolio. The notes will be issued under Downer Finance's AUD1 billion debt issuance programme and will be unconditionally jointly and severally guaranteed by Downer and its subsidiaries, which account for at least 90% of the group's consolidated total tangible assets and EBIT. As a result of this guarantee structure, Fitch regards the credit risk associated with the notes to be the same as that of the senior unsecured obligations of Downer itself. KEY RATING DRIVERS Shift towards Service Revenue Continues: Downer's Spotless acquisition has continued to move its portfolio away from the cyclical mining and engineering, construction and maintenance sectors towards the infrastructure and civil sectors. Segments excluding mining, which are mainly service-based, made up 89% of group revenue in the first half of the financial year ending June 2019 (1HFY19), up from 74% in FY14 for Downer on a standalone basis. The combined Downer group is the largest diversified-services group in Australia and New Zealand that offers end-to-end service capabilities. The group's work-in-hand (WIH) rose to AUD43.5 billion at end-1HFY19 from AUD39.2 billion at end-2017 or AUD22.5 billion at FYE17 for Downer only. Spotless Integration Risk: Fitch believes Downer's strong record in integrating newly acquired companies - most recently following the 2014 acquisition of Tenix - and executing business turnarounds reduces execution risk around the integration of Spotless. Downer's actions to date include performing a comprehensive review of Spotless's operations and financial position and integrating a number of key business operations, including the creation of a joint bidding committee. Downer continues to work on enhancing Spotless's risk-management capabilities and major bid approval processes. The group reported underlying cash conversion of greater than 90% of EBITDA in 1HFY19 and FY18, despite the negative cash impact from Spotless's 30-year Royal Adelaide Hospital contract. In our view, this highlights Downer's ability to successfully integrate companies. However, we have not seen evidence of oversight on bidding to date given the early stages of integration. Separate Financial Management: Downer continues to manage the financing of its legacy operations and the Spotless business separately, with no guarantees between the two entities, as it was only able to acquire around 88% of Spotless. The Spotless business had AUD833 million in debt outstanding at FYE18. In our view, this creates some structural subordination for the creditors of Downer as cash generated at Spotless will be applied first to the debt outstanding at that entity. However, this structural subordination has no impact on the ratings in light of the size of Spotless's EBITDA contribution to the combined group. High Earnings Visibility: Around 85% of Spotless's revenue is contracted, with tenures ranging from short-term up to 30 years for public-private partnership-related contracts (PPP), which has improved Downer's earnings visibility. Spotless had PPP contracts worth around AUD11 billion in lifetime revenue within the contract portfolio at FYE18 (end-2017: AUD10.8 billion) with tenures typically between 25 and 30 years. The inclusion of these long-term stable contracts in the group's order book complements Downer's improved earnings and cash flows visibility - with around 85% of 1HFY19 EBITA derived from its service-based businesses - which is driven by the shift towards projects that are lower risk, less capital intensive and maintenance-oriented. Focus on Government Spending: Government-related revenue has increased as a proportion of Downer's total revenue, as the Australian economy shifts away from the resources sector and the government prioritises infrastructure spending. The acquisition of Spotless has diluted this marginally, but Fitch continues to expect government infrastructure spending to be the primary source of major new opportunities for the combined Downer group over the medium term. Robust Project-Risk Oversight: Downer's robust project bidding and execution skills will become increasingly important as competition intensifies across all sectors. Downer's senior management is directly involved in monitoring the bidding and delivery of all major projects to identify potential problems and avoid major cost overruns. Downer has implemented an approval process and changed Spotless's risk-management capability following its acquisition, which we view as positive to the newly formed group's risk profile. Further M&A Detrimental: Additional large, debt-funded M&A may pressure Downer's rating at a time when it has little headroom within its negative rating guidelines. However, we do not expect significant M&A in the short term, as Downer remains focused on integrating Spotless and taking advantage of any opportunities the acquisition provides. DERIVATION SUMMARY Downer's scale and diversification across sectors have improved following its Spotless acquisition. However, the combined group is still smaller and less geographically diversified than major global peers, including Vinci S.A. (A-/Positive), accounting for the two-notch differential. Downer has lower leverage than LafargeHolcim Ltd (BBB/Stable), while LafargeHolcim has exposure to the inherently cyclical building-material sector. However, LafargeHolcim's geographic diversification provides some cash flow stability to counter the volatility in its sector, and combined with its stronger profitability, lead us to rate the two companies at the same level. Ferrovial, S.A. (BBB/Stable) is among the top Fitch-rated engineering and construction companies. However, its construction margins are under pressure and its UK services business is being weighed down by uncertainty in the country. Notwithstanding these challenges, which are in stark contrast to the favourable environment in Australia, Spain-based Ferrovial has a conservative balance sheet and hence it is rated at the same level as Downer. KEY ASSUMPTIONS Fitch's Key Assumptions Within Our Rating Case for the Issuer - Revenue growth in FY19 to be generally flat, reflecting lower opening WIH in Utilities and engineering, construction and maintenance. Revenue growth from FY19 to FY22 above Fitch forecasts for Australian GDP growth as Downer continues to benefit from increased investment in public infrastructure in the country (FY20: 3.7%; FY21 and FY22: 3.4%). - Project delivery governance to remain in place with no further major write-offs not already publicly disclosed. - Capex to moderate to around AUD330 million per year from FY19 to FY21. - Downer dividend payout ratio at between 50% and 60% of consolidated underlying net profit after tax and amortisation. No dividends to be paid at Spotless. RATING SENSITIVITIES Developments that May, Individually or Collectively, Lead to Positive Rating Action - No positive rating action is anticipated over the medium term due to Downer's geographic concentration and scale. Developments that May, Individually or Collectively, Lead to Negative Rating Action - Adjusted net debt/operating EBITDAR rising to above 2.5x for a sustained period (FY18: 2.2x) - EBITDA margin falling below 6.0% for a sustained period (FY18: 6.2%) LIQUIDITY Adequate Capital Market Access: Downer has access to a wide range of funding sources, including syndicated loans, capital-market debt and equity. Downer will continue to manage each entity's debt on a standalone basis, as it was unable to complete a 100% takeover of Spotless. It also conducted a detailed review and refinance of Spotless's debt and bonding facilities as part of its refinancing of the group's facilities in 2H18. Following the refinance, the group's weighted-average debt duration increased to 3.8 years at end-1HFY19 from 2.3 years at end-1HFY18, including the issuance of a 15-year yen-denominated bond. Contact: Primary Analyst Kelly Amato, CFA Director +61 2 8256 0348 Fitch Australia Pty Ltd Level 15, 77 King Street, Sydney, NSW, 2000, Australia Secondary Analyst Leo Park Associate Director +61 2 8256 0323 Committee Chairperson Vicky Melbourne Senior Director +61 2 8256 0325 Date of Relevant Rating Committee: 13 September 2018 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com; Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com. Additional information is available on www.fitchratings.com Applicable Criteria Corporate Hybrids Treatment and Notching Criteria - Effective from 27 March 2018 to 9 November 2018 (pub. 27 Mar 2018) https://www.fitchratings.com/site/re/10024296 Corporate Rating Criteria - Effective from 23 March 2018 to 19 February 2019 (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10023785 Corporates Notching and Recovery Ratings Criteria (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10024585 Sector Navigators (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10023790 Additional Disclosures Solicitation Status https://www.fitchratings.com/site/pr/10068867#solicitation Endorsement Policy https://www.fitchratings.com/regulatory ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTPS://WWW.FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. 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