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

While construction activity in the Engineering, Construction and Maintenance (EC&M) business in the minerals and metals sector runs off and multi-year Mining contracts complete a further year, the overall business and financial profiles remains consistent with its rating.

KEY RATING DRIVERS
Order-Book Shrinking, Still Strong: Downer's order-book remained strong at AUD18.5bn at 30 June 2015 (FY15), benefitting from the 2014 acquisition of Tenix which added around AUD1,200m at the time of acquisition, despite having shrunk in recent years due to falling capex and margin pressure in the resources sector. In 2015, Downer announced a number of new projects, including a 10-year, AUD1bn agreement with rail-freight operator, Pacific National, to provide a full suite of asset management services for over 300 locomotives.

Diversifying from Resources Sector: Downer's project-mix continues to reflect a transition in the demand for engineering services from the resources sector to other parts of the economy, such as liquefied natural gas (LNG) plant construction, communications, and infrastructure upgrades in Australia and New Zealand. While Downer continues to be exposed to the mining sector, its diversity provides some revenue protection relative to other contractors.

More Recurring Projects: The industry transition has caused an adverse shift in project composition towards regular low-risk maintenance-type work away from long-term contracts. Recurring projects accounted for 29% of Downer's order book at FY15, compared with 23% at FY12. Downer's recurring maintenance project exposure is spread across a large customer base, which the company expects will continue over many years.

Margins Squeezed: Fitch expects Downer's profitability to deteriorate in the short to medium term, as infrastructure projects, which have historically yielded the lowest margins of around 4%, increase as a proportion of the company's order book. Further, according to management, customers are increasingly seeking to cut costs which has resulted in a few of its larger contracts being renegotiated at lower margins or changed to fixed pricing. Previously, growth in the Australian resources sector had enabled the company to benefit from high-margin (7%-8%) mining projects

Robust Project Risk Oversight: As competition intensifies, Downer's robust project bidding and execution skills will become increasingly important. Downer's senior management are directly involved in monitoring the bidding and delivery of all major projects, to try to identify any potential problems early and avoid major cost overruns. In addition, bids above AUD30m are required to be approved by Downer's Tender and Contracts Committee and those larger than AUD250m by Downer's board, while all material bids are subject to a legal, insurance, treasury, tax and accounting vetting process.

KEY ASSUMPTIONS
Fitch's key assumptions with our ratings case for the issuer include:
- FY16 revenue growth forecasts based on order book and Downer management guidance, excluding the impact of successful tenders not yet confirmed
- Revenue growth from FY17 based on:
- Australia: Transport Services, Technology & Communications Services, Utilities Services, and EC&M segments expected to grow in line with general growth forecasts for the Australian economy (FY17 onwards: 2.5%)
- New Zealand: Transport Services, Technology & Communications Services, Utilities Services, and EC&M segments expected to grow in line with general growth forecasts for the New Zealand economy (FY17 onwards: 2%)
- Downer Mining expected to contract to reflect reduction in project scope and margin squeeze (FY17 & FY18: decline of 3%, thereafter 0% growth)
- Downer Rail expected to grow in line with general growth forecasts for the Australian economy (FY17 onwards: 2.5%)
- Variable costs expected to rise as a proportion of total revenues, reflecting margin squeeze currently being experienced by Downer
- Project delivery governance to remain in place with no major write-offs required

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

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

An increase in Adjusted Net Debt/Operating EBITDAR to above 2.5x (1.77x FY15), or a decline in the EBITDA margin to below 7% (7.9% FY15), both on a sustained basis; or
Changes to business risk profile such that there is a material increase in Downer's exposure to fixed-price construction contracts (total fixed-price contracts - including construction and maintenance: FY15: 34%; FY14: 29%).

The rating actions are as follows:

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'.