where to from here?

New boss aims to turn Downer EDI’s fortunes around

The Age
Adele Ferguson
August 21, 2010

After years of problems, Downer EDI shareholders are out of pocket and out for blood.

AS DOWNER EDI’s new managing director Grant Fenn spent the past few days trying to talk up the future of the engineering and construction giant, the market was dumping the stock and counting the number of heads that have rolled over badly managed contracts.

It is a problem that has plagued Downer for years and BusinessDay can reveal that it has now captured the attention of litigation funder IMF, which is believed to be investigating a multimillion-dollar class action over misleading information given to shareholders earlier this year relating to the Waratah rail contract.

Disappointments, contracts gone bad, profit downgrades, credibility issues and a revolving door for chief executives have been a recurring theme of the group, leaving shareholders out of pocket and out for blood.

The last chief executive to get the bullet was Geoff Knox two weeks ago. Before him was interim chief executive Bruce Waldron who left in 2007 and before him was Stephen Gillies who resigned in August 2006 following savage company profit downgrades in 2006-07, partly caused by a long-running dispute with Iluka Resources over Downer’s $150 million claims in cost overruns in Iluka’s mineral sands project.

The latest profit results released by Fenn have left investors cold. Net profit was a paltry $3 million as the firm’s troubled New South Wales rail project caused a 98 per cent plunge in net profit and even more chilling was that the earnings outlook for 2011 would be flat despite two new contracts worth $5 billion.

The market reacted accordingly. The company’s shares fell 7 per cent, down more than 50 per cent since the start of the year and analysts downgraded their recommendations and earnings forecasts for 2011 and 2012.

And in classic Downer revolving-door syndrome, chairman Peter Jollie agreed to fall on his sword in November.

All in all it was a big week for Grant Fenn. But each and every week will be a big week from now until the end of the year.

December 31 is a critical milestone for the company to deliver the first fully operational, fully certified train set to the NSW government.

And for Fenn, if he gets it wrong, the market — and the government that is three months out from an election — won’t give the company another chance. “There are risks, but I am confident we will get there,” Fenn said.

While the company’s results were not too flash, using a series of techniques to tart up the underlying earnings, the main focus is on a multibillion-dollar contract with the NSW government’s RailCorp to build, operate and maintain 78 train sets for the next 35 years.

They are already eight months late and this year alone the project has cost the company $190 million in cost overruns and delay penalties, and an additional $170 million in cash outflows.

The company is forecasting another $40 million in cash outflows in the next few months — assuming all goes well. The project is at 30 per cent completion point, and, according to Fenn, there are still many risks.

If there are more stuff-ups and delays then the shells of the trains, built in China, will pile up in Newcastle, NSW, and so will Downer’s working capital, which will squeeze its already challenged cashflow.

A further delay would also have savage repercussions on Downer’s share price and credibility in winning other rail-related contracts.

To ensure Fenn had sufficient incentive to meet this demand, the board, headed by Jollie, agreed to give him 100,000 Downer shares if he can deliver the first Waratah train by December 31. He will receive another 200,000 shares if he meets certain hurdles in the delivery of the Waratah train sets in the next 12 months.

The Waratah rail contract symbolises all that is wrong at Downer EDI — poor transparency, a contract that is too complicated and questionable risk management.

Besides trying to manage project risk, there is the issue of its financing model, which was put together by Babcock & Brown and ABN Amro before the global financial crisis.

To source cheap debt and keep that debt off its balance sheet, all parties agreed to create a so-called special purpose vehicle (SPV) called Reliance Rail, which had $2.2 billion of debt and equity. The vehicle used two monoline insurers, one being Syncora, which lent out its credit rating for a fee, to source cheap debt.

Sound complicated? It is. It is also risky.

On July 2, Downer was forced to put out an ASX announcement warning that Reliance Rail’s banking syndicate had issued it with a “reservation rights notice”. This means the dire financial situation of Syncora might constitute a financial guarantor event of default, which could trigger a switch date in relation to the undrawn bank debt facility.

Put simply, the $357 million bank debt facility, which is scheduled to begin drawdown in February 2012 to fund the balance of the rolling stock manufacturing contract, contains a specific provision that in the event of default for the financial guarantors, the banks have the right to terminate any undrawn commitments under the Reliance Rail bank debt facility.

This is scary stuff. If Syncora or the other struggling monoline insurer triggers a switch date and the banks pull the plug or force Reliance Rail to refinance the debt, the question becomes what will Downer do? Unlike the other shareholders in Reliance Rail, Downer carries the operational risk to build the trains.

Grant Fenn maintains that the debt is non-recourse and so it is not Downer’s problem, but there is a reputational risk associated with letting the company fall apart.

As one finance professor said, banks used special purpose vehicles for exotic derivatives such as collateralised debt obligations, but when things started to fall apart they put them back on their balance sheet purely to save their reputations with their clients.

In the case of the NSW government, it signed a contract with Reliance Rail in late 2006 to enter a public-private partnership to build 78 train sets. The way Reliance Rail chose to fund the project had nothing to do with the government.

But nobody can afford to let this vehicle collapse. For Downer it would ruin its reputation and put its financial situation in jeopardy and for the government, which is suffocating under a massive deficit and the prospect of a new government, it would be forced to pick up the pieces.

Peter Jollie, speaking exclusively to BusinessDay, said it was the company’s advice that there had not been an event to permit the banks to terminate the contract. But he said if something changed and they could terminate the contract, this could become a problem.

Jollie confirmed he was intimately involved in the negotiation of the contact, having been on the bid committee from 2004 until the bid was won in December 2006.

But he believed the confusion in the market boiled down to a confusing contract and some of it was created to help the bondholders push their case to refinance the bonds. There are at least $1.3 billion of bonds that have been drawn down in Reliance Rail and less than $100,000 has been expended to date, he said.

On top of the financing dilemma is the problem of mismanagement of the contract. In the past year the company was forced to take $190 million in provisions for delays and cost overruns.

But the worst crime of all was the mismanagement of the project. The team managing the project managed it from an engineering perspective, rather than a commercial perspective. As one insider said: “RailCorp was given information the size of telephone directories. They took them away and came back with questions that were double the size of directories. If they had said these are the key elements, if you want anything else let me know, we wouldn’t have had so many modifications, delays and cost overruns,” he said.

But with clauses in a contract that refer to failures by Reliance Rail to meet its ‘‘availability’’ obligations because of a PPP Co decision to withhold or withdraw a set from service, the suggestion is that if the trains miss by three minutes or more there are penalties.

There is also a clause that indicates availability payments could be negative if certain conditions are not met. For instance: “If the 78th train set has not achieved practical completion or if three or more months have elapsed since the target date for completion, September 2013, the availability payment for the month will be zero.”

Fenn is on a mission to fix Downer. He has promised $250million cost cutting to create efficiencies, an overhaul of management reporting lines, a commitment to deliver the first train by December 31 and focus on risk management procedures. Whether he can pull it off, time will tell.