Fat Prophets first recommended Downer EDI (DOW) in April 2003 at a price of $2.40. At the time, the stock was unloved and more importantly represented solid value. Following the initial recommendation, Downer performed well and we took profits on two occasions, once at $3 and again at $4.50.

---

"Despite management's positive guidance for the year ahead, we believe recent developments have significantly clouded the outlook for Downer."

---

With the initial capital off the table, we let the remainder run with the trend. Given our approach of using both fundamental and technical analysis, we believe riding the trend is a sound way to maximise profits. With Downer's earnings and dividends keeping pace with the share price, the call looked to be the right one.

However, following last week's shock announcement of a substantial profit shortfall, the share price tumbled. The company's earnings quality has now become a major cause for concern. Taking advantage of the subsequent rebound in the share price, we believe it is prudent to take profits at current levels.

As highlighted in our recent mid-week alert, Downer's management revealed the company will show a loss for the full year ending June of around $25 million. This falls materially short of management's previous expectations for a profit of $140 million.

The announcement brought about a sharp sell-off with the stock falling around 30 percent after trading resumed last Wednesday. Such a decline is highly disappointing and despite having taken profits earlier, undoes approximately 12 months of patient holding.

Management have advised that more than 20 projects are involved in the application of write-downs, due to questionable recoverability of costs. However, the $198 million Douglas mineral sands project for Iluka Resources accounts for the majority of the one-time after tax charge of $163 million.

Senior management have attributed blame to poor leadership within certain divisions where resolution of customer disputes has failed. As such the former CEOs of Downer Engineering and Roche Mining have been removed from their positions.

It appears that poor management has contributed to deterioration in relationships on this key project. A further concern is that a single project has had such a significant impact on the annual result. One poorly managed large contract can erase the profit of a dozen others. Downer's recent profit downgrade raises serious questions over management credibility.

Downer undoubtedly has a strong project order book. However, our concerns lead us to reassess this strength against the company's ability to manage its many projects profitably.

While the share price has fallen considerably following the profit downgrade, we do not believe the company represents good value at current levels, given the uncertainty over future earnings.

Despite management's positive guidance for the year ahead, we believe recent developments have significantly clouded the outlook for Downer. In addition, the robustness of Downer's upward trend is highly questionable after a loss of 30.5 percent in one day.

Consensus Valuation Estimates

	2007	2008
Price to earnings ratio	11.0	9.9
Dividend yield	4.5%	5.0%
Price to book value	1.8	1.5
Return on Equity	14.5%	14.8%

After falling so far so quickly, it is common to see a stock stage a short term corrective rebound. Although Downer has managed to lift from the 9th August low of $4.91, falling volumes and small daily ranges reflect a lack of commitment from buyers in our view.

Although the long term trend retains potential for rehabilitation, we believe the risks of further deterioration now outweigh the possibility of a sustained recovery. As a consequence, we recommend that Members sell their remaining holding in Downer at around $5.70.