Stockwatch: Infrastructure spending underpins ‘buy’ case here

In terms of the story, should you prioritise “top-down” or “bottom-up” for stock selection? Costain (COST), a circa £450 million construction services group exemplifies this dilemma currently.

Its share price chart this year looks dysfunctional: after a parabolic rise from 357p to 490p in the first half of 2017, it drifted and sits at 430p currently. Since nothing looks wrong in the financial record and forecasts, or narrative from the company, is this perception change a warning or opportunity?

A top-down macro view heralds caution

Construction can fore-run the economic cycle, its last two quarters experiencing the first consecutive declines since Q3 2012. For the UK last April to June, we are told there was a 0.5% decline in output then a 0.9% decline in July to September, said due to decreases in repair and maintenance.

At face value this dials into Costain, given 77% of group revenue is infrastructure services. And yet the company says: “We are transforming rapidly to differentiate Costain as the UK’s leading smart infrastructure solutions and are delivering technology-based solutions to clients spending billions underpinned by legislation and regulation…”

The macro story continues, September being especially harsh, with a 2.1% month-on-month decline in repair and maintenance and 1.3% in all new work. Thus, expectations for Q3 2017 are revised down from -0.7% to -1.0%. The statistics are confusing in the sense that “infrastructure” improvements have become politically virtuous as a means to bolster the economy, rail and roads benefiting from public expenditure in response to overcrowding. This includes conversions to smart motorways with variable speed limits and hard shoulders occasionally used as an optional lane.

There’s also the High Speed two connection from London to Birmingham, and nuclear new-build and decommissioning to meet carbon emission targets which Costain is involved with.

Costain has expanded its infrastructure side by two-thirds in the last three years with note 3 to its accounts, on segmental information, showing an operating margin of 3.7% which is relatively good for construction. That the table here shows the margin struggling to grow from 2% reflects past losses improving to flat performance in H1 2017 for the group’s natural resources side (which serves water, power and oil & gas markets), mainly due to a legacy private finance initiative (PFI) contract now fulfilled.

A bearish view on Costain therefore assumes a new period of government austerity axing infrastructure improvement but, if anything, the Conservatives are relaxing deficit reduction targets to fend off Labour’s critique. Next Tuesday’s budget will reveal more, but Phillip Hammond is not exactly on the Tory Hard Right.

Thus, Costain’s chart is more a valuation event, as shown by various UK small-cap equity funds up about 50% this year, hence it’s unsurprising to see profit-taking after parabolic rises. Yes, it’s a concern reflecting on what is a late-stage bull market, but a few UK companies can still prosper.

Confidence remains at the company level

Reporting has maintained a consistent “in line with expectations” theme and, according to Company REFS’ numbers, each of three brokers upgraded forecasts (except Peel Hunt with regard to 2018, which was top-of-range anyway) when publishing “buy” notes in March, end-August and early September.

At the 23 August interim results, the board raised the dividend by 10% after a 34% growth in underlying operating profit as costs were contained. The operations review read well and a £3.7 billion order book at end-June cited revenues over £2.2 billion secured for 2019 and beyond.

A possible niggle is this figure slightly was down from £3.9 billion like-for-like, which wasn’t explained, instead glossed over with “over 90% of the order book comprises repeat business”. Sentiment-wise, any share in a contractor-type business can be sensitive to change in the backlog or order book.

The segmental breakdown shows infrastructure achieving a £24.8 million operating profit on £694 million revenue, and natural resources a £0.3 million profit on £178 million revenue, improving from an £8.6 million loss in the last financial year.

Admittedly, it’s tricky to judge “the new Costain” when its technology-driven, infrastructure bias has yet to be tested over a UK downturn. Yet, its consultancy-type partnerships based on cost reimbursement with profits for hitting targets, differ from a fixed-price contracts approach. In theory this helps provide a more defensive, better quality earnings stream than other construction firms.

Natural Resources should be on an improving trend

The Natural Resources business had been a handicap until recently breaking even, the interims cite growth in water-related activities and no additional impact from a legacy waste PFI contract like last year. This fixed-price contract from 2007 – reducing leakage in wastewater networks – is now fulfilled at a total historic cost over £40 million.

H1 progress was, however, offset by lower contributions from oil & gas operations “where we have retained skills and capabilities in anticipation of an expected improvement in market conditions” (i.e. sustaining costs), which ought to follow from the current rise in oil prices.

Management’s overall target margin for this division remains at 4-5% which, if achieved, would underscore another profits re-rating, e.g. a margin of 4% on 2016 group revenue (say if infrastructure improves also from 3.7%) implies operating profit of £63 million.

Relatively clean strong accounts

See from the table, there is no discrepancy between headline and normalised earnings given a lack of amortisation charges, although mind the balance shows intangibles representing 51.5% of net assets, which helps explain net tangible assets at a 75% discount to the share price.

This also keeps earnings/cash flow and the dividend in focus for valuation, i.e. likely share price sensitivity to trading updates. At 430p currently, the 12-month forward price/earnings (PE) is about 12 times, and 6.6 times historic cash flow per share, with a 3.5% yield covered 2.4 time by forecast earnings.

Interim revenue rose 11.5% to £848 million and, while a 63.2% rise in the net finance charge to £3.1 million slightly trimmed the pre-tax profit advance to 29.8% at £18.3 million, it’s still very good progress for this sector. Despite pointing to a need for further progress to meet consensus for £43.9 million, the first half in 2016 constituted 37.6% of the full-year profit versus 41.7% this year. So, comparatively, Costain is doing better.


Costain Group – financial summary           Consensus estimates year ended 31 Dec 2012 2013 2014 2015 2016 2017 2018                 Turnover (£ million) 848 885 1,072 1,264 1,574     IFRS3 pre-tax profit (£m) 24.7 12.9 22.6 26.0 30.9     Normalised pre-tax profit (£m) 14.2 7.5 22.6 26.0 30.9 43.9 47.9 Operating margin (%) 1.8 2.5 1.8 2.3 2.1     IFRS3 earnings/share (p) 34.2 16.9 21.7 21.2 25.0     Normalised earnings/share (p) 18.7 9.6 21.7 21.2 25.0 33.6 36.1 Earnings per share growth (%) -30.8 -48.5 126 -2.3 17.9 34.5 7.3 Price/earnings multiple (x)         17.2 12.8 11.9 Annual average historic P/E (x)   14.6 29.0 15.2 16.4 17.3   Cash flow/share (p) -34.5 -48.0 43.0 15.4 65.5     Capex/share (p) 0.5 3.2 5.8 2.1 6.8     Dividend per share (p) 10.2 11.0 11.0 10.0 11.6 14.0 15.4 Yield (%)         2.7 3.3 3.6 Covered by earnings (x) 2.0 1.1 2.7 2.4 2.4 2.4 2.3 Net tangible assets per share (p) 20.0 15.4 78.9 66.9 32.3                     Source: Company REFS               Balance sheet benefits from £168 million cash

Liabilities such as a £43.5 million pension deficit (down from £57.4 million), short-term debt up 70% to £50.2 million and long-term debt stable at £30.1 million, are covered 1.4 times by £168 million cash reserves (up from £129 million). Cash has benefited from a working capital benefit, set to reverse this year, but Costain has strong liquidity in support of contracting growth.

Moreover, Company REFS statistics cite a strong 32.9% return on capital employed, affirming an asset-light business with limited working capital needs. See from the table how modest capex supports a strong element of payout capability.

Long-term takeover potential

Given these financial strengths and strategic focus, Costain is a potential long-term bid target both for construction groups seeking better quality earnings and support services contractors. It’s of digestible size, yet with substance to make a positive impact. Not to encourage speculative buying, but that’s a potential sweetener for tucking away the stock.

The chief market risk is of continued deterioration in UK macro, in a context where this company – on last year’s form – won’t update again until an early January pre-close statement. Yet Costain’s fundamentals imply using market weakness to average in and build a position. Accumulate.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.