Market Commentary - Housing, Infrastructure, Construction and Services
The year end closed strongly for the markets and the rally is set to continue today, according to trends in pre-market trading and in trading so far. In our note today we cover two topics, firstly the key themes for 2017 and secondly the moves last year. We shall cover our picks for 2017 tomorrow.
Happy New Year
The year end closed strongly for the markets and the rally is set to continue today, according to trends in pre-market trading and in trading so far. In our note today we cover two topics, firstly the key themes for 2017 and secondly the moves last year. We shall cover our picks for 2017 tomorrow.
There was no directly relevant newsflow first thing morning, not even a new update on the “Battle for Lavendon”, that is the bidding contest between Loxam and TVH. The levels of the bids are still failing to impress investors. The last one at 260p from Loxam being accepted by much less than 1% of the institutions. That is despite the Directors recommending the offer. But at 12.25 pm today TVH issued a second “cheeky” offer of 261p and it now owns 20.4% of Lavendon shares.
The time of the year may not be aiding decision making on Lavendon but the bids are at a low level in terms of EV/EBITDA valuations, even if they are 90% above the undisturbed price. The price closed at 264p in the last trading session of 2016 suggesting that there is more to come. The process begs many questions, not the least of which is whether there are other stocks that might be equally undervalued in normal trading taht may have a catalyst for change. The volume of trading in Lavendon is typically very low which clearly can lead to the price being unrepresentative for long periods; recent daily volumes have been much higher than normal but probably no more than a low level of Arb activity and TVH raising its holding to the current 34.6m shares.
Newsflow from companies will start to flow over the next few days with Persimmon setting the tone with its update for 2016 expected on Thursday. More follows the week after from the house builders with Taylor Wimpey’s update on 11th January. SIG and Grafton are both scheduled to update on 13th January. Others, such as Carillion, Balfour Beatty and Serco have said what they need to say already ahead of results in early spring. We shall issue a full list of planned announcements later this week.
Key Themes for 2017
The process of Brexit and the ebbs and flows of fact and sentiment on the issue will drive events in the market and especially in the HICS sector. That is overlaying a cyclical slowdown in the areas of the market that are most exposed to UK consumer behaviour. We make no political point in saying that we are only at the early stages of identifying the best outcome from Brexit and that expecting agreement on a two year timescale is, in the history of processes of nations reaching agreements short and. if accelerated too fast, might lead to damaging outcomes. That will become increasingly clear, in our view and, along with elections in Europe that complicate the process, we expect a prolonged transitional phase. We state that only as a working assumption for our views on teh sector and stocks. We hope our views go beyond statements of the bleeding obvious or just restate recent trends. The temptation is to be highly cautious but we believe that despite adverse cyclical trends, as well as Brexit there is room for the sector to perform well this year, given the start point for many stocks and events in 2016.
Outsourcing is likely to increase. The demise of using outsiders to provide services is oft-heralded but not achieved as so many essential activities are now carried out by third parties. And the skills sets to achieve on-going performance and step change do not exist among many clients. The growth will be much faster outside the UK where 2-3% pa growth has been the norm for a decade. The winners will be those companies that have made the right investment in control systems and customer innovation and relationships. The low level of IT support, accounting information granularity and shallow depth of reporting might surprise many people. There has been substantial improvement in recent years and decision making is starting to be more fact based, especially for bids. “Bucket” costing was not unusual which was approximate in terms of approach and disastrous in many cases in terms of outcomes. And clients are getting much more savvy, though even there asset registers were, and, in some cases are still, shockingly badly maintained. Good for Mears, Kier, Carillion and Serco. We suspect Mitie will up its game but that is not clear as yet as it’s too early and there is much work to do at Capita, Interserve and Lakehouse.
Social Housing, especially Local Authority provision and PRS will become more significant. While the Housing White paper has yet to be revealed parts are starting to emerge and it is unlikely to veer much from existing “inclinations” within government. The Autumn Statement included £2.4bn for Housing Infrastructure and £1.4bn for 40,000 more additional affordable homes and £3.7bn is committed to building housing on public sector land. Add to that the 30 Starter Home Land Fund partnerships, 14 new garden villages and three garden towns and something may start to happen! Good for Kier, Galliford, Mears and the brick makers, Ibstock and Forterra. Several housebuilders will also get substantial benefit especially Countryside, Telford and Gleeson. Civitas, Grainger and Sigma Capital should also benefit from these developments. Also note that by the end of 2017 capacity for an annual output of 10,000+ modular dwellings will exist (including Space 4), possibly many more if some plans proceed and while that will go mainly into Social and PRS is will start to alter supply chains and products. (SIG and Kingspan are the main companies with exposure in Modular components)
Skills shortages will increase. There is little doubt that the construction sector is losing skills and that in FM and softer services labour even outside London is difficult to recruit, train and retain. It is estimated that of the approximately 3m people employed in UK construction some 50,000-60,000 leave each year. In soft FM the London Wage/Minimum Wage has raised costs but we are not hearing it has increased the supply of labour, skilled or otherwise. There are few specific companies to identify in this context though clearly those with a high proportion of low skill level contracts are affected most; Mitie still stands out in that regard. Mears is reducing its activities in Care and restructuring how it works with the remaining customers to insulate from the negative impact.
M&A activity will rise. The back end of 2016 saw a number of sector deals progress. There is general interest from third parties (ie not traditional sector players) in buying activities with high ROCE, especially from the US (Consultancy, Hire and contracting) and in owning assets, especially from Asia and particularly in property and utilities. The Lavendon battle and First Reserve’s three recent buys are the most obvious evidence. We should also include the Rentokil/Haniel transaction of evidence that its not just industry outsiders who might shake up market supply structures. Whether we shall see activity among the larger companies remains to be seen (eg a Balfour/Carillion type deal). In general Buy and Build is less popular than it was due to significant issues that emerge, the most recent examples being Capita at one end and Bilby at the other but it can work for real experts, as Breedon has shown. There is much to add to this point in terms of companies but not for widespread publication in a note such as this.
London and the South East growth might reverse. Brexit has put on hold expansion plans for overseas based corporates and the finance sector. Those forces along with stamp duty changes have had, and may continue to have a disproportionately negative impact on the M25 area. The importance of this should not be ignored. The evidence is already present in house prices in some areas and in rental values. It has substantial implications for commercial developments of course and for the ripple effect on residential property values and transactions that is usual at certain points in the cycle. Declining economic activity in London is bad news for the UK economy over the next ten years as current financial services activities might reduce more rapidly than new activities , financial services or other, fail to take their place. This not good news of course for most sector stocks or indeed the economy in general.
Infrastructure Investment is happening. Hinkley Point, Heathrow, Thames Tideway, Mersey Gateway, Crossrail 2, HS2 and new work data from ONS all tell us that things are happening. But much is at an early stage which is evidenced by positive updates about UK workloads in Infrastructure from the consulting engineers such as Atkins, Arcadis and Arup; admittedly some of that was against a background of a slowing in commercial developments. The common cry is that everyone loves Infrastructure spend ideas but nothing ever happens. That is changing, in our view. Good for Costain, Balfour, Carillion, Kier, Morgan Sindall and Atkins. We are always surprised at the poor level of coverage and relative lack of interest in the Infra Co segment (JLG, JLIF, HICL, Bilfinger and others) which not only have an appeal to income funds but also have great relevance to sector watchers for read across.
FX and raw materials costs will continue to be volatile. While in the minds of many investors FX has been a helpful factor in maintaining reported earnings, especially of the FTSE100 stocks in this sector it has generated mostly uncertainty and potentially higher costs. BUT it has also boosted the prospects for materials that are mainly UK sourced and that points mainly towards heavyside products such as bricks and aggregates; good for Ibstock, Forterra, Breedon and Marshalls. The cost of raw materials for companies such as Polypipe and Tyman may not be so damaging when any hedging that is in place is removed. They have successfully passed through some FX surcharges so far and it may be they will make that more permanent if needed. .
Sector accounting may be much more reliable in future. In our view most of teh larger companies that were taking an over optimistic view of future revenues and costs have been smoked out. At the start of 2016 we highlighted Capita and Mitie and perhaps were a tad too easy on Interserve. In fact IRV was undone more by waste to energy risk assessment than general over optimism but there may be more to emerge, which is what the price might be telling us at present. The only companies on our “black list” at present are small (Bilby, T Clarke) though we suspect we have yet to see full recognition of past problems at Capita and Mitie. The sector will always have revenues and costs moved around between years as that is the nature of the operations but over the mid term the balance sheet will usually tell us who has been over optimistic. There may be concerns remaining over Carillion and Babcock but we expect they will trade through successfully.
In summary our view is that the markets for HICS stocks are reasonably favourable for progress in 2017. 2016 was a year of relative underperformance in stock price terms and there are storm clouds for 2017. But eh solid earnings among the best performers and the low start pnt for many others make us positive for at least market performance this year
· The private sector speculative build housing sector is caught a little. Its mainstays in recent years (sustained high employment, government encouragement for the sector, mortgage availability and favourable planning and land markets) look more vulnerable than for some time. But at this point in the cycle still seems positive, as the relevant company statements show. Underlying strong demand and good affordability outside the M25 should sustain the sector. As well as quite robust balance sheets, far more so than at any time in the post 2WW period.
· Profit warnings should be much fewer as the companies that have been over optimistic are now exposed and in the case of most contractors risk management has improved dramatically in the last three years and the 2013-2014 legacy projects are mainly settled (notably bar some waste to energy projects).
· The international services companies have provided excellent expositions of their strategies, markets, priorities for development and resource allocation processes which has been instrumental in them recently achieving high ratings. The most recent one was from Serco which was extremely well received and presented.
· We remain concerned that the management situation is unsettled at several companies (SIG, Interserve and Capita most notably) and there are few obvious candidates. The issues are clear at those companies and reflected in the current prices , in our view.
· The Merchants with mainly UK exposure have seen poor conditions in some markets (RMI, Plumbing and Heating) which we suspect will reduce in 2017, especially the latter as restructure benefits come through and replacing boilers return to a more normal cycle (in the absence of CERT, CESP and ECO).
We expect the sector to at least maintain relative performance with the market in 2017. The hot spots in 2016 were the internationally exposed services stocks and they should maintain good progress. For 2017 our suspicion is that the UK building sector stocks may be shown to be oversold, especially if the measures to counter Brexit uncertainty get traction.
Moves Last Year
The sector was much weaker than the market last year, as expected buy us, though the market’s strength probably took most observers by surprise, especially after 23rd June. The Housing sector index fell by 3.2% last year, the services sector had a late rally and rose by 3.3% and the Construction and Building index rose by 29% though much of that was due to CRH which rose near 50% last year and has a big weighting. Ex CRH the Construction and Building segment rose around 5%. The All A Share rose by 12.5% last year with the FTSE100 at a slightly higher level as, among other things, FX was favourable to the larger companies, due to international exposure. The table below shows the main moves last year
The key feature of course is the extent of the moves in many stocks. The range of moves with Capita down 56% and Serco and Homeserve up by 50% in the year will surprise. Target prices from mainstream brokers will rarely indicate such large shifts from the prevailing level but they happen. Now, arguably 2016 was an unusual year in terms of news and FX movements that were not expected but even so our point remains that exaggerated moves do occur and will, we suspect, in 2017. And looking at the moves, as we do below, most are triggered by company specific factors which macro issues may have exaggerated. Our point being that there is value in looking at the companies that may produce outliers in terms of moves as they are the ones that will have the most pronounced impact on portfolio performance.
The worst performers fall into two categories, those that had warnings and those where one is thought likely. Capita, down 56%, was clearly the main faller and the timing of its warning along with the weak explanations of how recovery might be achieved has not helped. Interserve, down 34% is in a similar position to Capita, in our view, as it also has an unsatisfactory situation regarding the recovery plan and the top team’s capacity to deliver change. Mitie, while still down 28% on the year has bounced strongly from its low point but is held back by concerns that there are still some write-offs to come, a view we support as the new management surely needs some “wriggle room”. Berendsen has started to “regroup” in a convincing way, ending the year down 19%, after a relatively mild warning. The price reaction to its warning was much larger than justified, in our view and may be due to more factors than just the warning (belated reaction to top team changes, profit taking, changes in the structure of the work-wear sector in Europe)
The Merchants with large UK exposure and high operational gearing also had a difficult 2016; SIG, Grafton and Travis Perkins were all down 25-30% as they signalled tough trading and restructure charges. There is little room for quick fixes in the sector given the nature of the cost base but it is not difficult to mount an argument that they may be oversold, as we do below.
That quick canter through the main fallers just leaves one exception, Carillion, which fell 22% and has not had a warning but remains heavily shorted with 21% of the shares in the hands of shorts. The company undoubtedly has issues with its balance sheet that will take a long time to work through. Balancing that however, has been a much more cautious approach to risk than many rivals which has helped to prevent a substantial warning and write-off. We are more optimistic than the average about the potential for solutions but believe they are not quick ones.
All of the best performers in our universe had meaningful exposure to the USA which helped in terms of trading and FX translation. The best performers last year are led by Serco, up 51%. Its combination of strategic and accounting clarity, contract settlements and awards and blatant straightforwardness has won many followers. Arguably the current price at 143p reflects earnings expectations in 2018 and a return to the dividend list sooner rather than later. But it has beaten its own guidance in most of its recent reports. Homeserve has staked its future on its US expansion and it rose a short 50% last year. We remain concerned that the business model is built only for growth. Rentokil’s 39% increase is also built upon many of the same elements of Serco’s rise but with a greater emphasis on US expansion and increased presence in its core market of pest control. Wolseley, up 34% and Compass up 27% also benefitted from US exposure and translation effects, along with very solid trading.
Exceptions to the good news that US exposure brought were Balfour Beatty, which was level for the year and Atkins which was down 11%. It may be that both stocks started the year at levels that were a tad optimistic at the time. Both have substantial US exposure and should be major beneficiaries of the infrastructure expansion plans in that country as well as in the UK. That leaves G4S which rose 8% last year, a slower rate than some rivals. It has US exposure but is focussed more on expansion in emerging markets than on N America. And its valuation is driven, disproportionately, in our view, by sentiment on its UK operations.
For most other stocks not mentioned specifically above 2016 saw limited share price movement over the 12 month period even though within it there were some substantial shifts in sentiment, not least with Galliford Try and Kier , which, due to exposure to housing had post Referendum blues from which some recovery was achieved, particularly at Kier. Both benefitted from Partnership Housing developments. Babcock drifted as the year progressed, weighed down by net debt and its own lack of transparency. For a company with its technical engineering strengths, UK customer relationships and international prospects it is not making the best of itself, in share price terms.
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