Market Commentary - Housing, Infrastructure, Construction and Services
Carillion has started the year with the announcement of a contract award in JV with Al Futtaim (its long term partner in the Middle East) worth £160m. The sudden departure of Richard Cousins (CEO of Compass) from the SID role at Tesco, announced yesterday, has received some press comment. We concur with the view that it was not clear why he took it in the first place. The best performance yesterday came from Serco which rose a further 2.1% to 146p. G4S was the back marker yesterday, down 2.2% to 230p
Carillion has started the year with the announcement of a contract award in JV with Al Futtaim (its long term partner in the Middle East) worth £160m. The project is to build offices in Dubai and the new work is additional to the some existing activity being carried out by the JV. So far the overall value to the JV of the work is £400m. The new work is to be completed by end 2018. This is good news for the company and while this is not large enough to change views on CLLN it is evidence that work is being won. Views on Carillion are divided among investors. We maintain our opinion that it can trade through the current balance sheet issues but it will take some time. At 238p at close last night there are reasons to be positive with EPS at around 35p and a dividend of c 19p.
The sudden departure of Richard Cousins (CEO of Compass) from the SID role at Tesco, announced yesterday, has received some press comment. We concur with the view that it was not clear why he took it in the first place unless it was to stop him getting bored as he wound down from his full time CEO role. Having been appointed in 2006 Richard shows no sign of wishing to step down, which is good news for Compass shareholders. They might be concerned that it signals issues at Compass. We suspect that Compass is in very good shape, though our sense is that the growth in revenue and certainly in margins is set to slow. At 1477p the shares are priced for a very good performance.
While we rarely comment on individuals we also note that Baroness Ford has stepped down as Chair at Grainger and is replaced by Mark Clare, ex CEO of Barratt. Justin Read, known to many from his days at Hanson but more recently as FD at Speedy and then Segro, joins the Grainger board as a NED. His appointment as a NED at Ibstock was announced just before Xmas. The new brooms at Grainger along with the relatively new CEO and refreshed strategy might at last cause the share price to reflect more adequately the prospects for the business.
The best performance yesterday came from Serco which rose a further 2.1% to 146p. Management at the company has done all it can to ensure that investors get a firm understanding that earnings will remain subdued at 5p per share or less until 2018. The strategic update in early December was, however, comprehensive and positive about long term prospects. They point to EPS of nearer 10p by 2019 and a dividend possibly sooner so patient investors are paying up at present. We also note that Morgan Sindall’s price is creeping slowly northwards and close at 758p last night. It rarely gets a mention because trade in the shares is thin. We have picked it out below as one of the shares that is potentially well undervalued at present.
G4S was the back marker yesterday, down 2.2% to 230p. It announced in the holiday period that it has sold its UK Utility outsourcing business to First Reserve for £52m. Based on earnings from that operation in 2015 the trade is likely to dilute earnings. But crucially it is another step to reduce net debt and it eliminates a non-core activity. The share price change yesterday was probably no more than the ebb and flow of trading so few conclusions might be drawn. Our sense is that management is ready now to accelerate earning improvements in the mainstream operations. EPS of around 15.5p last year justifies the current price level quite easily in our view and the 17-17.5p of EPS a much higher valuation given the rating of rivals and the trend in earnings and net debt.
Potentially Undervalued – Stocks to watch in 2017
SIG 102p Market Cap £604m. The core investment thesis around SIG is that the company has a fundamentally strong market position in its main markets and is capable of substantial earnings improvements. The outgoing management worked to bring together the various parts of SIG into a cohesive business. That process and other initiatives has delivered £23m of annualised savings we are told, with more to come but it’s not showing fully in improved earnings. To outsiders the plans seemed to lack detail and buy-in from suppliers. If SIG can appoint a CEO with the level of detailed understanding of Merchanting dynamics and who will pursue the drive into HVAC and Offsite there are plenty of reasons to expect a positive response in earnings. Net debt at £233m at the half year is uncomfortably high but the company is committed to reducing acquisition spend to focus on debt reduction. The stock is valued at around 30p EV for every 100p of sales. That is half of the level of rivals such as Grafton. The prospects are for EPS at SIG of around 9.5p this year and next. In our view the incoming top team delivers either substantial improvement or there is some form of corporate action. It is unusual to pick a stock with no settled top team. But in this case the risk/reward is positive and, in our view the downside very limited as the valuation is so low. It may at this stage be just potential but either the new CEO or the new owners (having paid a sensible exit price) will be able to bring about substantially improved performance.
Costain 355p Market Cap £373m (Net cash £70m in June 2016) Shares in Costain have traded at roughly the same level since August 2015 despite steadily improving prospects. Aside from brief forays outside the range the stock is stuck at 330-370p. Our sense that it is undervalued arises from its position as a market leader in UK infrastructure work, the innovation it is applying to construction, the order book of good work (roughly 2.5x current revenue run rate) and the boost to earnings that the ending of the waste to energy project in Manchester will provide. The latter is currently costing around £1m a month based on our calculations from company data, which is a large chunk of operating profit. The group has also tidied up its position in Spain on Alcaidesa; it should be able to dispose of that soon and eliminate its small losses from the P&L as well as add to cash balances. The group’s strapline for the 2015 report was that it is “accelerating growth” and that was shown at the half year with revenue up 27% on the prior year and operating profit up 21%. Investors are rightly wary of contractors but it has to be said that Costain’s currently unique approach provides for more stable earnings than is the norm in the sector and risk is spread over many JVs into which it sells its skills and experience. We believe the company is capable of substantial further growth in earnings in a UK market that is becoming more attractive for infrastructure providers. EPS of 27.5p is expected for 2016 (11.9p at the halfway stage, up 24%) and 31p in 2017. Yield of 3.5% at present. Results for 2016 are expected on 1st March 2017
Morgan Sindall 755p Market Cap £340p (Net cash c £50m) It may be unwise to pick two contractors as the most undervalued in our universe but in our view that is where some real value lies at present. Infrastructure spend is happening, risk management is improved, the cash profile of contracts is moving back into the contractors favour and the number of viable companies capable of delivering large scale projects is fewer than it was. For Morgan Sindall the key to much improved earnings is no more complicated than getting back to industry average margins. And conversations with the company, as well as its public statements, suggest that the process for getting to that goal are well advanced. The Partnership Housing operations have underperformed for several years but are now back into growth mode, revenue and earnings were up 7% and 21% respectively at the interim stage with margins at 2.5%; 5% is more likely in the longer term. In Construction and Infrastructure revenue was stable at the halfway stage but operating profit rose to a margin of just 0.5%; 2% is the norm and management tell us that is in its sights, on revenue of around £1.2bn a year, in our estimation. The story is not dissimilar in other divisions with Fit-Out probably the area to attract most attention as the order book is at record levels, despite concerns about commercial. The scene is set at MGNS for operating profit to rise to a margin on 3% on revenue of around £2.4bn this year thereby doubling the 2015 level of operating profit of £39m to near £80m by 2018. We have assumed stable revenue. That could take EPS to near 110p which is a big jump from 63p in 2015 and around 80p for last year. At 753p the stock does not look expensive.
Forterra 178p Market Cap £363m Britain’s second largest brick maker, with 30% market share was (re) floated in April 2016 at 180p. The shares have maintained the float price level, barring the Referendum induced dip that affected all sector stocks. The company returned to the market with a fully updated main plant at Measham and a programme of improvements to other works that should improve future performance. The picture looks very positive for Forterra with the number of new dwellings set to rise, FX providing a bigger constraint for imported brick and a mature market environment in terms of the key competitors. Forterra also has the edge with its unique Fletton product, the brick with which much of Central London’s housing is built. But with EPS of c 21-22p expected this year and next the stock trails its main rival, Ibstock (also recently floated), in valuation terms and is low by the standards of the materials sector. Marshalls is valued at 16.5x historic p/e and Ibstock at 11.5x. The potential overhang of Lone Star, which still owns 64% on Forterra is the answer to the undervaluation, of course. Our argument is that the overhang may clear at some point and that in any event Lone Star has remained a positive force for good in the business, as evidenced by the investment at Measham, among other things. Investors are right to be concerned but we believe that Forterra will surprise on the upside in terms of performance for last year and possibly with a better than expected dividend. The top team is not one that is inclined to exaggerate its position but that caution should not deter investors.
MJ Gleeson 545p Market Cap £295m. Gleeson has been a very interesting situation for some time and in our view remains so. We believe, from what we have seen and heard at the AGM and from presentations that it could build over 1,000 new dwellings this year and with seven divisions has the capacity easily to stretch to 1,400 units. Beyond that a doubling of size of annual completions from here is possible, assuming current conditions are not altered substantially, including mortgage availability, good levels of employment and relatively low interest rates. Several more new divisions may be needed to double output, which is possible, without impacting adversely on margins. The government’s Starter Homes Initiative, announced yesterday in more detail may impact on Gleeson a little but the conversely it is an opportunity as well as it may make even more land accessible. Looking at the strategic land operations we gained confidence, in discussions, from the willingness of land agents to use Gleeson in the South East, based on their previous good experiences. The demand for land that can be put to use swiftly remains high among the top 25 volume housebuilders. The big housebuilders boast of large land banks and they do have them albeit at various stages of development. But having a piece of land that can be used immediately, with detailed permissions is valuable and that is a big part of the gap that Gleeson’s land operations can often fill. The company flagged in December at its AGM that the results to June 2017 in this area will be similar to last year and second half weighted e shares are affected by sentiment on the housebuillders but should not be as Gleeson’s segment of the market is very different from the average. The management is highly incentivised to get to a TSR of 1000p and, given it has succeeded at every previous target that has been set, we have a feeling it will not miss that one. EPS for this year is expected to be around 45p and over 50p in 17/18. That does not make it cheap alongside its peers but its growth prospects are substantially better than its rivals and that is hardly reflected in the valuation.
Near misses for our selection include Speedy Hire at 50p and Balfour Beatty at 271p. Both companies have the potential for substantial improvements in earnings allied with a possibility of corporate actions that will benefit shareholders
Substantial concerns
Interserve tops the list of companies about which we have substantial concerns. But unusually the list is not long this year and does not include many on the larger companies in the space, Capita and Mitie now having “fessed up”. The sector is dogged with accounting issues that have arisen from over ambitious management taking a more generous view of revenue and costs than they should. Having said that all three named companies above probably still have some skeletons that need to be brought out to provide adequate provisioning for the future. We expect they will be at a low level at Mitie and Capita but Interserve could have a bit more to say of a quite substantial nature. We are not alone in our views and aside from some “shock and awe” on the day any announcements are made the next warnings are already priced in. Capita provides the best recovery prospect at present, given recent strength at Mitie and the CEO uncertainty at Interserve
Investors should also keep a very close eye on Babcock. We were sceptical for a long period and then turned positive at the time of the Avincis deal. That was an error on our part. The company continues to find markets variable, other than UK MoD, in our view. But the share price at 955p with earnings for the year to March 2017 expected to be 80p tells us something is not quite right. The net debt position at 2x EBITDA is unhelpful as is the £203m pension deficit. The opportunity to bring in fresh thinking at a high level has been passed up following the appointment to CEO of Archie Bethell, though his age on appointment suggests that it may be a short term reign
Finally, there a few tiddlers that give rise to our concerns. T Clarke is the most obvious example as it has weak profitability, a poor balance sheet and a substantial pension deficit that could break the company. Bilby has recovered a little from its December 2016 profit warning and confession to being a tad disingenuous with cost allocations last year. The company made operating margins of 4% in the half year to September 2016 having come to the market believing it could take its margins from 12% to 15%. The Buy and Build is on hold while net debt is brought down to below the current 2.5x EBITDA. The nature of its work and place in the supply chain suggests that 4% margins are about right.
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