Market Commentary - Housing, Infrastructure, Construction and Services - 1st December 2016
Serco is holding a CMD later today and has updated the market this morning, Fulcrum Utility Services has announced a £4m contract, Inland Homes has issued an AGM trading update and Grainger has issued its full year results announcement. We try to spot companies with substantial potential operating with talented management teams. We have been positive about Fulcrum for some time and remain so. Inland Homes is also a fast moving fledgling company that is well managed; its top team have built and sold a house builder before (Country and metropolitan) so they were always going to have some advantage
Serco is holding a CMD later today and has updated the market this morning, Fulcrum Utility Services has announced a £4m contract, Inland Homes has issued an AGM trading update and Grainger has issued its full year results announcement. Serco’s update simply confirms existing guidance that revenue of £3bn and trading profit of £80m+ is the most likely outcome this year and that 2017 is likely to show similar outcomes though earnings are balanced towards a lower outcome. The additional guidance today is that he range for next year is a little wider than previously expected due to FX and because earnings are a small proportion of two large numbers, both of which are subject to some uncertainties on legacy contracts. More below
We try to spot companies with substantial potential operating with talented management teams. We have been positive about Fulcrum for some time and remain so. The shares were 12p some 18 months ago and closed last night at 51p. The announcement today that it has won a contract for £4m to build, own and maintain a 12 km gas pipeline to a food manufacturing plant in SW England. That adds further to our positive view.
Inland Homes is also a fast moving fledgling company that is well managed; its top team have built and sold a house builder before (Country and metropolitan) so they were always going to have some advantage. The AGM update is very positive and shows the company successfully morphing from a SE England land developer into a house builder. The land bank now stands at 7,220 plots and it currently has 394 homes under construction on 12 sites. The share price 18 months ago was c 65p and it closed last night at 58p; we think that move reflects nervousness about the housing market rather than Inland’s performance. When the fog clears over the housebuilders Inland’s price is likely to move strongly upwards.
Grainger has reported very positively for year ended September Last year was a transitional one as the business disposed of several parts of its operations to focus on UK PRS and it legacy residential property portfolio, mainly in reversionary assets. The focussed strategy has allowed it to record an increase in PBT of 64% to £84.2 and reduce net debt by 33% to £764m as well as reduce the coupon to 3.7%. Of the £850m to be invested in a PRS portfolio some £389m has been spent and £347m is in planning or legal processes. We suspect that is just the start of a larger programme. The share price has yet to respond fully to the changes and remains stuck in the 200-240p range. We do not know the company well enough to comment on valuation.
Capita was the main talking point from yesterday as it was the largest loser in our universe, down 5.9% at 524p following unfavourable broker comments. The company is going through some upheaval we suspect as the existing top team has said it is reviewing its main contracts. The board restructure announced on 10th November along with a promise that in early December a cost reduction plan and strategy update will be released. Quite rightly the market is expecting that the new approach will bring with it cost that is currently unknown. Sometimes the tide turns against a company and its strengths are ignored for a while. We suspect that Capita is in that situation. But its too early to be positive as the size of the problems are not yet known and there is likely to be a need for new equity, in our view. The re-structure is arguably a positive move but questions might be asked regarding why it needed a crisis to get to that point. Our concern is that the reviews may not go far enough as the critical issue of how a relatively small company (in larger international context) operating mainly in the UK can compete effectively in IT based services in the future, especially when it spends a relatively small amount of cash on R&D and capital.
Polypipe was the main gainer yesterday, up 3.6% to 307p and it received deserved support. The company is not as well understood in the market as it might be. G4S also bounced back and rose 2.2% to reach 245p at close; it remains undervalued in our view.
Kier’s CMD yesterday was very helpful The main topic was the development of its mixed tenure model in conjunction with Registered Providers of Social and Affordable Housing. Kier has long operated in the private housing market on a geographically restricted basis producing around 600+ dwellings each year recently. The plan is to sustain that operation and perhaps move to 750 units but more importantly to grow the mixed tenure operations to around 2,500 + units ayear from the 450 units level in 2014. In the company’s view that should deliver ROCE of 20+ on the mixed tenure operations. That high level of return is thought to be sustainable due to the platform created in recent years that generates substantial entry barriers to rivals and a good proposition for partners in Local Authorities and Housing Associations. The plan sound highly credible , the people seem to be experienced and knowledgable and the resources are available so outsiders can be reasonably confident of success.
The aspects of Kier’s plans that will need close attention include the forthcoming Housing White Paper, now delayed to January 2017. It could provide some additional opportunities but equally may require teh company to make some adjustments. Kier’s plan also depends on a robust housing market but if that does not exist it will be due to a lot of other more worrying factors than just Kier’s plans. In short, given where we are today, Kier’s plans look highly credible. The top 20 UK Housing Associations are all seeking to build at a much faster rate than the in the last 3-4 years, in many cases they aim to double production. And they have the resources to do so from strong recent trading and the uplift they have received from existing property values. In our view the 1% decline in rental income between 2016 and 2020 was a blow but more than offset by the ability of the Housing Associations to crystallize gains on the sale of parts of the existing portfolios.
Serco’s CMD this afternoon should prove helpful in understanding the operations in more depth. The new top team installed nearly two years ago has been very candid in its assessment of the business and set about the turnaround in a sensible and structured manner. Our sense is that much more needed to be done than was expected as the risk levels in some contracts were disproportionate to any expectation of reward. Perhaps previous management expected they could renegotiate better terms as the incumbent; historically many operators in the space took the view that once the contract was won the client would fold under pressure and corners could be cut. That is not necessarily the case now. Serco has also announced that it has signed the £600/7+3 year contract to provide FM at Barts Hospital. That is important as new work is as essential as part of the strategy both to grow and to replace older, onerous contracts. Reflecting our earlier comment about “Win first, negotiate later” the Serco CEO Rupert Soames begins his quote saying that Serco is partnering with the Trust at Barts; while the term partnering may be misused it shows the changed attitude that now exists in FM. The valuation of Srco is high relative to rivals at 135p share price versus expected earnings of around 4.5p this year and 4p next at the EPS level. Our sense is that investors are buying the stock for 2018 when EPS of around 8p is most likely once all of the legacy issues are settled. The pattern of contract progress to date, in terms of new work and resolving old issues, has generated a very positive response from investors. The update to day that points to net debt of below £150m, an improved pipeline of potential new work and sustained expectations for the current year will sustain the current share price, in our view.
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