Market Commentary - Housing, Infrastructure, Construction and Services 24th October 2016
There is little relevant news this morning.There is little by way of formal news expected this week. Berendsen is due to update on Friday 28th October. Well it is half term! But as ever our source, The Times, may not quite have captured all expected statements and there will be unexpected ones as well so we shall not be idle. We look at moves YTD below. The stock that stands out from that exercise as being appreciably undervalued is Balfour Beatty.
Monday, 24 October 2016
There is little relevant news this morning. Sigma, a quoted regeneration and PRS specialist, has announced a £39m regeneration scheme in Liverpool which comprises mainly hotel, retail and student accommodation. Unite Group is also expanding further in it core student accommodation operations and today announces it has exchanged contracts on a site in Sheffield that will provide accommodation for 570 students by 2019. Unite says the project will provide a return of 8-8.5% on costs. There appear to be few concerns about the demand for student accommodation in a post Brexit world and the returns are competitive. Unite, in particular, has cracked the art of using modular techniques in its operations which provides for faster build times and more certain outcomes. Our sense is that modular and offsite construction in general may be starting to become more mainstream.
There is little by way of formal news expected this week. Berendsen is due to update on Friday 28th October. Well it is half term! But as ever our source, The Times, may not quite have captured all expected statements and there will be unexpected ones as well.
Atkins has settled into a range from 1525p to 1600p since early September and on Friday last it rose 2.2% to 1577p, the biggest increase on the day. It remains to be seen if it can push on from here. FX should be working in its favour along, with increased demand for Infrastructure in the UK, the contribution from the PP&T acquisition and better margins in the USA. There are therefore good reasons to believe it can consolidate at this level and perhaps kick on towards 2000p. Answers are needed though to issues regarding the pension deficit and cash coming from the Middle East; on the former the cash contribution of £33m in 2015/16 to fund the deficit reduces operating profit by £5m pa (assuming a 15% ROCE) and that continues each year until 2025 and, that is without compounding. The impact of taking over £30m additional cash each year from the business to get a return of 3.5% in the pension scheme when it could get over 15% in the core operations is making increasingly less sense for Atkins and several others. Getting cash from the Middle East is an art as well as a science; some do it better than others!
Grafton was the weakest performer on Friday, down 2.9% to 495p as it oscillates between 490p and 530p; the news from the Merchants and on Building Materials volumes and prices has not improved the picture for GFTU in the UK, since the interims were released on 31st August. With 42p of EPS expected this year and 44p next year the buy case is not at its strongest but the positive impact of the restructure and Euroland trading is underestimated in our view.
We look at moves YTD below. The stock that stands out from that exercise as being appreciably undervalued is Balfour Beatty. While this year and next remain clouded by “legacy” factors the likelihood of EPS of 30p+ in 2018 and a reasonable dividend and/or shareholder return is high. We argue below that the market value of the Infrastucture investment portfolio may be higher than external SOTP and internal Director’s calculations , given the quoted Infra portfolios recent performances. The hidden “gem” of the PPP/PFI portfolio needs to be de-merged in our view as, given the performance of similar assets in the UK market it is undervalued within BBY. Clearly it may be that it is still needed as it provides a balance sheet for the construction operations but if their performance rises as expected the arguments for demerging become much stronger. And that US exposure might be a strong tailwind due to FX but also due to improved performance and a stronger order book. More below.
Moves last week
The sector was down a tad for choice last week while the market was roughly level. The housebuilders are struggling to get traction and respond to twists and turns in sentiment on the housing market.
Looking at the picture from the start of the year the HICS sector a tale of three groups at present. There have been some big moves in the sector this year with, in general, a flight to safer havens and away from cyclical exposure
The stocks with substantial overseas exposure are doing rather well, Compass is up 26% YTD, Berendsen 15%, Wolseley up 21% and Homeserve and Rentokil are both up a whopping 47%. The exceptions may well be Atkins and G4S. The former is down 3.2% YTD, though it perhaps started at the wrong level there may be scope for a better valuation soon. The latter is stuck at the 230-240p level at present, up only 6.4% YTD; the catalysts for a move to the next stage are in place with news of disposals, FX tailwinds and we believe margins gains from better cost efficiencies. In the context of the reasons for the positive moves on some stocks Atkins and G4S may be undervalued
The second group is the companies that have indicated there may be a spot of bother ahead. Capita, down 49% YTD, Grafton down 33%, Interserve down 29%, Mitie down 34% and SIG, which was already at a low valuation down 22%. Polypipe has also fallen 25% and while it hinted at its interims that trading might be tough (and of course some of the tailwinds from last year have reversed) it has not warned but fallen as if it had.
The third group comprises those that seem unaffected. Babcock, up 0.9% YTD, Balfour up 2.8%, Morgan Sindall down 5.5%, Kier down 2.2% and Mears up 2.1%. All of these stocks are dependent for a large part of their revenue on the UK Public sector and have not signalled trading issues. Balfour might consider itself undervalued at this point as a substantial element of any value has to be the Infrastructure portfolio; infrastructure plays have had rather a good year with JLG up 30% YTD, JLIF 18% and HICL 16% so it might be expected that BBY could have done a little better. Clearly the yield on the pure Infra plays is the attraction versus the only recently resumed dividend at BBY but the potential for returns remains. Ally that with the US operations showing improved profitability and a substantially increased order book at the half ways stage and its starting to become a strongly positive argument. We also suspect that the UK “clear-up” will be advanced by several more stages and there may even be new targets for Build to Last.
The leaves three stocks that are “special” cases
Carillion, where the shorts are now up 0.5% at 21.3% than early this month, according to Castellain’s data. The message from the market is that incoming FD, Zafar Khan, will need to tackle the balance sheet issues soon. To date the thought process has been that the considerable debt capacity is sufficient to maintain trading but the lack of any obvious effort to reduce net debt is wearing for long investors, along with lack of earnings growth. News from the company and peers indicates that trading is in line and companies with similar trading exposure to Carillion have been relatively stable in share price terms. The hypothesis must be that it’s the Balance Sheet that is the problem, which we may have known already but the moves in share prices YTD is additional evidence. As with Atkins a large amount of cash is taken from shareholders each year (over £40m in CLLN’s case) to fund the pension deficit; a better balance between the pension and the company might be sought.
Serco, which has been in a 130-140p range since early August is probably ahead of events in terms of valuation but better times are ahead. The trend for the company has been to exceed expectations. There are few sellers at this stage and some keen buyers. The performance of the underlying operations is improving and the Barts win demonstrates the company is now back in business in terms of large scale, FM contract wins.
And Galliford Try, which is adjusting to its new CEO regime and considerable management change below board level. The 12% decline YTD is the lowest among housebuilders, reflecting GFRD’s exposure in Partnership Homes and Construction. The stock will move in line roughly with the housebuilders as Linden provided 85% of group operating profit last year, pre central costs. The company is due to provide an update on direction and targets early in the New Year as the new CEO delivers his plans. We suspect the stock will lack a specific catalyst for change until then.
Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.