Market Commentary - Housing, Infrastructure, Construction and Services 29th September 2016
A scheduled update from Atkins this morning and an unscheduled one from Capita. Capita tell us that underlying PBT will be £535-£555m and not the £614m the consensus is pointing towards. They tell us that what has gone wrong is a slow down in some trading businesses, delays in certain areas and one-off costs with the TfL congestion charge contract which was re-won last year The update from Atkins is a tad more positive than might be expected reading between the lines, we believe, though the company is quite cautious so the tone is quite moderate.
A scheduled update from Atkins this morning and an unscheduled one from Capita. Atkins tell us they are trading in line, including the FX tailwind and Capita has issued a profit warning. The update from Atkins is a tad more positive than might be expected reading between the lines, we believe, though the company is quite cautious so the tone is quite moderate.
Capita will attract the headlines so let’s deal with it first. Capita tell us that underlying PBT will be £535-£555m and not the £614m the consensus is pointing towards. They tell us that what has gone wrong is a slow down in some trading businesses, delays in certain areas and one-off costs with the TfL congestion charge contract which was re-won last year. The company tell us some of the detail behind each issue and the conference call at 8am will tell us a little more. Looking firstly at the TfL congestion charge which was re-won it would seem that it may have been bought not won. In some ways it is good that Capita is expensing the mobilisation costs of the work but it has clearly underestimated what was needed or taken risk it should not have done. The company is also having trouble with implementing a contract with the Co-op Bank which may need expensive lawyers to resolve.
The other two factors at Capita appear to be slowdowns in trading and in the award of contracts. The company does not tell us its view of the reasons for these slowdowns other than a nod to the impact of the Referendum. We suspect that the slowing of orders especially in the financial services area has a lot to do with the Referendum. But that does not mean that Capita does not have issues in its business as well. The key for us today in this text is that the company indicates that capital spending will be below the level of last year, as expected. Having capex below 4% of revenue has been a principle of the way the business is run for over 10 years. But in that period, as we show below, the impact may have been to choke off development leading to the company becoming increasingly dependent n expensive and often bad acquisitions. The congestion charge contract was re-won after Capita bought Parking Eye for £60m as it had number plate recognition technology, for example.
We suspect the problems at Capita are deeper than just this blip as the way the business works has hardly altered since Rod Aldridge left over ten years ago but the world has changed. The market will be concerned not just about strategic direction and demand levels but also about the rising level of debt which is now expected to be 2.7x EBITDA at the year end and not the already high level of 2.5x in previous guidance. More below
It was all positive yesterday in the sector. Grafton at last found strong support and took the lead with a 4.1% rise to 488p. The steep, post results decline in the share price of GFTU has surprised us as the restructure cost was not that large at £20m for a company of its size and trading was good. Perhaps the shock of the need for radical restructure was too much. The collateral damage from Wolsleley on Tuesday was also large and that created the opportunity. That opportunity still remains as with 41p of EPS expected this year on 16x (same as Wolsleley) the share price should be 650p. Accepting that the WOS rating might be high for structural reasons among the shareholder base (high level of US interest in WOS) what is clear is that 488p is potentially far too low for Grafton.
Mitie was the second best riser, up 3.0% to 185.8p and had its first positive day since the profit warning Monday last. The sound of thundering roofs getting more distant and stable doors being closed was typical of what happens. The prizes should go to guys who sold before the warning. The only reason to sell now will be if another warning is expected. We believe that if action is taken soon there may be a tremor but not another seismic shift in expectations. The shorts are not dashing to close but the easy money has been made. It is safe to conclude, in our view, that the company is not in real financial crisis so shorts may be taking some gains. It might be in greater difficulty if there is no clear demonstration soon, within weeks not months, of real change. Pretending it’s just a weak phase in its markets is an error, we believe and acceptance of that is crucial, along with appropriate changes.
WE WROTE THE NEXT TWO PARAGRAPHS LAST NIGHT PRIOR TO THIS WARNING TODAY Capita was the weakest performer yesterday, up 0.1% to 952p. It is over ten years since Rod Aldridge departed the company in mid March 2006 when the share price was around 470p. In the period since then the share price has doubled while the EPS have near quadrupled from 18.6p in 2005 to 70.7p in 2015. Shareholder returns have benefitted from dividends of course and growth prospects now are different from then which impacts on valuation but the width of the performance gap was not inevitable. Net debt to EBITDA in 2005 was 1.5x and in 2015 it was 2.5x. The business is more than ever dependent on acquisitions for growth; in 2006 the 21% revenue growth was 16% organic/5% acquisitions while in 2015 the 11.8% revenue growth was 4.3% organic/7.5% acquisitions. BD resource was stripped out in 2008-2010 and that is showing through, we believe.
The issue therefore is can Capita get back to previous glories, or even near and the current trajectory suggests not. The business has hardly altered its strategy since 2005 but has not really invested in itself, it could be argued. With 74.2p of EPS expected this year and a share price of 952p the valuation looks harsh. But the risks look high as its near 14% operating margins arguably have just one way to go and growth is not from doing what it does better and in more places but from other people’s business ideas and with increasing amounts of debt that may be cheap but is at levels that spook investors.
Clearly forecasts at Capita for this year will fall today. The company has not indicated it will take restructure costs as exceptional but that it will reduce costs and that will help next year’s out-turn. We suspect that there is more to come but will wait for the conference call
Turning to Atkins the update reveals that the business is performing very well and has had some good news at Hinkley that will aid future years. The crucial sentence for us is one we have not seen for some time, “Our North American business has enjoyed a particularly good first half”. The company has spent the last three years building up work in the US and taking action to improve the margins. It looks like the actions are yielding a positive outcome. For Atkins to be as positive as it indicates means trading must be very good!
But we and the company should not get too bullish. In the UK the business has been much stronger than expected for the last five years; in 2011 it was stated it would be 25% of revenue in time well it’s still not far from 50% though the PP&T deal has reduced its predominance a little. Elsewhere the company is trading as expected with cash collection in teh Middle East troublesome (as always) Asia Pac is improving slightly and the Energy business is suffering from the challenges of lower oil and gas prices.
Expect forecasts for Atkins to rise a little this morning partly due to trading and also due to the FX tailwind. Our expectation of 116p of EPS for this year is a bit high already but new forecasts will move towards 113-115p we suspect
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.