Market Commentary - Housing, Infrastructure, Construction and Services 3rd May 2017
Whoops, we missed Mitie’s announcement as we were a bit distracted by Galliford and Costain Galliford Try has provided a bit of shock this morning with a £98m write-off on two infrastructure JVs in a trading update that indicates almost all other activity is going as planned or better. We shall do a bit more work on GFRD and the company may call us back before the 10am conference call. There was some relevant news yesterday after close of play. Costain, John Laing Group (JLG) and Pennon all announced that Manchester waste project has moved to the next stage.
Whoops, we missed Mitie’s announcement as we were a bit distracted by Galliford and Costain. The news today has several parts but seem to draw a line under the previous regime’s worst habits and while trading is said to be challenging that is not new and is no worse for Mitie than others, in our view. The key thing is that the company can now look forward with a clean set of numbers albeit that here are some cash costs which will cause debt to rise and creates the need for an EGM to alter articles relating to debt limits. The write-downs announced today reduce reserves such that the company may technically breach net debt to reserves ratios. The company is also seeking to alter its banking covenants to remove the risk of a breach if cash costs of restructure and lower earnings in the restructure phase.
The key number today is that a further write-off of up to £50m is expected as the company now believes its treatment of percentage of completion on contracts and allocation of mobilisation costs is more aggressive than most rivals and needs to be adjusted. Of that amount only £6m is expected to be a cash item, payable this year. Also, somewhat curiously the company has identified “material errors” in the 15/16 accounts which mean the 16/17 accounts will show results up by between £10 and £20m; the phrasing is a bit vague but suspect it refers to operating profit. Finally the costs of change have risen to £15m from £10m as more redundancies than originally planned have been processed; this may be positive for earnings but we will need to wait for the results to find out, now planned for the later date of 12th June as a bit more work is needed.
This is probably the end of most of the storms the new team will face with just one more that is likely. When the Annual Report is published the departure terms for Ruby and Suzanne will be released. Given that the historic accounts contained not only substantial differences of approach to the timing of declaring revenue and cost, compared with sector peers but also material errors shareholders might be disappointed when they see the leaving packages. After that the new top team should be able to proceed with creating a £2bn annual revenue company with 4-5% operating margins and 4-5% annual revenue growth by 2019; that should deliver EPS of 18-21p depending on interest costs and tax rates. That prospect justifies the 200p++ share price.
Galliford Try has provided a bit of shock this morning with a £98m write-off on two infrastructure JVs in a trading update that indicates almost all other activity is going as planned or better. The group is anxious to point out that these were contracted in 2014 or earlier and are now “legacy” contracts, a term used more frequently in the sector these day to mean an expensive set of mistakes, usually which can be blamed on somebody else! We have yet to speak with the company to identify exactly which projects are being referred to and who the partners might be. The issues in the Scottish schools with collapsing walls are well known and came mainly as part of acquisitions. The problem for GFRD right now is of course that its risk management on recently contracted work is now in question. The costs are mainly cash it would seem and are due to be completed this summer and the larger proportion will be completed this time next year. It would seem to an outsider that the company expected to contain the costs within guidance but they are just too large. There will no doubt be some legal battles over liability and we suspect £98m is worst case but we have yet to confirm. There might also be questions around the timing as these issues must have been known on 21st February, if not quantified, when the half year results were announced and the new targets were outlined.
Of course this comes at a time when the new CEO is settling and in general the operations are performing well. In house building GFRD confirms the evidence of others that trading conditions are good and forward order books are strong and margins are higher than last year. The landbank has been shortened slightly to improve ROCE. It has secured planning on 97% of plots for 2017/18 and 76% for the following year so the changed approach to land should not affect production rates. In partnership homes the order book is up 6% compared with end December and margins have improved, as expected.
We shall do a bit more work on GFRD and the company may call us back before the 10am conference call. It looks to us as though this will not impact greatly on the achievement of the targets set out in late February other than in terms of the net debt. These contracts in question were large ones and were on a fixed price basis, a type of arrangement the company no longer uses so there is an expectation they are one-offs. The company has stated it intends to pay its dividends as outlined in recent updates. The share price has been winking at investors for some weeks and refused to budge while other sector stocks were rising a little. Our view is that this is a one-off but the company needs to have 6-12 months of solid performance, with no diversions into intended acquisitions, before trust will return. Damage may be limited today as this is really only about some historic projects but it may hit 1300p in the next few weeks before seeing 1800p again. It closed last night at 1461p.
There was some relevant news yesterday after close of play. Costain, John Laing Group (JLG) and Pennon all announced that Manchester waste project has moved to the next stage. The Greater Manchester Waste Authority (GMWDA) has agreed to serve notice to terminate the contract in which JLG and Pennon have a JV to supply waste treatment plants to GMWDA, the main subcontractor being Costain. The work started in 2009 and is said to be a £630m project. In JLG’s announcement the plants are said to be operational and landfill conversion is ahead of contractual requirements. JLG refers to a decision that appeared in the minutes of the GMWDA at its meeting on 28th April and not any formal direct notification to them; we suspect that the informal discussions started some time ago so the situation is not wholly fraught with tension. Whatever the communication process the toothpaste is out of the tube now and it’s not going back in, contract termination means contract termination. A joint transitional plan is due to be presented at the AGM of GMWDA on 12th June 2017 and a limited liability company is to be established to manage the facilities in the future.
For all parties this changes the dynamic and, in the JVs case the long term delivery contract it’s not clear. Costain is our main focus and its task was to complete all 43 facilities. That is nearly done to contract terms and is taking a bit longer than expected as the sites access is restricted because they are operational. We suspect the change makes little difference for Costain. No doubt discussions have been ongoing about the transitional deal as that is the way these things work but until the detail is known it’s difficult to assess the outcome on earnings. We expect Costain will see none and it may be good news as it will close the chapter on these events.
The winner yesterday was G4S which rose 2.9% to 314p; we have been saying for some time that the market had been missing the point on this stock. The update later this week is likely to be positive though the share price is getting nearer to being up with events. Catalysts for further improvement will arise from completion of the disposal programme, lower net debt and new work contracts. All three things are going to happen and there is still time to get on board on a 2/3 year view as revenue and margins are both set to grow faster than the sector average. Atkins was the back marker as it fell 1.8% to 2108p; the price has recently been pointing to expectations of another party entering the bidding but the move yesterday suggests that the sentiment has altered. The sector performed well yesterday with few losers.
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