Join our community of smart investors

A preference for Balfour Beatty

SHARE TIP: Balfour Beatty (BBY)
March 15, 2012

As a global construction and services group, Balfour Beatty can direct its energies to those sectors that are showing the most growth, whether it's winning a civil engineering project in Hong Kong or work in Australia's mining sector. This ability to concentrate on the world's hot spots is paying off. And, despite a fall in orders on the UK construction side, more business secured elsewhere has kept the order book strong at £15.2bn. Work continues to come in, with a £230m contract secured earlier this month to renovate or build 3,268 homes on four military bases in the US.

IC TIP: Buy at 289p
Tip style
Value
Risk rating
Medium
Timescale
Long Term
Bull points
  • Large order bookDiverse revenue streamUseful cash pileAttractive dividend yield
Bear points
  • Construction side under pressureUS professional services revenues weak

Balfour's progress has not been at the expense of its profit margins; although pressure has built up in some parts – notably construction – where margins fell from 3 per cent to 2.4 per cent in 2011. Predictably, civil infrastructure in the UK came under pressure, too; and, despite encouraging growth in Hong Kong and the US, profits from construction fell 16 per cent to £169m.

Balfour's other operations include support services and professional services, both of which pushed profits ahead modestly. That said, in the US professional services suffered because of the federal government's failure to fix a six-year budget for transport.

But the infrastructure side is showing the strongest growth. This stems from growing returns from investments in so-called private finance initiative schemes where a fall in bidding costs and the sale of two mature assets boosted profits from £30m to £71m. Balfour has a further 64 projects on the books valued at £743m.

Diversification is also key, especially in the way that management sells Balfour to potential customers. So new opportunities are opening up in the UK as local authorities, for example, are having to make every pound work as efficiently as possible, mainly through integrating contracts and offering longer-term agreements.

Balfour's finances are in good shape, too. It has net cash of £340m and in November it secured a fresh five-year revolving £850m loan facility. Management is aiming for cost savings of £50m a year by 2015 as well.

BALFOUR BEATTY (BBY)
ORD PRICE:289pMARKET VALUE:£1.99bn
TOUCH:288-289p12-MONTH HIGH:361pLOW: 214p
DIVIDEND YIELD:4.6%PE RATIO:10
NET ASSET VALUE:183pNET CASH:£340m

Year to 31 DecTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20088.2626736.911.2
20098.9526537.112.0
20109.2420123.012.7
20119.4924626.713.8
2012*10.3523827.013.3
% change-3+1-4

Normal market size: 10,000

Matched bargain trading

Beta: 1.1

*Bank of America Merrill Lynch estimates (turnover not comparable with historic figures)

We like the ordinary shares, but some investors might want to consider Balfour's convertible preference shares, in which there is a liquid secondary market. Holders are paid a gross 10.75p a share every year in two installments and, at the current 130p, this means a yield of 8.3 per cent. Unless the redemption date is extended, the prefs will be redeemed on 1 July 2020 at £1 each, so there would be a capital loss, which cuts the redemption yield to about 5.4 per cent.

However, the prefs also have the right to convert into Balfour ordinary shares at the rate of 24.69 ordinary shares for every 100 preference shares, which is a whopping 82 per cent more than the current share price of 289p, and equivalent to buying ordinary shares at 527p. Clearly that's not a sensible proposition, but the conversion rate is fixed. This means that, if the share price were to rise over the next eight years to beyond 527p, then the ordinary shares could be bought at a discount.

That's possible and, in the meantime, holding the prefs would bring an income advantage over holding the ordinaries. At least it would to begin with, but the dividend on the ordinary shares should rise, while the dividend on the prefs will stay unchanged.

So the key question is: how fast can Balfour's ordinary dividend grow? The faster it does, the more likely it would be worth holding the prefs rather than the ordinaries because the pace of dividend growth would pull the price of the ordinaries beyond the conversion price before the prefs mature. In other words – and depending on the nitty gritty of their tax position – mega bulls of Balfour, who need income now, could consider the prefs; others should favour the ordinary shares.