Constructing high-yield recovery plays

Sector Focus

For contrarian investors the construction sector is beginning to look alluring as high-yields, structural change and the prospect that the trading has troughed combine to provide a potential for significant upside for patient buyers.

Auf Wiedersehen, Pet

It's no longer possible to find a listed pure play on the UK construction sector. The construction sector has evolved over the past few years with companies broadening their revenues away from bucket and spade projects. This is just as well because any company purely focused on UK construction now would currently be staring down the barrel at oblivion. The big players have had the scale to chase work abroad, notably the Middle East and North America. They have also seized an opportunity to provide a one-stop service, offering customers planning advice, construction and post-construction maintenance on such projects as motorways. And some have spread their wings to win contracts for repair and maintenance work with a largely non-discretionary element, such as sewers, electricity infrastructure, underground pipes and nuclear.

To a large extent, this has helped to soften the pain caused by the tailing off of major domestic construction projects, such as the Olympic stadium or Crossrail. True, there are a number of potentially huge projects currently bouncing around including a giant sewer in London, a high-speed railway link, and possibly even a brand new airport in the Essex/Kent marshes. But all of these have met considerable environmental resistance not to mention the task of raising the necessary finance.

And yet spending on the infrastructure has been one of the government's main planks for reviving the economy. Nevertheless, spending levels are being squeezed. Several initiatives have been launched including efforts to encourage pension funds to part with their money and sponsor construction projects. But hopes of attracting £30bn or more have been dashed, not least because pension fund managers like to see a clearly recognisable and ultra safe revenue stream.

Feeding from the trough

Activity levels in UK construction have fallen sharply since the start of the credit crunch, with new orders peaking in 2007 at £76.1bn before sliding away to £46.2bn by 2011. But there are indications that current levels could represent the bottom of the cycle, not least because more government initiatives can be expected. And while profits for the big construction companies next year are likely to be flat, dividends are well covered and unlikely to be cut. For investors prepared to wait for the upturn, current share price levels could be seen as a relative bargain.

That said, short-term sentiment is not favourable and there could be bouts of share price weakness. Only last week, Balfour Beatty (BBY) was punished for stating the obvious; namely that pure construction in the UK and US is weak. Investors ignored the profitable sides of the business and the fact that the forward order book at £14.4bn was down only £600m, and the shares plummeted 16 per cent in one day. Clearly at some point this kind of markdown will have to stop, and we rather think that current valuations are already putting construction companies into the value territory. Carillion (CLLN), for example, trades on a forward PE ratio of just seven and offers a prospective yield of nearly 6 per cent, while the order book stands at over £18bn in addition to a record £35bn-worth of contracts in its bidding pipeline.

Reasons for optimism

There are some signs of life in the UK construction sector. For example, the Purchasing Managers' Index for construction rose from 49.5 in September to 50.9 in October, although only civil engineering output was up while both residential and commercial work declined.

Activity in the UK has been severely hit by a lack of PFI projects but this could be changing. The government virtually stopped awarding such contracts while it sorted out whether there was a better way to use taxpayers' money amid a welter of claims that the country was being ripped off by private contractors. And it has taken a year for the new PFI framework to be announced - it bears a remarkable similarity to the one it was supposed to have replaced. The reintroduction is crucial for two reasons. Borrowing money to finance infrastructure projects is now as cheap as it's ever likely to be, while the year-long hiatus has built up a significant backlog of work.

Just for starters, Carillion's chief executive, Richard Howson, reckons there could be £2.5bn of priority schools work up for grabs in the first quarter of next year alone. And in the current low interest climate one of the previous sore points about PFI has been erased. Previously, contractors priced in the high cost of borrowing to fund what were traditionally highly leveraged PFI projects over the full term of the contract - as much as 30 years. However, as interest rates fell, contractors were able to refinance at much lower levels and pocket the difference. That manoeuvre is no longer possible since interest rates are unlikely to get any lower than they are now. And PFIs have formed a significant part of total revenue. Around 21 per cent of Balfour Beatty's underlying earnings this year will have come from £52m of disposal gains on PFIs, while for Kier it's 11 per cent.

Meanwhile, it has become clear that there is some expenditure that simply cannot be avoided. Cutting back on funding for affordable housing has been a disaster, and dithering over how to avoid power cuts when nuclear power stations are switched off has to come to an end soon or it will be too late. In fact, the biggest reason for the stagnant nature of the construction sector this year has been the inability to get ambitious spending plans off the ground. And they are ambitious. Through the National Infrastructure Plan, the government has committed to invest over £200bn across all aspects of infrastructure before 2015. That's up from the £113bn invested in 2005-2010.

True, it might take a while before the momentum builds, but required spending on the infrastructure doesn't go away; it's simply being piled up. Meanwhile, alternative income sources are being developed, and many of these, such as project management and maintenance, command much higher margins than traditional construction projects. In the case of Balfour Beatty, the services sector now accounts for a third of group turnover, up from a fifth in 2008, but it is still not enough to fully offset the effects of the downturn in pure construction.

Naturally, companies will be more selective about what work they take on, because with already wafer thin margins and rising costs, the only practical alternative is to reduce the cost base. Balfour hopes to achieve this by losing workers and pulling out of some of the less productive areas.

IC VIEW:

Many companies have managed to establish a decent presence in the US, but recovery there has been reduced to a toss of a coin on whether the newly re-elected President can sort out the budget deficit before automatic tax rises and spending cuts come into force in January. This is a significant talking point, with various scenarios covering last-minute deals all the way through to financial meltdown. Whatever the outcome, the damage is already being done because corporate America is sitting on huge sums of cash that it simply won't commit until some clarity returns. And time is running out, although any compromise on the deficit will inevitably include higher taxes and lower spending. However, there are signs that the US housing market is already starting to bottom out, while lower energy costs are another plus factor. It might all turn out to be a slow burner, but we could be past the worst.

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