Lavendon's major re-rating potential

Reporting first half results at the end of August, chief executive Don Kenny said he was "disappointed with the performance in the UK" – historically the company’s core region. While many other companies in the construction and support services sector were by that time reporting a pick up in trading, Lavendon was behind the curve as the early recovery was driven by housebuilding, rather than the large-scale projects that provide Lavendon’s bread and butter.

But a trading update in November suggested that, at last, Lavendon was feeling the ripples of UK economic recovery. Rental revenue was up 2 per cent on-year in the third quarter, indicating a sustained, improving trend following 1 per cent growth in the second quarter and a 2 per cent drop in the first quarter. Lavendon said that its UK business, which accounted for around half of group revenue in 2012, was seeing volumes consistently ahead of the prior year and signs of better pricing too towards the end of the third quarter.

During the lean years, Lavendon has tried to mitigate the pain by self-help measures to squeeze costs out and also by maximising its position of strength in the Middle East. Lavendon is the market leader in powered access equipment rental in the Middle East with particular strength in Saudi Arabia and Abu Dhabi, and the region accounted for almost a third of operating profits in 2012.

Middle East rental revenues were up 20 per cent on-year in the third quarter, and that was on tough comparables after a strong performance in 2012. The company said in its recent trading update that demand for its equipment on large construction projects in the Middle East continues to be robust with the outlook remaining very positive.

As an equipment rental business, Lavendon has some asset-backing; a net asset value of 123p helps underpin the shares. But it also means that Lavendon must invest a fair chunk of money in maintaining its assets. In 2012, £48m was spent on the rental fleet and operating infrastructure, which was more than the £35m of underlying operating profit that year. But despite that, Lavendon still managed to reduce net debt by £9m to £97m thanks to strong operating cash flow, and the level of gearing looks manageable.

Given the need to invest large sums of capital, return on capital employed (ROCE) is a useful yardstick of performance for Lavendon. As long as ROCE stays above the cost of capital, then Lavendon should be creating value for shareholders. Lavendon has said its ROCE will dip for 2013 from the 10.7 per cent it achieved in 2012 due to the UK making up a smaller relative proportion. But the drop should be small (broker Peel Hunt is expecting ROCE to be 10.3 per cent), and Lavendon says it remains confident of delivering a ROCE above its cost of capital over the business cycle.