In the depths of the last economic depression, UK infrastructure spending was hailed as the panacea entrusted with pulling up the UK economy by its boot straps. A quick check on the UK's balance sheet put paid to that in the immediate aftermath of the crash, but the idea remained fairly well up the political agenda. Just one example will suffice. In the 2010 general election, infrastructure was a key element in the Conservative manifesto: "Cutting congestion and making Britain's roads safer".
What happened in the following two years is that spending on roads was halved. This may well have been an inevitable consequence of fiscal restraint, but it also meant that the backlog on construction and maintenance was simply kicked further down the potholed road.
Times have changed, or more specifically, finances have started to improve. Increased spending on infrastructure projects will not only improve communications, facilities and the quality of life; it will also make up for a decade of chronic under-investment. However, it's important to understand the basic definition, because infrastructure spending covers anything from a multibillion pound railway line all the way down to repairing the roof on the village school. Both are important in their different ways, but we must remember that a lot of so-called infrastructure spending is employed simply to keep things running as they should run; in effect, ongoing maintenance.
Putting a well constructed operational plan into action is beset with difficulties. Heathrow is a fine example. Most people concede the merits of a bigger airport to serve London, provided of course, that it's not built anywhere near where they live. The government kicked this one into touch after 2010, promising the results of a review after the 2015 election, thus highlighting the politically sensitive nature of the proposal to extend Heathrow. As suspected, the review came down in favour of a third runway, but the government may not announce a decision until the end of this year.
Other hurdles have blighted the planned HS2 link between London and the Midlands, and even if the whole process were steam rollered through, the trains won't run for at least another decade. Throw in other pressure groups, including the potential violation of a nightingale breeding ground in Kent, and it becomes clear how the process of getting a major development off the ground has become so laborious. After all, committees are renowned for keeping minutes and wasting weeks. And according to the World Economic Forum's quality of infrastructure rankings, the UK languishes in 27th place behind Saudi Arabia and Barbados.
Ready for take-off: the government is due to announce a decision about expanding Heathrow Airport by the end of 2015
In the pipeline
So, what's in the pipeline? Britain's power supply remains a chief focus, as many nuclear power stations reach the end of their useful life. A decision on building a new power station at Hinkley Point in Somerset took another step forward after the government announced a £2bn guarantee in order to kick start the delayed project. The proposed power station has received considerable interest after it became known that the £24.5bn project to be built by EDF to a French design would be in partnership with two Chinese companies. China is also expected to lead the construction of a Chinese designed nuclear plant at Bradwell in Essex.
The idea has two main attractions. Chinese investment would help pay for Hinkley and another plant at Sizewell in Suffolk, while Bradwell would be Chinese built and operated. For China, if its technology can be seen working in the UK, it opens up the prospect of winning new work elsewhere. In the UK alone, there are plans for five new plants.
On the transport side, having spent decades reducing the total rail network from around 18,000 miles to less than 10,000, huge amounts are now being earmarked to reverse the process. Crossrail is already on the way to completion and should transform travel along its route from west to east London. Of the total internal journeys made in the UK, less than 2 per cent are by air; 8 per cent by rail and the rest by road. This presents something of a logistical challenge, because to transfer just 2 per cent of road traffic on to the rail network, rail capacity would have to increase by 25 per cent. That's an investment programme currently beyond anything even mooted at the moment. There are other avenues that could also lead to significant increases in operational efficiency; especially since less than half the passenger network is electrified.
High speed 3?
Some progress, albeit painfully slow, has been made however, at least at the planning stage. Projects in the rail pipeline or under way are currently worth over £95bn, with a lion's share of this - £50bn - earmarked for HS2, the high-speed link between London and Birmingham and elsewhere. Crossrail and the Thameslink upgrade account for another £20bn, which doesn't leave a lot. What's left is being spread about rather thinly to upgrade some cross-country lines including electrification.
There have already been calls to boost economic development in northern core cities. Poor transport is seen as a major block on growth and job creation. So it comes as no surprise that there are calls for a Newcastle-Hull-Leeds-Sheffield-Manchester-Liverpool hub, or HS3. Unlike the funding, the wish list is seemingly endless, which is probably why the government moved quickly after the general election to mothball plans to upgrade major lines in the Midlands.
To some extent, the government's hand was forced by the appalling performance of Network Rail, which last year was reclassified as a public body. This introduced greater oversight on its ballooning debt. It also became clear that more than a third of its targets were missed, raising serious concerns about its ability to deliver future projects.
Easing congestion
Road improvements have also been targeted. It remains a sad fact of life that individual drivers and the transport of goods both remain firmly routed to the tarmac, so alleviating current bottlenecks can only improve delivery times and reduce congestion. Major schemes already identified include the A14 between Huntingdon and Cambridge, which will alleviate the congestion around the key ports of Felixstowe and Harwich, with Carillion (CLLN) and Balfour Beatty (BBY) awarded a joint venture to start work late in 2016. Plans are also in place to improve access to Manchester and Birmingham airports. There is also a scheme to improve access to the Port of Liverpool, including a £600m Mersey gateway bridge.
With the significant use of containers as a means of transporting goods, the newly completed London Gateway container port also has planning consent for up to 9.5m sq ft of space that will create the largest logistics park in Europe. Other proposals include increasing capacity at Felixstowe and Liverpool 2; the latter opens at the end of this year and will use barges to deliver freight along the Manchester ship canal.
And after almost a decade crawling its way through the planning pipeline, terms have been agreed for the £4.2bn Thames Tideway Tunnel, a project designed to upgrade London's overstretched sewerage network constructed in the 1880s by Joseph Bazalgette. The 15-mile tunnel will take around seven years to build, and while margins are likely to be tight, the project at least gives the likes of Balfour Beatty and Morgan Sindall (MGNS) a chance to show off their skills in an area that is likely to attract more business in the future.
However, recent research by consultancy group KPMG has revealed disquieting news about the number of projects in the government's construction pipeline. Since previous analysis in December last year, it seems that the number of projects in the pipeline has dropped from 3,148 to 2,262 in August this year. A number of those projects have dropped off the list following completion, but with 860 lost projects relating to the unprotected defence, justice and police sectors, it appears that potential projects have been removed from the pipeline to avoid pre-empting decisions in the forthcoming spending review. Furthermore, a total of 1,784 projects haven't even been given a start date. However, until the spending review in November, the drop in project numbers suggests that government departments may be putting projects on hold in the expectation that they will be culled. This may all be part of the political process, but it's hardly helpful for the construction sector, where good visibility would help in forward planning.
Renewable cuts
There have also been a number of warnings, notably from the Confederation of British Industry, about the cut in subsidies for renewable energy. The UK Treasury, never slow to identify a way of saving money, has pointed out that lower costs mean that parts of the renewable industry should be able to survive without subsidies. However, imposing the Climate Change Levy on wind and solar power which emit no net carbon doesn't seem to make a lot of sense. It also raises questions as to whether there will be sufficient incentives within the renewable sector to meet the government's target of 30 per cent of UK electricity coming from renewables by 2020. Active wind turbines currently contribute just 5 per cent. There is another hurdle to overcome here too. Offshore energy generation is less intrusive but also less efficient. But onshore generation meets more resistance at the planning stage, wasting more time and money.
There are also implications from the government's decision to axe funding for the national Green Deal Finance Company and the Green Deal Home Improvement Fund. Birmingham city council recently pulled the plug on a £1.5bn deal signed in 2012 to save energy by improving home insulation. The council specifically blamed the government for its decision, adding that with the goalposts constantly on the move, there was no chance of hitting the target of improvements on 60,000 homes and 1,000 non-domestic buildings without the council having to subsidise the project. The Green Deal has been a failure because it has broken its own golden rule: that the costs of repayment and the costs of the loan and investment in energy efficiency should never be greater than the benefit received. As a consequence, the council has torn up its agreement with Carillion, which was worth around £600m over eight years for the company. And more recently, power generator Drax (DRX) abandoned plans for a carbon capture and storage system at its huge North Yorkshire power station, blaming the government's ever changing stance for making the project financially too risky.
Ready and waiting
The big listed companies with their sleeves rolled up ready to take a chunk of the infrastructure spend centre on Kier (KIE), Costain (COST), Balfour Beatty, Carillion, Galliford Try (GFRD) and Morgan Sindall (MGN). Some of these are regarded more as support services because a significant part of the workload is maintaining and servicing existing assets, such as motorways, street lights, and railway work. By and large, contracts are usually over a fairly long time period but margins are relatively low. Overall performance is much better now that the recovery has taken root, but more construction companies face problems after the end of a recession rather than during it. Part of this stems from the need to take on fixed price work when the workload itself is pretty thin. This is fine when wages are depressed and raw material costs static or falling. The problem arises when both start to recover; quickly eating away the already low margins on fixed price contracts.
Even some of the big players have been caught out. Balfour Beatty, for example, issued a string of profit warnings after identifying a catalogue of issues such as poor operational delivery, as well as cost increases and delays in its UK construction arm, culminating in the resignation of its chief executive. It also sold its profitable Canadian operation Parsons Brinckerhoff and fought off a hostile bid from rival Carillion.
Some consolidation has been seen in the sector however. Kier completed the acquisition of infrastructure group Mouchel in June; the most immediate effect was to boost the forward order book from £6.2bn a year earlier to £9.3bn. The acquisition pushes Kier up to being the leading operator in highway maintenance services in the UK, and poised to grab some of the £17bn Highways England five-year investment programme in the strategic road network.
Balfour is ready to take a chunk of the infrastructure spend
One-stop shop
Costain has already secured a place in the Hinkley Point C construction consortium, leaving it well placed to secure more business when other planned nuclear power stations leave the drawing board. It's also part of the Thames Tideway Tunnel consortium. There's also been a change in its business model, with greater emphasis on providing a one-stop service for major customers, covering planning, construction, maintenance and a host of other essentials. Big companies prefer to work this way, as it means that they only have to deal with one major contractor. And in August, Costain bought professional services consultancy Rhead Group, which will help to enhance the group's ability to offer services throughout the full life cycle of any project.
Carillion is performing well too, despite the Birmingham green deal fiasco. But while the company is sitting on a pipeline of contract opportunities of over £40bn, headline profits have been squeezed by pressure on margins as a result of much higher contract mobilisation costs as the company started work on a host of new contracts secured in 2014. Order intake was slow at the start of the year, which the company blamed on the uncertainty ahead of the general election.
Galliford Try is best known for its housebuilding arm, but it also operates a successful construction division. Winning new contracts and buying Miller Construction last year transformed this side of the business, pushing turnover up by over a half in the year to June. Even margins are improving, up in the first six months of the year to 1.5 per cent from 1 per cent.
The infrastructure supertanker is undoubtedly moving in the right direction, albeit against some strong currents, but the less than joined up picture presented by the progress of various schemes has led to calls for a more integrated structure. According to research by PwC and the Smiths Institute, large transport infrastructure developments need a new, more flexible approach. The methods used in appraising transport infrastructure with a view to assessing marginal improvements to capacity tend to fall down when more transformational projects are planned, where costs currently take precedence over economic impact. This is important, when considering that central government is looking to devolve more transport powers to regional bodies such as the Greater Manchester's Combined Authority. In doing so, there is a greater need for a new collaboration between local, regional and national transport bodies. In short, many places suffer from a fragmented approach and a lack of liaison between the relevant bodies.
Steady stream
Dysfunctional, delayed, uncoordinated, politically swayed; all of these can readily apply to the government's macro planning of infrastructure products, and taxpayers may well ask whether they are receiving best value. The good news is that public finances are now better than they have been for nearly a decade, which suggests that the drip feed of financing may yet turn into more of a steady stream. It's important to remember, though, that bulging order books translate into pretty thin margins in many cases, leaving little room for error. However, most of the key players in construction and maintenance supplement their revenue stream with overseas work.
Carillion, for example, is showing solid growth in its Middle East operations, has low gearing, margins close on 5 per cent, and also pays a dividend yielding over 5 per cent. Galliford Try is another solid performer, backed up by its house building side, and has a dividend yield of over 4 per cent, as does Kier. Carillion has been boosted by acquiring a stake in Rokstad Corporation of Canada, generates 60 per cent of its revenue from maintenance and pays a dividend yielding over 5 per cent.
The pervading strength among these companies filters down to a host of smaller companies all benefiting from increased demand for goods through the supply chain from bricks through to window frames. This may not be a fast burner as sectors go, but the inexorable shift towards addressing the dearth of previous spending on infrastructure bodes well.
Infrastructure funds: yield at a high premium It is hard for private investors to invest directly in infrastructure projects because you need to put in a minimum of millions of pounds. However, there are investment trusts which directly invest in infrastructure, including areas such as private finance initiative (PFI) and public-private partnership (PPP) projects in the UK. A key attraction of these trusts is their yields which are mostly between 4 and 6 per cent. They also have low correlations with other asset classes and typically lower volatility: for example, during the sell-off in the third quarter of 2011, the FTSE All Share peak to trough fall was 19 per cent while infrastructure trusts only fell 3 per cent. Their underlying cash flows are underpinned by long-term contracts with the public sector, and in some cases have a high degree of inflation linkage. However, these trusts are likely to lag rising equity markets and have also traded on high premiums to net asset value (NAV) for years, in some cases double digit ones. If you buy something overvalued you probably won't make as much money on it, and if interest rates rise, the income level of infrastructure trusts will not seem as attractive and their shares may become less popular, causing the premium to fall. But if you hold an investment trust for the long term and it makes good returns these could compensate for the premium to NAV. And if you don't expect the premium on the trust to narrow any time soon because it has been fairly constant, you may also be able to sell it at a premium. We count HICL Infrastructure Company (HICL) among our IC Top 100 Funds. It mainly invests in operational projects yielding steady returns. It has a reasonable ongoing charge of 1.21 per cent and a yield of 4.8 per cent. It has outperformed most of its sector peers over one, three and five years, and is well ahead of broad indices such as the FTSE All Share. Although predominantly invested in UK PFI and PPP, it is expanding its overseas investments. For the year to 31 March HICL paid dividends of 7.3p, a 2.8 per cent increase on the previous year. The trust has set a dividend target of 7.45p for the year to March 2016 and has grown its dividend every year since launch in 2006. But it trades at a premium to NAV of about 13.6 per cent, though this is tighter than its 12 month average premium of 15.4 per cent. John Laing Infrastructure (JLIF) focuses on PPP infrastructure in developed markets and currently has no construction assets, giving it a lower risk profile, though it can put up to 30 per cent of its assets into the latter. It has access to its manager John Laing's projects, reducing the risk of cash drag on money waiting to be invested Its total returns are at the lower end of its peer group average but it yields nearly 6 per cent, and for 2014 paid dividends of 6.63p. It is on a premium to NAV of 9.5 per cent against a peer average of about 11 per cent. GCP Infrastructure (GCP) invests mainly in the debt of infrastructure projects and renewables – rather than equity. This theoretically makes it lower risk as equity investors in projects absorb initial losses. It offers the highest yield in its sector – more than 6 per cent. Its share price returns beats its peer average over one and three years, and it beats the FTSE All Share over one, three and five years. But it trades on a premium to NAV of 13.4 per cent – slightly wider than its 12-month average. It invests in 39 assets in areas including renewable energy, education and healthcare PFI. If you don't want to buy an investment trust on a high premium to NAV you could invest in an open-ended infrastructure fund. However these do not offer direct exposure, but rather invest in the shares of infrastructure companies. Options include IC Top 100 Fund First State Global Listed Infrastructure (GB00B24HJL45) which invests in a diversified portfolio of listed infrastructure and infrastructure-related securities globally. The US accounts for nearly half of its assets with the rest mostly in developed countries. The fund invests in infrastructure subsectors including toll roads, rail, airports, ports, water, gas, electricity, and energy and communications infrastructure. It has beaten its benchmark, FTSE Global Core Infrastructure 50/50 Total Return Index, over one, three and five years, and made positive returns over the last six calendar years. In 2008 it fell 13 per cent – considerably less than the FTSE All Share. It does not offer such a high yield as the infrastructure investment trusts at around only 3.1 per cent. It can be bought on platforms for about 0.9 per cent. Leonora Walters |
