Bidders move in on a cheap sector

The catalyst that has prompted the market to sit up and take notice of the sector was when a little-known Canadian company, Genivar, came along with a takeover offer for WSP at a 67 per cent premium. Shares in sector peer WS Atkins jumped 8 per cent and Hyder Consulting soared by 15 per cent in a week. "The value placed on UK engineering expertise is high, and international acquirers are exploiting currency strength and valuation discrepancy to get UK names on the cheap," says David Brockton from Espirito Santo. Analysts were not surprised by an overseas offer as the sector has been undergoing years of consolidation. Concerns over a construction downturn and infrastructure cuts have meant the market has largely overlooked the sector, until now. But what kind of returns can investors expect from further deals?

Takeover potential

The price paid may look like a chunky premium but the deal was done at a multiple in line with previous deals. Analysts at Espirito Santo calculate that the 435p a share offer for WSP equates to a multiple of 0.54 times historic sales, and 0.55 times prospective sales. This puts the deal marginally ahead of last year's takeovers of Halcrow and EC Harris both done on multiples of 0.49 times sales, but behind the takeover of Scott Wilson on 0.64 times sales and Davis Langdon on 0.75 times, both of which were done in 2010. Analysts at N+1 Brewin reviewed the ongoing consolidation in the sector and think that the premium paid for WSP would imply a price of 1,013p for WS Atkins, a 45 per cent premium, Hyder at 525p, a 27 per cent premium, RPS at 232p, a 14 per cent premium, and Waterman at 66p, a 37 per cent premium.

Investing in the hope of a takeover is always a risky game, especially when it looks as though one of the key reasons WSP became a target was its debt burden. Both WS Atkins and Hyder reported net cash in their most recent results. But even removing the chance of a deal analysts are reporting that after three years of organic revenue declines the market is showing signs of a structural recovery, driven by a Middle East construction boom and increased infrastructure spending in the UK.

Middle East delight

Joe Brent, analyst at Liberum Capital, says the mistake investors often make about the Middle East is to treat it as one market, when in fact it is many markets at very different stages in the economic cycle. So while Dubai is still suffering from its debt-fuelled construction binge, which is having knock-on effects in Abu Dabi and the rest of the United Arab Emirates, the other Gulf states such as Qatar, Bahrain, Kuwait and Saudi Arabia are driving a construction boom through vast reserves of petrodollars. Perversely, a knock-on effect of the Arab Spring and associated unrest is not less construction, but more as ruling elites, keen to hold onto power, are improving road, water and leisure facilities in an attempt to mollify agitated locals. Further unrest or a weakening oil price clearly present a major risk to the projects out there, but for now both seem to have stabilised, and the outlook is bright.

Qatar has become a focal point for engineering consultants as it races to beef up its infrastructure before it hosts the 2022 football World Cup and bids to hold the 2020 summer Olympics. The authorities have pledged to spend around £65bn on infrastructure to modernise the state. The work is coming through steadily, and last December Hyder Consulting announced the largest design contract ever awarded by Ashgal, Qatar's public works authority. The £80m contract will deliver roads and drainage improvements in the northern area of Doha, and WS Atkins has also been involved, winning £65m of work to improve Doha's drainage and road networks.

UK engineers are ideally placed to benefit from the flood of work, as they have spent decades building relationships with the tightly knit coterie of the Royal Family who control all major spending decisions. Both Hyder and Atkins also have local construction licenses, without which it is impossible to bid on some projects in the region. These factors should allow UK engineers to make the most of any further developments in the region.

UK turning a corner

The home market has been an unhappy one for the engineers as three years of organic revenue declines and job cuts have weighed heavily on shares. Christopher Bamberry of broker Peel Hunt thinks we have reached an inflection point and points towards the growing order books and growth in staff as a key indicator of a recovery. The reason for the optimism is that he thinks the regulated sectors of rail and water have been through their low points. Maintenance spending in the water sector is now being increased as it passes the midway point in the five-year regulatory period and spending on the upkeep of the rail network is also increasing. As a sign of confidence in the latest results, Hyder's headcount and order book increased by 2 and 16 per cent respectively and Atkins reported 3 and 10 per cent growth in staff and order book.

IC VIEW

The infrastructure consultants have had a tough few years. They've been hit by the double whammy of a private sector construction slowdown and public sector cuts in the UK. But they have made the necessary job cuts and focused on overseas expansion to protect profits and deliver dividend growth throughout the downturn.

Signs from the order books are encouraging and employment indicators are pointing towards management confidence. The valuation gap is also clear when you look at the WSP deal. But this is still very early days as far as a recovery is concerned. Those who can't stomach the risk could wait for another strong set of results before jumping in.