Constructing a future income

Broker Numis reckons that pure construction in the UK accounts for less than a quarter of profits generated. It shouldn’t be like this, however. Spending money on infrastructure was one of the big ideas to pull the UK economy out of recession, but a combination of miscalculation, dithering and political constraint has left the whole process largely on the drawing board. How has this all come about? First off came the idea that since the government coffers are empty, private money from pension funds could be used to sponsor major projects. As well as helping to boost growth, this would also provide pension funds with the sort of long-term revenue stream they need. But the Treasury stopped short of underwriting this, and pension funds not surprisingly kept their hands in their pockets. So instead of mobilising a projected £20bn, barely £1bn has been forthcoming.

Next came the idea of toll roads, whereby outside capital would be attracted by the prospect of an income stream. But politics knocked this idea into touch simply because charging over-taxed motorists to use a motorway would have been deeply unpopular. Sure, you can offer an alternative route, but as the M6 toll road has shown, given an alternative, many motorists don’t use them. Meanwhile, many UK power stations are reaching the end of their working life or are being closed down by EU rules designed to cut pollution. But the government has set off a ticking time bomb by failing to reach agreement with power companies over the level of subsidies on a new generation of nuclear power stations.

Other countries have been more willing to provide guarantees if, for example, a toll road fails to generate forecast returns. In fact, global institutional investors have pumped over £140bn into unlisted infrastructure funds since 2004, and, unsurprisingly, this is where UK construction firms have been focusing to compensate for the strangled domestic market. Over here, the government has belatedly promised an extra £3bn a year, starting in 2015/16, and the potential use of guarantees to fund nuclear power plants. But analysts estimate a staggering £400bn is needed over the next decade to upgrade the country’s creaking infrastructure. Politicians have another chance to address the problem in June when an update on plans is expected to accompany the spending review.

Overall, construction in the UK paints a gloomy picture. Some momentum seen in the last quarter of 2012 was probably due to projects put on hold as a result of the Olympic Games finally coming through. And the New Year has started off badly, with the latest Purchasing Managers’ Index coming in below the 50 level that defines a contraction in output. According to the Construction Products Association, construction output this year will fall by more than 2 per cent, and that’s after including a more active housing sector. Inevitably, there have been casualties, but these have been confined to the smaller players who are unable to diversify and, where they act as subcontractors, to margin pressure from the larger companies.

Moving away from UK construction sector has, then, proved to be both timely and a wise move. Switching more into support services has been one of the major areas of development, helped along by the need for local authorities to get the best deal from their dwindling resources. And considerable progress has been made by construction companies through offering a broader range of services to provide a one-stop facility covering consultation, management services, maintenance and refurbishment. Local authorities like the idea of dealing with bigger players who can offer a more comprehensive range of services.

Costain (COST) now has this off to a fine art, with a £2.4bn forward order book comprising in excess of 90 per cent of repeat orders, and covers highways, rail, power, airports, water, hydrocarbons and chemicals, as well as nuclear process and waste. The point here is that while work in some of these sectors has been held up for reasons already explained, a lot of expenditure is non-discretionary, while the rest is simply being stacked up for a later date. Building a new motorway network may be dependent on new funding, but servicing the existing network is an expense that cannot be cut out. Maintaining sewers comes under the same category, as does servicing the rail network, not to mention the maintenance requirements of the existing nuclear power station network.

For Carillion (CLLN), a decision to downsize its UK construction operation in 2010 has paid off handsomely. It has become much more selective about the projects it takes on so, while turnover in UK construction fell 31 per cent last year to £1.28bn, underlying operating profit jumped 25 per cent to £72.4m as margins grew from 3.1 per cent to 5.6 per cent. Significantly, support services accounted for 48 per cent of the bottom line. What’s more, by expanding into the Middle East and Canada, it has built up an £18bn order book, and a pipeline of contract opportunities worth an eye watering £35bn. But investor sentiment appears to be focused on the state of the UK construction sector alone, which has left Carillion trading on a forward PE ratio of just 6 while sporting a dividend yield of 6.4 per cent. True, UK construction work will remain weak in 2013, but Carillion's earnings visibility is already at 75 per cent, and the group remains on target to double revenue from both Canada and the Middle East to around £1bn each in the five years to 2015.

And there is at least one ray of sunshine for the UK because after a long two-year consultation, the government has revised and relaunched the Private Finance Initiative, suitably modified to avoid any repeat of the excesses enshrined in the original PFI. Indeed, the Treasury has already signed off on a £288m deal for a new hospital in Liverpool, which suggests that more schemes in the pipeline could soon be given the go-ahead.

IC VIEW

The UK construction sector will one day return to rude health as the mountain of work needed on schools, hospitals, roads, water pipes, power stations and roads finally gets under way. But for the coming year, at least, the state of public finances will slow growth to a pedestrian pace. So, by concentrating on the support service side and expanding abroad, UK construction companies will achieve much to offset the lack of momentum on home soil. And, given the lowly rating, many construction companies look cheap on current valuations, and some offer a great yield too.