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Hill & Smith looks set to step up a gear

This fund manager favourite is well-positioned to capitalise on rising global infrastructure spending
June 17, 2021
  • Benefit from efforts to revitalise US infrastructure
  • New chief executive to boost margins
IC TIP: Buy at 1,486p
Tip style
Growth
Risk rating
Medium
Timescale
Long Term
Bull points
  • Structural growth and rising infrastructure spending
  • Improving margins
  • Fund manager pick
  • Analyst upgrades
Bear points
  • Cyclical vulnerability
  • Exposure to raw material prices

Starting out life in 1824 as an ironworks in the West Midlands, Hill & Smith (HILS) has evolved to become a leading provider of road and safety products and galvanising services, operating from 76 sites across six countries. While it may not be a household name, its infrastructure solutions line our streets and highways. For example, in the UK, the group has captured a 65 per cent share of the temporary road safety barrier market. Its 400km of barriers amount to almost double that of its competitors put together.

Hill & Smith focuses on niche infrastructure markets with high barriers to entry, such as regulation. Broker Shore Capital estimates that at least half of its revenue is driven by government spending, which helps offset more cyclical end markets such as construction and agriculture.

The group’s activities are split across three divisions – roads and security, utilities and galvanising services. The roads and security business accounted for two-fifths of total revenue and around a fifth of underlying operating profit in 2020. It designs and manufactures temporary and permanent road safety barriers as well as other street furniture such as signposts and lighting columns.

Road projects also help drive demand for Hill & Smith’s galvanising services, which is where it coats iron and steel products with molten zinc and provides powder coating finishes for fencing and structural steelwork. Offering protection against corrosion, galvanising is becoming an increasingly popular alternative to paint given its superior durability and lower maintenance costs. The group is one of the largest suppliers of galvanised steel in the UK, and while it is vulnerable to changes in the zinc price, it is able to pass these on to customers with a lag.

Galvanising services is Hill & Smith’s highest margin business as plants operate natural monopolies in a given geographic radius – it is uneconomic for rivals to set up shop in between existing plants that already cover parts of the same area. The division recorded an underlying operating profit margin of 19.3 per cent last year, so while it only accounted for 28 per cent of total revenue, it generated 51 per cent of Hill & Smith’s profits.

Finally, the group’s utility business makes products that are used in water, electricity and railway infrastructure. Through its flood defences and more environmentally friendly composite products, Hill & Smith is capitalising on growth opportunities associated with climate change.

 

A global infrastructure play

Hill & Smith is a popular choice among funds. AXA Investment Managers is the group’s fifth-largest shareholder and has it as a top 10 holding of the AXA Framlington UK Mid Cap Fund (GB00B5032Q31). AXA’s UK equities team points to the “strong structural and cyclical drivers providing tailwinds for this business”, including climate change, health and safety, rising urbanisation and increased government investment in infrastructure.  

Exposure to global infrastructure spending is a key attraction to Hill & Smith’s investment case. Even before Covid-19 struck, there was a need to modernise ageing infrastructure in developed countries, and governments are incorporating this into their pandemic recovery plans to kickstart economic growth. Broker Jefferies estimates that rising infrastructure spending could propel 6 per cent of annual organic revenue growth between 2021 and 2024, double the group’s historic rate.

“The company has leading positions in roads and utilities in structural growth markets in the UK and North America as well as other overseas markets that are benefiting from increasing government budgets for infrastructure expenditure,” says Amanda Yeaman, investment manager at Aberdeen Standard. “In addition to spending plans being agreed in the US, which is looking near-certain, we believe these markets will enable reliable revenue growth for the future.” Standard Life Aberdeen (SLA) is Hill & Smith’s top shareholder and holds the company in its Aberdeen Standard UK Smaller Companies Fund (GB0004331236).

The US is the land of opportunity for Hill & Smith amid the particularly dire state of the country’s infrastructure. While the group was almost entirely UK-focused back in 2006, more than 40 per cent of revenue and 70 per cent of underlying operating profit now comes from across the pond. But there is still room to grow as US markets are relatively immature and Hill & Smith has a low market share.

The American Society of Civil Engineers (ASCE) periodically reviews the state of US infrastructure, and its 2021 report card gave it an overall rating of ‘C-‘ , which equates to “mediocre”. It says that almost $6tn (£4.3tn) of investment will be required by 2029 just to upgrade the country’s infrastructure to what it classes as “adequate for now”, of which only $3.4tn is currently funded.

 

 

President Biden is proposing to spend $2tn over the next decade to modernise 20,000 miles of roads and more than 10,000 bridges, as well as the US’s ageing electricity grid. His ‘American Jobs Plan’ includes $135bn of spending on roads, $111bn on water infrastructure and $100bn on the power network.

The package has yet to secure the requisite 60 votes in the Senate and reticence from certain Democrats is also blocking the simple majority required to pass the bill through the ‘budget reconciliation’ process.

But even if Biden’s plans don’t emerge unscathed, infrastructure spending is still likely to increase – Senate Republicans’ latest counterproposal actually outlines a higher $506bn investment in roads and bridges. While negotiations over broader infrastructure spending continue, there is a bipartisan ‘Surface Transportation Reauthorisation Act’ in the works that would unleash $304bn of investment in roads and bridges over the next five years.

Aside from the US, Hill & Smith should also benefit from the Road Investment Strategy 2 (RIS2), which will see more than £27bn spent on England’s road networks through to 2025 – that’s an 80 per cent increase in investment over the previous five-year period. RIS2 will expand the rollout of so-called ‘smart motorways’, and while the safety of these roads is currently subject to a parliamentary review, Hill & Smith believes that work will ramp up in the second half of this year.

 

A bump in the road

Hill & Smith has proved fairly resilient to the Covid-19 pandemic with revenue falling by just 5 per cent in 2020 to £661m. Operational gearing (a relatively high fixed cost base) does mean profits are more sensitive to a drop in sales and underlying operating profit declined by close to a fifth to £70m, with the margin contracting by 1.8 percentage points to 10.6 per cent.

The biggest hit was in the roads and security business where underlying operating profit plunged by more than two-fifths to £13m. While demand for temporary and permanent road barriers held up, the security business was squeezed by the cancellation of public gatherings. The latter should recover as the vaccine rollout continues and lockdown restrictions ease.

As demand rebounds across its divisions, the four months to 30 April saw revenue come in a tenth higher than a year earlier and also ahead of the same period in 2019. The group says there has been a “strong recovery” in operating profit, and while it has flagged headwinds from US labour shortages and higher global steel costs – Hill & Smith’s largest raw material cost is steel – its full-year expectations are unchanged. As the outlook continues to improve, brokers have been nudging up their forecasts.

Analysts are currently pencilling in an underlying operating profit of £82m in 2021 on a 12 per cent margin. The margin has been declining since peaking at 13.9 per cent in 2017, and Hill & Smith is aiming for it to rise to between 12 and 15 per cent. The group looks set to achieve this target through a combination of a recovery in its end markets, earnings-boosting acquisitions and the divestment of weaker parts of its business. If a US infrastructure boom were to transpire, Numis believes that the underlying operating profit margin could hit 16 per cent in 2024.

 

The next leg of the journey

New chief executive Paul Simmons took over in November, having previously headed up the safety business at Halma (HLMA). He succeeded Derek Muir – who ran Hill & Smith for 14 years – and is hoping to oversee a new era of growth.

AXA’s UK equities team says it is “very impressed by new CEO Paul Simmons, he is bringing all his learnings from Halma and applying them to the not-too-dissimilar Hill & Smith decentralised business model”. It believes that the changes he has introduced are likely to bring “a more consistent, higher level of organic growth than the group has historically been able to produce and with it a likely higher rating”.

Since his arrival, Simmons has tweaked Hill & Smith’s strategy in the hope of creating a higher-quality business. The group is now looking to bolster organic growth by increasing focus on product innovation, selling weaker parts of the company and pivoting towards faster-growing areas. Up to 15 per cent of existing sales could be disposed of over the next couple of years, and Hill & Smith has already announced the closure of its lossmaking Variable Messaging Signs (VMS) business, which should improve the roads and security margin.

A more discerning acquisitions strategy means that two-thirds of the previous pipeline has been scrapped, and Simmons wants Hill & Smith to focus on M&A targets with strong organic profit growth and margins at least in line with the group average. While this approach means that Hill & Smith is likely to pay more for future acquisitions, it should result in higher-quality growth being bought in and could also narrow the gap between adjusted and reported profits caused by restructuring costs and goodwill impairments.

The group has spent £16m a year on bolt-on additions since 2008, and the balance sheet should have sufficient firepower to enable further M&A. It was sitting on £160m of net debt at the end of April, up a tenth from the December year-end thanks to spending on acquisitions and the payment of the interim dividend. Jefferies is forecasting that net debt will fall to £140m by the year-end, equivalent to 1.2 times cash profits (Ebitda) and below Hill & Smith’s target leverage multiple of between 1.5 and 2.

The group also has a good track record of free cash flow generation, which surged from £33m to £83m last year.

While it pulled back on acquisitions activity in 2020 to preserve cash during the Covid crisis, Hill & Smith purchased off-grid solar energy solutions business Prolectric in March for an initial consideration of £12.5m. As a beneficiary of the net-zero transition, Prolectric is emblematic of Simmons’ new M&A strategy as it enjoys margins above the group average and is expected to boost earnings from this year.

Fragmented markets mean there are plenty of consolidation opportunities. In the US galvanising market, for example, while the group is the number three player, it still only has a 6 per cent market share and more than 50 per cent of the market is comprised of smaller independents. Galvanising services in the US tend to command higher margins, and Hill & Smith could eke out further efficiencies with the benefits of its scale.

 

Time to hitch a ride?

Hill & Smith’s shares are currently trading at 18 times consensus 2022 earnings, which is lower than its five-year average price/earnings (PE) ratio of 28. That valuation doesn’t seem unreasonable given the group is already well-positioned in attractive, defensive end markets and is set to benefit from multiple structural growth drivers. Throwing in the improving margin trajectory and management’s efforts to boost the overall quality of business, we think this could be a good entry point.

Last IC View: Buy, 1,343p, 10 Mar 2021

HILL & SMITH  (HILS)    
ORD PRICE:1,486pMARKET VALUE:£1.2bn  
TOUCH:1,485-1,487p12-MONTH HIGH:1,600pLOW:1,157p
FORWARD DIVIDEND YIELD:2.2%FORWARD PE RATIO:17  
NET ASSET VALUE:403p*NET DEBT:46%**  
Year to 31 DecTurnover (£m)Pre-tax profit (£m)***Earnings per share (p)***Dividend per share (p) 
201863876.377.231.8 
201969579.480.333.6 
202066162.662.826.7 
2021***69579.277.829.1 
2022***72690.787.433.2 
% change+4+15+12+14 
*Includes intangible assets of £189m or 237p per share
**Includes lease liabilities of £32.4m
***Jefferies forecasts, adjusted PTP and EPS figures