A value opportunity hiding in plain sight

In January, it featured on a screen of UK value stocks inspired by the "magic formula" of legendary investor Joel Greenblatt. Three months later, it showed up on a screen derived from Tobias Carlisle’s book The Acquirer’s Multiple, which looks at companies' enterprise values in relation to their operating profits to find potential takeover targets. This month, it also appeared on our list of fund managers’ favourite UK shares.

Abrdn is the institutional investor that has given the company the strongest backing. It holds an 11 per cent stake in Morgan Sindall through different vehicles including the Abrdn UK Smaller Companies Growth Trust (AUSC) and Shires Income (SHRS).  

It is a top three holding in both, with Shires Income manager Iain Pyle arguing that – like many of its listed contracting peers – Morgan Sindall has improved its risk profile in recent years by eschewing fixed-price contracts in favour of cost-plus agreements.

Morgan Sindall has the added advantage of having a co-founder as chief executive. John Morgan started Morgan Lovell in 1977, then merged it with William Sindall in 1994, and retains a 7.6 per cent stake. Having a chief executive with a long-term mindset “helps in terms of the prudence of the way it’s run”, Pyle says.

Spreading the risk

Morgan Sindall breaks its operations into six different units. Four of these – construction, infrastructure, fit-out and property services – focus on building and are the main sources of regular cash flow. This cash is then funnelled into the group's two development arms: a partnership housing business that works with local authorities to provide affordable homes and urban regeneration company Muse Developments.

The regeneration activities are good for long-term profitability, typically generating beefier margins than general contracting, but they can need funding for several years before they generate returns. As a result, revenue and profits are lumpier than in contracting, but they've grown in significance in recent years.

When costs relating to group activities are stripped out, profits from the regeneration business have grown at a compound annual rate of roughly 13 per cent over the past five years, compared with the 7.6 per cent achieved by contracting operations. Regeneration now makes up roughly a third of (pre-central costs) operating profit.

This is mainly due to the partnership housing business, which generated a fifth of Morgan Sindall’s operating profit last year, up from 14 per cent in 2018. Numis analysts expect the division to be “the key driver of future earnings growth”.

Management measures the partnership arm’s success in terms of return on average capital employed, which it calculates by dividing adjusted operating profit by average capital employed. Although this metric fell last year to 12 per cent, from 19 per cent in 2022 and 21 per cent in 2021, this is because the amount of capital it is pushing into the business has soared – from £115mn five years ago to £255mn last year. The medium-term return on capital target for this business is 25 per cent.

Numis analysts think partnership housing could achieve an operating profit of £100mn within four years, based on 50 per cent sales growth and an operating margin of 8 per cent. This sales target looks ambitious, but it is “underpinned by increased scale and capability, evidenced by transformative growth in workload, site numbers and size”, the bank argued.

Management is certainly pushing hard. In a trading update earlier this month, Morgan Sindall said it expects to increase the division's average capital employed this year by around 30 per cent to £330mn.

Perks of the office

Partnership housing now generates roughly a fifth of group revenue. Construction (mainly buildings) generates another 23 per cent and infrastructure (road, rail, energy and water) contributes 22 per cent. Both reported double-digit revenue and profit growth in 2023, and 77 per cent of their workload is for public sector clients, who are generally seen as lower risk.

The group’s biggest money-spinner, however, is the fit-out division, which generates 27 per cent of group sales and more than half of its operating profit. Made up of contractor Overbury and design-and-build specialist Morgan Lovell, it makes the lion's share of revenue from the commercial office market, with a heavy weighting towards projects in the capital.

It is clearly exposed to market vagaries, therefore. However if – as Abrdn’s Pyke suggests – Morgan Sindall has been “a very consistent company in terms of delivering earnings above expectations” in recent years, it is because the fit-out arm continues to outperform.

Investment in central London offices fell to £7.1bn last year – 57 per cent below its 10-year average according to Savills, which blamed higher interest rates and “continued speculation on the future of the office”. Yet Morgan Sindall’s fit-out arm grew revenue by 14 per cent to £1.1bn and increased its operating margin by 110 basis points to 6.5 per cent.

Its operating profit is already ahead of the group’s medium-term target range of £50mn-£70mn and it finished the year with secured orders of £1.1bn, a 31 per cent year-on-year increase.

There have been several trends supporting its growth. Companies rolling off leases have been thinking about their offices differently, moving towards more flexible and collaborative workspaces. They are using office space “as a tool for enhancing staff retention and brand image”, Morgan Sindall said in its annual report. Some companies are also looking for more energy efficient spaces and to relocate roles outside London to cities where overheads are lower.

Morgan Sindall is the biggest player in the fit-out market, landing around 36 per cent of the major contracts awarded over the past 12 months, according to construction data specialist Glenigan. The other major player is ISG, which won 33 per cent.

It’s also a market that could keep confounding expectations. Deloitte’s latest London Office Crane Survey said a record 5.1mn sq ft of new office construction started in the six months to September 2023 – the highest half-year figure since the survey began in 2005. Moreover, a much greater proportion of this is refurbished space, meaning a greater share of the contract’s value should end up with fit-out firms.

Weaker forecasts

Not all parts of Morgan Sindall are thriving. The property services arm, which carries out maintenance and repair work for local councils and housing associations, reported an operating loss of £19.7mn last year. It blamed higher costs for being unable to deliver contracted work at a profit but said a remediation plan has begun with a view to restoring profitability by next year. Until this turnaround is delivered, it won’t bid for any major new work.

The underperformance of property services helps to explain brokers’ pessimism for this year, with earnings per share expected to slip. Analysts at Liberum expect the division to incur higher costs extracting itself from an underperforming contract, as well as a lower level of completions by its urban regeneration arm.

This makes Morgan Sindall’s share price look relatively expensive on a price/earnings basis, at 10 times forecast earnings, compared with a five-year average of nine times.

Tobias Carlisle’s “acquirer’s multiple” paints a more flattering picture, though, particularly given that average daily net cash rose to £389mn between January and April, from £282mn last year. Enterprise value is measured by subtracting cash from a company’s market capitalisation, and Morgan Sindall trades on an EV of just 4.5 times forecast operating profit, well below its five-year average of six times.

Acquirers at the top end of this market have been elusive in recent years but, as other UK companies are finding out, if something is deemed cheap enough it will attract interest.