Costain bull case no longer built on sand

At their core, building contractors are service businesses with no economic moat. While reputation matters, what one competitor does can often be easily done by another.

As such, construction firms often operate on (sometimes very) thin margins in a cyclical industry, with overheads that are difficult to reduce quickly when downturns begin. This can lead to companies taking on work with little chance of earning a profit just to cover costs, which in past downturns has caused a race to the bottom in terms of pricing. In turn, that can lead to inadequate risk pricing. Taking on complex projects involves making judgements about the price and availability of materials, labour and transport years in advance. 

Costain’s recent history shows the equity destruction that can occur when these risks aren’t properly managed.

The group’s shares have lost 90 per cent of their value in four years, as problem contracts led to repeated losses. Between 2019 and 2021, Costain booked more than £150mn of charges, including provisions related to a project to build gas compressors for National Grid (NG.) in Peterborough and Huntingdon, a road project for the Welsh government and remedial work on the national synchotron science facility. A £100mn equity raise was required in May 2020 to shore up its balance sheet, but plenty more goodwill has since drained away.

However, the tide finally looks to be turning. Last week, the company reported a 42 per cent increase in first-half pre-tax profit to £11.2mn, and although it suffered a net cash outflow of almost £28mn, this was after shelling out £48mn on historic contracts, including a final payment to settle the Peterborough and Huntingdon dispute.

Risk and reward

In a call with investors, chief executive Alex Vaughan offered assurance that Costain is taking a more cautious approach to contract selection and shaping the deals it does sign “to better reflect the balance of risk and reward”.

Its order book at the end of June stood at £2.7bn, down a fifth since December and sharply lower than the £4bn reported a year ago. The company puts this down more to timing than selectivity and expects decisions on some major bids between now and June 2023. Vaughan also said the current works figure excludes some £800mn of deals on which it is the preferred bidder, and positions on around 50 secured frameworks for higher-margin consulting and digital services work which “will yield meaningful revenue”.

The company has been restructuring its operations over the past few years to focus more on segments of the construction market that are less prone to boom and bust. This should give some comfort to investors as the construction market enters another slowdown. The latest purchasing managers’ index data showed the sector contracted in July for the first time in 18 months, hampered by lower civil engineering and housing activity.

Costain now targets four markets – transport, water, energy and defence – whose spending is underpinned either by government or regulatory commitments. All offer steady, multi-year commitments to upgrade and maintain networks, as well as exposure to big-ticket projects such as the HS2 high-speed rail line linking London to the north of England.

Leo Quinn, the boss of competitor Balfour Beatty (BBY), has even talked up the potential for a decade of growth for infrastructure investment in the UK, following former chancellor Rishi Sunak’s pledges to facilitate more than £600bn of spending during the current parliament.

It was this potential that convinced Dubai-based contracting group ASGC to back Costain’s £100mn fundraise in 2020, injecting £25mn in a deal which made it the company’s biggest investor. It now has a stake of more than 15 per cent, held through a London-based vehicle, Innovo. Around half of the remaining shares are in the hands of institutional investors.

According to its chief executive Bizhoy Azmy, Innovo backed Costain after deciding the company was one of only a few players with the scale to service the state’s grand visions.

“At the time when we invested, they... were trading at an attractive entry point price because they were still in the middle of significant losses due to earlier contracts going awry,” Azmy explained.

As a contractor, ASGC was comfortable with the company’s levels of risk, which Azmy said had been handled well by Costain’s management. Still, the company’s share price has fallen by around a third since it bought in at 60p a share.

While disappointed in that ourcome, Azmy argues that factors including the pandemic, governmental changes and sectoral de-ratings are to blame. “I really try to ignore it – partly because we are not interested in selling. We’re a long-term investor,” Azmy said.

Bombed-out valuation

Judging by Costain’s market value of £113mn, just over half mid-year book value, few share Innovo’s belief. Subtract the £96mn net cash on the group’s half-year balance sheet, and investors currently ascribe a £17mn enterprise value (EV) to a business with decades of complex project delivery experience and annual sales of more than £1bn.

House broker Liberum puts EV higher at £135mn, adjusting for pension assets, but even against the more conservative FactSet-compiled consensus estimate of £48mn, Costain’s cash-adjusted value is less than the £52mn cash profit it is forecast to make this year. Factor in all its liabilities, payables, and costs, and the shares still trade at less than five times Investec’s free cash flow forecast of 8.5p per share for 2023.

However, while the shares look cheap against sum-of-the-parts valuations and stable order books, it is profitability that will determine the outlook.

The first-half adjusted operating margin was flat at 2.1 per cent, but the company thinks 6 to 7 per cent is possible. To get there, management is focusing on contracts with “complex programme delivery” that deliver margins of up to 5 per cent, with the bulk of profits coming from more consulting and digital technology expertise where margins can reach 10 per cent.

This will all be achieved partly through a greater attention on costs. Last year’s savings hit £12mn, which Liberum expects to increase to £20mn by the end of 2024. If the company’s more ambitious margin targets can be hit, the broker argues adjusted earnings per share for 2023 could hit 20p, around half today’s valuation and almost double its current forecast.

Many things need to go right for this to happen, not least an effective handling of spiralling inflation. Construction costs in June were more than 25 per cent higher year on year, according to government figures. Costain said inflation protection mechanisms built into its contracts were to thank for the adjusted operating margin stability seen in the first half, notwithstanding incurring higher bidding costs, particularly around transport work.

Liberum anticipates “a steady flow” of award announcements in the second half of this year, rebuilding confidence to such a degree where its dividend could be reinstated next year.

There is, of course, a lot that could derail the tentative recovery made so far, but given its bombed-out valuation, it’s difficult to see the share price slumping much further. Indeed, at its current price we think Costain could be susceptible to a takeover bid.

Even if that doean't materialise, a more resilient business model, with a greater focus on risk, means Costain now can point to much more solid foundations on which to build.