Cracks in the Balfour Beatty bull case

It’s been a good year so far for the UK’s biggest listed building contractor, Balfour Beatty (BBY). Even in a less turbulent market, its year-to-date share price gain of 13 per cent (admittedly supported by £150mn of buybacks) would be solid enough but, when pitted against the 40 per cent-plus falls experienced by peers such as Kier (KIE) and Morgan Sindall (MGNS), it’s a cause for celebration.

Looking over the longer term, an impressive job has been done by a team headed by chief executive Leo Quinn, whose turnaround credentials were forged at De La Rue (DLAR) and Qinetiq (QQ). When he took on the top job in January 2015, Balfour Beatty was also in a hole, posting a full-year pre-tax loss of over £300mn for 2014. A dash for growth had led to poor contract discipline, a structure that had become too complex and overheads which were too high. 

It took another year, and another £199mn of pre-tax losses, before the fruits of Quinn’s  turnaround plan, Build to Last, started to deliver results. Balfour Beatty disposed of a bunch of businesses that were deemed non-core, including contracting arms in the Middle East, Indonesia and Australia. More recently, it has withdrawn from bidding for fixed-price residential building schemes in London. 

This has been part of a general move aimed at reducing risk in its order book, by taking on fewer contracts where it is on the hook if materials or labour costs move against it. In 2018, half of its pipeline was made up of fixed-price contracts. Now, that figure has declined to 14 per cent. Target cost work, where the contractor and client agree a likely cost plus a fee and then share the gains from savings (or the pain of overruns), now makes up around three quarters of its order book.

Reduced risk

The changes mean Balfour Beatty is a much less risky business than it was. However, it wouldn’t be too churlish for long-term shareholders to wonder if they’ve been commensurately rewarded for their patience. In terms of size, its £7.2bn turnover last year was marginally lower than when Quinn took over and, although it hasn’t lost money since 2015, it hasn’t exactly made runaway profits either.

Last year’s operating margin was just 1.4 per cent, weakened by a $65mn (£58mn) fine imposed by the US Department of Justice after its Balfour Beatty Communities arm admitted to fraud by overcharging for the provision of military housing. Margins in contracting are generally fairly lousy so one-off hits, such as that, can really affect returns. However, even its underlying operating profit hasn’t budged much – last year’s figure of £197mn was basically flat compared with the same metric four years earlier. Since Quinn’s appointment, the company’s share-price performance has been below average, albeit only marginally – the shares have gained in value by 45 per cent, against an industry benchmark of 49 per cent. 

Its outperformance this year can be attributed in part to an improved profit outlook. In its first-half results, the company said its UK construction services arm, which contributes 34 per cent of revenue, is on track to achieve the industry standard margin of 2-3 per cent and its support services arm is expected to generate a return “at the top end” of its sector margin range of 6-8 per cent. The group is also expected to make  between £55mn and £65mn profit from the sale of infrastructure investments.

The big question, though, is whether gains will be sustained? Much of Balfour's investment pitch is that there are key macro trends supporting its growth, with governments on both side of the Atlantic currently splashing the cash on infrastructure. 

The UK government launched a National Infrastructure Strategy in response to the global pandemic that entailed £650bn of public and private sector spending – the highest level of investment in decades. And Quinn told the Financial Times in April that the future for the UK infrastructure market “looks very optimistic”. He added: “We are entering into an era of 10 years of infrastructure growth.” 

Around £200bn is meant to be allocated by 2024-25, with the government providing £100bn of this, according to an analysis of the National Infrastructure and Construction Pipeline by the Infrastructure and Projects Authority.

Filling holes

That picture looks a little less certain since the disastrous ‘mini-budget’ last month that torpedoed Liz Truss’s tenure as prime minister and shook the markets’ faith in the UK’s fiscal position. Even though most of those proposals have been reversed, the cost of the scaled-down energy price guarantee and other measures will push up public sector borrowing beyond limits set in the Charter for Budget Responsibility, according to Pantheon Macroeconomics. 

Abandoning unfunded tax cuts will save around £30bn but the new chancellor still needs to find about £38bn to plug funding gaps, says Pantheon’s chief UK economist, Samuel Tombs. He expects this to be rounded up to £50bn to ensure the government has enough headroom to meet fiscal targets, and that 75 per cent of this will be achieved through spending cuts rather than tax increases.

Capital Economics expects the cuts to be less extreme – about £30bn, given further falls in gilt yields following Rishi Sunak’s appointment as prime minister. But it still argues that a dramatic shift in fiscal policy is under way, from one that was set to boost the economy to one that will be a drag, says its chief economist, Ruth Gregory. 

She expects investment spending will have to be cut by around £14bn to 2 per cent of GDP. Higher interest rates are also likely to dampen both business and housing market investments, the firm argues.

Home and away

Of course, a weaker outlook for UK government spending doesn’t automatically mean Balfour Beatty’s profits will fall. As already pointed out, the US construction services arm is bigger in revenue terms, and the passing of the $1.2tr (£1.05tr) Infrastructure Investment and Jobs Act last year should trigger $550bn of new federal construction spending over a five-year period.

Yet the US is a much more competitive place in which to win work. Balfour Beatty is the top dog in the UK by some distance – its £7.2bn of sales last year dwarf rivals such as Kier, Morgan Sindall (both £3.2bn) and privately-owned Laing O’Rourke (£3bn). In the US, it is only the 16th-biggest contractor, according to trade title Engineering News Record.

Its exposure to markets outside the UK may justify a premium rating for its shares over peers, but the question is, how big should this be? Balfour Beatty shares trade at 10-times forward earnings, compared with six-times for Morgan Sindall shares, four-times for Costain and just three-times for Kier. At their current price, Balfour Beatty shares have a PEG ratio (price/earnings to growth, measuring how much an investor pays for the growth on offer) of 6.8, way above the neutral level of 1.0. That suggests the shares are overvalued.

True, City analysts generally disagree. Four out of the five recommendations on Balfour Beatty’s shares from data provider FactSet are a buy, with a mean target price of 366p, implying a potential upside of 24 per cent on the current price. 

This month Liberum set a target price of 400p on Balfour Beatty’s shares, arguing the company could benefit from a ‘golden age’ of infrastructure through grand projects such as HS2 and the new Sizewell C power plant. Yet these are examples of the potentially riskier outlook, where a cash-strapped government will look to make savings. Sizewell C is years behind schedule and is already running £8bn over budget before construction work has begun. A Financial Times report earlier this month said phase one of HS2 is running “many billions of pounds” over its £40.3bn budget and that the Treasury is looking at ways to save money on phase 2, either by cutting or delaying parts of the scheme. 

The concern for Balfour Beatty is that a financially stretched UK government will be forced to do this across the board – a risk that does not seem to be factored into its share price. Sell.