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This unloved UK company could shine in the desert

In the latest instalment of our smart small-caps series, Jemma Slingo talks to two Artemis fund managers about an unloved contractor
January 25, 2023

Along the western coast of Saudi Arabia, swathes of desert meet the Red Sea. Here, in the province of Tabuk, excavation work has begun for The Line. The brainchild of Mohammed Bin Salman, the kingdom’s crown prince, The Line refers to a ‘vertical city’ that will be 170km long, 200m wide, and taller than the Empire State Building, encased in two mirrored walls and home to 9mn people – according to the plans at least. 

The Line is gargantuan, grandiose and – to many eyes – entirely unworkable (the wider development, known as Neom, is also due to feature an all-year, outdoor ski centre). However, the building project will determine the future of an unlikely UK small cap that handles the more mundane side of fantasy: foundations. 

Keller (KLR) is a geotechnical specialist contractor. This means it prepares the earth for construction projects by sorting out the soil, building foundations and stabilising the ground. In June last year, Keller revealed that it had been chosen to contribute to the Neom project. The first stage of work is expected to generate revenue of £45mn and, according to Keller’s management team, has “the potential to generate contract revenues in the hundreds of millions of pounds in future years”. 

Artemis fund managers Mark Niznik and William Tamworth are cautious, but maintain that The Line has the power to transform Keller's “good return into a very good return”.

 

Laying the groundwork 

Niznik and Tamworth, who co-manage Artemis’s UK Smaller Companies Fund, look for businesses that are market leaders in a particular niche. Keller fits the bill nicely: it has a 10 per cent share of the global foundations market, which itself makes up just 0.5 per cent of the total construction market.

“When you’re a market leader you tend to have better pricing power than others in the market, which is especially important in inflationary times,” said Niznik. “You can more easily put up your prices, and cover wage inflation or cost of goods inflation.”

This seems to be holding true for Keller. Group sales have grown steadily over the past five years – excluding a slight dip in 2020 – and profits were on the up until Covid-19 struck. Keller’s order book is also extremely strong at £1.6bn, up from £1.04bn in 2019. Management noted a number of recent contracts in the energy and infrastructure sectors, as more countries look for alternatives to Russian hydrocarbons and begin natural gas projects.

Investors are often wary of contractors – and for good reason. The sector is packed with corporate disasters, including the collapse of Carillion in 2018 and the fall of Interserve a year later. There are some important differences between these companies and Keller, however. Keller is largely a subcontractor as opposed to a prime contractor, with bigger margins and smaller projects. The group’s largest customer represents just 3 per cent of total revenue, and projects are usually short, with an average value of £375,000.

“It’s still a cyclical business, but it doesn’t have wafer-thin margins where if you go from 2 per cent to -0.2 per cent you go bust. It’s a different model,” said Tamworth.

Cash is also high up on Niznik and Tamworth’s agenda. This is particularly important when it comes to contractors, which often recognise revenue before they have actually received the money. “We look to the cash flow statement to hold the P&L statement to account,” said Niznik. “Profits can easily be fiddled – there are a myriad tricks – but cash flow is more difficult to fiddle.”

Keller has historically been very cash-generative. Its operating cash flow has repeatedly exceeded its operating profit, and free cash flow – used to pay dividends and make acquisitions – has been strong. This has resulted in an average dividend yield of 5.3 per cent over the past five years, and 27 uninterrupted years of dividend hikes.

Things went off the boil a little in the first half of 2022, when working capital shot up by £93mn, resulting in a free cash outflow of £48mn. Higher steel prices and supply chain issues were partly to blame, and “operational challenges” in North America did not help matters – more of which later.

Tamworth admitted that working capital is “more volatile at Keller than at many companies”, but stressed that some of the problem was seasonal. “Typically, the construction sector is busiest during the summer and quietest during the winter period. You see a working capital outflow in the summer months – ie at the half-year – and an inflow in the second half of the year. And that’s down to weather, rather than them trying to budget at the year end.” 

 

Fraud unearthed 

Even the most diligent investor can be caught out, however. In January, a trading update revealed a financial reporting fraud in Keller’s Australian subsidiary, Austral. The “deliberate and sophisticated” scheme meant Austral's performance was overstated from 2019 onwards. Management estimated the impact of the fraud to be £6mn in the first half of 2022 and £8mn-£10mn in the prior years.

This is clearly not good news. However, it is not necessarily disastrous – particularly for investors taking a longer-term view. For starters, the fraud hasn’t resulted in a massive profit downgrade. Management said the overall performance in the second half of 2022 had been strong, and only expects operating profit to be “slightly below” the bottom end of the range of market expectations  (analysts previously forecast underlying operating profit of between £109mn and £114mn). The group’s cash position has not been affected and the dividend is still due to go up by 5 per cent as planned. 

Niznik and Tamworth were far from thrilled by Keller’s revelation, saying they had hoped for profit upgrades next year. Instead, extra profits will be used to fill the hole left by the fraud. However, they praised the group’s quick response and said the share price reaction was at the harsher end of what they expected. 

 

Risk versus reward 

The question for investors now is whether Keller is worth the risk. On the one hand, there is the lingering stain of the fraud issue, and the possibility that the group’s full-year results will be delayed (after the scandal, Keller’s auditor will want to make extra sure it gets it right this time). Recession also poses a threat: about a fifth of Keller’s revenue comes from residential projects, which are likely to be affected by a housing slowdown.

“The risk of it going wrong is that there’s a much more severe US recession than people currently fear,” said Niznik. Margins have already come under pressure in North America as a result of inflation and supply chain hold-ups.

However, Niznik is quietly confident. “When we’re chatting to companies, they are much more optimistic than ratings by investors seem to suggest. We’re taking the view that a lot of the recession worry is already in the price.” Keller itself also expects “gradual margin recovery back to recent North America levels in the medium term”.

Recession fears plus the fraud scare have pushed Keller’s share price down by almost 20 per cent over the past 12 months. The group currently trades on a price/earnings ratio of just 6.7, compared with a five-year average of 8.4. Artemis does not think the group warrants a high rating, but “nor does it deserve the rating it has today”. 

“This is a lowly valued company at about a 25 per cent discount to its long-term average, making margins that are below its long-term average – so with potential upside if they can get their margins back to where they should be,” said Tamworth. 

“The icing on the cake is the enormous possible opportunity in Neom, which no one is valuing at the moment. There are no forecasts for it. We own Keller because the valuation is attractive and there are upsides on the margins. We don’t own Keller for Neom – but that’s the bit that could make a good return into a very good return. And we own Keller despite the fact that there are US cyclicality risks.”

Whether The Line is ever fully completed doesn’t really matter, Niznik suggested. “The good thing is that because you have to dig the foundations first, Keller is at the very beginning.” 

“Real money is being spent on it,” said Tamworth. “Will it be a 170km long, $500bn project? No one knows. But could it be very significant and a tenth of that – yes, it could easily be. No-one’s going to value this on a long-term multiple and assume it’s a 50-year project, but it should be cash-generative and profitable throughout the project.”

This assumes that Saudi Arabia will pay for the work that has been done. Some British contractors were caught out during a building boom in 2014 when the price of oil dropped and the kingdom subsequently delayed, cancelled or renegotiated building projects at much lower rates.

Nevertheless, for investors who are able to hold their nerve, this unloved British small cap could be a golden opportunity.