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Trouble ahead for Balfour Beatty

Facing a transatlantic construction slowdown, perpetual delays to HS2 and now allegations of fraud in its US military housing business, Balfour’s outlook is looking increasingly uncertain
July 25, 2019

As UK construction companies struggle to escape the long shadow of Carillion’s demise, Balfour Beatty’s (BBY) transformation is often hailed as a beacon. Under the ‘build to last’ programme launched in 2015, 89 problematic contracts blunting profitability and cash generation were whittled down to five by the end of 2018. With more selective bidding on higher-margin and lower-risk jobs, the £12.6bn order book is considered a higher quality pipeline of work. Although construction revenue (79 per cent of the group total) fell by 8 per cent last year, underlying construction operating profit (40 per cent of the total) increased by 32 per cent to £95m.

IC TIP: Sell at 224.6p
Tip style
Sell
Risk rating
High
Timescale
Medium Term
Bull points

‘Build to last’ programme

Higher quality order book

Bear points

Low margins

HS2 delays

Military housing allegations

Poor cash generation

But even mighty Balfour cannot outrun the industry’s demons. Although the group achieved so-called “industry standard” construction margins in the second half of 2018, for the full year they remained wafer thin at 1.5 per cent and 1.3 per cent in the UK and US respectively. In a highly competitive sector notorious for underbidding and squeezing margins, sustained margin improvement is questionable.

With over three-quarters of the order book underpinned by construction services, Balfour is looking to capitalise on rising government infrastructure spending – the UK’s 2018 national infrastructure and construction pipeline contains around £190bn of planned investment by 2020-21 while the US is benefiting from state-backed infrastructure bonds. Meanwhile, exposure to major large and complex projects can be costly. Schedule slippages and cost increases on the Aberdeen western peripheral route (AWPR) project saw the group recognise a £29m loss in 2018, including £10m to fulfil Carillion’s obligations.

As part of joint ventures, Balfour has significant involvement in HS2. A £1bn contract to build Old Oak Common station in London and £2.5bn-worth of civil engineering works are yet to be included in the order book as the early contractor involvement stage drags on. Given the spiralling budget, a sceptical Boris Johnson plans to review the project’s scope and costs, which could mean further delays, a trimmed scale, or even cancellation. With the initial tender for Birmingham Curzon Street station recently abandoned over bidders’ concerns about risk transfer, it raises questions regarding the risks Balfour has assumed to secure contracts. What's more, rival Bechtel has mounted a legal challenge over the accepted bid for Old Oak Common, which was considerably below the £1.3bn tender, on the grounds that such a low-ball bid presents a "risk to the safe and timely handover" of the project – accusations incongruous with the notion of “disciplined bidding”.

Controversy surrounding US military housing could present problems for Balfour's infrastructure investment division, which generated 41 per cent of group underlying operating profit last year. North America accounts for 57 per cent of the portfolio, with US military housing representing over 80 per cent of this, valued at £532m. A Reuters-CBS investigation in June reported potential falsification of records in the US military housing business to secure bonuses. The Air Force has now suspended incentive payments across the group’s 21 military housing projects and is reportedly probing allegations of fraud at three bases. 

With the negative impact of the AWPR project, Balfour experienced £132m of operating cash outflow last year versus a £41m inflow for 2017. This means the group has only generated cash from operations once since 2011. Supply chain financing has ended, which contributed to a £196m cash outflow from paying suppliers more quickly last year – a key reason for an overall £229m working capital outflow. True, operating cash flows before working capital movements and pension payments jumped from £39m to £124m. However, already suspended from the voluntary prompt payment code, upcoming government rules threaten to bar late payers from winning public contracts, which could drive future working capital outflows as supply chain payment terms tighten.

BALFOUR BEATTY   
ORD PRICE:224.6pMARKET VALUE:£1.5bn 
TOUCH:224.6-224.8p12-MONTH HIGH:302pLOW:220p
FORWARD DIVIDEND YIELD:3.5%FORWARD PE RATIO:10 
NET ASSET VALUE:180p*NET DEBT:6% 
Year to 31 DecTurnover (£bn)Pre-tax profit (£m)**Earnings per share (p)**Dividend per share (p)
20168.2627.42.7
20178.216520.93.6
20187.818124.84.8
2019**7.818321.87.3
2020**8.119823.47.8
% change+4+8+7+7
NMS:7,500    
BETA:0.65    
*Includes intangible assets of £1.2bn, or 170p a share
**Liberum forecasts, adjusted EPS and PTP figures