Shares digital

Is a 39% fall year-on-year in share prices in the construction sector justified? It could be argued the sell off is overdone given many companies in this sector are not primarily exposed to residential housing or commercial property building. After all, the UK still has a massive need for new and refurbished infrastructure and the government cannot simply stop building roads, hospitals and schools.

A closer look reveals there are quite a few housing-related stocks in this grouping too. Companies such as Morgan Sindall, Galliford Try and Kier are bound to do well in good times as they run well-balanced portfolios of businesses in different sub-sectors. But their housing exposure is a big liability in the current crisis, and their share prices show it.

Outside interests

The residential and commercial property market will certainly pick up again at some point, but we do not know when or even how much worse things could get before they get better. Therefore investors should focus their attention on the firms which do most of their business outside of residential and commercial property.

These range from heavyweights such as Balfour Beatty to Renew Holdings, an Aim-listed firm with a £47 million market cap. Many companies can boast long-standing ties with the public sector which should provide them with contracts even during tougher times.

These flourishing relationships represent one of the most interesting changes seen within the construction industry in recent years and in many ways these are now the key to the sector’s fortunes. Companies have been establishing ‘frameworks’ or ‘partnerships’ which mean that they are chosen as a sort of ‘preferred partner’ by a government department for certain projects. This provides them with a healthy, and more predictable, revenue stream.

Andy Brown, analyst at Panmure Gordon, says: ‘In recent years there has been a general recognition that construction firms can get a lot more repeat business, as the government keeps spending.

‘Firms have been starting more partnerships and framework type relationships which mean that they “lock in” their customers. Having partnerships and opened book discussions ensures a much better relationship on the ground on both parts,’ he continues.

The benefits of establishing close relationships is also reflected in the much-talked about private finance initiative (PFI). There have been some hiccups along the way, most notably the big and complex Metronet project which came to grief last year. Generally, though, the PFI seems to work well.

It takes the burden of building big projects off the government’s back, and transfers the risk of the projects on to the contractors’ balance sheets. In turn they are happy because they get a stable cashflow over the duration of a project. The banks are happy too as they provide non-recourse debt at good rates.

Equity investors in the projects can also decide to sell those holdings at a later stage and realise a profit. Many companies in the sector have PFI assets, which can be anything from schools to roads, and some have even traded them. Balfour Beatty, Carillion, Kier, Galliford Try all have PFI exposure.

Unless there is a radical, and unlikely, change in ideas at the top, the government will continue to develop projects through the PFI which means that construction companies will have somewhere to go to for stable cashflows.

This changes the nature of the industry quite significantly, in that to win PFI work a firm has to offer the ability to maintain the assets as well as build them. Companies therefore have to specialise in services as well as construction and those that are doing it more quickly, like Balfour Beatty for instance, are winning. Carillion is another example of a construction-turned-services business, having been re-classified as a support services company recently.

Silver service

The idea that developing a project, be it a road or a school, should be seen as a service rather than a mere construction exercise is becoming more popular. In fact, firms like Rok are showing how this idea can be used as a strategy to reap healthy profits.

That is not to say the construction industry, even excluding speculative property development, is risk free. Some PFI projects, and their financing structures, can be very complex and no one know what lies around the corner. PFI only really took off in the last few years and now we are heading for tougher economic times the degree to which this will pressure government budgets remains unclear.

Panmure Gordon’s Andy Brown says: ‘The relationships between companies and government bodies have been generally good but the problem is that we have not seen those relationship tested in tough times.’

Indeed, some analysts – and the City seems to know it already judging by the poor performance of the sector – are flagging up the idea that the credit crunch might feed through to the public sector, with the government having to cut spending.

This would not mean infrastructure projects are suddenly pulled, but the government may have to focus primarily on the big, indispensable ones like the M25 for instance. Companies that already have the skills which will allow them to get a piece of the action will then be rewarded.

Opportunities in the UK will also arise from much-needed improvement to water assets and to the energy network. Companies such as Renew Holdings, which has a specialist engineering division, should prosper as a result.

Harsh times

What is in no doubt is that 2008 and 2009 will be remembered as bad years for the construction industry. Investors looking for growth in the construction sector should constantly look outside of the UK and the US, and possibly Europe altogether. A gloomy trading update by Austrian cement maker Wienerberger this week shows the European construction industry is also in the doldrums.

There are some companies in the sector that offer exposure to very exciting growth markets. Balfour Beatty, Kier, Carillion, Panceltica and Driver Group are all exposed to the Middle Eastern market, which has had a storming run in recent years and should continue to perform strongly. Another international player is Keller, which has some blue-chip projects in its portfolio, and should continue to grow, despite worries about its exposure to the US market.

Whether share prices have bottomed, and whether all the bad news is reflected in them is hard to say. It is very likely that the upcoming months will be tough across the board as more bad news about the housing market and the economy feeds through.

The companies that stand out from the rest of the beleaguered crowd, even those with a housing exposure, are different from their their ‘cousins’ in the house building sector. It is unlikely they will have to write off many assets or refinance their businesses. A recent trading update by Galliford Try showed how its dividend is safe, although it is unlikely to be raised for some time.

The key in this market is steering clear of the firms which are more likely to surprise on the downside. Those investors who wish to take a long-term view and are reluctant to write off the the construction sector altogether, should focus on the highly skilled firms, with PFI and international exposure and this should shield them from the worst of the ongoing credit and housing crises.

Key indicators

The economics:

• Government spending on infrastructure

• Availability of project debt (PFI-type projects)

• Availability of labour, both skilled and non-skilled

• Demand for commercial property

• Demand for refurbishment services

• House prices and mortgage finance

• Interest rates

Sector facts & figures

Number of companies – 24

(Main market – 14)

(AIM – 10)

Sector PE – 8.1

EPS Growth – 1.7%

Prospective yield – 5.3%

TOP ANALYSTS

Andy Brown – Panmure Gordon

Seeing two sides

Working on both sides of the fence, as a buy-side and a sell-side analyst, can give you a different, useful perspective in analysis, believes Andy Brown.

He started on the buy-side, moved over to the sell-side in 2000 and has focused specifically on the construction industry in the past few years.

'On both sides of the fence our job is to spot the winners. However, as a sell-side analyst, you are more drawn to getting the forecasts right, whereas on the buy-side you are more drawn to getting the share price right,’ He says.

He suggests that 'getting the share price right' is still one of his main interests and this means trying to identify the important influences on share prices at any one time.

The analyst has been with Panmure for a year and a half after working at other broking firms, and identifies the presence of 'a lot of hedge-fund-type investors' as a factor in the massive sell-off in construction stocks. This means a sector re-rating will ultimately be event-driven rather than purely valuation-driven, believes Brown. 'I don't think valuation is a catalyst at this stage', he says.

One risk is public sector spend may not be as high as forecast, and corporate activity may not take off either, but Brown argues there are still good investment opportunities in the sector. He particularly highlights those firms that have exposure overseas, particularly to the Middle East.

Brown's preferred picks are ground engineering specialist Keller, disputes resolution expert Driver Group, and support services firm Carillion.

Michael Parkinson – Brewin Dolphin

Power of PFI

The opportunity of the private finance initiative (PFI) first drew Michael Parkinson to construction.

He started his career at PriceWaterhouseCoopers, doing due diligence on behalf of venture capital investors. He moved to his current employer in 2000. He says: 'As a firm we were attracted by long-term cashflows that PFI could provide back in the early 2000s, as we moved away from technology companies that offered poor visibility of earnings.'

Parkinson believes PFI remains a big opportunity, even though there may have been some hiccups, such as the failed Metronet project. Even if the government is forced to cut spending on some projects, Brown argues it will still need help with much-needed infrastructure projects.

Yet the analyst is aware the market correctly anticipated a downturn. 'The sector had been trading very well and the City was naturally sceptical that this would continue. The key now is picking stocks that are going to outperform in a tougher period,' he says.

Parkinson leans toward companies with a lot of support services revenues or PFI equity on the balance sheet, and cites Balfour Beatty and Carillion as examples. He accepts larger companies may be more capable of reacting to short-term changes in the market but still picks out Renew Holdings as a favourite. The Aim-quoted stock has broad exposure across the industry, PFI skills and £3 million in cash on its balance sheet.

Howard Seymour – Numis Securities

Watching changes

A PhD in economics and construction has seen Howard Seymour work at several investment banks since 1985, including ABN Amro, Credit Suisse First Boston and UBS. He was then a founder of Bridgewell, and moved to Numis after that firm was taken over last year by Iceland's Landsbanki.

Seymour believes the credit crunch could feed through to public sector spending. This should not mean government will suddenly abandon its commitments to infrastructure spending. But in the event of cutbacks, Seymour believes the Brown administration would focus on big-ticket items such as large PFI initiatives, the Building Schools for the Future programme and the M25.

The Numis analyst also believes the rules for procurement in construction are changing, with more emphasis on maintaining assets as well as building them. 'Large companies that can offer maintenance services through the whole life cycle of a project are the ones more likely to win work,' he says.

As the sector seems increasingly to resemble a service industry, Seymour says the focus of analysis has to be on cash generation. 'It's a service business, you always have to look at the underlying cash relative to profits', he says. Balfour Beatty can offer good maintenance services and is therefore among Seymour's favourites. Kier and Keller are two other picks, despite the latter's exposure to the US non-residential market.

BEST BUYS

Driver Group – Forging ahead

A 2008 forecast PE of just under 14 times, according to recent research by Driver’s house broker Panmure Gordon, should not scare off prospective investors in Driver Group. The Aim-listed company provides dispute resolution and other services to the construction industry. While its main market is the UK, it is growing in the Middle East.

The company is targeting not only Dubai but also Abu Dhabi and Oman too, where it has an office in Muscat. Sales and profits have grown strongly in recent years and in tough times, contractors are likely to become more litigious. This should benefit Driver, and its broad sector exposure should also be a help. As such the £21.5 million market cap, which joined the junior market in 2005, should continue to perform well and the shares are attractive to investors who feel it would be foolhardy to completely write-off construction-related stocks.

In the UK, the company is exposed to commercial property but it advises on projects and does not develop them and commercial is by no means its main focus. It has a larger exposure to the civil engineering, public and nuclear sectors. The acquisition of CMC last February put the group in a strong position, as it added new sectors and increased head count. Sales and profits should continue to grow as the company expands organically and integrates CMC into the business. June’s interim numbers were encouraging as turnover came in 73% higher and pre-tax profits 35% higher than last year. Panmure Gordon forecasts a 24% uplift in profit before tax to £2.08 million for the fiscal year which ends in September, against £1.11 million a year ago and this leaves the stock on a prospective PE of 14.3 times.

Renew Holdings – Solid foundations

The company, led by former Laing Construction and HBG Construction chief executive Brian May, operates from two divisions, specialist engineering and specialist building. It has very little exposure to troubled sectors such as commercial property and housing, and can instead boast of a presence in ‘specialist’ sectors such as nuclear, water, land remediation and social housing. This means Renew should continue its track record of growth, despite the general weakness in the construction market, and achieve its target of £500 million of revenues and a 2.5% operating margin by 2010.

May’s interim showed the company is on track with its programme, as the numbers came in slightly higher than expected by analysts, with taxable profits 25% higher than the prior year at £4.1 million. The order book stood at £248 million, or 8% ahead of the prior year, and much of the revenue in the first half came from those specialist sectors. Yet shares in the Aim-quoted firm fell very quickly from a peak of 114p in May to the current 79p level, which takes them to a 2008 PE of 8.6 and a dividend yield of 2.7% according to house broker Brewin Dolphin.

A fat order book and exposure to specialist sectors are both attractions and a further plus is a net cash pile of £25 million on the balance sheet. This both provides security and should permit the company to make interesting bolt-on acquisitions.

Balfour Beatty – Too big to sink

There is little doubt Balfour Beatty should be less affected by the current construction downturn, thanks to its size and to its expertise. The shares have fallen from a peak of 516p before the end of the year to the current 396p but they are a safe investment in the construction sector, with a 2008 PE of just over ten times, a justifiable premium to the sector’s 8.1 times. The group’s four main divisions, building & construction services, engineering & services, rail and investments continue to trade well, as shown by an upbeat trading statement at the start of this month.

The company has also been very active in making earnings-boosting acquisitions and said in the recent update the confirmed order book had grown to £11.8 billion. This will receive another massive boost by the M25 project, for which the group has won the preferred- bidder status. The ability of Balfour Beatty to offer long-term maintenance services means the company is winning bundles of PFI work which offers great visibility of earnings. The group is getting it right in being both a construction and a services business.

Balfour Beatty also offers great geographical exposure to regions like the Middle East and Asia. Its Middle East joint venture should contribute £700 million in total revenues, says analyst David Phillips at Landsbanki. The company has recently won a contract for the design, installation and electrification of 330 kilometres of new double rail tracks in Malaysia.

STEER CLEAR

Galliford Try – Damage limitation HOLD

Shares in ‘hybrid’ Galliford Try have collapsed in the last year, from 160p to 43p, although they have enjoyed a rally of late. A bank of 9300 plots of land means the share price will remain very sensitive to any further bad news coming from the housing market. There are growing signs the current crisis could turn out as bad, or even worse, than the property crash in the early 1990s and Galliford Try would suffer, due to its large exposure to the housing market.

The firm has strong relationships with the public sector but authorities may have to slow down investment on many infrastructure and housing projects, to focus on the larger ones.

In an update two weeks ago the company said full-year pre-tax profits would be no less than £60 million, the same level achieved in 2007. Analysts’ consensus is the dividend (which is not being raised) is covered 3.4 times, and gearing is at 2%. Galliford Try is not an unattractive investment in the medium term, however, it will underperform its peers in the short term, due to the housing exposure and also because of its primary UK focus. The fact the shares look cheap, on a prospective PE of 5.4 times for fiscal 2009, is not reason enough to jump in as it is hard to see what could act a positive catalyst for the stock in the current environment.

Morgan Sindall – Weak and exposed

After a weak trading update at the start of the month, analyst Howard Seymour at Numis commented Morgan Sindall is ‘one of the highest exposed to the private sector within the contractors’. The firm’s private sector exposure comes through both its open market affordable housing and its commercial property operations and this means profits are likely to suffer further before things get better.

Analysts’ consensus estimates of only an 8% drop in pretax income for 2009 could prove optimistic, as the £200 million cap may not be able to reposition itself quickly enough. Seymour noted Morgan Sindall’s open-market, affordable housing operations are being hit significantly, and reduced his forecasts for both the group’s housing and fit-out businesses. He has cut his 2009 profit before tax estimate by 18%.

In the same trading update, company management also said it may have to make a £58 million fair value adjustment to an acquisition from Amec made in 2007, due to lower margin on completed projects and contractual issues. The shares have already fallen a long way, from more than £17 a year ago to the 465p level now, but this has not made the valuation look cheaper as a result. A 2008 PE of 6.5 and a 5.5% dividend yield is more expensive than several peers This means the shares could go down further, and there are no significant catalysts for a re-rating.

MJ Gleeson – In need of a sale

The group, which is involved in urban regeneration, is having to restructure heavily, in order to reduce overheads and narrow its geographic focus. At a trading update in June MJ Gleeson said it has started to close down its offices in the south, sell assets there and cut jobs. The wider restructuring programme means the firm will take a £12.8 million charge to its income statement for the year to the end of June.

The restructuring operation this year is part of an effort to reposition MJ Gleeson that started some time ago, but the ongoing credit crunch continues to make the board’s life very difficult. February’s interim results showed a loss before tax and flagged up problems for the company’s housing and property operations. The group is also trying to sell some land but it cannot do it at satisfactory terms at the moment, as land prices have fallen sharply.

At the latest update the company insisted that it has a cash positive balance sheet but has said it is experiencing a ‘marked reduction in reservation rates and an increase in cancellation rates’. The restructuring charge and the ‘shortfall of income’ from house and land sales means the full-year results will show a big loss.

The shares have collapsed from 400p a year ago to the current 137p but they could fall further, given the difficulties that the company faces. It is simply not the right time to invest in a company that has a mainly residential exposure and a need to sell land.

RISING STAR

A personal touch

Keeping work local is the key for the chief executive of Rok

Analysts and fund managers who want to ask Garvis Snook, chief executive of Rok, uncomfortable questions about his business, should be aware his lengthy career in the construction industry means he knows how to handle explosives.

Snook learned to blow things up working for his father’s demolition business. He has since built a solid business, which should be able to dodge the worst fall-out from the credit crunch bomb.

Snook took the helm at Rok in 2000. Since 2003, sales have grown from £380 million to £947 million and pre-tax income from £10 million to £28 million.

The shares rose more than five-fold between January 2003 and May last year, peaking at 245p, but have fallen to 60p in the market-wide decline.

Fears about the £127 million cap’s commercial property operation have prompted the sell-off. But Snook points out Rok is scaling down exposure here.

‘I try and not focus on the share price at the moment. We said we’d find our way out of the commercial property sector and it’s now less than 10% of profits,’ he says.

Snook accepts construction is in trouble due to the credit crunch, but argues it was never risk-free, as the UK lacked sufficient trained staff to help firms meet booming demand.

Big redundancy programmes at large house builders such as Taylor Wimpey and Persimmon may be good news for Rok: not because it will hire those who have lost their jobs, as they are mainly white-collar workers, but rather subcontractors are looking for work with Rok, helping to reduce its cost base.

Commercial exposure may pose problems, but Snook thinks the market should focus on the maintenance and repair order book, which continues to grow, despite recession worries.

Think local

Rok aims to become ‘the nation’s local builder’, which summarises its winning business model.

Snook argues he and his team are trying to build a business of people who care about customers, believing happy customers are more willing to pay good prices and offer repeat business. Through organic growth and acquisitions Rok has built a network of local subsidiaries sourcing work and employing locally.

This also underpins the success the building division, which develops social housing, education and health for local councils.

‘In the small team I worked with in my father’s business, few of the workers could read and write. Yet it was a strong team and that taught me to value people for what they can bring, rather than their academic titles,’ Snook says.

After failing to set up a demolition business in London, Snook joined Stansell, in Taunton. It had been part of the community for decades. ‘We used to do repair and refurbishment jobs, and work came to us because we were part of the local community,’ says Snook. ‘The business was wrong at that stage in that it employed some people who seemed lazy. But they were lazy because the company never involved them in its business.’

Snook focused on employing people who saw what customers wanted. ‘I would then share with them the positive results.’ Profits soared, Snook says, remembering the effect on his employees. ‘How proud and confident of what they were doing that made them.’

After revenues had grown to £50 million, Snook agreed in 1996 to a management buyout. Before this was completed Morgan Sindall bought the company and he found himself a regional managing director for the listed company. He says that helped him build experience in the City, ahead of his move to Rok in 2000, then known as EBC.

After rebranding to Rok, Snook had a platform to test his ideas. ‘It was only a theory seven years ago. But now I can say it works.’

As a PLC ‘you can create a network that brings together the subsidiaries and gives them the buying power of scale’. Snook concludes: ‘The idea that if you focus on customers they will reward you is so basic. It’s so normal in other industries, why is it not in construction?’

CHARTING THE SECTOR

In common with other sectors exposed to building, the group of companies that constitute the heavy construction sector have been suffering over the last 12 months. Having risen over five fold since it based in late 1998, it showed strength during the general bear market of 2000 to 2003, correcting to the long-term bull trend growth line drawn on our chart in early 2003 then entered a period of almost continuous gains that lasted some four years, during which the 200-day average clearly provided conclusive support to what little downside occurred.

When the average was finally broken last summer, the alarm bells should have sounded for bulls. The subsequent fall has amounted to a drop of some 50% in the value of the sector.

There was a clear bear pennant formed at the start of the year, the conservative projection from which targets a test of 79 on our chart or 17.5% below current levels. For this to occur though it would necessitate a drop below the long-term rising bull line (approximately 7% below current levels) and likely support from the highs seen in 1996 and 2002.

Better still the sector is currently sitting on the Fibonacci 61.8% retracement level of the 1998 to 2007 bull move. If these levels fail then we must expect further significant losses perhaps producing a further drop of 23%.

If current levels can hold and produce a recovery, this could be as sharp as the preceding sell off has been with the first target being a test of the 200-day average and the congestion of the old pennant some 38% above present levels.

Galliford Try (GFRD)

BUY - 42p

TARGET PRICE - 78p

STOP LOSS - 30p

The break below the important support close to 134p last November signalled the company’s weakness and subsequently the shares have dived by more than three quarters in a move that has been defined by a tight bear channel, with the upside conclusively capped by resistance from the 50-day average.

Perhaps the expectation was for the shares to continue to fall and to finally hit support from their super long term bull trend line, drawn off the lows seen in 1995, 1998 and 2003, and which is currently pencilled in at 24p. Looked at more closely the chart reveals that 29p has provided significant support and resistance historically and it seems that for now at least the shares are basing off this level.

The bear channel upper return line has now been broken through on increased volume and a minor double bottom has been completed that suggests a move to test important resistance at 48p (lower horizontal line on our chart) is likely.

This level marks the beginning of a significant zone of congestion that held the shares throughout 2004. If the bulls can build momentum it might be that a proportionate correction to the recent sell-off would work through producing a return to 78p and the 38.2% retracement.

Kier Group (KIE)

BUY - 833p

TARGET PRICE - £11.90

STOP LOSS - 740p

Another chart which suggests the worst might be over is that of the diversified construction company Kier. Having all but returned to levels not seen since the start of 2005 and in the process losing some 70% of its worth, the shares are close to testing the 720p to 705p zone, an area on the chart that first terminated gains in 2002 and then acted as both resistance and subsequently support in 2004.

This level would be expected to offer strong support, but ahead of this we should consider the possibility the large top pattern, formed between mid-2006 and the end of last November, could be interpreted as a head and shoulders pattern, whose £10.00 move when subtracted from last November’s break point of the neckline (drawn in mauve) pointed to an eventual test of 752p.

It is very early to call for a full change in direction and we may only see a correction upward within the context of the bear channel that remains intact on the chart. Even this could produce a jump of 30% if it happened quickly. The downside risk seems limited to a slip to 705p and the deviation from the long-term 200-day average is currently historically large. While this will narrow to some degree as the average continues to fall, it also mitigates in favour of some upside potential. Perhaps a speculative foray with the application of judicial tight stops could provide a worthwhile profit the coming weeks.

30 second Rok

• Founded in 1939 as Exeter Building Contractors (EBC) and participated the post-war rebuilding effort

• Rebranded as Rok in 2001 following the appointment of Garvis Snook as chief executive

• Employs people from the same local communities it works for

• Has grown from a local business to a 5,500-strong operation with 60 Rok Centres around the country

• Acquired seven businesses in 2007 alone