Interactive Investor

Stockwatch: A buy ahead of ratings upgrade

24th November 2017 12:18

Edmond Jackson from interactive investor

Are investors unduly jaundiced towards £225 million structural steel, construction group Severfield?

The market appears in two minds: cautious that ultra-low interest rates may be on the turn, and the UK economic upturn since 2009 is long; and yet a 15% jump in the FTSE Small-cap stock to 74p - in response to bullish interims - shows the market alert to undervaluation.

Severfield is engaged in the design, fabrication and erection of structural steel-works for bridges, car parks, city centres etc, hence, it is well-placed as a beneficiary of the now fashionable political theme for infrastructure spending, which UK political parties agree on.

Full-year results to end-March 2018 are guided "comfortably" ahead of expectations as shown in the table, reiterating a target to double pre-tax profit to £26 million over the 2016 to 2020 period.

Yet the forward price/earning (PE) multiple may only be about 10 times (forecasts in the table need upgrading), the cash flow profile is strong versus modest capital spending needs, hence the dividend growth looks intact with a prospective yield of about 3.5%.

If the group's commercial momentum continues, then risk/reward favours upside. Some context of its recent history is needed though.

Turnaround from the depths of 2012/2013

Severfield is UK leader in its field with a 17% share, the design, fabrication and build of structural steel being quite a specialist market.

Scroll back to year-end March 2013 results and the group had struggled with various contract issues, meaning a £19.5 million underlying operating loss - a huge reversal on November 2012 guidance for a £1 million pre-tax profit - amid "a difficult climate with pricing pressure and protraction of contractual settlements posing significant challenges as clients and the supply chain compete harder in a shrinking market".

An April 2013 rights issue raised £45 million and the business was reorganised under new leadership. Certainly various procedures have improved, although each downturn has special features, so I wouldn't expect this 'new' team to be immune as and when the cycle turns.

So, the crux for buying into Severfield is macro: if low interest rates persist amid weak UK economic growth, and public spending on infrastructure is pursued, then Severfield is well-placed for a few years.

The stock is most likely cheap because memories linger, but, as they fade, more investors will be impressed by current figures and not look back. So, unless a spike in inflation pushes up interest rates, this discount to fair value is set to narrow.

Management heralds "opportunity pipelines"

First-half progress is strong: a 59% hike in underlying interim pre-tax profit to £12.9 million on revenue up 16% to £137 million, with higher steel prices helping also.

If same applies over H2 then, on a simple basis, £25.8 million annual profit is implied (versus 21.8 million recent consensus). Although the 6 September AGM update guided "full year results to be more first half weighted than last year", this is now absent from the narrative which asserts annual profit is now expected "comfortably ahead" of expectations.

While the interim dividend is up 29% to 0.9p per share, it's from a low base after payments resumed only in 2016, and is backed by £31.6 million cash reserves - i.e. don't assume the rate of increase is mirrored in growth prospects.

Operations are in rude health, though: over 80 projects were undertaken during the period such as a new stadium for Tottenham Hotspur football club, a retractable roof for Wimbledon's No. 1 Court, and a new commercial tower in London's Bishopsgate.

The UK order book is up from £229 million at 1 June to £245 million as of 1 November, and in India from £73 million to £79 million. Also in support of the 2020 profit target, Severfield has employed a European business development director based in the Netherlands, with a European "opportunity pipeline" said to be growing in Ireland and Belgium.

As I regularly say with regard to EU prospects, be aware that companies may significantly depend on the UK achieving a trade deal.

Efforts are also being turned towards higher-rise construction projects, traditionally a concrete market but where Severfield believes it can offer steel-based solutions.

Biggest shareholder is effectively locked in

At end-October, JO Hambro Capital Management, Severfield's largest shareholder, edged up its stake from 15.98% to 16.04% though post-interims has trimmed to 15.81% - that's still significant exposure to a small -cap cyclical if the industry does turn down.

Such a stake is quite locked in as the bid price would collapse if attempted sold down in a recession.

This shareholder needs watching in the sense that if it does try to reduce further it can easily hit the price; yet this extent of exposure implies confidence both in the macro context and Severfield's development plan.

Indeed, on a PEG basis - the PE ratio divided by the earnings growth rate - this rating is highly attractive, being sub 1.0, although conservative investors would reckon it inappropriate to apply PEGs to cyclical industries; that you should at least view the PE in cyclically adjusted terms.

But, as younger traders scour for value and five years will seem like an ice-age ago, it's probable "low PEG screams value" claims will appear.

Quite similar behaviour as house-building stocks

Severfield did rally from 75p to 88p in the first half of 2017; justifiably, as its numbers and narrative at June's prelims were strong, yet the stock fell as low as 60p quite recently.

Thus, overall the stock has been in a volatile-sideways trend this year quite like other construction stocks and house-builders.

Enough investors appear to mistrust these companies' prosperity in a belief the current momentum will ease now interest rates are at a turning point, then operational gearing is liable to cut profits.

It's a broad comparison, but Crest Nicholson for example, in the Mid 250 index, has a quite similar chart and, according to forecasts, now trades on a forward PE of 7 times, yielding over 7%, despite strong operating margins that have risen from 17% over 20%.

Severfield is more akin to a typical construction company, its margin having recovered from around break-even to 7% lately. So the context of its 2017 stock rating is somewhat shared by the "sector".

Severfield - financial summary           Consensus estimates
year ended 31 Mar 2013 2014 2015 2016 2017 2018 2019
  15 months            
Turnover (£ million) 255 231 202 239 262    
IFRS3 pre-tax profit (£m) -23.1 -4.1 -0.2 9.6 18.1    
Normalised pre-tax profit (£m) -21.2 1.2 -0.2 9.5 18.3 21.8 24.5
Operating margin (%) -7.8 2.2 0.2 4.6 6.6    
IFRS3 earnings/share (p) -10.8 -0.9 0.05 2.9 5.1    
Normalised earnings/share (p) -10.1 0.5 0.03 2.7 5.1 6.1 6.8
Earnings per share growth (%)     -94.2 8733 91.7 20.1 12.0
Price/earnings multiple (x)         14.5 12.1 10.9
Price/earnings to growth (PEG)              
Annual average historic P/E (x)   114 1694 535 18.3    
Cash flow/share (p) -0.4 0.6 3.3 8.0 8.3    
Capex/share (p) 0.6 0.5 0.4 1.4 1.8    
Dividend per share (p) 4.0     1.0 1.7 2.5 2.7
Yield (%)         2.3 3.4 3.6
Covered by earnings (x)       2.7 3.0 2.4 2.5
Net tangible assets per share (p) 36.5 26.5 26.5 29.9 32.7    
Source: Company REFS              


Balance sheet is broadly strong

If the UK economy weakens, Severfield is well-placed in balance sheet terms: no debt and £31.6 million cash despite £7.7 million investment and £4.8 million dividends paid out over the six months.

A £25 million borrowing facility does exist with a further £20 million available until July 2019, whether for potential contract needs or acquisitions.

Its covenants do require interest covered by operating profit over 4 times though, as if lenders are mindful how the construction cycle can deteriorate. The ratio of current assets to current liabilities is strong at 1.43 times.

Just over 34% of net assets comprise goodwill thus net tangible assets per share of 35p as of last September. There's a slight niggle by way of a £20.2 million pension deficit, slightly down on £21.4 million at the end of last year due to changes in bond yields.

So, if trading updates continue positively an improvement in Severfield's rating is likely; it's not as if a weak or intangibles-heavy balance sheet holds it back.

Investors may be comparing some of the rich yields offered by house-builders as "construction" stocks and feeling 3.5% is about right for Severfield. But, given scope to raise the group's payout as it moves towards its 2020 profits target, the stock can rise over 100p and maintain a useful yield in support. Buy.

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