Stockwatch: buy the drop in this hot stock?

Small-cap shares in Costain Group (LSE:COST) plunged 17% to 136p on Wednesday in response to half-year results showing a mixed story on revenue – down 18% to £525 million albeit a 3% rise in adjusted operating profit to £16.8 million.

The sense has been that UK infrastructure is contra-cyclical and a promising investment area, which has helped Costain rally from 35p in late 2022 to 166p as recently as 11 August.

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Indeed, I rated it a “buy” at 96p in January on an apparent forward price/earnings (PE) ratio of 7x and with share buybacks manifesting. The rally strengthened from mid-June after an update conveyed an all-round sense of onwards and upwards; and after the government published its 10-year infrastructure strategy with a £725 billion programme across sectors such as transport, energy, housing and public services. The private water industry is also undertaking major upgrades.

If a circa £350 million company like Costain can replenish its workforce as plenty approach retirement, and manages contract relations well, it ought to leverage growth.

What has essentially happened here is a reality check. In truth, major infrastructure contracts are lumpy and timing issues do intervene. Also, the stock market more generally has been in a rose-tinted glasses phase since April.

So, does this drop represent mean-reversion to fair value – the chart implies in line with the three-year trend after getting over-cooked – and is it enough to again suggest a “buy” rating?

Source: TradingView. Past performance is not a guide to future performance.

Poor communications the recent revenue hiatus

Notably, the shares steadily lost another 5% to 129p yesterday, despite management opining in presentations that the fall was overdone, adding that they remain confident in the 2025 financial outcome with revenue growth manifesting from 2026.  

If consensus for £37.5 million net profit is fair, this represents 9.2x expected normalised earnings per share (EPS) of 14.0p based on £37.5 million net profit, easing to 8.5x in 2026 assuming £40.0 million profit.

However, Costain’s broker Panmure Liberum has only now cut its full-year revenue forecast by 11% to £1,109 million versus flat previously, although the margin estimate on the natural resources (water) side has been raised, hence this compensatory aspect means its earnings forecasts are unchanged. They are also slightly better than consensus with 14.4p per share this year, 15.9p next and 17.7p for 2027 which would represent a PE of 7.3.

Take your view as to whether guidance implicit in Costain’s finance director signing off these forecasts – as always happens in commercial relations – is usefully reliable or represents the “shop view” according to cynics of company brokers.

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What I find hard to square is Panmure’s seemingly overdue revenue downgrade with the CFO’s pitch in a results’ presentation. She effectively said that it was always the case how completion of various major road projects was going to result in a hiatus. They were assigned as long as a decade ago, on margins the board nowadays would not like, and had to withstand periods such as Covid.

I did not glean real substance as to what replacement contracts have been finalised in terms of supporting a growth scenario from 2026. The chief executive talked of bidding on other road works, with the M60 cited as he did, but I have yet to see any exposition of how “forward work over four times annual revenue”, which they cited on 16 June, actually stacks up.

There has also been some rephasing of work on HS2, this being communicated to Costain “from mid-June”, the CEO said. Investors also expressed concern as to the situation at Thames Water, but the boss remains confident of work evolving, whoever owns this utility.

Obviously, sound reasons of client confidentiality and competitiveness could be involved, but this leaves us taking management’s word on it.

I am also unsure how sustainable their pitch is about a 4.5% adjusted operating margin run rate this year. There is, of course, a risk that it might ease thereafter, which would seem an inherent uncertainty of contracting.

Costain Group - financial summary
year end 31 Dec

Source: historic company REFS and company accounts.

Director deals

Possibly share buying by the non-executive chair – 10,000 at 137.5p - is notable in the sense that she is not amid these communication matters, which essentially just reflect the nature of contracting. Instead, she has her sights on the positive industry context and modest earnings valuation – assuming worthwhile contracts evolve.

You must therefore take a view as to whether the further fall to around 130p marks even better value if management’s execution backs this up, or perhaps wait and see if the CEO and CFO also buy stakes in the business.

It was not a great sight – now we have the results – how the CEO on 24 June exercised 751,810 options at 0.0p and sold all those shares into market strength at 143p, banking £1,075,539.

But at least when the CFO also exercised 458,662 options near 143p, she sold “only” 73.5% by way of 337,117 shares, banking £481,133. Some of this will go to pay tax, although it looks like she decided to hedge her exposure and lock in some gains also.

It exemplifies how share options get annoying because they put managers and shareholders in different boats. They also cloud interpretation of trading.

Apologists for the 24 June sales will argue that this is how the schemes work and that they will get more awards soon. But this insulates managers financially from the kind of upset we have just seen, relative to shareholders.   

Lack of yield support accentuates share plunge

At 129p, the prospective dividend yield is a modest 2.3% given 3.0p per share as consensus for the 2025 dividend, rising to 3.4p or 2.6% in respect of 2026. Such figures would have substantive earnings cover towards 5x but Costain is still in a relatively early stage of resuming payouts since 2023.

In 2019, the group suffered a triple whammy of contract delays and cancellations, then a court ruling increasing its liabilities on a Welsh road project, meaning a £100 million rights issue in March 2020 to repair its balance sheet. Around a third of its revenue was then suspended by Covid.

After a 3.4p per share dividend was last paid in respect of 2019, 1.2p was paid for 2023, albeit on a diluted share base, meaning the near 3.4p expected for 2026 will be significantly greater than the amount paid out for 2019.      

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A current hike in the interim dividend from 0.4p to 1.0p is being interpreted by some as underlining confidence, although the board is also normalising the dividend split between the two half-years.

In a presentation, the CFO said the board was aware of a need to restore returns after a period of investment, although a dividend parity clause in the pension scheme means contributions in must match dividends, hence they are quite cautious on dividend guidance.

Costain has only just – 18 August – completed a £10 million share buyback programme and is now prioritising other aspects of the business, which seems unfortunate given that the shares are now materially lower. Possibly buybacks have been another catalyst for momentum buyers this year.

Decent asset-backing from the balance sheet

As of 30 June, net assets were £243.5 million equivalent to 91.3p per share, with 21% constituting intangibles. The balance sheet can reasonably be described as strong given £145 million cash and no debt beyond £23.3 million leases.

Obviously it does not help any search for a “margin of safety” in Costain shares, which, and according to a lack of clarity as to medium-term contract build, have to be viewed as speculative rather than investment grade.

Shares like this have a “marmite” flavour, some investors preferring to avoid relatively low-margin contracting due to its uncertainties, while others see opportunity in modest valuation.

With the price attracting support and some recovery to 131p, I retain a “buy” stance although be mindful of inherent risks.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.