Stockwatch: Recovery case building here

A sudden rights issue highlights credit tightening, but companies analyst Edmond Jackson believes the current share price may offer the chance to lock in a fat yield with capital upside. 

Does a deeply discounted rights issue from FTSE 250 construction and public services outsourcer Kier, mainly reflect risks in the business or a broader warning how the credit cycle is rolling over? 

A third of Kier's market value was wiped off last Friday afternoon, down from 759p to 500p after the company declared a 33-for-50 rights issue at 409p - and even then, the take-up among investors was indicated at 32%.

This week has started with a more modest example – Southend airport operator Stobart Group trimmed its dividend and launched a capital review in order to bolster cash flow with new investments. Otherwise, it was relying on selling down its stake in Eddie Stobart Logistics – now hit by Brexit uncertainties - to pay a high dividend.

Among unlisted companies it appears at least four of Kier's peers are facing similar credit cuts.  The common factor is companies having to amend their ways and bolster cash, indicating more constrained times.  It comes after high-yielding shares had already drifted down, as if a warning to be extra-vigilant lest they're a value trap.

Kier initially rebounded to over 560p on Monday before slumping to 420p by Tuesday morning where, if brokers' latest back-of-the-envelope forecasts are fair, post-rights earnings per share (EPS) of about 90p for the year to end-June 2020 implies a price/earnings (PE) sub-five times and 2020 dividend per share of about 36p for a yield of around 8.5%.

I've left numbers in the table (below) as those pre- the rights announcement, based on a share price of 750p, as a lesson in wariness towards late-cycle forecasts.  Much depends on the post-Brexit UK scenario where Kier derives over 90% of revenue.  

Source: TradingView monthly chart (*) Past performance is not a guide to future performance

Banks and customers have turned screws

Barely a fortnight ago, Kier's AGM exuded confidence in expectations for the financial year to June 2019; albeit with "second-half weighted" results which could be interpreted as a mild profit warning. The "Future Proofing Kier" programme was said to be making good progress on streamlining the group and improving cash generation.

Either it hasn't been wise to trust PR slogans, or the rights issue shows the board adhering strictly to it as lenders tighten their approach and (potential) customers look for stronger balance sheets and shorter payment cycles.  Kier is rushing to dress its end-December balance sheet, hence only a three-hour window last Friday for anyone seeking to buy shares with entitlement to the rights.

Net debt has leapt from £186 million at end-June to £624 million as of end-October, the AGM citing average monthly debt for the six months to end-December around £390 million.  In which context the rights is expected to cut debt by about £180 million on an annualised basis; so quite whether the ensuing trading environment will prove the debt-cut enough, the board/advisers are likely trying to mitigate dilution also.

Kier's recent jump in debt hasn't been explained, but there's a parallel with Interserve, a small cap construction and public services group, whose debts have soared to nearly £650 million.  Quite as if such companies have taken on a lot, trying to sustain profit (albeit fundamentally low-margin business) but cash generation doesn't prove sufficient as UK uncertainties weigh - hence recourse to debt for working capital.

Affirms the trade creditor/debtor imbalance 'red flag'

At 1,090p last January, I wrote how Kier "intrigues if also quite horrifies me" given various oddities.  Net debt was proclaimed modestly higher from £99 million, at the lower end of forecasts, but long-term debt had nearly doubled to £582 million, the net debt figure rescued by cash balances up from £187 million to £500 million - the cash flow statement did not explain.

The leap in cash also meant a mismatch in trade payables – at £1,434 million outweighing trade creditors by a factor of 2.7x – was the only way Kier escaped a negative ratio of current assets to current liabilities.  Its last accounts to end-June showed this working capital imbalance at 2.6x times and the current ratio marginally in the red at 0.99.

So, while city forecasts implied the dividend was covered 1.7 times by earnings, and the total paid in respect of the last financial year has been 69.0p per share, Kier's balance sheet has looked exposed to any tightening in credit criteria.

Source: Company REFS             Past performance is not a guide to future performance

Speculative recovery case albeit a complex group

The directors appear determined to prove Kier is not "another Carillion", although the UK economic/political environment is out their hands.  There's another company-specific factor too: how Kier has been the classic acquisitive stockmarket vehicle with a gulf between reported and normalised earnings (see table), most of its directors being accountants; the kind liable for its engine to sputter or the odd wheel to come off, when the business cycle finally turns down.

You can't easily spot its problems in advance, but investors with experience over a few cycles know to beware.  For example, were any past acquisitions window-dressed financially, before sale?  All such become reality when an indebted parent plc meets with cyclical downturn.

Short sellers allege aggressive accounting – e.g. using a percentage of completion method on construction, where revenues booked may not align with cash flows, even to an extent of recognising unbilled revenues.  That professed cash flow figures are in truth much weaker, also joint venture debt bumps up true gearing.

£200 million operating profit target, albeit risky

The rights prospectus doesn't specify medium-term dividend payout prospects, instead a policy of "dividend cover about 5.0x underlying earnings per share" in respect of the current financial year and thereafter "2.5x underlying EPS."

That may be consistent with a broker projection for dividend per share of 36p in respect of the year to end-June 2020. Meanwhile, I'd target something like 25p in respect of the current financial year, though still a meaningful 5.6% yield around the current share price.

The board entertains £200 million operating profit for the year to end-June 2020, give or take £20 million, versus £160 million in the last financial year, and based on continuing operations.  Mind a plethora of risks attached, like whether the Brexit fiasco leads ultimately to a radical left government curtailing outsourcing, and/or EU nationals (a vital part of Kier's workforce) become harder to recruit.

Such uncertainties are more critical in a low-margin industry, making challenges harder to withstand.  I've previously drawn attention to Kier's 1.2% reported operating margin, or 3.4% before non-underlying items, which edged up to 3.6% in the last financial year.

Recovery case still possible, subject to timing

The deeply discounted rights issue, and volatile market price in response, suggests perception has tipped towards "last-chance saloon".  You take your chance amid this exceptional period of uncertainty for the UK. 

But even if Kier represents too high risk for you, it’s worth noting in terms of the credit cycle – which if genuinely turning down will have far wider significance.  A tougher financial climate is for a start, “finding out” those over-stretched groups.

It’s still possible a recovery case builds for this stock, at least on fundamentals because balance sheet risk has been mitigated, at least in the short term; and, technically, given Kier is London’s most-shorted stock with 13.9% out on loan, so the business need only stabilise for its stock to rise as shorts are closed out by repurchasing.

The question is, from what level, and about whether the UK environment gets worse.  But if Kier's "future proofing" is finally sealed by this rights issue, then the current phase around 420p offers the chance to lock in a fat yield with capital upside.  Speculative buy.

*Horizontal lines on charts represent levels of previous technical support and resistance. Trendlines are marked in red.

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