Stockwatch: serious upside potential at this small-cap

Can talk from the management of Costain Group (LSE:COST) about doubling its operating margin to around 5% be taken seriously? It is the crux for the small-cap shares in this infrastructure group serving transportation and resources – especially water industries.

Since I drew attention as a deep value “buy” at 50p in March 2023, following better-than-expected 2023 results, the stock has doubled to 105p. I re-iterated “buy” at 53p last August after interims and at 72p last January. The market appeared over-cautious – a 12-month forward price/earnings (PE) multiple as low as five, that has risen to about eight times – despite Costain being strategically well-positioned as Britain tries to improve infrastructure.

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This new Labour government is fiscally constrained yet infrastructure spending is going to be a key element in its electoral pledge to deliver growth. Today brings news that it is seeking to adjust the measure of national debt, so that investment spending is not included.

The stock has climbed a wall of worry, how big infrastructure projects can end up in over-spend and acrimony. Over five years ago, Costain’s A465 road project in Wales ended up two years late amid engineering and contractual challenges. There was then the disruption of Covid.

Costain’s CEO since May 2019 contends that there is nowadays a broader customer and service mix. Financially and also limiting downside risk, I note the 30 June balance sheet was absent of debt and had net tangible assets of 65p a share. Achieving this was helped by a May 2020 issue of 167 million shares at 60p, the current total being 278 million. In which case, the five-year chart suggests Costain has effectively just regained its February 2020 value:

Source: interactive investor. Past performance is not a guide to future performance.

In 2018 it traded over 400p hence 200p or so nowadays would mark recovery to the old high.

Scope to re-rate margin is the crux issue going forward  

The table since 2017 shows the highest achieved – in terms of reported operating margin – has been 3.0% and for this score I have looked back to 2012 when it was 1.8%, rising to 2.5% in 2013. This is quite as you would expect in a competitive tendering industry.

Peer group Kier Group (LSE:KIE), for example, similarly had its best operating margin in its June 2018 year at 3.1% and, since Covid, has managed to deliver only 2.4%.

Costain Group - financial summary
year end 31 Dec

Source: historic company REFS and company accounts

Costain proclaims it can raise operating margins towards 5%, hence would transform profit on, say, £1.4 billion revenue – considering there is no interest charge, instead, net interest from £166 million cash. The capitalisation around 105p currently is £290 million.

Care is needed swallowing such a claim, given management will be talking of an adjusted, not reported, margin; although Costain also says it is expecting exceptional and restructuring-type charges to tail off in 2025. For now, the latest interims to 30 June proclaim an adjusted margin of 2.5%, while the income statement computes at 2.2%, hence no major discrepancy.

Within the two main divisions: transportation-related works were on a a 3.1% adjusted margin on £444 million revenue, while natural resources’ work achieved a better 4.3% on £195 million revenue, possibly the water industry has helped - revenue up 12% - although the relatively smaller defence and nuclear is up 16% also.

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The financial summary table shows scant capital expenditure required over the years; but implicitly something radical needs to happen within administrative expenses that eased from 5.0% of 2023 interim revenue to 4.8% in 2024. How practical is it, to grind them materially lower?

Competitive pitching on contracts’ price is not going away, unless Costain can demonstrate more effective work, worth paying more for. Government and utilities seem likely be price-conscious. Yet Costain’s CEO has put his neck on the block, saying he can nearly double the group operating margin.

Mind, his referencing a 3.5% margin this year means the run-rate – which could imply exiting 2024 at such a level, than delivering with the annual results.

The dynamics of Costain’s income statement are such that a reported interim net profit of £13.5 million can be outstripped in the second half, hence £30 million or more, plenty achievable for the full year. In which case, earnings per share (EPS) around 12p with scope to double by 2026 if the CEO delivers on margin. If realistic, this share is on a mid-single-digit forward P/E like it was around 50p.

Not to fret overly on margin but make clear, buyers on such hope are trusting management.

‘Strategy of the past years has built momentum’

Again, is the CEO’s pitch versus interim group revenue easing 4% amid a small fall in the main transportation side versus growth in natural resources. Such a contractor is always going to be “lumpier” than, say, a licensing business with majority recurring revenues, so I would not read much into an interim slip.

He contends, a significant volume of high-quality work has been secured in the first half and the group order book is three times revenue. In a presentation he has hinted at more announcements due in the second half.

Over £500 million work has been awarded from the water industry in the last two months, and this sector is seen as offering the best growth opportunity over the next few years. Indeed, public controversy persists over water quality, sewage spillages and so on, with utilities under pressure – from the new government also - to improve.

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This helps counter concern over how Labour’s new chancellor has axed some infrastructure projects after a spending audit located nearly £800 million unfunded transport projects. After experiencing cancellation on parts of the HS2 rail link, in 2022 Costain won £60 million work for the £1.7 billion road tunnel under Stonehenge – now put on hold. This is modest, however, in context of a £4.3 billion order book which has moved on from risky fixed-price construction contracts.

Modest dividend yield albeit £10 million share buyback scheme

It appears that buybacks to March 2025 are an alternative means of delivering shareholder return than materially raising the dividend, where a parity arrangement exists with contributions to the pension scheme.

From a question at the interim results’ presentation, the chief financial officer said this parity matter will be reviewed next March, but hopefully will not persist and the board considers it very important to return to a progressive dividend policy.

Meanwhile, it looks as if earnings cover for the dividend could end up as high as 10x this year alone – so if the operating margin is raised then dividends over 5p a share (as in previous years but respecting dilution) would provide a more material yield in due course.

With a robust cash flow profile (albeit interim net operating cash flow down 20% at £14 million) management says it is also seeking acquisitions. If proving attractive then they ought to help sustain interest in the stock besides contract wins.

Shifts from ‘deep value’ to a more speculative ‘buy’

Costain’s financial profile has overall become less risky and I regard the stock as at least a strong “hold”. In a relatively tight market, it has been teased up from an 80p range since last spring to a week ago, as buyers react to upside potential towards 150p and more – if operating margins around 5% can be delivered.  

On an enterprising view I maintain a “buy” rating; but please respect that this involves an aspect of speculation rather than a disciplined investment approach based on “margin of safety”.

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