Interactive Investor

Stockwatch: why I like this deep value play

17th March 2023 10:34

by Edmond Jackson from interactive investor

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This small company looks better placed than it has for some time, and if the UK does indeed avoid recession, its shares look cheap, believes analyst Edmond Jackson.

Excitement over a stock 600

On the bright side of stock market slumps, it is always intriguing to see which gilded minority manage some rise – as a signal where valuation and the business are deemed to be attractive. 

Perhaps the mid-March 2023 prize should go to Costain Group (LSE:COST), a small-cap infrastructure engineering services group. As the FTSE 100 probed a 4% loss on Wednesday, Costain jumped over 10% from 48p after reporting slightly better than expected 2022 results.  

This marked a one-year chart break-out, a real achievement amid a sea of red ink, as if confirming enough investors are firmly convinced as to its value. 

The group nowadays involves two main divisions: transportation, serving road and rail; and natural resources, serving water, energy and defence. On the face of it, such industries should be medium-term resilient, enjoying investment whether from government trying to promote growth or private company operators justifying their ownership. Given that such commitments may be for years, they might be less affected by talk of a UK recession. 

Looking back to 2009 for example, Costain made £21 million operating profit on £1,016 million revenue, which advanced to more than £29 million in 2010 amid various five-year contracts and repeat-order customers constituting over 80% of the order book. 

The dilemma for investors is shown 12 years later, by numbers that have not massively advanced and where a contract dispute followed by Covid meant three years of losses and a substantially dilutive equity issue. 

Such is the risk where contractors’ margins are slim, hence concern in the last year or so is how inflation would be compromising. Yet last July’s interim results asserted how inflation was being built into contracts and 2022 annual revenue was still guided upwards. 

Costain Group - financial summary
Year end 31 Dec

Turnover (£ million)1,6841,4641,1569781,1351,421
Operating margin (%)2.83.0-0.3-9.4-0.82.5
Operating profit (£m)47.543.4-2.9-91.8-9.535
Net profit (£m)3333-2.9-78.0-5.825.9
Reported EPS (p)27.126.8-2.4-36.7-2.19.4
Normalised EPS (p)
Operating cashflow/share (p)42.8-39.2-26.5-
Capex/share (p)
Free cashflow/share (p)41.1-40.3-32.2-
Ordinary dividend per share (p)12.413.
Covered by earnings (x)2.22.0-
Return on total capital (%)19.817.5-1.3-41.1-3.815.1
Cash (£m)249189181151159124
Net debt (£m)-178-119-34.9-70.8-93.2-99.7
Net assets/share (p)12915112956.972.476.8

Source: historic company REFS and company accounts

Management’s latest pitch is for margins to improve 

It is probably the crux reason why the stock rose in a sea of red ink. At around 50p a share, Costain is a sub-£140 million company achieving revenue of over £1 billion, so if higher margins are genuinely realistic it can leverage profit – assuming no other disruptions. 

Indeed, revenue is up a very respectable 21% to £1,421 million, with net profit near £26 million versus consensus estimates for around £24 million. Contracting can be lumpy, however, and while the “preferred” bidder book is up 78% to £1.6 billion, the overall order book is down 18% to £2.8 billion. 

The company said: “Costain has effectively negotiated the challenges of material availability and inflation, as well as delays to some contract awards, delivering a robust operational performance. We expect to increase margins as we enact further operational improvements in the business during 2023 and beyond, and as we continue to grow the scale of our consultancy services.” 

There is scope to doubt this given competition for contracting, and also Costain’s track record generally showing a margin ceiling of 3% at the operating level. Perhaps the CEO since 2019 is making a difference. 

If the 2.5% operating margin achieved last year improves say to 3.0% then on around £1.3 billion revenue it implies operating profit rises from £35 million to £39 million. A 3.5% margin equals profit of over £45 million. While the balance sheet has £24 million lease liabilities, there is no financial debt to weigh on profit. 

Inflation-pegged pension contributions are only nuisance element  

While the end-2022 balance sheet classed a £60 million “retirement benefit asset” among non-current assets, it has required well over £10 million annual cash contributions in the last two years – a third of net profit in a decent year.  

Looking back to the 2019 accounts, the scheme pivoted from deficit to surplus – albeit linked to a liability reduction according to more recent mortality tables.  

Given an arrangement with pension fund trustees to inflation-proof contributions through to 2029, there is the prospect of a rise to £11.9 million this year.  

It seems odd how such a material element is not reflected in the cash flow statement, which on the financing side cites only repayment of leases and loans. But the annual cash contribution is plain from the “Pensions” section of the Financial Review. 

This may compromise an otherwise strong net asset value 

At first sight, end-2022 net tangible assets were £159 million or 73.5p a share - implying a 32% discount in the stock price, even after it has improved from a 33p low last July. 

It appears to convey a classic “margin of safety” limiting downside risk, say to tuck the stock away in an ISA or SIPP – taking advantage of the tax-free wrapper. Management could get lucky with contracts and margins, and price re-rates. 

But if this pension fund is effectively a millstone, subtracting it leaves £99 million net tangible assets or 36p a share. Moreover, and although I am not an accountant, it seems common sense to me that this pension fund agreement is effectively a contingent liability and should be represented on the balance sheet as such. A hard-line view might be that Costain should derive a net present value for the payments to 2029 and slap that on long-term liabilities. 

Anyway, I just posit another reason to explain why, besides low margins and potential risks of contracting projects running into “issues”, that this stock has for years appeared to trade at a discount to balance sheet net asset value (NAV).    

Otherwise, and despite cash down 22% on the year to £124 million, it constitutes 87% of market value. 

Mind that while trade payables exceed trade receivables only by a moderate 125% - at £233 million and £187 million respectively – their movement was unhelpful. Trade payables rose 8% while trade receivables slipped 6%, which can appear like benefiting profit. 

Consensus for steadily rising profit and a return to dividends 

While a 6% targeted fall in revenue to near £1.3 billion rather aligns with the order book, net profit is expected to advance from £26 million to £29 million this year, then to £32 million in 2023. 

It implies a price/earnings (PE) multiple dropping from a seemingly already cheap five times on a trailing basis, to nearer four times with earnings per share (EPS) rising to over 11p. 

Moreover, a return to dividends is expected this year, with 2.9p a share targeted to rise to 3.4p in 2024. If made, it implies a circa 6% yield. 

So unless a UK recession was indeed to disrupt Costain, its stock looks cheap against the company appearing better-placed than for some time. 

I can however empathise how analysts might have fudged a steadily-improving scenario. You sense the business on an improving trend but are cautious at what googlies the contracting industry can bowl. So you target a steady rise. Mind how the reality of Costain’s record has been more volatile. 

Directors share buying has been sporadic

Buying by four directors has been small-scale, from 64p in April 2021, albeit foreshadowing Costain’s turnaround into profit. After a 20,000 shares’ buy at 55.8p that November by a new non-executive director, there was no trading until a year later the CEO acquired a modest 4,534 shares at 35.9p. 

With Baroness Rock assuming chair of the board as a non-executive director since 2020, she purchased 50,000 shares at 38.5p last December – albeit as a maiden holding.  

Non-executive directors are anyway expected to hold shares. 

More interesting perhaps is the 15% stake held by ASGC Construction LLC – a Dubai-based construction conglomerate which has pursued vertical integration since founding in 1989. This derived from a placing and open offer of a total 167 million shares at 60p nearly three years ago and appears friendly. It does however invite speculation that if Costain is finally achieving sustained improvement then now is the time to buy the entire business. 

For investors who appreciate the risks in contracting: Buy. 

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

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