Reassuring interim results from “sustainable infrastructure group” Costain Group (LSE:COST) have raised its small-cap stock from around 45p a week ago, to 53p currently.
This represents a forward price to earnings (PE) below five times, assuming consensus for around £29 million net profit this year and £31 million in 2024, implying normalised earnings per share (EPS) of 10.7p rising to 11.5p. Market capitalisation is a relatively modest £144 million.
Concerns linger, how low-ish margin contracting can see profits disrupted by setbacks; yet management stresses it has diversified the service and customer base well.
Also, dividend growth is liable to be compromised in the next few years by agreement with pension trustees to make a similar payment into the fund.
End-June net tangible assets of 59p a share does, however, limit downside risk, and despite renewed recessionary fears, Costain says discussions with the Labour Party indicate a similar pattern of infrastructure spending as the current government should there be change at the next election.
I am interested to see how progress compares with my “buy” stance at 48p last March, with a rationale of a return to profits and dividends, with an aspect of margin of safety given end-2022 net tangible assets of 73.5p a share.
CEO: ‘definitely on the road to where we want to be’
All milestones – profit, cash and margins – are being achieved, despite flat interim revenue around £665 million. IT investment and a “transformation programme” clip the normalised operating profit gain from £15.0 million to £7.6 million reported; likewise, the margin from 2.3% to 1.1%.
So, if these are real costs of maintaining the business, it remains low-margin. Management contends its transformation will mean an adjusted margin of 3.5% in 2024, then 4.5% during 2025, helped by higher-margin contracts.
The natural resources division (27% of revenue) has at least enjoyed a margin jump from 1.5% to 4.2%, although transportation (73% of revenue) saw its slip from 3.2% to 2.5%.
Road revenue has eased 16% as projects got re-phased and re-scoped, with management citing challenges with the Department of Transport (amid tighter funding). New smart motorways are being scrapped due to financial pressures and low confidence among drivers.
Rail advanced 18% chiefly due to work on the southern section of HS2. Upgrading Gatwick Airport rail station continues and work has expanded with Network Rail.
Despite an 11% first-half-year fall in the order book to £2.5 billion, they say it reflects special factors such as timing, hence is not being a complete guide to revenue. The second half is expected to be broadly similar to the first.
Dividend matching with pension fund contributions to March 2027
This recent triennial agreement with pension trustees – of £3.3 million (plus CPI inflation) – replaces near £12 million annually.
The board is thus considering a similar dividend payout, which implies near 1.3p a share (my estimate versus recent consensus for 1.7p, rising to 2.3p in 2024). It implies only a modest 2.5% yield, and while they say they will consider paying out more according to future cash flow, the pension fund agreement demands the same by way of annual contribution.
It appears compromising for the next three to four years although the logic of “pension funding currently 97% and contributions stop if/when funding reaches 101%” implies that this will happen sooner if contributions are greater. Not as if dividend growth implies shareholder value will be ceded to the pension fund.
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An irony of pension fund accounting is such deficit payments are required to address a £25 million deficit, despite it being represented on the end-June balance sheet as a near £60 million asset.
Otherwise, the cash flow statement shows a 22% increase in operational cash flow (before working capital changes) to £21 million; and the net basis has moved from a £20 million outflow to £18 million generated.
The fact that bank facilities have been renewed for another three years – adding NatWest – conveys financial confidence.
Overall strong balance sheet context
Within net tangible assets of £164 million equivalent to 59p a share, there was £132 million cash and there is no debt beyond £24 million lease liabilities, which generated a £2 million expense – albeit offset by £3 million interest on cash.
Some will say, a market cap nearly covered by cash implies the business “in for free” but there is a chief liability of £243 million trade payables versus £193 million trade receivables. The ratio of current assets to current liabilities is satisfactory near 1.4 times.
It means that despite the nuisance pension fund contributions, Costain should not be compromised for investment, although a strong cash base is likely a pre-requisite customers will want to see as part of agreeing contracts.
Costain Group - financial summary
Year end 31 Dec
|Turnover (£ million)||1,684||1,464||1,156||978||1,135||1,421|
|Operating margin (%)||2.8||3.0||-0.3||-9.4||-0.8||2.5|
|Operating profit (£m)||47.5||43.4||-2.9||-91.8||-9.5||35|
|Net profit (£m)||33||33||-2.9||-78.0||-5.8||25.9|
|Reported EPS (p)||27.1||26.8||-2.4||-36.7||-2.1||9.4|
|Normalised EPS (p)||27.1||35.2||16.1||-31.2||-2.1||9.4|
|Operating cashflow/share (p)||42.8||-39.2||-26.5||-22.1||10.7||5.1|
|Free cashflow/share (p)||41.1||-40.3||-32.2||-24.0||9.9||4.9|
|Ordinary dividend per share (p)||12.4||13.4||3.4||0.0||0.0||0.0|
|Covered by earnings (x)||2.2||2.0||-0.7||0.0||0.0||0.0|
|Return on total capital (%)||19.8||17.5||-1.3||-41.1||-3.8||15.1|
|Net debt (£m)||-178||-119||-34.9||-70.8||-93.2||-99.7|
|Net assets/share (p)||129||151||129||56.9||72.4||76.8|
Source: historic company REFS and company accounts
Potential to climb a wall of worry over recession
Fears have re-appeared this week after a UK purchasing managers’ index contracted for the first time since January – as if higher interest rates are finally bearing down on the economy.
S&P Global – what used to be known as the Standard & Poor’s credit ratings agency – offers no better hope for the international context, suggesting the eurozone is in even worse shape, China is slowing and the US faces recession.
How many times have we heard such claims and yet economies have muddled through?
Financial markets will also have a positive angle: the bad news at least means we are at peak interest rates; central banks are now more likely to wait and see what happens.
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Governments’ post-pandemic fiscal challenges mean an aspect of tighter spending on infrastructure (like Costain’s narrative reveals), yet it offers quite a bulwark against recession in mixed economies, and is likely to feature in the next UK general election debate.
Costain cites various factors in favour of infrastructure renewal: the impact of climate change, higher population and demand for economic growth; which drives demand for improved services, especially water, for example, to limit sewage discharges.
It sees no need to diversify abroad given its strength of customer relations and scope for ongoing investment.
Unless the UK falls into serious downturn, I therefore think Costain stands a fair chance of delivery on its transformation plan, with consequent EPS and cash benefits, even though 167 million shares issued at 60p in May 2020 has compromised EPS recovery into a 20p to 30p range like in 2017-18.
Scope to double on a two-year view
Most likely, the market is yet to shake off memories of 2019 when results slid due to contract delays, a cancellation and arbitration.
Despite ongoing risks in contracting, I incline to give the CEO since May 2019 the benefit of the doubt, his transformation programme improves Costain’s overall economic and risk profile.
Government re-phasing of transport spending, and a medium-term check on dividend growth are somewhat compromising – but not of overall attractions in the risk/reward profile.
If the PE multiple can improve to eight to 10 times, over the next two years, the stock can double. I therefore retain: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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