Stockwatch: why I’d still buy this recovery share
This share tip has returned over 40% in under a year, and the world’s largest asset manager is investing heavily in the sector. Analyst Edmond Jackson explains the outperformance and what might happen when annual results are published.
16th January 2024 11:49
by Edmond Jackson from interactive investor
Does a break above 70p – last seen on this £200 million small-cap share’s chart nearly three years ago – affirm an uptrend for infrastructure solutions group Costain Group (LSE:COST)?
Alternatively, is technical analysis of a contractor stock with an operating margin of 2% or so, mumbo-jumbo relative to the key fundamental issue: can Costain now avoid major or serial upsets with its contracts, which caused a 93% slump in its stock from around 450p in mid-2018 to a near 30p low in March 2020?
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Do not assume anything like similar scope for recovery, given dilution from a £100 million equity-raise in 2020 in support of partnering on contracts. Furthermore, £164 million cash recently cited on the year-end balance sheet implies scope for big distributions – at least until a modest pension fund deficit is resolved.
Broadly delivering on an investment case 10 months ago
I drew attention to Costain as a deep-value “buy” at 50p last March after reporting slightly better-than-expected 2022 results. While its history since 1865 has involved a substantial amount of housebuilding, it has morphed into civil engineering. For example, this century, the Channel Tunnel rail link with the modernisation of St Pancras station.
Activities divide between natural resources (water, nuclear process and oil & gas) and infrastructure (highways, rail and power). Whoever forms a majority government this year, there appears consensus around infrastructure being a key UK policy objective.
Admittedly, HS2 has involved controversy but there is the “energy trilemma” framework to deliver security (reliable access to sources), equity (affordable for all), and sustainability (minimising the impact of production/consumption on the environment). Britain aims to quadruple its nuclear power capacity by 2050.
The water industry is attracting its biggest investment for decades after the privatised companies have been pinballed by the media for shortcomings, and regulators responded.
Admittedly, part of my rationale back then was a one-year chart breakout versus a sea of red ink in stocks elsewhere. As to fundamentals: revenue was up 21% to £1,421 million with net profit near £26 million, ahead of £24 million consensus, although the overall order book was down 18% to £2.8 billion.
Last August I reiterated “buy” at 53p relative to end-June net tangible assets of 59p a share, suggesting scope to double on a two-year view if the price/earnings (PE) multiple can improve to eight to 10 times.
Source: TradingView. Past performance is not a guide to future performance.
Scope to continue improving from a six times PE
A 10 January update has affirmed financials “in-line”, which in terms of consensus implies a near 4% reduction in revenue to £1,370 million, although a near 11% increase in earnings per share (EPS) means better margin. A further 8% reduction in revenue to £1,263 million is currently targeted for 2024, with normalised EPS up 7% to 11.5p.
It implies a forward PE multiple of 6.3x with the stock currently 72p. However, if the dividend grows from consensus for 1.1p then 1.3p this year, the yield is barely over 2%.
Medium-term sentiment therefore hinges on whether Costain has moved on from past slip-ups. That could be a tad subjective: can good management achieve this, or is inherent risk in infrastructure-related contracting out of their control?
Losses from 2019 to 2021 were as much a conflation of project-related issues as shutdowns related to Covid: delays to the award of the HS2 southern section construction contract, the M6 smart motorway project and a road in Preston. The Welsh government also cancelled a £1.4 billion contract on the M4 near Newport. Dividends were therefore cancelled from 2020, also to prioritise pension payments, which resumed with 0.4p a share in respect of the first half of 2023.
Costain Group - financial summary
year end 31 Dec
| 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | |
| 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 |
| Capex/share (p) | 1.7 | 1.1 | 5.7 | 1.9 | 0.8 | 0.2 |
| 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 |
| Cash (£m) | 249 | 189 | 181 | 151 | 159 | 124 |
| 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.
When the stock traded down at 40p, on a forward PE more like four times, enough investors felt they simply did not want exposure to low-margin contracting after various project setbacks.
Newsflow has more recently appeared more settled and progressive, potentially reflecting the maturity of initiatives of a new CEO appointed in May 2019. He has, however, been the executive board since 2006 and drove Costain’s transformation into a smart infrastructure solutions business via consultancy and technology services.
Water industry infrastructure upgrades add an element of “something new” and comparatively lower risk, seemingly involving less chance for disruption than major transport projects.
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The 10 January update included a framework agreement with Northumbria Water over 12 years “with a potential value of up to £670 million”. Mind, that represents revenue, but margin is not disclosed and may need careful management to ensure decent profit.
The overall prognosis therefore seems good: “our cash performance has been very strong, driven by continued improved operational performance...” as if management has improved its act.
Outside their control, you still have to figure out the probability of project setback. A shift to smaller ones ought in principle to result in less earnings variability and risk of disruption.
Notwithstanding general market volatility there looks to be a decent chance the stock continues broadly to recover. Management should nowadays be alert to mitigating risks and how they became financially cornered three years ago.
Dividends still compromised by pension deficit
Expected earnings cover looks huge at 10x and net cash of £164 million compares with a £200 million market value. But if the pension fund deficit is still around £25 million, then dividends cannot exceed pension contributions without triggering a top-up.
It appears the board is well aware to avert this, given consensus for the total 2023 dividend has dropped from 1.63p (that would have cost £4.5 million, still plenty short of £7.4 million total expected, annual pension contributions) to 1.13p.
More dramatically in respect of 2024, this year’s potential payout seems to have been guided down from 3.2p to 1.3p given the near £9 million cost would have triggered nearly £6 million extra for the pension fund.
It will therefore be interesting and relevant to see what the annual results for 2023 say when they’re published on 12 March, about modelling on when these top-ups are likely to complete. This requires 101% funding where it appeared 97% the last time it was mentioned.
Strong cash performance by the business, helped by continued operational improvements and useful working capital movements, would seem to bring forward the date when Costain can remove this impediment to better distributions. End-December net cash soaring from £124 million to over £164 million has been significantly higher than market expectations.
BlackRock continues to accumulate in the sector
The world’s largest asset manager is acquiring Global Infrastructure Partners for nearly £10 billion equivalent, taking its total infrastructure asset exposure to near £120 billion – from US liquefied natural gas export to French wastewater services and airports in England (Gatwick) and Australia.
BlackRock’s CEO describes infrastructure as “one of the most exciting long-term investment opportunities, as a number of structural shifts re-shape the global economy”. It should therefore provide a fair tailwind also for project developers and ongoing services.
Possibly, there’s a consolidation phase following the latest rise from 63p following the positive update, and market volatility generally might result in a better buying price – quite like the stock’s modest roller coaster through 2023. But if the March results reinforce a “recovery-to-growth” story, it seems likely buyers than profit-takers will prevail. Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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