Shares in housebuilder/constructor Galliford Try (LON:GFRD) tanked 25% on Tuesday as further problems to its construction projects has meant cost overruns eat into profits. The share price action was immediate and sustained:
As in common with many companies offering profit warnings nowadays, this does not show the extent of the destruction of value for shareholders, and the price has been on a roller-coaster ride for the past few years, with the shares over 1800p a few years back. Today’s drop still puts it comfortably above the lows seen in the past recession.
Galliford should be well-known to most despite being a member of the FTSE250. It operates many high-profile construction projects as well as building homes, having being highly acquisitive. It is the construction division that has given it plenty of headaches over the past couple of years, with the fallout from Carillion. It needed to raise a fresh £150m in funds last year as a result.
The warning comes in an RNS entitled ‘Operational Update’. We begin:
Galliford Try plc, the housebuilding, regeneration and construction group, announces that it is undertaking a strategic review of its Construction business.
The review will reduce the size of the Construction business, focusing on its key strengths in markets and sectors with sustainable prospects for profitability and growth, where we have a track record of success.
This comes as no surprise. Perhaps this is leading us on to the specifics:
The Board anticipates that this review will result in reduced profitability in the current year reflecting a reassessment of positions in legacy and some current contracts and the effect of some recent adverse settlements, as well as the costs of the restructure. The single largest element relates to the Queensferry Crossing joint venture, which has recently increased its estimated final costs on the project.
This is terrible news, and one that shareholders will be all-too familiar with, as the company had disclosed as recently as November that another contract was impaired in a similar way. So what is the damage this time?
The Board expects that the outcome of this assessment will reduce the Group’s full year post-exceptional profit before tax by £30m-£40m below the current consensus analysts’ forecast1. The majority of our construction businesses continue to perform well, and these adjustments are not expected to have a significant impact on the Group’s previous guidance on average net debt for the year.
Unlike other housebuilders this amount of cash is likely to be significant: 2018 operating profits came in at £147m.
Galliford Try’s business is quite easy to understand: it is split into roughly into three divisions offering building homes, redevelopments and construction. In terms of revenue, construction is by far the largest, delivering over half of revenues. This is no surprise considering the scale of contracts it takes on, which tend to be extremely large and complex.
There is no real hiding that construction is a much lower margin business than building homes. The metrics for margins are here (taken from Stockopedia, most recent year on the right):
This compares to close to 20% for home-only operations. As we can see, Galliford’s home-building division (Linden Homes) does deliver this type of margin (19.5% in the last year), but this is dragged down by the others: Partnerships has a margin of around 5%, and Construction barely creeps above 0% and is actually negative once exceptionals are factored in.
It is already known that this division is the real problem child, and has had an adverse effect on the balance sheet. Cash has increased here, but so has net debt, which isn’t a great thing in an industry where many players are building up this balance in preparation for turbulence ahead. The equity raise of last year allowed the company to move back into a net cash position but that is anticipated to be used up thanks to the recent problems.
Perhaps talking about the construction problems are irrelevant now, because the company has signalled its intent to reduce its exposure to this side of the business. That is too late to avoid the current problems, for which it will be committed to sort out, but may avoid a similar situation in the future.
One of the key differences between this and Carillion/Interserve is that the company is not indebted to the extent where the whole company is at risk. Finance costs were £17.7m in the past year, and profits after tax were £118m. On the cashflow statement though, this was not as rosy:
The company is paying out something like £75m in dividends per year, which in the last year has not been covered by free cash. We can see from the working capital movements that the working capital movement has been adverse, perhaps as a result of the construction problems. In the future year this may become even more apparent, as the hit to profit eats into the bottom line. As we also can see, there is a fair-sized pension deficit, although this looks manageable.
So whilst the current troubles do not look like troubling the company in the longer-term, it does not seem very likely that dividend payouts of £76m will be able to continue. At this level, the market is signalling that the yield on this share in excess of 13%, and quite often that is a signal that this might not be sustainable. The level of dividend was trimmed 10% in November on the back of a similar warning, and although not mentioned here, looks set to fall again.
This is quite a classic scenario about the dangers of construction companies. As we have seen with Keller large contracts are often problematic because there a price is fixed upfront but cost-overruns can eat into profit. With profits so thin, this means often taking a loss in order to deliver.
The origins are in putting in low bids to get work, but failing to deliver can get companies into real problems. The nature of these complex projects mean that even small problems can prove to be very expensive. And ultimately it is the investors that suffer, either by dilution or the company increasing debt and risks.
Galliford becomes more interesting however, because there is a profitable housebuilder inside the group of companies. From the accounts, Linden Homes delivered £137m of its £143m profits before tax. The market cap of the company is now approximately £600m so either this is massively undervalued, or more likely the market is ascribing a negative value to the rest of the business. The shares trading below net asset value is further indication of this.
Sadly there is no real way for Galliford to immediately step away and winding down contracts may take some time, blighting the accounts with impairments and exceptional costs. Credibility is also an issue here, with somehow these issues not being on the table in November, but suddenly becoming apparent today.
There may be scope for a turnaround here, but with many other home-builders in better shape financially I would prefer to shop elsewhere. 2/5