Shares in maintenance provider Costain (LON:COST) have sunk almost 40% in early trading today after the company issued an update which warned that revenues and underlying profits this year will be below previous expectations owing to contract delays.
The share price reaction was large, and an already cheap share has gotten even cheaper:
The contracting sector, particularly those working on large government contracts has been suffering from a general investment malaise ever since Carillion went under. In more recent times, we’ve seen large companies like Capita destroy much of their shareholder value, as well as groups such as Kier suffer massively.
In many cases the issues seem to be similar: big lumpy contracts and unforeseen circumstances affecting profits. This has not been helped by the general macroeconomic picture, where a looming Brexit and spending discipline has seen a varied amount of appetite from the government to complete some of its marquee projects.
Underscoring this is the nature of the industry: to some extent many of the contractors are played off against each other as contracts are tendered, and operating margins are very thin as a result. Therefore the bottom line is quite sensitive to a large deviation from the plan. In the case of Carillion, it was simply unable to keep the mistakes rolling forward and collapsed under its own weight.
This comes in a trading update RNS. First the good news.
Trading on current contracts during the first half has overall been in line with expectations. New orders secured in the first six months of this year include the A19 improvement contract and long term AMP7 awards for Severn Trent Water, United Utilities and Yorkshire Water which have strengthened the Group’s position in the water market.
This is reassuring in some ways. They have also mentioned that the bulk of revenues for FY2019 and FY2020 are secured. Onto the bad:
However, the Group has recently seen a number of delays to the timing of contract start dates and new awards. Projects affected include the M6 Smart Motorway, Preston distributor road and HS2 Southern Section main works. Additionally, the M4 Corridor around Newport project was cancelled by the Welsh Government earlier this month. Consequently, revenue for FY2019 will be lower than previously anticipated and underlying operating profit for the full year is expected to be in the range of £38.0 million to £42.0 million.
This appears to be a large miss: underlying operating profit for the last year was £52.5m and a marginal increase was expected. Therefore the miss seems commensurate with the price drop today.
There is also a material item which will affect the statutory but not underlying profit measure:
The H12019 results will include a one-off charge of £9.8 million in respect of a recent arbitration award in favour of Diamond Light Source Limited for the cost of remedial works deemed required to the roof at the National Synchrotron facility which was completed in August 2006.
First of all, it is clear that Costain is not the basket-case that some other contracting companies have become. These results point to either a decent management or a decent market for their products:
This could be a bit of both. Margins however, show the same low figures common across the industry, around 2%. Cashflows are volatile in the sector: no surprise when revenues and expenses can be lumpy. This results in some years where money flows out of the business in a big way, and some years where the opposite happens, big swings. There is an inherent danger that too many bad things happening stretches the company past its debt limits. When this happens either more debt is taken on, or an equity raise is required. This happened recently at Kier, although this option becomes harder the further the share price drops.
This is not so much of a problem for Costain, and they have run up a large cash balance in excess of £100m. This isn’t entirely reliable as the accounts are merely a snapshot of one date, but the trading update points out that average monthly year end cash was £65m. Cashflow swings here can be large, although the bulk of it is working capital movements.
There is also some pension related issues here, as the accounts point out:
The pension deficit on the balance sheet has made somewhat of a heroic recovery over the years, from over £70m in 2016 to just over £4m in the latest set of accounts. This seems to have been driven mainly by a marked decrease in the projected liabilities, in turn assumes that projected living ages have slightly decreased. This seems rather optimistic in the long-term, so it could be the case that this figure moves up again.
Either way, the cost to the company currently is expensive: a £9.6m charge, which has to match the dividend. Last year dividends totalled £13.7m, so the charge is pretty hefty relative to profit, and will be again this year should the dividend be held.
This is a bit of a mixed bag. As always, we can ask what is the nature of the profit warning? It seems that this is less to do with the company and more to do with temporal factors. It is perhaps understandable that delays to new contracts have occurred given the current political climate, and these will resume (and perhaps more things being built) after this is cleared up.
It is also fair to say that Costain enjoys a more robust balance sheet than others in the sector. It is not riddled with debt, and its cash position should be able to see out any short-term wobbles, unless things get worse.
It also has its fingers in many pies, from Infrastructure (roads, railways etc) to power generation. This adds a manner of diversification. The ‘Leading Edge’ strategy aims to add more differentiation, and that can only be good for the company as these types of projects for the moment enjoy higher margins.
On the downside, it currently has a lot of contracts on thin margins. The share price is almost pricing in that another event may occur with them. The pension issue has committed a lot of cash away from the business, and by mandating that it has to meet the same level of the dividend puts pressure on the business on a reduced level of profit. With a current forward yield of 8% it seems reasonable to assume that this will be cut, but the contribution will still remain high.
I reckon this is priced attractively enough on balance. The share price has plummeted more than half since the start of the year, and if the problems are ironed out it could get back there. The downsides are if it does not, in which case this could stagnate at lower levels. With other contractors currently on portfolio this rules out a buy just now. 4/5.