Costain Group PLC (LSE:COST, Financial) is a small-cap industrials sector company providing construction and consulting services to the United Kingdom's energy, water, transportation and defense markets.
Based on historical ratios, past financial performance and analysts' future earnings projections, the GF Value rates the stock as modestly undervalued.
The company also has a reasonable Piotroski F-Score of 6 out of 9 and an Altman Z-Score of 2.6.
It is fair to say that construction companies often operate on thin margins in a cyclical market. Costs can be difficult to control quickly when downturns begin. Sometimes, a race to the bottom in pricing occurs, which can lead to inadequate risk pricing. Working on complex projects means making uncertain judgements about the price and availability of needed resources and logistics well in advance. In short, it is difficult to have a competitive advantage in this sector.
Costain is a case study of the equity destruction that can happen when these risks are not managed properly. The share price declined 90% in four years due to problem contracts leading to repeated losses. Between 2019 and 2021, the company recorded more than 150 million pounds ($173.1 million) of charges, including provisions related to a contract to build gas compressors for National Grid (NGG, Financial), a road project for the Welsh government and remedial work on a national science facility. This mean a 100 million-pound equity raise was needed in 2020 to boost its balance sheet.
Now, though, things are turning up. Costain reported a 42% increase in first-half pre-tax profit to 11.2 million pounds last week, and it made a final payment of 48 million pounds to settle the National Grid problem.
In the earnings presentation, CEO Alex Vaughan said Costain is taking a more prudent approach to selecting contracts it signs “to better reflect the balance of risk and reward.”
Its order book at the end of the first half was 2.7 billion pounds, down 20% since 2021’s year-end and down from the 4 billion pounds seen a year ago. This is more about timing as Costain expects to bid on more major projects between now and June 2023. This order book also excludes about 800 million pounds of deals on which it is the preferred bidder and wins on about 50 secured higher-margin consulting and digital services projects which “will yield meaningful revenue.”
Restructuring
Costain has reconfigured its business in the last couple of years to go for areas of the construction market that are less volatile. This should reduce risk and make revenue more stable going forward. The company now targets transportation, water, energy and defense. These sectors have spending supported either by government or regulatory commitments. They also give steady, multiyear projects to upgrade and maintain networks, as well as opportunity to work on massive projects such as the “HS2” high-speed railway linking London to the north of England.
Competitor Balfour Beatty (LSE:BBY, Financial) was recently discussing the potential for a decade of growth for infrastructure investment in the U.K., so this provides a great opportunity set for Costain as it is one of only a few construction companies with the scale to service the U.K. government’s big plans.
Valuation
Costain trades on a price-book ratio of just 0.5. This is due to the pandemic, governmental changes in the U.K. and sectoral de-rating.
Take away the 96 million pounds net cash on the group’s balance sheet, and the market currently gives the business just a 17 million pounds enterprise value. This is for a business with decades of project delivery experience and annual revenues of more than 1 billion pounds! It looks very cheap. The stock trades on an enterprise value-to-forward Ebitda ratio of just 0.85 and a price-to-projected free cash flow ratio of 0.65.
Of course, U.K. investors are known for obsessing over profits and dividends, so ultimately it is going to be profitability that will move the needle on the stock price. However, a less risky order book should result in profits. The first-half adjusted operating margin was flat at 2.1%. However, management said it can get to 6% to 7%. A mix of contracts with “complex program delivery” that get margins of up to 5% and consulting and digital technology projects with margins of up to 10% will average at the 6% to 7% rate.
Greater attention to costs will be key here. Last year, Costain managed to cut 12 million pounds, but this can increase to 20 million pounds by the end of 2024. If the company can get to a 7% margin, then earnings per share for 2023 could potentially get to 20 pence based on my calculations. The shares currently trade at 40 pence, which would be a price-earnings ratio of just 2 times.
Of course, that will not be easy. However, Costain noted that inflation protection mechanisms built into its contracts have insulated it from the bulk of price increases and helped operating margin stability for the first half of the year. A steady flow of bid wins in the rest of this year would mean the company could reinstate its dividend and U.K. investors would jump back in the stock.
Conclusion
At the current valuation, Costain could be a takeover target for a larger player. That is not the investment thesis, though. A tighter business model with more focus on risk management makes me conclude the company has a stronger foundation despite its practically distressed valuation.
