|Shares Out. (in M):||110||P/E||8.0||0|
|Market Cap (in $M):||235||P/FCF||0||0|
|Net Debt (in $M):||69||EBIT||0||0|
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Costain is a UK-focused infrastructure engineering company and one of a small number of companies with a long track record of building and delivering large infrastructure projects. Population growth, decaying infrastructure assets and a revolution in technology use, support infrastructure spending. Costain still generates most of its revenue from complex programme delivery, but the focus is increasingly moving to higher margin consultancy services, directed towards the optimisation of the existing infrastructure.
An unfavourable arbitration decision, cancellations and delays of a few large contracts in a concentrated orderbook and poor sector sentiment (due to problems at construction companies such as Kier and Carillion) explain the drop in the share price from about 500p in 2017 to 165p today. Costain’s business model of cost reimbursement, as opposed to fixed price contracts, combined with a net cash balance sheet makes it look very different from its troubled peers. The company generates GBP 1.2b in revenue and has an order book of GBP4.2b. Management expects revenue and margins to grow as the higher margin advisory work increases in the mix to 55% from 35% today. At the current share price, we pay 8x this year’s estimated after- tax earnings. This valuation offers the potential for an attractive return, even when the largest infrastructure project, connecting the North and South of England by High Speed Train (HS2), is cancelled and the margin improvement is not achieved.
Costain has more than 3,700 employees and generates GBP 1.2b revenue in transportation, water, energy and defence sectors. The UK market for construction-related services is £100 billion per annum and Costain’s target sectors represent approximately £20 billion. (Costain does not build houses, hospitals, schools, retail, etc.).
Owners of infrastructure assets in the UK operate with multi-year contracts agreed with their regulator. They include targets for opex, capex and performance. Population growth and a decaying infrastructure that is already at capacity make enhancing that capacity a challenge. Historically, enhancing capacity implied building more assets. Today, the balance is shifting away from building more assets as regulators push for investments that allow for a better and smarter use of the existing infrastructure. Examples of this trend are the smart motorways programme to increase capacity, with technology as the single largest expenditure or Network Rail’s plans to change and upgrade 67% of the signalling over the next 10 years. Technology to allow trains to drive with less intervals and to get them in and out of platforms faster, is estimated to increase the capacity of the existing rail network by 20%.
In response to this industry trend Costain has positioned itself around 5 services for the owner/operators of infrastructure in the UK:
- Complex programme delivery: e.g. for the upgrade of London Bridge Station, Costain has provided advisory, concept development, programme management and maintenance services
- Consultancy and advisory: e.g. advise the Ministry of Defence on procurement and delivery of equipment
- Shaping our future infrastructure: e.g. convert public transport in Liverpool to hydrogen fuel.
- Digital technology solutions: e.g. develop and install the next generation road signs
- Asset optimisation: e.g. Costain’s scientists develop improvements to wastewater base
Until 5 years ago, complex programme delivery was almost 100% of Costain’s business. The company is now transforming into a leading smart infrastructure solutions company. Costain has been investing to develop and acquire the skills and expertise to grow these new services, which already represent 35% of the business mix today. The company hopes to grow higher margin services to 55% of the business mix.
To meet this ever-greater urgency and complexity in delivering the UK’s infrastructure needs, their major clients are consolidating their supply chains by investing in increasingly long-term, collaborative multi-billion-pound programmes and service enhancements, underpinned by redefined legislative and regulatory imperative. Costain’s expertise and track record in building and delivering large infrastructure projects in the UK is a competitive advantage compared to strategic consultants who lack that expertise. Its track record, long standing strategic relationships and strong balance sheet make that Costain is very well positioned to be amongst a select group of strategic advisors to the owners of UK infrastructure assets.
Costain runs project risk and their objective is to keep this in a manageable band. Historically, the company has achieved this goal through the nature of the contracts, diversification and realistic targets for both timing and cost. The order book now contains over 90% cost reimbursable contracts, the balance being consultancy contracts with little or no project risk. Cost reimbursable contracts clearly define estimates for timing and cost and if final costs deviate from target, Costain shares 50/50 in the gain and the pain. Customers generally agree realistic targets as large deviations make them look bad, either they have to go back to the government to ask for more money in case of cost overruns or they create the perception of being inefficient if targets for timing and costs were not aggressive enough.
All services, except for complex programme delivery, are invoiced based on time and materials. Complex programme delivery historically benefitted from negative working capital but recently the Prompt Payment Code has increased pressure on the timing of payments. The other services require some working capital for monthly employee payrolls. The Company anticipates that the cash conversion ratio going forward will decline from 100~110% to 80~90%.
Costain’s strategy assumes that total infrastructure spending will remain stable with a shift away from building new assets in favour of services directed towards the optimisation of existing assets. The company believes that the combination of its service offering, with its expertise and track record in building and delivering large infrastructure projects, will allow it to gain market share in a declining market for complex project delivery. Costain therefore believes its revenues can remain stable for this business.
Costain has invested in technology and expertise to further grow its consultancy and technology services to 55% of the business mix. Complex programme delivery is a 3-5% margin business, the margins for higher margin services should be 8-10%. The margin differential between the higher margin activities and the complex delivery activity is currently not significant, as Costain’s revenue from higher margin activities is lower than its cost base can support. This is the result of a deliberate strategy to invest in skills, capabilities, technology and business development activities for this division. In 2019 Costain invested in a technology centre, in technology capabilities for the future and also created a new position and appointed a Chief Digital Officer. This is diluting the returns from these divisions and explains why current margins are around 4%, when they should be delivering 8% to 10%. Costain believes they will be successful in pursuing work and their anticipated normalised utilisation levels can be achieved.
Source: Costain capital markets day July 2019
Costain’s shares trade at a P/E of 8x, assuming that HS2 gets cancelled. This is based on a revenue estimate of GBP 1.02b and operating margins of 3.0%. HS2 is the planned high-speed railway between London and Birmingham. It is a large contract in their orderbook and the construction remains in doubt. The government announced last August that it will perform a second review of the costs and benefits associated with HS2. Costain does not believe that HS2 will be cancelled because GBP 5b has already been spent on this project. Ultimately, we believe the cancellation of HS2 would not impact the long- term earnings power and the current valuation compensates us for the short- term impact on earnings.
We view the current valuation as cheap given the company’s normalised revenue target of 1.1b to 1.2b and upside potential in margins from 3% to 5%/6% due to the shift to higher margin activities.
2019 expected revenue of around 1.2b is 30% lower than 2 years ago as a result of the transition of the business model (Costain deliberately exited some low margin complex project delivery business) and the delay and cancellation of several large contracts. This is now behind them and revenue and profit margins are expected to increase in the medium term as the company grows the higher margin services business.
Alex Vaughan was appointed CEO in May 2019. Alex joined Costain in 1992 and since 2013 served as managing director of the Group’s natural resources division. He played a leading role in the transformation into a smart infrastructure solutions business through his leadership of the development and growth of the Group’s consultancy and technology services.
Last year the total compensation for the CEO and the CFO was GBP 1.56m and GBP 1.04m respectively with the performance related component representing just over 60%.
- Client wins: Costain spends a lot of time and money on efforts to win new business and they must ensure they have the skills to meet their customer’s needs.
- Project concentration risk: see impact on recent results of delays and cancellation and the above comments about HS2. Concentration risk is inherent to the complex delivery of large infrastructure projects and is much lower for the higher margin consultancy and technology services.
- Project risk: Costain shares in the pain if targets (timing and cost) are not achieved.
- Reduced visibility: The order book is dominated by complex programme delivery business (75-80% of the order book) as consultancy agreements are generally much shorter (3 months). As the business mix changes in favour of more consultancy work, the order book will be a less reliable indicator of future revenue.
We believe a structural decline in infrastructure spending in the UK is unlikely. Costain’s longstanding client relationships, its track record and capabilities make for the company to be well positioned in winning business in both complex programme delivery and higher margin consultancy and technology services. The target cost nature of the contracts, diversification and a change in the business mix towards more consultancy business should keep project risk in a manageable band. Delays and cancellations of large projects can impact short term results. HS2 in particular can have a significant impact on current year’s earnings. Longer term Costain should be able to generate GBP 1.1b to 1.2b in normalised revenue at margins that are higher than today, if it can increase sales in higher margin activities. Depressed earnings and uncertainty have caused the share price to drop to a level that offers the potential of an attractive return in the most likely scenarios, including downside protection in case HS2 is cancelled and Costain is not winning more higher margin business.
- Normalisation of earnings and cash flows
- Revenue stabilises or starts growing again
- Increase in operating margins
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