Stock In Focus - Costain Group Plc

This feature is part of a new series titled “Stock in Focus".  Each week we'll be taking a look at a stock highlighted by the StockRanks in a specific sector - this week it's Costain Group from the Industrials sector.  As ever these are not recommendations… so DYOR.

When a profitable company decides to raise fresh capital by issuing new shares, there's usually a good reason. The fresh cash often points to acquisition or expansion plans. This often changes the investment outlook for a stock, so it's usually worth a closer look.

A case in point is Costain Group Plc (LON:COST), a £330m construction and engineering business listed on the London Stock Exchange, that raised £75m through a placing and open offer in March 2014.

Costain's management believes the fresh cash will enable the firm to move up the value chain and compete successfully for larger, more profitable projects. It's this opportunity which I believe lies behind the investment case for the stock and makes it this week's Stock in Focus.

From houses to infrastructure

Costain was founded by Richard Costain and his brother-in-law in 1865. The firm first grew by meeting the fast-growing need for new housing in south-east England.

Costain then branched out into infrastructure work and started to expand overseas. Big projects in the Middle East, Asia, Australia and the US sat alongside high-profile UK projects such as the Thames Barrier. However, an overambitious venture involving deep coal mines in the US nearly destroyed the company in the 1990s.  

Since then, Costain has regrouped and now focuses only on UK water, energy and transport infrastructure projects. Turnover was £1.1bn last year, and projects are often undertaken as joint ventures with peers such as Balfour Beatty and Morgan Sindall.

Costain's current projects include the redevelopment of Bond Street and London Bridge railway stations. The firm is also managing the supply and delivery of an additional evaporator at Sellafield nuclear power station.

Costain's goal is to target larger and more complex projects, in which it can take a leading role. If successful, I believe this should gradually add to Costain's profitability and to its defensive moat. Could this deliver substantial upside for investors?

In a sweet spot?

Costain ended last year with a record £3.5bn order book.  The firm's 2014 results suggest  that the firm may currently be sitting in a sweet spot combining growth, value and momentum.

A first glance at Stockopedia's StockReport for Costain appears to support this conclusion. Costain's StockRank of 99 is backed by scores of 94 for quality, 92 for momentum, and 83 for value.

Quality

Although Costain's operating margin has only averaged 2.6% since 2009, that's not bad for this type of business. The firm's margins have been fairly consistent over this time and all debt has been repaid.

Drilling down further, Costain's improving fundamentals are illustrated by a strong Piotroski F-Score of 7. This nine point checklist of financial direction highlights cash-generative profit growth, a strong balance sheet and improving productivity.

In an interview CEO Andrew Wylie, who owns over £1m in Costain equity,  highlighted the company's focus on long term, low risk projects. Costain's ROCE has averaged 24% since 2009, more than double that of close peer Morgan Sindall. In my view, this adds to the attraction of Costain as the pick of this sector.

Investors may note that Costain's return on capital employed (ROCE) has varied widely over the last few years. Personally, I don't think this is a big concern, as the firm's small asset base means that changes in profit have a big impact on ROCE.  

Growing momentum?

Broker forecasts for Costain have moved steadily higher over the last year, but the firm's momentum appears to have been underestimated by City analysts. Costain has qualified for the Stockopedia Earnings Surprise screen since February 2014, and beat earnings forecasts by 11.5% last year.

Interestingly, Costain also qualified for the Josef Lakonishok momentum screen in February 2015. This screen aims to identify undervalued companies at the point when the market is starting to recognise their appeal. This can often signal a good time to invest.

Costain's inclusion in these two momentum screens is a positive signal that recent outperformance may continue in the short term. Earnings per share are expected to rise by 13% in 2015, and while last year's fundraising caused Costain's share price to slide sharply, the firm's stock has since rebounded strongly.

Costain was one of the honourable mentions in Ed Croft's “New Year NAPS" and is already up 16% year to date. Costain shares have risen by 20% over the last 14 months and by 45% over the last five years. This puts them well ahead of the FTSE All-Share index, which has gained 4% and 33% over the same periods, respectively.

Value

Costain's shares currently trade on forecast P/E of 15, which on first impressions doesn't appear particularly cheap.

However, by stripping out net cash and focusing on Costain's enterprise value, the firm's forecast P/E falls to around 11.

This looks more attractive, but small cap blogger Paul Scott has highlighted reservations about this approach in his previous comments:

"I wouldn't get carried away with the net cash position as the cash has come from a favourable skewing of working capital, which is almost certainly up-front stage payments by customers being ahead of the costs incurred at any point in time."

In other words, Costain receives payments from its customers before it pays its own sub-contractors. This is highlighted by Costain's negative working capital and is standard practice across the industry.

In a liquidation scenario, net cash would be largely absorbed by outstanding creditors and the pension deficit, as Paul implies. However, I think this view is overly harsh, given Costain's strong order book, consistent profitability and lack of debt.

I'd be tempted to discount net cash by 50%, instead, giving a forecast P/E of about 13. I believe this is a reasonable price to pay, especially given Costain's 3.1% prospective yield.

Last year's figures suggest to me that Costain's 2015 dividend should be covered by free cash flow. Looking ahead, the dividend is expected to rise by 11% to 11.2p in 2016, giving a 3.5% prospective yield.

Too good to be true?

Costain's optimal blend of quality, value and momentum suggests it could be classified in the Stockopedia 'taxonomy' as a 'super stock'.  However, it's worth taking a look at possible problems which could derail the firm's progress.

I believe the two biggest risks are declining profitability and stagnating sales revenue.

The simplest way to monitor profitability is with the operating margin, which I'd prefer to see remain above 2%.

The critical factor is that Costain continues to win projects that are structured to reimburse costs and provide adequate returns. As Paul Scott highlights, companies in this sector tend to run into trouble when they are exposed to cost overruns or underbid to win work.

Another important sign of progress will be revenue growth. Costain's fundraising last year was meant to help the firm move into the big league. If this fails to translate into top-line sales growth, investors will need to ask why.

Finally, it's also worth taking a closer look at last year's fundraising. At the time, the placing price of 225p seemed a big discount to the previous day's closing price of 319p. Were investors reluctant to participate?

We're never likely to know, but private investors were able to avoid dilution by taking part in the open offer. Looking back, I believe the fundraising has reduced risk and improved the stock's growth outlook. Costain's management now needs to deliver on its promises.

Positive outlook

Costain has a strong record of delivering projects successfully and 90% of its order book is repeat work. I personally believe the shares could do well from here if Costain can deliver on the promise of its strengthened balance sheet and broad skillset.

As ever when making any investment decision, it's important to come to your own conclusions and do your own research.  If you have any thoughts or additional insights on Costain please do help fill in the picture by adding comments below.