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Budget 2020's spending on infrastructure – what it means for investors

We look at why infrastructure investors shouldn’t get carried away with the budget and the outlook for construction companies.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Since winning the election back in December the government’s given the High Speed 2 (HS2) rail project the green light. It’s even suggested the idea of a bridge between Scotland and Northern Ireland.

It tells us infrastructure is high up the list of priorities, and many expect a bumper day for the sector in the budget.

That probably goes some way towards explaining why some of the UK construction groups have seen their shares jump since the election. It sounds like great news, but we think there are a few reasons investors should take a cautious view of the apparent windfall.

This article is not personal advice. If you’re unsure, please seek advice. All investments rise and fall in value, so you could get back less than you invest.

Is it a meaningful change?

December’s Queen’s speech included a commitment to spending £100bn on infrastructure. That’s a substantial, but also familiar, number.

In 2016 former Chancellor George Osborne committed to investing more than an extra £100bn in infrastructure by 2020-2021. Together with existing plans that meant the government was expecting to spend £59bn a year on infrastructure projects for the following five years.

While the infrastructure investors will welcome extra spending commitments, £100bn isn’t so far away from what we’ve seen in the past.

We’re also not clear on whether the planned spending increase includes new commitments to HS2. Given that estimates for the project costs have risen to as much as £106bn, the government might not have as much room to splurge as first expected – especially since the 2016 commitment only priced in the start of the work.

Massive infrastructure projects come with similarly massive price tags. That makes new project announcements sound very impressive, but it’s important to put this in the context of pre-planned spending.

Spending spread thin

The government’s extra £100bn of spending is expected to achieve a lot. Transport, decarbonisation and digital infrastructure were all earmarked for investment in the Queen’s speech. That means the benefits of increased spending will be spread thin.

Nor will UK companies be the only ones working on these projects. While rumours of Chinese contractors working on HS2 have attracted headlines, Stockholm listed Skanska, and Paris listed Vinci, are just two of the international groups already awarded contracts.

Competition for contracts will be fierce, with benefits to individual companies potentially small.

It’s also worth noting that the UK’s larger construction groups operate all over the world. Increased infrastructure spend in the UK might not be as important as a ramp up in the US.

Micro margins and cost challenges

Intense competition means companies cut prices to win major construction contracts. This can lead to wafer thin margins.

As an example one of the UK giants, Balfour Beatty, is currently working on achieving an “industry standard” operating profit margin in its UK construction business of 2-3%. That’s incredibly low, even before considering things like interest costs and tax.

Assuming Balfour is correct about its industry standard, then £100bn of infrastructure spending translates into around £2.5bn of operating profits industry-wide. However, that’s before accounting for any over-aggressive contract pricing in a fiercely competitive market.

To make matters worse thin margins mean profits can quickly turn to losses if extra costs turn out to be higher than originally expected. For an “industry standard” contract a cost overrun of just 1.3% would wipe out half the profit. And HS2 is an excellent example of how wrong early estimates of a projects costs can be.

Remember high revenues don’t guarantee high profits. And this exact problem led to Balfour Beatty’s near-death experience just a few years ago.

Should I invest in construction?

While we sound quite downbeat, increased spending on infrastructure by the UK government is certainly a good thing for construction companies. All things being equal more spending should mean more work and more profits.

However, sometimes good news isn’t good enough. Investors should take care not to get caught up in the headlines where infrastructure spending is concerned.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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