Nicholas Hyett, Equity Analyst 26 April 2019
Last week Galliford Try revealed problems in its construction business would knock £30-£40m off full year profits.
It’s the latest in a string of profit warnings from a sector that’s seen former giants Carillion and Interserve collapse. Others have been forced to turn to investors, cap in hand, looking for a bailout.
So what’s gone wrong, and does it mean investors should steer clear of the sector for good?
This article isn’t personal advice. All investments can fall as well as rise in value so you could get back less than you invest. If you‘re not sure if an investment is right for you please seek advice. Past performance isn’t a guide to the future.
When the going gets tough, margins start falling
The core problem is construction contracting is an intensely competitive industry.
In most cases, construction groups act as project managers, subcontracting out actual building work to third parties. Contracts like motorway extensions are fairly standard, and since the services each company offers are pretty uniform too, differentiation from rivals is all but impossible. As a result bidders are forced to compete on price.
The problem is compounded by the fact the public sector is the largest commissioner of infrastructure projects. Pressure on public sector budgets means total cost has become all important. That’s increased the prevalence of fixed price contracts – where contractors agree to complete a project for a pre-agreed sum.
With bidders only building in the smallest of profit margins, there’s little or no room for error. Galliford’s construction business has been running at an underlying operating margin of 0.9% in recent years. Even a small increase in costs has the potential to demolish any profits, and larger cost overruns can be hugely damaging.
In Galliford’s case, a £200m contract would be expected to deliver an operating profit of around £1.8m. But a 5% cost overrun would wipe out £9.9m – that’s the equivalent of the profit from £1.1bn of contracts.
Galliford’s wafer thin margins aren’t unusual either. Balfour Beatty, one of the stronger names in the sector, is targeting ‘industry standard margins’ in its UK construction business of 2-3%.
Foundations rotted by debt
Because actual construction work is subcontracted out, physical assets on the balance sheet are usually in short supply. The company may consider contracts as assets – but they depend on successful delivery and are not easy to sell if the company needs to raise capital (as Carillion discovered).
Throw in some debt and the mix can be toxic.
Kier’s rights issue at the end of last year was aimed at strengthening the balance sheet, as customers and shareholders became nervous about the effect large debt piles were having on companies’ long term viability.
Building a stronger approach to investing
While most of the companies in the sector have seen their shares fall, there are some tricks that could reduce the chances of being too badly burned.
Seek a specialist
If incredibly tight margins are the biggest challenge facing the sector, then the obvious solution is to seek players able to charge a premium. The more specialist a job, the fewer companies are able to bid for the work. Reduced competition means the potential for higher margins.
Oil & gas engineers are a classic example. Petrofac’s engineering division has generated margins of 7%, despite the recent troubles facing the business. Of course there are industry ups and down here as well, but a healthy margin means companies are better positioned to absorb losses when they occur.
Eyeball the balance sheet
An alternative is to look for businesses with assets on the balance sheet that can be sold or borrowed against in times of emergency.
This usually means the company’s involved in more than just construction contracting. Balfour Beatty’s infrastructure investment business helped it out of a hole when aggressive overexpansion left it facing significant losses a few years ago (incidentally Carillion tried to buy it at the time… how times change!).
Similarly Galliford Try’s housebuilding business is likely to mean its current problems, while painful, are passing. The balance sheet has plenty of property assets and a relatively modest net debt position following a rights issue last year.
Avoid falling knives
Buying shares in a company which have just fallen dramatically is sometimes referred to as ‘catching a falling knife’.
It’s a common technique, with investors hoping to benefit from a recovery in the short term, and appears to have attracted a lot of recent investors to the construction sector.
But it’s also a very high-risk strategy. When a company’s shares fall, there’s usually a good reason and they could fall further. Our recent article provides some tips that will hopefully reduce the chances of getting your fingers cut. But the key thing to remember is, there’s no foolproof way to reach for a falling knife.
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