Stockwatch: a share to benefit from infrastructure spending

There are risks here, of course, but analyst Edmond Jackson continues to favour this modestly rated company, believing it has a few years of good progress ahead.

28th January 2025 11:24

Edmond Jackson from interactive investor

The small-cap shares in infrastructure services company Costain Group (LSE:COST) are showing how market volatility can bear little to no relation to fundamentals.

This month, Costain fell from 112p to 86p as of last Friday, a 23% fall that would have triggered selling by smaller investors respecting a stop-loss approach – where a 20% fall is generally the maximum you should allow. Such an approach dictates not to “let emotions take over” and make excuses for a share.

Yet the price has jumped to 96p after an “in-line” trading update in respect of 2024 adjusted operating profit and year-end net cash. Moreover, prospects look ahead of expectations, in terms of a 38% increase in Costain’s year-end “forward work book” to £5.4 billion. This is defined as the order book plus the preferred bidder book: revenue from contracts partially or fully unsatisfied and probable revenue from water-related.

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It’s unclear whether that could have benefited from the profiling of work projects or even delays, but momentum looks too strong to question the sense that things are picking up. The significance in share terms is a contractor like this being rated on a low price/earnings (PE) ratio because margins are relatively slim, Costain’s financial history showing losses, and the need for a dilutive share issue in 2020 after various contracts hit trouble.

Costain Group - financial summary
Year end 31 Dec

	2017	2018	2019	2020	2021	2022	2023
Turnover (£ million)	1,684	1,464	1,156	978	1,135	1,421	1,332
Operating margin (%)	2.8	3.0	-0.3	-9.4	-0.8	2.5	2.0
Operating profit (£m)	47.5	43.4	-2.9	-91.8	-9.5	34.9	26.8
Net profit (£m)	33	33	-2.9	-78.0	-5.8	25.9	22
Reported EPS (p)	27.1	26.8	-2.4	-36.7	-2.1	9.4	7.8
Normalised EPS (p)	27.1	35.2	16.1	-31.2	-2.1	9.8	8.5
Operating cashflow/share (p)	42.8	-39.2	-26.5	-22.1	10.7	5.1	19.7
Capex/share (p)	1.7	1.1	5.7	1.9	0.8	0.2	0.0
Free cashflow/share (p)	41.1	-40.3	-32.2	-24.0	9.9	4.9	19.7
Ordinary dividend per share (p)	12.4	13.4	3.4	0.0	0.0	0.0	1.2
Covered by earnings (x)	2.2	2.0	-0.7	0.0	0.0	0.0	6.5
Return on total capital (%)	19.8	17.5	-1.3	-41.1	-3.8	14.9	11.4
Cash (£m)	249	189	181	151	159	124	164
Net debt (£m)	-178	-119	-34.9	-70.8	-93.2	-94.3	-140
Net assets/share (p)	129	151	129	56.9	72.4	76.8	79.3

Source: historic company REFS and company accounts.

Well-suited to national objectives to upgrade infrastructure

While a prospective dividend yield possibly as low as 1.5%, and price-to-net tangible assets around 1.4x do not exactly scream value, I would take Costain seriously given it is well-placed to serve both the water industry needing to improve its act, and infrastructure spending being a key means for Labour to achieve UK growth.

Its interim results cited a second UK “national infrastructure assessment” and the “construction pipeline 2023” set out over £700 billion investment over a decade. Water investment is due to at least double to the highest level in decades, in line with the regulator Ofwat’s resolve. Long-term growth is also expected in UK energy due to changes in the provision mix.

Notwithstanding this month’s seemingly irrational down-dip in the shares, their overall trajectory looks to remain intact since I made a deep-value “buy” case at 50p in March 2023.

Source: TradingView. Past performance is not a guide to future performance.

By last August the price had doubled to 105p when I retained “buy” partly because the incoming government set out to exclude infrastructure spending from the national debt measure.

The 50-day moving average made a steady climb to the new year, when possibly the market began to question if the Budget’s hike in employment costs would compromise Costain’s target to raise its operating margin that has historically been stubborn around 2.5%.

The last time management reassured on margins was at interim results in August when they cited the adjusted margin up from 2.3% to 2.5% like-for-like, saying it was “on course to meet margin targets of 3.5% and 4.5% during 2024 and 2025”.

Yes, there has been a new CEO since 2019, but seemingly most UK businesses now complain at the damage the Budget has done by way of higher costs from this April. Can these be sufficiently well absorbed with attention to costs and an aspect of operational gearing from Costain’s strong forward work book?

Forward PE multiple around eight times

While making four separate “buy” cases here, the forward PE has improved from around 5x to 8x. Consensus for adjusted 2024 earnings per share (EPS) of 12.4p implies a PE of 7.7x and a latest 2025 upgrade to 14.3p tempers the multiple to 6.7x.

Such are snapshots in time, but with Costain signalling rising demand this scenario implies earnings growth of around 15%, hence a perception that the share is cheap on an earnings basis.

Mind, it is not going to recover to anywhere near its 450p levels of 2017 and 2018 after a £100 million dilutive rights issue in March 2020 following 2019 losses and tighter payment schedules being requested.

The key opportunity – uncertainty also – is the extent that Labour’s infrastructure spending can offset what now appears a doom-loop of sentiment in the UK private sector. Costain would be rather uniquely placed among listed companies to benefit, and the chancellor is due to outline plans for growth tomorrow.

But if the UK does end up in recession, mind the risk of how lower tax receipts would compromise the UK’s ability to service its debt and therefore potentially affect infrastructure spending – even if the government keeps it out of the national debt calculation.

More positively, Costain’s latest reported momentum follows a government barely six months into its term, hence even if Labour’s objectives on infrastructure spending become tempered, the industry context may still improve. Chancellor Rachel Reeves’ speech on Wednesday will need to be affirmative on transport infrastructure besides the oft-mentioned schools, hospitals and prisons.

Weighted towards transportation which can be variable

Costain’s transportation side serves government and local authorities in road, raid and electrification - constituting 69% of interim 2024 revenue but slipping nearly 9% as various projects completed – with management reassuring on the pipeline.

The natural resources side works mainly with private water and energy companies plus some public sector organisations. It rose 10% in the first half to near 31% of group total, reflecting growth in water, defence and nuclear. It said: “We have strongly increased our presence in the water sector during the period...”

Showing how the group narrative is likely always to be somewhat mixed, energy-related revenue eased 10% due to delays to investment decisions.

Overall interim group revenue slipped nearly 4% and consensus is for a 5% fall in 2024 to £1,268 million, emphasising margin improvement for an implied jump in consensus net profit from £22 million to near £35 million.

Quite remarkably, given a supportive political context, a further 2% revenue slip is consensus for 2025, which at least hints at upside if government spending increases, although it’s not clear whether such effect would be felt from this year or 2026 onwards.

Reassurance on cost control is therefore needed with the 11 March annual results. End-2024 net cash of £160 million is in line with consensus if it’s down £6 million from June.

Recent buyback programme despite modest dividend

A £10 million share buyback was completed last November, and another looks possible, although it’s hard to be sure. Costain is likely to need strong cash reserves to assume major projects (and by implication, successfully tender for) especially with the pipeline growing. This largely explains why earnings cover for the dividend is expected to be near 10x in respect of 2024 and 2025, despite no financial debt to service beyond £23 million leases. Costain is well-financed nowadays to withstand a worsening scenario, relevant to its share rating.

Despite some uncertainties, I continue to favour Costain, which should now be positioned for a few years of good progress. Key risks are costs proving tougher to limit in the short term, and further out the law of averages meaning some kind of issue erupts on a contract somewhere. A UK recession would not help but may not compromise infrastructure spending by much.

While a circa 1.5% yield, based on consensus only for a 1.4p/share dividend, seems inadequate for the holding risks, a 7x PE is modest given a supportive three to five-year context. I therefore retain: Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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