1. Carillion (LSE: CLLN), rated a BUY by Colins Stewart
The world’s top economists and equity analysts are forecasting slow yet positive growth amid moderating inflation. US third-quarter GDP came in at a credible 2.5%. So it’s time to side with the optimists. That means cherry-picking pedigree stocks with robust balance sheets, defensive characteristics and the ability to prosper even in harsher economic climates.
A great example is Carillion. It is one of the UK’s top three outsourcers, with 52% of earnings before interest, tax and amortisation (EBITA), providing support for property, roads, railways and other essential infrastructure under long-term contracts. For instance, it maintains 43,000 houses for British soldiers and 120 million miles of copper cable for BT Openreach.
The overall strategy is to offer a broad spectrum of activities that will encourage local authorities and governments to hand over more business as they look to cut overheads. The approach seems to be working: the secured-order backlog jumped to £17.7bn by June, or more than three years’ sales. At the last update in October, the chief executive, John McDonough said: “We’re on track to deliver strong earnings in line with market expectations” – ie, with underlying growth of about 7%. Additionally, the existing pipeline of work was the largest ever – up 25% in the first half of the year and worth £32.3bn.
This is not just a UK success story either. Nearly a quarter of Carillion’s sales come from overseas. New deals have been bagged in Canada, most recently a £200m road contract in Alberta. And it remains the board’s aim to double turnover, both here and in the Middle East, to £1bn by 2015. That’s probably a realistic goal, given that the United Arab Emirates is embarking on a $1trn infrastructure spending boom until 2030. Qatar, meanwhile, is investing $149bn ahead of the 2022 Fifa World Cup. And the firm is already bidding on several substantial projects for new schools, hospitals, shopping centres and rail networks throughout the region.
Regardless of these positives, the market seems to be in doubting-Thomas mode, worried about the possible impact of the UK government’s austerity measures on the UK building arm. But this represents only 17% of profits and is being scaled back. The City is forecasting 2011 turnover and underlying earnings per share of £4.7bn and 42.1p respectively, to be lifted to £5bn and 45p 12 months later. Consequently, the shares trade on a mean price/earnings (p/e) ratio of 7.8, and also pay a decent 4.9% dividend. On a sum-of-the-parts basis, I value the outsourcing unit at £1.5bn, the construction division at £500m and the public finance initiative (PFI) portfolio at £144m. Taken together, and after deducting the net debt of £125m and a £205m pension deficit, that produces a fair value of about 420p a share; equivalent to a p/e of around ten.
Now for the bad news. The UK is likely to remain challenging as clients squeeze more savings from their partners. On top of this there are the usual risks inherent in the industry, including poorly priced contracts, non-performance, fines, customer bankruptcies and foreign-exchange fluctuations. That said, Carillion has a mammoth order backlog and offers attractive returns for the patient investor. The next update is scheduled for 7 December. Collins Stewart has a price target of 475p.
Rating: BUY at 327p
2. Cape (LSE: CIU), rated a BUY by Atrium Capital
Another cheap outsourcer is Cape, a specialist in everything energy-related. It offers services such as scaffolding, fire protection, insulation, painting, blasting and cleaning for the likes of oil refineries and liquefied natural gas (LNG) facilities. Indeed, its operations cover the full life cycle from plant construction and commissioning, through to repair and eventual demolition. Moreover, 55% of sales are derived from maintenance contracts, mainly in the UK. These under-pin the vast majority (over 91%) of this year’s sales targets,based on a £850m order book. The rest is derived from new-build projects, primarily in emerging regions such as Asia, the Middle East and the Caspian Sea. BP, E.ON, Exxon Mobil and BHP Billiton are just a few of its expanding portfolio of blue-chip clients.
Cape’s major bread winner for many years ahead, though, will be its interest in LNG. It is currently quoting on large terminals in Australia, which will supply vital fuel to Japan after the recent nuclear meltdown boosted demand for gas.
In the first half of the year, turnover rose as predicted 1.1% to £335m, with pre-tax profits falling to £28.6m from £35.5m. That drop was due to larger financing costs, although the chief executive, Martin May, was upbeat about prospects. “We confidently expect a return to growth in line with our double-digit target range in the second half” on the back of several big projects.
He adds: “Looking forward to 2012, we are poised for another period of sustained growth as we enter a new up-cycle for our construction support services, particularly in the Gulf/Middle East and gas/LNG in the Far East/Pacific Rim.” So assuming 10% plus organic growth over the next few years, future earnings growth could hit 15%+ as the benefits of operational gearing kick-in.
The City is forecasting a 2011 turnover and underlying earnings per share of £690m and 44.7p respectively, rising to £756m and 51.6p in 2012. As such, the stock trades on a mean p/e ratio of 10.4, while also paying a 2.4% dividend yield. However, I rate the group on a ten times EBITA multiple. After adjusting for the net debt of £76m and £69m of asbestos pension obligations, that delivers an intrinsic worth of 575p a share.
On the downside, Cape could get squeezed by competition with larger rivals. And as with any international group, there are currency exposures to manage. Also, any sharp and sustained drop in energy prices could trigger a downturn across the industry.
Nevertheless, Cape is ideally placed to benefit from the planned global rollout of relatively cheap LNG (cheap compared with oil). Australia alone offers a market estimated to be in the region of A$6bn by 2015. Atrium Capital has a price target of 670p. Watch out for the next trading statement due out on 9 November.
Rating: BUY at 464p (market cap £548m)
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