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Questor: buy this Carillion stablemate? It’s not quite as crazy as it sounds
Questor share tip: Costain may be a contractor but its business model is far more sensible than that of its former rival – and the shares aren’t expensive
After Carillion, Capita and Interserve, dare any share-tipping column recommend a contracting company?
These businesses now have the reputation of pursuing growth at the expense of sensible profit margins and exposing themselves to huge risk if a problem arises with any of their contracts.
But although Costain belongs to the same sector, the way it does business is entirely different. However, some investors shun it by association, so the shares look cheap relative to its quality.
“I would say Costain is a million miles from the likes of Carillion,” said Matt Evans of Investec, who holds the shares in his UK Smaller Companies fund. “It all depends on the structure of the contracts. Carillion and others would offer to build a hospital, for example, at a fixed price. This meant that the contractor bore all the risk, for example if costs rose during the contract.”
Costain’s business model is different. It operates in specialised areas where there is less competition, and its services can save its customers money over the course of long-term partnerships.
In these circumstances it would make no sense for customers to drive such a hard bargain as to put the supplier’s financial health at risk – they might thereby lose access to expertise that would benefit them in future. So instead of risky fixed-price contracts, Costain’s agreements with clients tend to be on a “cost-plus” basis.
For example, one of the firm’s main businesses is in water supply. It works with the water companies to minimise breakdowns at infrastructure such as pumping stations by organising programmes of preventive maintenance and installing sensors.
“It has positioned itself close to its key customers,” Evans said. “I can talk to them at an early stage and plan the work needed. This way the water companies, for example, can save money by having fewer breakdowns.
“Costain thinks strategically about all the assets involved, with an emphasis on maintenance rather than reacting to problems and reducing energy use.”
It takes a similar approach in the other sectors in which it operates. For example, it has built a good long-term relationship with Network Rail.
A key advantage of working in these infrastructure sectors is that investment programmes tend to be laid down by regulators, so are less influenced by normal business cycles.
“In Britain we have underinvested in infrastructure for a long time,” Evans said. “Many projects now have ring-fenced budgets and Costain’s small size relative to the huge sums involved also gives us some comfort.”
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The firm’s specialised services do not make it immune from the low margins prevalent in the contracting sphere – across the group it makes about 3pc – but the stable and predictable nature of those margins, thanks to the cost-plus contract model, sets it apart.
“Because so much risk has been taken out of the contracts and because they do not require the company to commit a lot of capital, these apparently low margins are reasonable,” the fund manager said. “Costain also aims to improve margins over the next few years.”
Turnover is forecast to be relatively flat for a couple of years, while infrastructure funding rounds are renewed, then start to increase. Evans said mid-single-digit growth from 2020 was likely. As margins are under the company’s control, profits should grow at the same sort of rate.
Returns on capital and cash conversion are strong. The shares trade at an undemanding 9.8 times expected earnings for 2018 with a 4.2pc yield twice covered by earnings.
“The shares have suffered because of Carillion etcetera and there is no doubt that contracting is a tough sector but Costain’s partnership approach puts it in a strong position,” Evans said. “The earnings growth plus the yield should produce double-digit returns even if the market refuses to give the shares a higher earnings multiple.”
Questor says: buy
Ticker: COST
Share price at close: 361.5p
Update: FDM
In June last year we tipped FDM, the recruitment firm, on the strength of a conversation with Matt Evans. He still holds the stock. “It’s one for the long term,” he said. “It’s reasonably highly valued but that valuation is more than justified by its growth rate.”
Questor says: hold
Ticker: FDM
Share price at close: 845p
- Questor archive: telegraph.co.uk/questor