The Costain (LSE: COST) share price has fallen over 50% since the end of June. The shares are now cheaper than they were during the global financial crisis more than a decade ago and are down some 70% from the all-time high set in 2017.
In the first half of 2019, the British engineering company was beset by contract delays and cancellations of key projects. On the financial front, revenue was 22% lower than at the same point last year, while operating profit fell by a larger 56%. To make things worse, the CEO of 14 years stepped down and the interim dividend was reduced by 26%.
On the face of it, this is a stock to avoid. But take a closer look, and things are not as bad as they first seem.
Operating profit may have been much lower year-on-year, but this was largely the result of a one-off charge of almost £10m, relating to legacy work that a now defunct subcontractor was liable for. An exceptional cost if ever there was one. Without this, underlying operating profit was only 6.7% lower – hardly a disaster.
The resilience of underlying operating profit in the face of a big reduction in sales, reflects Costain’s move towards higher-margin work. The new CEO has already set out his new strategy to turn the firm into a smart infrastructure solutions company, focusing on that higher-margin consultancy work, and moving away from complex delivery programmes where operating margins are as low as 2%.
Costain is looking to ride the wave of the fourth industrial revolution. For the firm, this means focusing on asset optimisation, smart motorways, connected and autonomous vehicles, hydrogen, and digitisation.
The order book is up to £4.2bn, with £900m of that relating to 2020, providing good visibility for the future. Costain is near the front of the queue to benefit from huge government investment in the UK’s motorway network, rail system, and water industry. Despite the contract delays that have blighted performance in the first half of 2019, its income is reliable, as its traditional work is strategically important — from a customer perspective — and thus not discretionary.
Progressive dividend
Ignoring this year’s performance, the company has enjoyed eight years of underlying profit growth, and a progressive dividend. At the time of writing, the shares trade at a discount to net asset value, at just five times last year’s earnings, and still below 10 times when accounting for an uncharacteristically poor first half.
Even after cutting the interim dividend, the current dividend yield is still 9%. And a cut to the final dividend – in line with the cut to the interim dividend – would leave a yield of 7%. Despite its low margins, Costain gets the most out of its assets, with a highly credible return on capital employed.
There are undoubted risks to short-term performance. There is a new CEO, and a company transformation that brings both strategic and execution risks. Then we have Brexit and a review of HS2, not to mention a huge cash outflow that needs to be stemmed.
But I think the market has overreacted and that downside risks are already fully priced in. At this valuation, I think this stock could be one to watch for the adventurous investor.
