Pockets of value appearing for investors in construction sector

The deterioration in the fundamentals of the construction industry, following the downturn in the sector post the World Cup stadia spend and infrastructure boom leading up to the event, has resulted in pockets of cheap investment opportunities starting to

“The operating economics are essentially the same for construction companies worldwide. There are very few barriers to entry, as shown by South African contractors sourcing work from places like Australia to Dubai. In general, the construction industry is not an industry that RE:CM considers a good place to find quality businesses as measured by competitive advantages. However, this does not mean that these industries do not offer up bargains. RE:CM has the luxury of focusing on high quality businesses in our global investable opportunity set which would exclude most construction companies.”

Court says that an investor in a construction company is essentially purchasing the construction contracts that the business attains, combined with management’s ability to price for the inherent risk in these contracts and execute on these contracts in order to generate profits for shareholders.

“A ratio of Enterprise Value to Sales (EV/Sales) is therefore a relevant ratio to consider when evaluating construction companies. Enterprise Value is the value of the entire business, being the equity outstanding as well as any net debt (debt less excess cash). The EV/Sales multiple represents how much the market is willing to pay the business for current capacity to generate revenue and that particular management team’s ability to convert that revenue into profits.”

He explains that a comparison of the construction companies current EV/Sales multiple assigned to it by the market with the long-term median multiple is a good indicator of which companies might be offering value.

He says that RE:CM has recently allocated some of its client’s capital to two other construction companies – Aveng and Raubex, but for different reasons. “Aveng was trading on a far lower EV/Sales multiple compared to its median, which drew our attention to the business. Closer inspection of Aveng highlighted a significant manufacturing element relative to its multi-disciplinary construction competitors, which means that EV/Sales is less relevant when considering Aveng in our estimation. The shares still however offer value, which is why we have some exposure to this business.

“Raubex is a more specialised construction company which focuses on road construction. Again, our estimation of the intrinsic value of the business showed that it was trading at a discount in the market, and again RE:CM took the opportunity to allocate client’s capital to this investment idea.”

He says it is interesting to note that WBHO is trading at a premium to its long term median EV/Sales multiple of 0.3 times. “WBHO has not dabbled to the same extent in non-core assets, such as construction materials, like its competitors have, and its management has earned the respect of the industry in terms of their ability to price and execute on a contract.”

Court says that WBHO’s track record is appreciated by market participants. “WBHO’s Returns on Equity are superior over time in comparison to their listed peers. The investing public seems to be aware of this, hence why WBHO is trading above its long-term median EV/Sales. While we appreciate WBHO’s management, we simply are not interested in buying or owning WBHO shares at these levels.”

Court says that the challenges remain the same for the construction industry. “Competition for construction contracts in South Africa is still fierce, which translates into lower prices being accepted for contracts and implies that the construction companies are not being remunerated for the operational risk that they are incurring.

“However, the lack of barriers to entry for construction companies does have a silver lining. It is possible for a construction company to move from one construction discipline to another discipline which is showing greater demand for construction services. This is the case whether the new market is offshore or in a different market, such as the oil and gas or renewable energy sectors. This allows construction companies to change and follow the demand for their services.”

He says that the collusion charges within the industry do not change their view on the economics of the industry. “In terms of valuation, RE:CM does its utmost to include the financial impact of these charges into our valuations. Additionally, RE:CM allocates capital to businesses at a price that builds in a margin of safety – in other words, well below what we believe the stocks are worth. This protects us against permanent losses of capital,” concludes Court.