The construction sector looks a good recovery trade, albeit high risk because of mixed trading conditions and exposure to UK housing which has already enjoyed a strong rally. If you are judging the direction of the FTSE All-Share Construction index, that’s effectively a view on FTSE 100 building materials group CRH (CRH) as its £15.8 billion market cap towers over the rest of the market, even being almost 10 times bigger than the second largest constituent Balfour Beatty (BBY) at £1.6 billion.

Housebuilding continues to drive the lion’s share of activity in the construction sector. The long tail at the end of the construction cycle has proved remarkably attenuated and many of the major contractors are still struggling to work through contracts and PFI obligations which - due to fierce competition at the tender stage - have in hindsight proved to be decidedly unprofitable for the winning contractors.

But there are signs that the long-awaited upturn may finally be on the way. It was reported at the beginning of July that construction activity in the UK grew at its fastest rate in four months in June. It would also appear that confidence in the sector is on the rise, reaching an 11-year high, as normal service was resumed following a pause for breath in the run-up to May’s General Election.

The monthly Markit/CIPS Purchasing Managers’ Index (PMI) printed at 58.1 in June from 55.9 in May marking its biggest gain in a year and beating all forecasts. There is some evidence that commercial and civil engineering work is starting to make up for lost time.

The latest market survey from the Royal Institution of Chartered Surveyors (30 Jul) suggests that construction workloads rose across all sectors and in each part of the UK in the second quarter of 2015.

The data maintains that 44% more surveyors reported higher activity levels in the three months to June, up from 37% on the previous quarter with the increase driven by office development and private house building.

Balfour blues

While we don’t doubt the recovery potential of builders like Balfour Beatty, we nevertheless remain unconvinced that now is the time to snap up the shares, particularly in light of its 9 July profit warning. This cited problems with contracts in Britain, the Middle East and the US. Analyst consensus had pencilled in £77 million pre-tax profit before the latest warning and Balfour now looks likely to remain in the red, having run up a loss of £304 million last year. The troubled builder has scrapped its dividend and shelved a share buyback as well as reorganising its pension fund payments.

Shares in Balfour have declined 8% over the past 12 months, yet this is arguably better than you might expect for a business still battling problems after several years of earnings setbacks.

Berenberg analyst Chris Moore is buyer of the stock on the basis that Balfour is through the worst; even if he still reckons ‘it is still too early to call an end to its run of profit warnings.’ The shares are up 9.7% year to date and the sum-of-the-parts valuation remains compelling, particularly for investors willing to suffer near-term turbulence. But we aren’t brave enough to dive in yet.

Cost issue

Recent research by MarketingWorks and the University of Reading suggests that bidding cost inflation is likely to be problematic going forward and that this risk may not be managed properly by contractors.

The research posits that for contracts between £2 million and £250 million, the average cost of winning was £60,208 in 2014. As a proportion of the overall contract value, bid costs can be as high as 1.2%. ‘The level of investment into bidding for new projects is, therefore, significant yet it is an area where processes are often not adequately defined and controls are not robust.’

The implications of bidding for the wrong project or choosing the wrong contract price can be significantly more severe.

Recent data backs up concerns about rising tendering costs. The RICS Building Cost Information Service (BCIS) reported on 15 July that civil engineering costs fell by 1.4% in the first quarter of 2015 compared with the previous quarter, and by the same amount compared with a year earlier.

But at a more granular level, it also forecast that civil engineering costs - along with tender prices and new infrastructure output as a whole - would rise over the coming five-year period.

Costs will, according to RICS, rise by between 3% and 4.5% a year, with both the price of materials and nationally-agreed wage awards increasing. Tender prices are predicted to increase by 4.3% between the first quarter of 2015 and the first quarter of 2016 with another rise of 4.8% expected the following year.

A corollary of this squeeze on materials is the much vaunted UK brick shortage which can only provide rousing tailwinds for the UK’s only listed brickmaker Michelmersh (MBH:AIM). Stockbroker Cenkos says Michelmersh ‘is operating in an industry impacted by a supply demand deficit with high barriers to entry preventing significant additions to supply capacity.’

Mergers and acquisitions

From the point of view of industry consolidation, it has been a busy 12 months and Kier’s (KIE) acquisition of Mouchel in April perhaps remains one of the most strategically attractive deals in the sector. It will make Kier a clear market leader in highways.

Liberum analyst Joe Brent counsels investors to assume the deal will result in ‘10% (earnings) accretion in 2016 rising to 15% in 2017 pre-the bonus factor’.

When last we reviewed the FTSE All-Share Construction sector in June 2014, we thought that Kier’s attractions as a one-stop-shop had been greatly enhanced with the purchase of service group May Gurney in 2013. The successful integration of that deal certainly bodes well for the Mouchel acquisition.

Keller (KLR), the international ground engineer, has also been busy on the acquisition trail. In May, the £763 million cap picked up US-based diaphragm wall specialist GeoConstruction for circa £26 million. On 2 July, the group bought Austral Construction for an initial cash consideration of £20.5 million and deferred payment of up to £9.8 million.

Investec’s Andrew Gibb reckons the Austral deal will be immediately earnings enhancing and help strengthen its existing presence in the near-shore marine work market in Australia.

Playing the US recovery

While some of the monthly data implies a patchy recovery across the pond, we believe there is good reason to be bullish on the US construction market.

The latest data from the Commerce Department shows US construction spending hitting a new post-recession peak in May. This bodes well for windows and doors specialist Tyman (TYMN). While the group’s commercial offering in North America still lacks the comprehensiveness of its Amesbury offering in the residential space, management told Shares recently that Tyman would not rule out an accretive acquisition in any of its territories in the £75 million to £80 million price bracket and that augmenting its non-residential offering in the US might be the way to go.

Europe may be an ailing market for Tyman right now but with a brisk housing market and RMI (Renovation Maintenance and Improvement) in both the US and the UK on the up, these positives should offset sluggishness in Germany.

Tyman makes the right noises from the point of view of the balance sheet and management has set itself a three-to-five year target of 15% return on capital employed (ROCE). The recent half-year report saw Tyman report a ROCE of 11.8%; up 170 basis points on the 10.1% ROCE reported in the first half of 2014.

Sector giant

Irish headquartered CRH offers a blue chip play on US markets and shares in the sector bellwether have advanced more than 30% over the past 12 months.

US highway contracts went up 26% in June compared to the same month last year, according to latest data from ARTBA (American Road and Transportation Builders Association). This brings the increase in the first half of the calendar year to 28% marking the biggest increase in first half contract awards for at least the past 15 years and implies strong growth in highway construction activity over the next one to two years. As the largest provider of raw materials into the US highway construction sector, CRH is well-placed to exploit this theme.

Breedon Aggregates (BREE:AIM), the UK’s largest independent aggregates business, reported on 23 July that its first-half revenue at £160.5 million was up 28% on the same period last year. The fact that underlying EBITDA margin (earnings before interest tax, depreciation and amortisation) is up 17% perhaps highlights the company’s robust fundamentals in a more meaningful way.

This strong trading performance is set against a backdrop of low unemployment and long-awaited rising real wages. While oil prices have certainly come off their fourth quarter 2014 troughs, the company maintains that even with margin pressure associated with price rises in this commodity, Breedon still believes that if second-half performance continues in the same vein, then ‘market expectations for the year will be exceeded.’

Hard landscaping expert Marshalls (MSLH) in May reported a healthy increase in revenue in the four months to the end of April as the £638 million cap’s trading update points to further growth going forward. A 6 July trading update confirmed that the momentum reported at the 20 May 2015 had lost some pace.

For the six months to 30 June, group revenue had increased 11% to £199 million, a slight slowdown versus 12% growth at its May trading update. Numis comments: ‘We think the risk to estimates is firmly on the upside as the new management team continue to drive cost and revenue synergies and Marshalls takes market share from its distracted competitor base. The shares have remained strong, which in our view reflects the continued momentum in the business which has fed through to significant upgrades over the past year, and we believe this will continue.’

Construction
SUMMARY

After years of languishing in post-recession doldrums, UK-based contractors may finally start to feel the benefits of recovery. In materials and distribution, the likely winners will be those with a strong line in supply chain management and an ability to extract maximum synergies from acquisitions.

SHARES’ TOP PICKS

Breedon Aggregates (BREE:AIM) 52p

Prospective PE Dec 2015: 22.9

Prospective PE Dec 2016: 19.7

CRH (CRH) £19.15

Prospective PE Dec 2015: 23.5

Prospective PE Dec 2016: 15.9

Tyman (TYMN) 306.75p

Prospective PE Dec 2015: 15.7

Prospective PE Dec 2016: 13.6