Pensions, PFI and profits

Favourable trading conditions in 2002 means contractors have now had two good years in a row. Strong demand and rising margins resulted in many contractors announcing record pre-tax profits, even better than those achieved in 2001.

The industry might be enjoying a welcome period of sunshine but two clouds have appeared in the distance: concerns over the cost of topping up pension funds; and the city's yo-yo perception of PFI involvement.

Fortunately, the latter is already moving back up, with a semblance of rationality already in sight, but pension cost worries continue to harden. The problem here is that with construction being a mature industrial sector, it is seen as being a tougher nut to crack than newer markets where companies have less history, and where pension funds are less mature.

The big issue bubbling to the surface, after reading all the contractors' financial results, is the potential impact of pension funds on future profits. Carillion will need to retain almost £10m of next year's profits in order to top up its pension fund, while Interserve has pointed to a figure of £9m. When your total profits are no more than £50m, this is a significant chunk.

As construction groups tend to have mature pension funds, shortfalls can't easily be made up by simply asking for higher contributions from existing employees. Most have closed their final salary schemes, but even these companies are carrying big pension funds as a result of their extended history.

How big is big? Well in the case of Galliford and Carillion, for example, the size/value of their pension fund is bigger than the market capitalisation of the companies themselves.

"Pensions are more important than the PFI issue," says Mike Foster, construction analyst with stockbroker Peel Hunt. "However, construction groups have enjoyed strong demand, with margins doing well, and despite their pensions hit, profits have gone up. In a funny way, the pension issue demonstrates the strength of current trading."

Looking at construction companies at the trading level, where chief executives should stand or fall according to the quality of their decisions, most had a good time in 2002. The forward-looking benefited from a rise of partnership agreements and pushed further into framework deals that offer stable long-term workloads.

In the City, the pendulum of sentiment has swung back and those construction players that so vigorously tore up their roots and plunged headlong into the new world of support services are the ones at the receiving end of most scepticism. Just how safe are their margins? And how many have been hiding costs? Amey and WS Atkins have sown many seeds of doubt.

Housebuilders

Which brings us to housebuilders. They had an excellent time in 2002 with the big players still getting bigger and showing that size pays (see table). Profits hit all-time records as planning permissions artificially cut back the total number of new properties that could be built and finance directors stood firm, persuading their management boards of the value of policies that focus on maximising profit per house.

Analysts who follow the housebuilding sector were so impressed with the 2002 results that they have already upgraded their profit forecasts for the future, not only for 2003 but also further down the line.

Favourite contractors

When it comes to favourite contractors, Foster plumps for Enterprise. "It digs up roads for utility players, has a turnover of £250m, and enjoyed a very good year in 2002," he says. "Many contractors steered away from the local authority area of work, given the concerns over TUPE issues, but there have been accommodations and this hasn't proved to be a problem."

The same name also crops up on the list of favourites of fellow analyst Stephen Rawlinson, who works for stockbroker Old Mutual Securities.

His top five are Carillion, Connaught, Enterprise, Mowlem and Morgan Sindall. The first four are there because they all have good growth potential, while the latter is seen to have "got the worst of its troubles behind it".

Wooden spoon

Amey and Atkins both head the competition to win the 2002 wooden spoon.

"Those who tried to do clever things in support services have come a cropper," said Foster. "They were on too high a rating [the market price of their shares in comparison with the group's future anticipated pre-tax profits] and there turned out to be trading issues as well."

Carillion, meanwhile, has completed a remarkable transition, moving over the past four years from a group, before the Tarmac de-merger, which had major grey hole issues that Sir Neville Simms and his senior management team wouldn't address, to a player with a glowing reputation in the City.

"Carillion is now straightforward and extremely helpful," says Rawlinson. "Out has gone social housing, Maxxion - the plant hire division - and its small civils business, while Crown House, the M&E player, has also been downsized. At the same time, Carillion has bought the balance of its rail maintenance division and snapped up part of Citex.

"It hired John McDonough as chief executive and he's now brought in Don Kenny, also from Johnson Controls, to give more help [Kenny is managing director of Carillion Services]. McDonough is driven. He wants to go fast - faster than finance director Chris Girling lets him. Girling tries hard but only calms McDonough down for three days at the most.

"The founders' equity plan has ensured that Carillion has a motivated management team. Last July [the first trigger point for the incentive scheme] it all went wrong as Carillion's share prices fell, but that was nothing to do with Carillion," says Rawlinson.

The scheme is still in place. To be triggered, Carillion's share price must increase at a minimum of 10% compound and for the top payout it has to hit 26% growth. That means management is hoping to see shares reach 205p by the end of July.

Balfour beaten

As Carillion finally moves to the top of the class, Balfour Beatty comes crashing down.

One construction analyst says: "It was the one company that couldn't quantify the implications of its pension fund review. So does the problem amount to £10m or £50m? Balfour won't say and outsiders just don't know.

"At the analysts' meeting that Balfour staged, it didn't seem sure about some of its other figures. Balfour said that one financial hit would be 'significant' but wouldn't reveal what it meant by that. Also, there was a lack of clarity over what's going on at Barking Power Station. We need financial numbers for both issues.

"Balfour was rattled before the meeting even got under way. Wimpey staged its analysts' session in the room next door, taking an earlier slot, and Wimpey chief executive Peter Johnson, who loves to talk, kept us there too long. So Balfour started with 10 of us missing and got upset when we all arrived late - it threw the rattle out of the pram."

A second analyst adds: "At Balfour they don't seem to have clicked that they need to get out of their contracting mind-set. Amec and Costain have successfully stepped away from that approach, but at Balfour something is still wrong and we need answers."

Rawlinson also has praise for Amec and Costain. He adds Mowlem to his list of solid performers. "Mowlem's share price has risen since its results announcement, from 108p to 134p, and deservedly so," says Rawlinson. "It has done better than analysts imagined."

At Costain, Stuart Doughty has done a "fantastic job" since taking over the reins less than two years ago, says Rawlinson. "He's built an orderbook worth £1bn despite turning £350m of business away on risk grounds," he adds. "It's crazy how he has moved Costain forward. The good news for shareholders is that Doughty still wants to prove himself, so he'll be there for another three years."

Another analyst backs up Rawlinson's analysis, saying: "John Armitt, the previous chief executive, took Costain backwards. He was conducting an orderly wind-down because he couldn't see a way forward and he failed to sort out issues with the board.

"But with Doughty at the helm and active wisdom from David Jefferies, the new chairman, Costain now has £200m-worth of term contracts. Whereas Armitt saw problems, Doughty sees opportunities."

Prospects ahead

But with 2002 now in the past, what are the prospects ahead? The industry faces two major problems: the need to find (and then pour) extra cash into company pension funds; and the downturn in some of its market sectors, notably offices and commercial.

Geoff Allum, analyst with Investec, says: "Pensions have lowered profit forecasts. With Serco and Interserve, for instance, the pensions issue adds £9m to 2003 costs and a similar sum for future years. It causes uncertainty.

"As a result, our pre-tax profit forecast for Interserve for 2003 is 14% down despite the anticipation of operating profits being 3% higher this year."

Allum sees little upturn in the office sector for a few years, although he anticipates other industrial clients that have cut back on both capital budgets and maintenance will have to start spending in the second half of 2003. "They can't postpone maintenance forever," says Allum, "as they need to keep certificates of operational safety."

The forecast may be clouds casting chilling showers, but the higher government spend, the size of the PFI pipeline and the approach of more responsible clients all suggest that some contractors will find ways of keeping warm and dry. n