Is Kier Group a good investment in a recovering construction sector?

Kier Group is one of the UK’s leading construction companies, although with substantial Services and Property divisions, it does much more than just construction.  Given that the UK construction sector may be recovering I thought I’d take a look at one of the big players.

A brief history of Kier Group plc

The company started life in 1928 as a venture between Mr. Kier and Mr. Lotz.  Its first project was a bridge in Bath; completed in 1929 and still in service today.  As you might expect, the Kier Group has grown somewhat in almost a century and now employs some 16,000 people with a revenue pipeline of around £7.5 billion (£6 billion Construction and Services order book plus £1.5 billion property development pipeline).

Operational overview

Kier is organised into Construction, Services and Property divisions, and together these cover a vast array of activities:

• Construction – Involvement in the construction of a wide range of building projects including power, water, waste, transport, mining and infrastructure facilities.
• Services – Now includes (after the recent acquisition of May Gurney) housing maintenance, highways, environmental, vehicle fleet, facilities management and utility services.
• Property – Encompasses the whole property lifecycle from finance, design, construction, lease negotiation, facilities management and eventually sale.  Projects are either PFI, commercial or residential.

The company is part of the FTSE 250 index and has a market cap of around £950 million, with 2013 revenues and underlying pre-tax profits close to £2 billion and £65 million respectively.

Performance review

So now we have a rough idea of the scale and operations of the company, let’s have a look at how it has performed in recent years.

That’s not a bad set of results.  Profits were made and dividends were paid in every year, and the dividend went up almost every year.  But (there’s usually a “but”) earnings have stagnated and the dividend cover is getting thin.

A market-beating, inflation-beating, but not electrifying growth rate

Growth-wise it’s a bit of a mixed bag, with dividends increasing by about 12% a year while revenues grew by just 2% a year.  Earnings growth was non-existent.

Put those together and you get an approximate long-term Growth Rate of 4.7% a year, which is not bad considering the cyclical nature of the industry, and that the FTSE 100 companies in aggregate have managed to grow at just 2.2% a year over the same period.

Compared to other consistent dividend payers it’s not such a rosy picture, as those companies have managed to grow, on average, at 6.7% a year.

Decidedly mediocre growth quality

While the dividend has grown consistently, earnings and revenue growth has been more suspect, and without revenue and earnings growth that dividend growth will eventually have to come to an end.

I don’t want that, so I like to see growth of the top line and bottom line in order to support a progressive dividend.  If a company doesn’t have steady growth at every level then the share price needs to be lower in order to compensate.

In Kier’s case, the company has managed to grow revenues, earnings and/or dividends 67% of the time, which is okay, but not in the same league as something like SABMiller (nor would I expect it to be).

In comparison, the FTSE 100 companies have, in the aggregate, grown one of those three factors just 58% of the time over the last few years, which is of course even worse, and worse than I would normally expect.  This weak growth quality is primarily down to this never-ending (or almost over depending on who you listen to) Great Recession.

The average growth quality amongst other consistent dividend payers is 74%, so Kier is somewhat behind that group.

Prudent levels of debt

With total borrowings of just over £200 million, Kier’s debts are about 3.6 times my estimate of its average post-tax profits over the next decade (which I call its estimated future earnings power, and for Kier, the estimate comes out at £58 million a year).  I prefer this debt ratio to be less than 5, so by that measure, Kier seems to have a prudent level of debt.

Defined benefit pension obligations are also around £200 million, and so these are a long way below my preferred maximum of 10 times the estimated future earnings power.

So overall, Kier Group plc appears to be a leading company in the construction sector which has grown faster and more consistently than the average company, but is somewhat mediocre when compared to other companies that pay a reliable dividend.

However, having said that, it’s more than good enough in my opinion to be part of a high-yield, low-risk portfolio of shares, but only at the right price.

A fair valuation and attractive yield

Today the shares are priced at just under 1,700p, so what are we getting in return?

For starters, there’s a reasonable yield.  The dividend yield is currently 4%, slightly ahead of the yield on the FTSE 100 which is 3.6%.  It’s also better than the yield on most other reliable dividend payers, where the average yield is just 3%.

With a long-term growth rate of 4.7% and a dividend yield of 4%, a naïve interpretation of that would suggest a reasonable estimate of future returns is 8.7% a year.

But of course, such an extrapolation of the past is naïve because there is just so much uncertainty around the future of any company.  But I think it’s a reasonable ballpark figure to have in mind.

Other than a change in the company’s fortunes (for better or worse), the biggest impact on future returns will come from how Mr Market values the company.

Currently, investors are willing to pay about 14.5 times the company’s average earnings over the past decade (i.e. the PE10 ratio is 14.5).  That’s a pretty reasonable valuation ratio, especially when the more pedestrian FTSE 100 is valued almost identically, at 14.2 times.

So the price, relative to past earnings, doesn’t seem to factor in the fact that Kier has produced above-average growth.  In addition, the above average dividend yield seems to suggest that investors are pessimistic about its future prospects.  However, I’m not so sure.

The May Gurney acquisition and a recovering construction sector

In July 2013 Kier bought May Gurney Integrated Services plc, a support and construction services business to expand the scale and range of services Kier could offer to existing and potential clients.

The purchase price was £223 million, and at the interim results in December 2013, the addition of May Gurney was being felt, with revenues, underlying earnings and dividends up 47%, 41% and 5% respectively.

So things are looking better for the 2014 results, but a big acquisition like this does add to the uncertainty.  If those increases from the interim results could be carried through to the annual results then Kier would of course look a bit more attractive at the current price.

The continuation of the recovery in the construction sector would also be a helpful tailwind.  However, I have no idea what’s going to happen in the general economy (and I think most investors and economists don’t either) so I prefer not to speculate on macro factors, no matter how entertaining it may be.

A slightly above-average company at a slightly below-average price

So there we are.  Kier Group plc has a decent enough track record.  It is consistently profitable and pays a (so far) reliable, progressive dividend.  It has grown faster than most companies, but only just, and it has a better dividend yield than most companies, but again, only just.

I would add the company to the UKVI Defensive Value Model Portfolio at the right price, but I don’t think 1,700p is the right price.

To get into my top 50 stocks (the zone that I generally buy from) the price would have to drop by about 30% to 1,200p. At that level, the dividend yield would be 5.7%, so it will probably take some quite unpleasant news to get the share price down that far.

So as is often the case, I think this is another one to add to the watchlist.

Disclosure: I don’t own shares in Kier