When Balfour Beatty, the large UK-listed construction company, issued its second profit warning in six months at the end of April, its share price dropped from above 245p to below 210p in less than a week. Such a sharp fall would suggest the announcement came as something of a shock to investors but should it really have done? For those familiar with the financial performance of construction companies across an economic cycle, we don’t think it should have.
For one thing, construction companies can appear to show resilience in difficult economic environments because they are often involved in multi-year projects. That means, for some years after a recession starts, a construction company can still have a number of years where it enjoys a tailwind of work it bid in the good times. Only when all that has run out does it really start to suffer.
Another quirk of the sector is that the better construction firms, like Balfours, will account for the uncertainty that forms a natural part of their business by booking only a small amount of profit in a project’s early stages and back-end loading profits to the final stages of the contract, when they are sure everything is running to plan. So not only can revenues hold up for longer than might be expected into a downturn, but profits can appear unaffected too.
This is where analysing how a business performs over a whole cycle, not just over the last few years, becomes really important. if you went back far enough in the history of any construction business, you would see these periods of ‘resilience’ tend to end eventually – and often quite abruptly as, suddenly, all the legacy work ends and profits are driven purely by the projects bid for during tougher times. That is essentially what has happened with Balfour Beatty’s UK business – its performance is now reflecting the harsh reality of the post-crisis years.
This profit impact will be compounded by another cyclical issue, which is that as construction companies grow in the good times they are very cash-generative because they can receive upfront payments from clients for the contracts that they win and only pass this on to their subcontractors etc. with a lag. This can make contractors appear very cash rich.
Of course, when things start going the other way these dynamics start to work in reverse and these cash balances sheet can shrink. This too has happened to Balfour Beatty, a sub-£1.6bn market capitalisation business at the time of writing that has seen some £500m of cash head out the door for this reason over the last couple of years. Once again, this is a natural function of the way the business’s cycle works for many construction companies, but it will inevitably have caught some people unawares.
Those who had carried out their due diligence and thought about the potential ups and downs of Balfour Beatty over an entire cycle rather than just the last couple of years are more likely to have been prepared for, and to understand, how and why the company’s profits and cash position might change.
As value investors we attach a lot of importance to understanding how companies perform financially over a full business cycle to help us appraise what a business’ valuation looks like on a ‘mid-cycle’ basis and to prepare us for what to expect at the peaks and troughs of the cycle. This is not only a more reliable basis for valuation in our view, but also leaves one better prepared for what changes in the cycle might bring.