Under the Radar Report

Beating Inflation with Contractors

04 March 2022
Richard Hemming

If I mentioned a stock that leveraged off nuclear, renewables, batteries and other emerging technologies, the excitement might dissipate quickly when, in the next breath, I mention the word contractor.

Contracting is also associated with hard, physical work. Somebody’s got to build and design the plant, crush the rocks, dig the holes. That’s what contractors do. You might also remember the renewables go-go stock RCR Tomlinson, which crashed after cost blow outs on solar installation contracts.

We've all heard of contractors blowing up. RCR is one of quite a number, which now includes Probuild. The builder had an order book of $5bn; hence the reverberations of its collapse will echo for ages. Why bother? The recent reporting season highlights that costs are rising and are unlikely to come down, but it also underlined that companies that are meeting earnings growth expectations are being heavily rewarded. Conversely, those that aren't are getting punished.

The fact is, when you get contractors right, they make a big difference to your portfolio.

In the past 12 months GR Engineering (GNG) has returned 95%, while Southern Cross Electrical (SXE), and SRG Global (SRG) have both returned 30%. The benchmark S&P/ASX 200 has returned 6%, which is about the same as these companies' average dividend yield.

The key here is that demand for their product is stronger than the cost rises and hence profit margins are being maintained, the bottom line is growing and dividends are being paid. Yes, I'm talking about beating inflation. Innovation is also important with both GNG and SXE expanding into renewables segments.

How do you pick a contractor?

Look for quality to start with: financial flexibility, meaning the ability to chase work, along side a strong customer base and an even stronger niche. BSA Limited (BSA) is being punished because management's growth aspirations are shot as key customers Foxtel and NBN Co put pressure on margins.

This is the fundamentals side of the equation. When it comes to picking stocks, the other key is how much you are paying, which determines the vast majority of your returns.

These companies are highly cyclical, hence we come back to the sustainability of customer returns. Timing is all important in picking contractor stocks. You can't just rely on metrics like the PE. RCR was trading on a low PE before it collapsed because earnings were strong. Dividend yields can be illusory. A high one usually means distress.

Look at the PE combined with what that company's order book is saying because this is as close to certainty as you can you can get. I’m talking about the length of contracts and the type of contracts, whether they’re fixed price or cost plus. We have confidence that commodities prices are going to stay stronger for longer, especially at the so-called 'future facing' end of the spectrum. Hence, we might pay more for this business than in the past.

Let’s go through some, starting with the big guns:

Worley (ASX:WOR) has been chasing annuities style work and is now a highly diversified business, although they still do oil and gas work, its increasingly focused on green energy, wind, solar, nuclear AND hydrogen. Trying to be in everything that’s future facing and looks solid value.

Downer EDI (DOW) looks better value because of the pains it has experienced in exiting mining on urban services – utilities, telephony and transport as a builder of roads and trains. It is doing lots of work for the government, so theoretically should be less cyclical but got caught out in Covid where even the government slowed down.

We think the real value in the sector still resides in select operators at the smaller end. Some of the guys involved are very experienced and most importantly, hands on and entrepreneurial. They roll their sleeves up and get out of the office. Looking at the results it’s clear that the best operators are the ones that have been able to hold on to their staff. While this is true of the bigger operators, you get much more leverage from success at the smaller end.

Look at the mining and civil services contractor Maca (ASX:MLD). Revenue for the half was $841m, up 19% produced a 285% increase in the bottom line with NPAT of $20.8m.

Operating leverage where you get big increases on profits through a fixed cost base is the key to making the big returns in the stock market and contractors are no different.

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ABOUT THE AUTHOR

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.