Are mergers answer for M&R and rivals?

February 2, 2016, 5:21am


The M1 bridge collapse was yet another blow to M&R. Picture: AFP on BDLive

By Reitumetse Pitso, Business Day Live

CIVIL engineering company Murray & Roberts (M&R) is putting a brave face on the dire circumstances in which construction companies seem to be stuck.

But the cold facts are ugly: most of the companies in SA have shrinking order books and squeezed profit margins — and their share prices reflect this dismal scenario.

In the past five years, M&R’s stock has plunged 77%. It’s not Lonmin, sure, which has lost 98% in that time, but it’s still far worse than the overall JSE.

Most construction firms have had a torrid time: Basil Read’s share price is down 71% over the past five years; Group Five is down 48%; Stefanutti Stocks is down 64%; and WBHO 9,9%.

Worst hit has been Aveng, down 93%, so dire that SBG Securities was recently moved to write that "we remain concerned about the possibility of a future call on additional equity capital if operating performance and tender success do not improve".

The question for investors is, when will this cycle turn? When is the right time to buy construction shares ahead of the upturn?

Analysts are confident that their fortunes will improve — at some stage. But can shareholders hold out until it does, and risk losing more of their capital?

Here’s one reason they should: experts believe there may soon be a rash of consolidation in the construction industry. Those companies still standing may either merge entirely, or combine their infrastructure arms.

Profit would likely improve as head office costs would be stripped out and the pipeline of potential deals would be strengthened. Perhaps most importantly, the companies would be able to wield greater bargaining power when it came to negotiating building contracts, particularly with government.

This should also uncork value in the share prices.

Makwe Masilela, a portfolio manager at BP Bernstein Stockbrokers, says the time is right for this to happen. "It makes sense to get things at these cheap levels [by merging] so that [when] things start booming and government starts spending on infrastructure, you are ready."

As Masilela points out, these construction firms have been through an awful time since they reached their peak in 2010. "They were [hit with] penalties by the competition tribunal and, because they were all making money from mining, which is on a downward spiral, they are in a double whammy," he says.

He’s not wrong about those companies being lip-smackingly cheap right now: M&R is trading on a price-to-earnings (PE) ratio of 4,3, and analysts expect its forward PE for next year to be just 5,1. Group Five is now trading on a ratio of 10,4, but its forward PE is just 5,8. Stefanutti Stocks is even cheaper, trading at 3,6 times earnings.

But the reason they’re so cheap is that sentiment has soured so badly, few investors have any belief in their prospects.

Despite the bargain basement price, most analysts still consider M&R either a "sell" or "hold". It’s the same story with Aveng, while the consensus for WBHO is that it’s a "hold".

Of all the large construction shares, only Group Five is considered a "buy" — and even then, analysts expect its share price to edge up only to R26,50 from its current levels of R20,50.

Were they to team up, it might be a different story.

Charles Henwood, WBHO’s chief financial officer, told IM this month that while no merger offers had yet come his way, he wouldn’t be surprised if they did. "The market is ripe for that [consolidation] financially, given that share prices are low, but for that to happen, people have to have faith," he said.

There are, of course, many reasons why the market lost faith in construction firms. Not least among these is the revelation in 2011 that all the firms secretly colluded to fix tender prices.

In all, the construction firms admitted to the competition authorities that they had rigged bids in 298 projects worth a combined R111,9bn. Notoriously, this included the World Cup stadiums, which meant that taxpayers were effectively robbed.

In February 2011, the competition commission announced the investigation into bid-rigging — and the slide in share prices really began.

To get a sense of just how precariously the industry is placed now, take M&R. For many years, it was the flag-bearer for the construction sector. With a distinguished track record dating back 113 years, it could do no wrong, and in the heady years until 2010, contracts piled up at M&R’s door.

Between 2001 and 2009, its pretax profits soared from R209m to R2,8bn. Investors fell over themselves to grab a slice, as the company’s stock soared from around R2,50/share at the turn of the century to more than R110/share at its height in 2007.

Today, it’s a different world — dropping margins, low-value projects and a poor order book. Its share has slunk back to less than R10.

And just when a silver lining appears, it all suddenly gets worse again. During rush hour on October 14, a temporary pedestrian bridge built by M&R over Johannesburg’s busy M1 highway collapsed entirely. Two people died and 19 were injured.

A few days after this disaster, the company held its AGM in Bedfordview. Chair Mahlape Sello arrived and exchanged hugs with her fellow board members, exclaiming that "after the bridge, I could do with a hug".

At the meeting, CEO Henry Laas also referred to the disaster. "What happened was tragic but we handled it well. It can only raise questions with future construction projects," he said. But he added that "infrastructure and construction is not our core area of business as it only accounts for 5% of our profit".

In recent years, M&R’s revenues have been dropping steadily, adding up to R30bn for the year to June, from R36bn the year before.

And while the infrastructure division showed an improvement in its operating profits (up to R205m from last year’s R196m), it has reported a series of losses in that arm since 2012.

Investors are eagerly looking for any clues that the orders are beginning to arrive again.

But they’ll have to wait a bit longer. In 2012, the infrastructure division had a R9bn order book, which has shrunk to R7,1bn today.

This dire scenario reflects problems in the wider economy: government is just not spending the many billions it promised on building new infrastructure projects under the National Development Plan (NDP).

There are many reasons for this. One is that government is cash-strapped because it has to keep Eskom and other state entities afloat. There are also political reasons, as the ANC’s alliance partners have fought to stop the NDP from going ahead.

The result is a de facto freeze on state spending, which has left many companies, including M&R, struggling for revenue. And for those projects still being awarded, it has sparked a race to the bottom for low-margin tenders.

Speaking at the AGM, Laas said: "We haven’t seen any large profits coming from the market segment besides small projects within the housing market."

It’s just as bad in some other parts of the business. For example, its water and power division reported an operating loss of R134m from a previous profit of R144m, largely due to the phasing out of the Medupi and Kusile power projects. In its oil and gas division, profits slumped by 22% to R838m because of a falling order book and low construction activity.

M&R’s saving grace has been, perhaps surprisingly, its underground mining business, into which it has poured resources. This might seem counter-intuitive, as SA’s mining industry is under strain because metals prices have collapsed.

But M&R operates in a specific niche, providing "infrastructure replacement services" on operating mines, where there is apparently still scope for growth.

In November, M&R said that while "prolonged weak demand for commodities" had "limited the growth potential", the company still had a solid line-up of mining projects in Canada, Australia, Mongolia and even Indonesia.

The order book in that mining division grew from R9,9bn to R16,9bn in the last financial year too, while operating profit increased 59% to R441m.

Xolani Mkhwanazi, one of M&R’s directors, reiterated Laas’s view: "Construction is not our core business. It just happens to be in the public’s face. Our core area is in mining. When mining stumbles we kneel down. When it sneezes we are in ICU and when it coughs we are in a coma."

And yet M&R is still pinning its hopes on government starting to build infrastructure projects, rather than on mergers.

Ed Jardim, the company’s investor relations head, says: "There is talk of major opportunities outlined in the national budget. Naming a few, [there] is a third coal-fired power station, the Durban port dig-out and phase two of the Lesotho Highlands Water Project. Nuclear is also being touted. Consolidation will affect employee numbers, so it shouldn’t be the first [choice] where there is money in the ‘bank’," he says.

Perhaps — but consolidation would strengthen the bargaining position of these firms when government does start spending.

In the construction field, all the companies appear to be struggling. WBHO’s combined order book for building, engineering, roads and earthworks in SA was worth R13,6bn as at September — but by 2017, it is projected to be worth less than half that number, at R6,6bn. The group’s Australian order book is, however, stronger (thanks to housing projects) and has grown by 4% to R25,3bn in the three months to September.

WBHO CEO Louwtjie Nel admits that his company’s order book is "under pressure".

"In the next 12-18 months, we are looking solid. But after that, we are nervous as to where the work will come from," he says.

These dismal prospects haven’t exactly endeared the companies to the unions, as they shed staff to "right-size" for the work they have to handle.

Nel says WBHO has already reduced its workforce. "We might have to reduce more as the workload keeps dropping."

It also means these companies are having to think creatively about where to find new sources of revenue. While M&R is putting more energy into underground mining, WBHO has expanded into markets it wouldn’t have dreamt of entering a decade ago.

It also entails changing strategies: whereas a decade ago, WBHO might have focused on six major projects, it is now working on 40 smaller projects.

"You have a lot of overhead structures to comply with to compete with smaller companies which don’t have to do so, as they are growing. We had to change our whole management and plant philosophy to win these projects," says Nel.

Many companies are now looking at doing big projects further north in Africa. But, as MTN’s disastrous fine in Nigeria indicates, there’s no small amount of risk on the continent.

WBHO’s Henwood appears to concede as much, while discussing plans to expand north: "We are also looking in East Africa for opportunities. There is, however, a lot of talk but no context. Unfortunately, Africa is not going to save us."

At this point, it’s hard to see what can save the construction firms. Experts believe mergers are one route to survival, though, and that they will start happening soon.

And when they do, the bravest investors will come out tops.