Description

Galliford Try (“GFRD”) has no enterprise value despite having a profitable and growing business. The company has 100% of its stock price in cash and investments, an arbitration claim that could be worth 40% of the share price, and a large order book providing visibility into 90% of next year’s revenues. There is no debt, no pension, a growing cash balance and the company pays a dividend.

Additionally, the UK is unleashing massive government stimulus and infrastructure spending. Nostradamus is not needed to predict this should be highly beneficial to UK construction companies like Galliford Try. However, stock prices across the industry sit near multi-year lows, indicating that Mr. Market is not basing its future predictions on Les Prophéties but rather historic industry issues that have mostly been resolved.

Why Does the Opportunity Exist

Welcome to the wonderful world of UK construction, a sector that has some of the worst sentiment we have ever seen. Investors have been disappointed for decades as aggressive competition and financial leverage drove several large players into bankruptcy. In normal times, contractors face risk from bidding too aggressively on projects, using fixed price structures to secure wins, executing poorly on contracts, and employing excessive leverage to fuel growth. On top of these risks several management teams tried to “juice” share prices through accounting shenanigans that inflated earnings and understated debt, eventually driving companies to insolvency. The poster child was Carillion, a firm with 43,000 employees and £1.5bn in market cap that was wiped out nearly overnight in 2018 when all its issues came to head.

As a JV partner to one of Carillion’s problem projects (as well as exposure to other problem projects), Galliford was forced to cut its dividend and commence a £150mm rights offering. Since then, the pendulum has swung in Galliford’s favor – there is significant cash on the books, the dividend has been reinstated, and the order book de-risked – yet both investors’ memories and the stock remain depressed. Many companies in the industry are valued at single digit earnings multiples, and even more extreme is Galliford’s zero enterprise value, which reflects the market belief that the company is priced more for an infrastructure bust than boom.

Investment Thesis

At the current valuation, investors are paying for the cash + investments and getting a profitable/growing business for free, in addition to free optionality on an arbitration award and deployment of excess cash. We think the stock has 50-150% upside.

This is a fairly asymmetric payoff and for our thesis to work investors need to believe the balance sheet is “real” and the order book / bidding framework are de-risked. These should limit downside while upside can be framed by the company’s FY26 target of ~£65mm of EBITDA. At a paltry 3x multiple and using consensus FY23 EBITDA of £33mm, the stock is worth £2.97 (52% upside).

Our key investment points are below:

Pay for the cash, get the business for free. Our first investment point is that the balance sheet needs to be “real.” While this should be obvious, history of the industry tells a different story as intra-period cash balances deviated significantly from period end balances and the use of supply chain financing understated debt levels. Galliford has the strongest balance sheet in the group as it has no debt (it doesn’t even have a credit facility) and no pension. Additionally, the company discloses month end cash balances as well as period low balances. As of 6/30/21 there was £262mm of cash and investments on the balance sheet (£2.30/share) composed of £216mm of cash and £49mm of PPP investments. For valuation purposes, we have elected to use the average month end cash balance of £164mm instead of the period end balance of £216mm. In addition, GFRD has a PPP portfolio valued at £49mm (which generated £4mm of interest income and is set to grow). The value of the portfolio was determined using a 7% discount rate, which seems conservative. Every 1-pt reduction in the discount rate adds £4mm to the value. Using the more conservative metrics for both accounts yield a balance sheet value of £213mm or £1.87/share. Furthermore, with no debt or pension liability, we are getting a profitable/growing business for free.

Core business has high visibility and is worth £0.50 – 1.50/share. Galliford has a £3.3 billion order book, which provides high visibility for future revenues. For the investment case to work, investors need to believe the order book has been de-risked and management’s approach to risk management is in stark contrast to prior periods. Prior to our analysis, here is how management frames their approach:

“So here's a bit more detail on our risk management process. And this underlies our order book and everything that's in it. So what happens is our business unit managing directors review potential tenders using a defined process to identify any onerous contract conditions or risks. And if any of these arise and if the BUs still wants to proceed, then the project comes to an executive meeting, which we meet monthly to look at these bids and decide whether the bid can progress or not. If it does, we'll either then stop the bid or allow it to progress on strict sort of risk-mitigating parameters. But the really important thing here is that the culture of the business has evolved to the point where very few projects will come up to the exec now because the business units reject them on the basis of a poor risk profile before they get anywhere near us. So it's really working well in that regard.

And then the bottom line there, commercial control and reporting, once we're in contract, we have robust project controls to manage an overview of the project forecast. And in addition, we have a system, what we call commercial health checks, whereby our operational and commercial directors from another part of the business spend a couple of days on another region of this project to review that project, the forecast and to give their view on the likely outcome. And again, I believe that the culture of the business means that these health checks now are welcomed by the receiving site and any recommendations or observations by the visiting directors are taken seriously and acted upon and reflected to the forecast. So this is really working well for us overall.” (March 8, 2021 earnings call)

The key takeaway is that the company’s culture has been redefined and geared towards risk management. This approach has been enacted for 3+ years, thereby completely de-risking the current order book (since projects are typically 18-36 months). Additional details that give us comfort:

·         The company no longer bids on larger, fixed price contracts, instead favoring smaller projects with the average size < £20mm

·         87% of contracts are through frameworks agreements that are typically cost-plus and require prequalification, and therefore are not completely price dependent. These projects are typically with long-term customers that produce positive outcomes. Per the company, the benefits to frameworks include:

o   Offer repeat business with clients who we know and on established and well-understood terms and conditions – a mutual benefit.

o   Greater certainty in tendering and typically reduced cost of tenders.

o   Improved risk allocation.

o   Improved ability to plan for retention of our project teams. 

o   Early involvement leads to greater influence over value-adding and social outcomes and allows for deeper collaboration.

·         Over the last year, target margins were raised from 2.0% to 2.5% to 3.0% to reflect the early success of the risk management program and improved execution.

The company typically starts its FY with 85% of its full year revenues in backlog and that value currently stands at 90% indicating strong visibility for the upcoming years. Additionally, 92% of the order book is with repeat customers. UK infrastructure spending is expected to grow 6% annually through 2024. Galliford itself is targeting 8% revenue growth during this period, and at their target margins would generate nearly £65 million in EBITDA. At an undemanding 5x multiple, the business would be worth nearly £2.85/share. For conservatism, we are valuing the business at £0.50 – 1.50/share based on two-year projections.

Arbitration claim could yield an additional £0.80/share. In addition to the balance sheet and business value, Galliford has an arbitration claim worth as much as £94 million. The claim stems from a prior project where Galliford is no longer on site. We believe the likelihood of collecting is quite high, although the actual value may be reduced during the claims process. We do not believe any of this is factored into the stock price, despite management’s expectation for collection in the next 18 months. While it is hard to handicap the outcome, it is all upside to Galliford.

Valuation: Sum of the parts points to 50-150% upside. We have presented a range of outcomes below. The largest delta in determining value will ultimately be fundamentals of the core business and to a lesser extent, the arbitration claim. At the current price, the market is assuming significant deterioration in the business, which will end up burning cash. Directionally, we think this is completely wrong. It can be debated what the ultimate earnings power of the business will be, but even using a 3x multiple on FY22 consensus EBITDA yields £80mm or £0.70/share of value. EBITDA is expected to grow to nearly £65mm  based on management’s FY26 targets, which would value the business at £210mm or £1.85/share at the same 3x multiple.

In addition to the values we highlighted, we believe management will start to opportunistically deploy its excess cash. Using just half of its cash at a 10% ROC would add 50% to the current operating profit run-rate.

Risks.

a.       Cost overruns: the biggest risk to the investment are cost overruns on any given project. However, given the majority of projects have some type of cost reimbursement structure and the average contract value is less than £20 million, the risk to a single project has been reduced.

b.       Inflation: Commodity and wage inflation are significant and pose risks to margins. GFRD usually procures materials at the time of pricing contracts and is able to pass through wage inflation to subcontractors, partially mitigating the impact of inflation.

Catalyst

1. progression of margins towards 3.0% target

2. deployment of excess cash