Berenberg starts Costain at 'buy'

(Sharecast News) - Berenberg initiated coverage of construction and engineering group Costain on Friday with a 'buy' rating and 140p price target. It said the company has overcome its recent challenges, as it improves both its profitability and its free cash generation, and it has strengthened its balance sheet, to the extent that in 2024 it was able to buy back shares for the first time in at least the past 10 years.

It pointed to a pipeline of revenue opportunities. Berenberg said there are significant infrastructure spending commitments in the coming years that it expects to benefit Costain.

"That it ended FY 2024 with a forward work position of £5.4bn, £1.5bn higher than the previous year, suggests the company is capitalising on these opportunities," it said.

"A strong order book not only underpins future revenue but should also enable greater discipline in contract selection and help Costain to pursue only those contracts with acceptable terms."

With this in mind, the bank said its base case is for group revenue to be broadly flat in the coming years, with growth in the Natural Resources division offsetting lower revenue in the Transportation division.

Berenberg also highlighted improving margins and reduced exceptionals.

"Earnings growth will, in our view, be driven by improving margins and fewer exceptionals," it said. "We expect margin growth to be driven by a combination of more higher-margin digital and consulting work, and the ending of older, lower-margin contracts."

It said improved controls were implemented in 2022 and should limit exceptionals.

It pointed out that management expects to achieve its target EBIT margin run-rate of 3.5% during FY 2024 and is targeting 4.5% during FY 2025 and more than 5.0% beyond that.

"These margins are not included in our base case, but we expect a circa 30% incremental benefit to EBIT if they are achieved."

Berenberg also cited the company's balance sheet strength, cash generation and the prospect of further returns.

"Costain's improving free cash flow profile will, in our view, enable it to grow its net cash balance, give the business optionality on further investment, and allow for further shareholder returns," it said.

"We believe Costain should make balance sheet strength an absolute priority, but we nonetheless expect its strong free cash generation to allow for further shareholder returns."

Finally, the bank said the stock's valuation is "undoubtedly cheap", trading at 7.3x FY 2025 price-to-earnings, 1.8x EBITDA and 2.4x EBIT, with an 11.4% free cash flow yield.