Costain Group PLC (COST) Earnings Call Transcript & Summary

Good morning, everyone. I'm Alex Vaughan, Chief Executive of Costain, and thank you for taking the time to join this presentation and Q&A session this morning. Tony Bickerstaff, our CFO, will be presenting the financial performance for the first half of the year as part of this presentation. We are encouraged to have all of our contracts now operational, working safely and to have delivered profitable operations in the first half of the year. Clearly, we are disappointed that our results have been impacted by charges in respect of the A465 arbitration decision and the required accounting treatment for the Peterborough and Huntingdon contract. I will shortly share the decisive actions I've taken to ensure we don't have these issues moving forward. Following our capital raise earlier this year, we have a strong balance sheet with over GBP 140 million worth of net cash, which has helped us secure over GBP 2 billion of contracts and framework positions in the first half, contracts that give us clear momentum in the delivery of our strategic objectives in markets that remain resilient and positive. Firstly, I want to talk to the issues that caused our contract issues on the A465 and the Peterborough and Huntingdon contract and to share the actions I have led over the last 12 months. The key issue affecting the A465 contract was the ambiguity that existed about who owned and had responsibility for the works information and therefore, who was liable for changes in the design and the resultant additional scope and cost of that work, which were required to address the ground conditions experienced on that project. Since 2018, the contract has been through a resolution process with ourselves first winning an adjudication, but having now lost an arbitration following our clients' appeal against the adjudication. We are now working to conclude the account and complete the work. On the Peterborough and Huntingdon contract, the issues relate to the clarity of assumptions behind the original design, changes due to the clients revising and changing their equipment, which has resulted in additional costs. We have agreed a mutual termination of the contract and a mechanism to agree the final account over the next 18 months. As I've previously said, over the past 12 months, I've made a number of critical changes in 3 areas. I've made some changes in the contracts we will pursue, including the decision to no longer pursue energy EPC contracts, targeting longer-term investment program. I'm also ensuring we rebalance the downside risk on contracts to be commensurate with the returns, and we are increasing the minimum level of acceptable profit and removing a reliance on gain share. Over the past 2 months, we have already declined 2 opportunities, where we believe the risk apportionment to be wrong. I've also made some changes to our leadership with Sue Kershaw now appointed as Managing Director for Transportation. Sue brings extensive assurance and program delivery experience. I've also removed 2 layers of management to simplify the lines of accountability. I've implemented a training and commercial cultural behavior reset, where we now challenge change rather than encouraging, therefore, reducing our exposure to budget increases. Our risk management approach has also been enhanced with a number of changes, including independent risk reviews as part of a 5-stage new contract approval gate process, rolling out a group-wide operational excellence program, updating our risk appetite policies and enhancing how we monitor, manage and report our contract operations. These measures have been implemented, are in place, giving confidence in the quality of the work secured over the last 18 months, and we have reviewed all of our other contracts to ensure we have confidence in their delivery. Our strategy, business model and the team's response has enabled our business to be resilient in how we have responded to the current COVID-19 pandemic. We set very clear priorities for the business in doing the right things and delivering critical services. We manage the operational impact and recovered quickly to a position where we are now operating at 90% productivity. We also took a number of strong mitigating actions to minimize the impact and accelerate the pace of our recovery. These have included strong social distancing, safety measures, management salary reduction and the temporary furlough of some of our teams. I want to take this opportunity to thank our team, our partners and our clients for being outstanding in their joint response to this pandemic. For keeping our teams safe, we are, as you can imagine, very proud of them. Tony?

Thank you, Alex, and good morning to everybody on the call. I'd like to start the review of the half year results by providing some detail on the revenue for the group in the first half. Overall, revenue was down 8% as compared to the first half of 2019. However, as the graph on the slide shows, the revenue in Q1 2020 was actually at a very similar level to both Q1 and Q2 of last year. Q2 2020, however, reduced by 15% from that Q1 level due to the impacts of COVID-19 and the disruption to the group's activities. Splitting that down further. April was 20% lower; May was 17% lower; and then June, that reduction was 12% lower than last year, which demonstrates how, from the initial impact to the operations, we recovered. And now from July, we are operating at 90% of the level we would have expected to with our revised safe working practices now established across all [ strides ]. Also to give you a breakdown of the reduction in the revenue by sector, rail was down 23% in the second quarter compared to the first quarter. This was due, in particular, to the Crossrail activities in London, which were paused due to the restricted working environment. Highways was less affected at 9% lower, given the more widespread nature of activities, and we've been able to keep disruption to a minimum. Similarly, in water, it was affected by 8% lower, although our Thames Tideway project, again in London, was initially paused. And energy was 32% lower in Q2 on smaller revenue numbers, due mainly to the Peterborough and Huntingdon capital project. And finally, in defense, where we provide only consultancy services, we were able to quickly move to remote working and maintain the revenue level. Hopefully, that's provided you with a full picture of the revenue impact on the group on the first half due to COVID-19. On the next slide, as a reminder, we have set out the way that we were disrupted and, importantly, the actions that we've taken to mitigate the impact. In terms of disruption, as I said, several activities were paused, and we had to adapt our working practices to maintain social distancing, strict personal numbers on site where appropriate and replan our activities as necessary. We've also seen a delay for new contract awards and starts, and this is an area we'll continue to monitor closely, given the importance of new awards and project commencement to the business. We took immediate action to mitigate that impact. We furloughed at peak 360 employees, which represents 11% of our employee base. Almost all of those have now returned to work. We have recovered GBP 1.6 million of cost for furloughed employees under the job retention scheme, and this will be just over GBP 2 million at the end of this month. We haven't needed to access any government loan schemes, although we have deferred PAYE and VAT payments, and I will cover that when I talk through the cash flow of the business. We immediately implemented a cost reduction program, which included salary reductions for employees of 10% increasing to 30% for the senior team and for a 3-month period. The outcome from that disruption and our mitigation -- mitigating actions was that we were able to maintain the delivery of profit from both of our divisional activities as shown in this table. Obviously, that was on a reduced level of turnover, as I've set out, and at a reduced profit level and therefore, lower margin being 1.4% in Transportation and 2.3% margin in Natural Resources. The margin impact in the Natural Resources division was less as we have a higher proportion of consultancy services in that division, which we were able to quickly continue to deliver services remotely. We expect margins to increase in the second half and also increase further to more normalized levels in 2021, and Alex will touch on that in a moment. You will have seen from the results this morning that importantly, in order to provide clarity on the business in the group and the divisions, we have reported profit on an adjusted basis, which excludes the A465 and Peterborough and Huntingdon contract adjustments made. We'll complete this. On this slide, I've set out the full statutory income statement, which shows the impact of those adjustments. To confirm, the adjustments made on the A465 and P&H, as previously announced, reduced the revenue recognized on those contracts for the level of cash received to date. Hence, the material adjustments made, as set out in the table. I'd just like to highlight a few other items. In August, we completed the sale of the Marina in Spain for EUR 4.75 million, and we have booked the loss on the sale of GBP 0.6 million as an impairment in H1. This completes the group's exit from all of the activities in Spain. We have written off a minority legacy investment in our hotel business of GBP 0.6 million due to the impacts of COVID-19 on the activity in that sector. And also in the first half, we completed the sale for GBP 1 million of a very old Zimbabwe property investment the group held, which also represents the level of profit as it was carried at 0 value. And with GBP 0.7 million of refinancing fees relating to the new capital and amortization of GBP 0.5 million, that gives you the full picture of the various items in the group's income statement in the first half of the year. Turning to the cash flow of the group. On this slide, we have set out the significant elements of the cash bridge from the start of the year to the end of June. Firstly, timing. The positive timing from the year-end of GBP 35 million, as I've set out in March at the year-end, reversed as expected, although we did have GBP 25 million of positive timing benefit at the 30th of June. We've also had good positive cash flow -- cash -- working capital in H1, 21 -- GBP 22 million and benefited by GBP 25 million from the deferment of a Q2 PAYE and VAT payments. The PAYE is GBP 15 million and was paid in July. The VAT is GBP 10 million and will be paid by March '21. We've had the operating profit cash and the usual pension deficit payments. We've also had a cash outflow on the P&H contract in the first half of GBP 40 million, which was both payment of the accrued costs from last year and costs this year. And there is a further GBP 15 million of cash-out in Q3 of this year on the contract to complete our work. On the A465, we had a cash-out of GBP 15 million in the first half, and we have a further GBP 20 million cash-out in the second half. Then we have the net receipts from the successful capital raise of GBP 93 million at the end of month. These movements result in the GBP 141 million net cash balance at the half year. The level of our share of cash insurance operations has been consistent through the first half of circa GBP 83 million. Simply for the numbers, the average month in net cash balance during the first half was GBP 56 million. But that, of course -- that's distorted by the new capital, which was injected at the end of May. By way of guidance, if you take the reversal of PAYE and the period end timing and the A465 and P&H cash-out that I've highlighted, we expect the year-end net cash balance to be circa GBP 70 million to GBP 80 million, although this may vary due to year-end timing. Again, for completeness, we had average supplier payments of 38 days in the first half, just a small increase on the -- from second half of last year due to timing. And importantly, we continue to pay over 90% of invoices within 60 days, which is a key metric regarding the Prompt Payment Code. I'll now turn to the balance sheet on the next slide. You will recall that I set out some key target metrics at the year-end. Obviously, the new capital was expensed on the balance sheet significantly, although that has been impacted by the 2 significant contract adjustments. In terms of the target, whilst the net asset isn't quite at a target level, it has increased since the year-end. And with the H2 profits expected and profit in 2021, we expect net assets to move up towards over the target in that period. The current asset ratio that I set out is on target. We've significantly reduced the debt level within the business and have a very high net cash balance. Therefore, we are confident that the enhanced position will continue to provide the balance sheet strength and confidence required by our clients. Finally, on the numbers, just turning to the order book. We have an order book at the end of June of GBP 4.2 billion, which is at the same level at the start of the year. However, that excludes the orders on the Smart Motorway Alliance framework, which we successfully secured a place on in the first half. We expect that to be over GBP 1 billion of order book, which we will include at the various schemes, which will be reallocated to us, move to the delivery phase. In terms of the timing of the order book, as the bars on the slide show, with the Smart Motorway Alliance, we have increased the secured order of acquisition for each of the next 5 years and beyond, which provides a very good foundation of secured work going forward. Alex, back to you.

Thanks, Tony. Over the past 12 months, I've outlined our strategy and received a lot of feedback. And I'm also cognizant that many will be wondering how our strategy has been affected by the pandemic. Therefore, with the aim of giving greater clarity and confidence, I'm going to talk about our strategy, what our plan is, share the progress we're making and our plans for the next 18 months. We have focused our business to address the needs in highways, rail, aviation, water, energy and defense markets, where we believe investment is a priority and continues to be strong. In these markets, we are focused on working with the key clients who have primary responsibility for meeting the needs of the general public. As a result of the changing nature of these clients' need as they respond to challenges, including climate change, population growth and efficiency demand, we have aligned the services we will provide to address these changing needs with the objective of being both their partner of choice and in evolving our service mix to increase our profit and business margins and therefore, the value of our business. The evolved service mix is the result of growing our higher-margin consultancy and digital services and enhancing the delivery of our complex programs and is targeted to achieve divisional margins of 6% to 7% in the medium term. Recognizing the ongoing impact of this pandemic, I'm going to give you an update about what's happening on the ground from the conversations I have with the chief executives of our clients. In Transportation, Highways England and Network Rail are proceeding with the implementation of their respective RIS2 and CP6 investment programs. There is some adoption moving away from capacity challenges moving towards climate change resilience as a result of the current pandemic. However, the programs continue to be delivered. HS2, having started the Southern main work, is now beginning to procure the follow-on phases of work, which we are actively pursuing. The exception of this positive narrative is our aviation clients and transport for London, who have all been significantly affected from a dramatic revenue reduction and most investment remains poor. In water, the water companies that I speak to are progressing with their AMP7 plans, although we have seen some impacts as programs have been rephased to address short-term cash flow issues arising from the retail market impact and concern as to additional costs. Some of our energy clients, as you would expect, have been impacted by the oil price decline and have deferred investment programs. However, we are also seeing an upturn in the pathfinder green energy programs being progressed, and we are continuing to see good volumes of work for us. In defense, our clients are continuing to progress with the delivery of the established defense equipment programs we're involved in. In overall terms, the government's GBP 600 billion 5-year investment plan, we continue to see and are confident in the size of our addressable market. I'm going to take you through 3 slides now, which aim to give more detail and clarity about the plans underpinning our strategy and the growth and delivery of our service lines. Complex program delivery forms a strong core to our business, and we are focused on positioning ourselves to deliver the strategic long-term investment programs of our clients. We have built strong foundation of work for the next 5 to 10 years, with further new work being secured in the first half of the year, including the Anglian Water Strategic Pipeline Alliance; Highways England 10-year Smart Motorway Alliance, which Tony talked about; and Highways England's A30 contract as part of their regional delivery program. These new programs operated under our operational excellence model, our target to deliver divisional margins in the 3% to 5% range. Leveraging our core expertise as a business that manages and delivers complex programs, as a business, we are positioning ourselves as a consultant who not only provides great services but also provides a focus on their implementation. We are growing our position in 4 areas. We are increasingly building a position as a delivery partner or program manager in positions where Bechtel and Jacobs, amongst others, are positioned. Our 10-year Cadent contract is our second delivery partner position alongside our AWE contract. We are also expanding our design services, both self-delivering design to our complex programs and providing design services to clients. As an adviser, we provide services to clients, leveraging our core skill set to meet their business needs. And we are successfully growing a strong volume of long-term framework supporting our clients in the delivery of their business objectives. We are securing work that will deliver divisional margins of 6% to 8%. And with growth in our scale, we will see this increasingly enhance the group's blended margin. Incorporating digital applications into our service propositions presents us with the opportunity to optimize not just our own operational performance, but that of our clients. Our approach focuses on 3 areas. Firstly, we are increasingly providing solutions, which are totally digital. We have, for some time, been a leading provider of digital technology to the U.K.'s highway network and have expanded this into rail, helping them with their remote level crossings. And most recently, supporting customer confidence at Heathrow Airport through our thermal imaging cameras as well as, importantly, leading the Department for Transport Intelligent Infrastructure Control Center, which will use data to improve infrastructure delivery performance. Secondly, many of our contracts include an explicit digital component. And recently, as part of the Anglian Water Strategic Pipelines Alliance, we are providing services to develop their industry-leading digital twin, which will allow them to optimize the asset performance of their network. And on the Smart Motorway Alliance, we are integrating the digital vehicle management systems into that network. We are also increasingly digitizing our services and operations to make our services truly leading edge. I've strengthened our leadership, simplified our focus and expect to increase the pace of growth in this area so that we can deliver the 6% to 8% divisional margins we target. I want to give you a little more detail around some of the strategically important contracts that we have secured in the first half of this year. As Tony and I have said, we've secured a place to deliver the Northern program as part of Highways England Smart Motorway Alliance. And over the next 10 years, we will deliver capacity improvement to the network through both our complex program delivery and digital solutions. Securing a place on Highways England's VAT 2 strategic consultancy framework was an important milestone for us, allowing us to help shape their future networks and delivery plans. Network rails have also given the green light to implementing our innovative digital railway safety solution across a broad range of their remote level crossings. As well as the Anglian Water SPA contract that I've discussed, we've also won our largest consultancy delivery partner contract, program managing cadence investment program in the East of the U.K. over the next 10 years. These contracts are clearly strengthening the mix of business for Costain. In the first half of this year, as I've said, we have made progress in securing new work and broadening our services. We have implemented a number of critical changes to enhance our contract risk management, further focusing on our contract selection and operational working practices. In improving our operational efficiency, we have secured GBP 7 million of annual efficiency this year and are on track to deliver GBP 12 million worth of efficiency next year, and we continue to strengthen the leadership team and focus on investment on the strategic opportunities available to us. Now that's a measure of progress in the first half of the year, but I've also set a number of key short-term milestones to ensure that we achieve our strategic objectives and ultimately deliver a step change in the performance and value of this business moving forward. The 5 key strategic milestones are to increase divisional margins, deliver consistent profits in our complex program delivery, grow our higher-margin services, improve efficiency and enhance our group capabilities. As an outcome for 2021 next year, recognizing the enduring impact of COVID-19, we are targeting margin progression across both divisions in the 3.5% to 4% level as part of our plan towards 6% to 7% divisional margin. As part of that, we must achieve consistent returns on our complex program delivery project. The strong measures we have put in place to reinforce our contract risk management will support us achieving this, together with the new operational excellence model that we have and the quality of the work that we've now secured. As an immediate measure, we are targeting that by the end of next year, every one of our complex programs, which commenced from the third quarter last year, will be delivering 3% to 5% margin. By 2024, all contracts are targeted to be performing in line with these profit targets. In growing our higher-margin services, we will deliver the work secured, win further work and unlock the opportunities in our secured frameworks so that 40% of our profits represent our higher-margin services, moving towards our target of 55%. I've already talked about the efficiency gains we're making, which is enabling us to both invest across the business and to ensure we can deliver the best value proposition to our clients. We have a good line of sight to achieving GBP 12 million by the end of next year and GBP 20 million by 2024. This investment enhances our capabilities and ultimately, the number and type of opportunities we can bid for and win. Cadence confidence in awarding us their delivery partner program recently is a perfect example of this. And our ability to win similar types of programs is a strong indicator that our strategy is working. I've challenged my team to win at least 2 further delivery partner programs by the end of next year. In closing, it's encouraging that all of our contracts are operational and have adapted to cope with this extended pandemic. I've taken strong actions to address the recent contract issues and strengthened our balance sheet. In delivering on our strategy, we've secured over GBP 2 billion worth of new work and made important momentum in broadening the mix of our services. Our targeted margins remain resilient and positive, and all of the above gives me confidence in delivering significant growth in profit for 2021 and beyond. So we're now going to open the floor to questions, and I'll now hand back to our operator, Ruby, who will manage the Q&A for us. Ruby?

[Operator Instructions] Our first question is from Johnny Coubrough of Numis.

Three questions from me, please. Firstly, are you able to give guidance for average month end net cash for the current year? And perhaps also what you expect the shape of net cash to be into 2021, whether you have visibility of further writings beyond those VAT deferrals. The second question is on C-19. And just wondering really whether you have a sense of what impact C-19 and related lower productivity has had on profitability in H1 and what ongoing impact do you expect there? And then the third question, if I could just ask for a bit of clarity on the 2024 margin guidance from Slide 23. Just in terms of if you're expecting or targeting to do a 6% to 7% overall margin, how you get there is 55% of profits will be coming from 6% to 8% margin contracts. And so by inference, 45% comes from 3% to 5% margin contracts.

Okay. Tony, do you want to take the first 2 and I'll take the last one?

Okay. Well, in terms of average month end, as I said, Johnny, the average is distorted by the GBP 93 million at the end of May, just by way of guidance. I suspect the average in the second half will be at a similar level to the year-end guidance that we'd given, GBP 70 million to GBP 80 million. And therefore, average for the full year is probably GBP 60 million to GBP 70 million just to give you the guidance around that. Just going forward, in terms of 2021, the cash impact that we know already is, obviously, as you say, the reversal of VAT at GBP 10 million, which will be by March. The A465 is circa GBP 15 million, that's 1-5, of costs through next year. And obviously, we have the continuing pension deficit of GBP 10 million. So kind of in the round, pre any other items, it will be broadly GBP 60 million to GBP 70 million. So pre any fixed assets or dividends or any other items like that, it will be broadly flat excluding those items by way of guidance.

Yes. In terms of the second question, which is in relation to COVID-19 and the half 1. Obviously, we've not -- like many others, we've not tried to kind of break out what were the impacts of COVID, et cetera. We've given the results of the business in the round. And as we've said, we've been able to mitigate pretty much from March, as we've said before, circa 1/3 of the business was paused straightaway. So we had that impact to deal with back in March. We then had -- we got some recovery, but we did have a number of projects where we just agreed a cost reimbursement on the projects during the period for the first couple of months. So whilst we were getting cost recovery, we were getting no -- effectively no fee and therefore, no contribution out of those contracts. So that had an impact through the second quarter as well. And then, finally, obviously, as we've said, we are operating at a lower level of productivity. So we -- and if I look at the numbers for July and August, we are operating about that 90% of where we would expect to be. So it's a combination of all those things that I meant where we got the impact that we've had in the first half.

And Johnny, if I come back to your third question, just around the clarity. What I've tried to do in setting out Slides 18, 19 and 20 is to be able to give people the road map that we've developed for how we're going to grow our services. So in complex program delivery, very focused on making sure that we deliver the 3% to 5% margins, and we're looking to get more and more to the upper end of that range. And then in the consultancy and digital services, we've set out how those come together. So in consultancy, it's the 4 areas on that [ chart ]. So to increase the sale of our delivery partner roles, grow our design services, advisory and framework. And then similar, we've set out the 3 areas on the digital services. And as you say, if we look at our profit, we are looking for 55% of our profit in 2024 to come from the higher-margin services in the 6% to 8%, and we'd like it to be at the higher end of that, certainly for the digital work. And then 45% of our profit coming from the complex program at a higher margin. And that, together with the efficiency that we're driving, will give us a route map to be able to deliver that 6% to 7% margins by 2024. Okay.

Our next question is from Joe Brent of Liberum.