Balfour Beatty demands patience

Parachuted in at the start of this year to save fallen construction giant Balfour Beatty, Leo Quinn has kept the City very much onside. As we predicted in September, a new boss would do the customary "kitchen-sink" job on arrival. And Quinn has obliged. His maiden full-year results included a huge loss, another big write-down and a decision to scrap the dividend for a year.

Balfour lost £304 million from continuing operations before tax compared with a £49 million deficit a year ago. Include a £234 million profit on the sale of its Parsons Brinckerhoff (PB) US consultancy business and the loss narrows to £59 million.

Clearly, the construction division remains troubled. It reported a loss of £391 million in the period, offsetting profits of £118 million and £23 million in its infrastructure investments and support services businesses, respectively. After infrastructure's record results, management has a strong pipeline of new investment opportunities and has earmarked £300 million for investment over the next five years.

However, after announcing £70 million of contract write-downs following a review by KPMG in January, Balfour has had to side-line a further £118 million for provisions. At the end of December, the group had net cash of £219 million.

Alastair Stewart, an analyst at Westhouse Securities, says: "The key thing for us is the underlying average net debt - we can't see current pro forma average net debt post PB disposal. Even with serious management efforts, we believe it will take at least another year before there is a reliable balance of investment risk and reward."

Balfour's problems are blamed on a failure to properly integrate a series of acquisitions, which were largely responsible for a four-fold surge in revenue since the millennium.

"This resulted in an overly complex, devolved organisation with poor controls and weak disciplines in cost control and project bidding," explains Quinn. "Following a major industry downturn, the UK construction business was extensively restructured in successive waves and began to exhibit serious project issues which, together with other factors, resulted in substantial operating losses for the group. The cost base remains too high, with current group-wide overheads approximately 1% of revenue above industry benchmarks."

But the boss is confident in the strong characteristics of the group - strong brand, reputation and customer relationships. His new "Build to Last" strategy focuses on making the company lean, expert, trusted and safe. In the next two years, Quinn hopes to improve the group's operating cash flow by £200 million, with £100 million of cost savings against 2014.

Management steered clear of providing earnings guidance for the year ahead, probably in a bid to prevent further profit downgrades. In its 2013 results, Balfour warned that operational issues in UK construction and a downturn in the Australian natural resources sector were weakening its performance.

Offloading its poor performing assets didn't help as much as intended, and Balfour kept taking the red pen to estimates, which ultimately led to former CEO Andrew McNaughton being shown the door. The construction firm batted off a takeover bid from Carillion, refusing to keep hold of Parsons Brinckerhoff, which promised to return £200 million to shareholders. Balfour's sixth profit warning in two years meant the share buy-back scheme was also scrapped.

Although not easy reading, nothing in these results came as a surprise - Quinn's decision to scrap Balfour's final dividend makes sound financial sense. Investors seem to think the new boss has completed his "kitchen-sinking" of the firm, and scrambled to buy shares, which pushed their value up 7% to 246p. The shares trade on 22 times forward earnings,

Bank of America Merrill Lynch reckons Balfour will report earnings per share of 8.95p in its 2015 financial year, up over 200%.

We have trimmed our SOTP-based PO [price objective] to 260p from 265p, mainly due to lower Construction JVs and Support Services valuations, while we continue to assign no value to Construction in the UK. We cut 2015E underlying EPS by 23% due to more conservative forecasts for the UK, Middle East and Support Services, but reduce 2016E more limited 3%. Our rating remains at Buy.

There are still significant risks here and Quinn has a lot of work to do, but at least the business appearson a more even keel. It's unclear yet whether the worst is over - the construction division is obviously still struggling - and it will take a couple of years to "work through the severe legacy of 'problem' construction projects". Cultural change is required, too, and "we face major short-term challenges," admits Quinn. Investors may require patience here.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.