Interactive Investor

Five key stocks rated 'buy'

28th June 2017 09:28

David Brenchley from interactive investor

The support services sector is one of the broadest around, home to blue-chips as diverse as security provider G4S, pest controller Rentokil Initial and credit checker Experian. Performance has been equally diverse, but one team of analysts has found five constituents with something in common - they're all rated a 'buy'.

In a 128-page report, broker Liberum says most support services stocks it covers have not been negatively affected by the Brexit vote - some even claim it's a positive - but that is likely to change.

Pension deficits remain high and many are increasing, with Carillion, Interserve and Balfour Beatty burdened with the largest gross obligations relative to market cap.

Dividends are also at risk due to strained balance sheets, with analysts "nervous about companies with [dividend] cover below 2 times".

However, Liberum has named the five support services companies on its 'key buy' list:

AA

The AA's bright yellow breakdown vans are a familiar sight on UK motorways. It's a leader in most of its markets, including breakdown cover, insurance and loans. High barriers to entry insulate it from competition and defensive revenues, high margins and underlying cash generation make it an attractive investment.

Its share price is currently near an all-time low, and regular increases in insurance premium tax (IPT) remains a headwind.

However, recent results suggest it is turning a corner, particularly at its insurance business, where Liberum sees "plenty of untapped opportunity". That includes scope to leverage the brand, cross-sell and use insurer hosted pricing.

Liberum set a price target of 340p, with a price/earnings (PE) ratio of 9.4 times, dividend yield of 4.6% and free cash flow yield (FCF) of over 9% for calendar year 2017.

Babcock

It's been a rocky ride for Babcock since the EU referendum. Initially plunging by a quarter, shares finished 24 June down just 8%. They quickly hit a one-year high above £11 before drifting to around £9 currently.

With mid-single digit revenue growth expected in 2018, Liberum thinks the company is "too cheap to ignore", with a forecast 2018 PE of 10.3 times a 32% discount to the sector. A yield of 3.3% is attractive, too, and the broker ups its sum-of-the-parts derived target price to £11.

The positives are well-known, it says: strong track record of EPS growth, defensive characteristics, and a recent history of strong cash generation.

"We see the valuation as compelling and our worry list is shortening."

Balfour Beatty

Construction giant Balfour has pretty much traded sideways since August, with 300p proving a tough nut to crack. Last time it topped that was April 2014, but Liberum thinks it can do 335p in time.

Balfour is a clear beneficiary of supportive infrastructure policies introduced both in the UK and US recently. UK construction is tipped to keep generating big profits, while America is now its biggest market.

Elsewhere, Liberum sees construction opportunities in the Far East, with strong demand for infrastructure in Hong Kong. Construction margin of 2-3% is also possible.

"We believe recovered earnings of 24.4p are achievable for FY19, implying a PE of 11.5 times," says the broker.

Costain

Focus is the key for Costain, the engineer whose shares are currently running just below a 10-year high. Previously, Liberum had called the stock up correctly, sailing past its 450p target three months ago. It's still bullish, calling Costain up to 510p.

Strong order book growth shows it's the "most focused player", and a strong balance sheet means it is well-placed to exploit competitor distractions and fund working capital.

This is a pure-play on UK infrastructure with a huge addressable market of around £20 billion. While its forecast 2018 PE of 13.3 times is above peers at 8.5 times, its enterprise value/operating profit (EV/EBIT) of 8.8 times is more attractive.

Mears

Mears shares slipped Tuesday after it warned of challenging conditions in both its care and housing markets. Still, the firm reckons it weathered those well.

And Liberum sees plenty of long-term drivers in its social housing division, while £2 billion of government funding for the care sector, which "has become a hot political issue" should help. An ageing population will increase demand for care, too.

An expected 14% compound annual growth rate in earning per share in the three years to 2019 is strong. After Babcock, Mears is the cheapest in the sector on EV/EBIT of 10.2 for 2017 and strong free cash flow yield of 7.9%.

The dividend is well covered, and a solid balance sheet offers scope for continued growth in the payout. A target price of 540p implies 20% potential upside.

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.

Related Categories

    UK shares
    Infrastructure
    Industrials
    Consumer goods and services
    Income Investor