Edmond Jackson's Stockwatch: Morgan Sindall Group

Does the recent plunge in the FTSE Small Cap-listed shares of this construction and regeneration group amount to a buying opportunity? I have followed Morgan Sindall Group periodically since listing in 1994: its shares have shown some fine runs and offered useful trading, although be aware that the inherent volatility of a cyclical share is enhanced in a tight market.

After a 725p, 12-month high amid last January's "risk rally", the shares drifted then plunged from about 660p to as low as 508p when a 6 November update for the July to early November period said ominously: "Since the half year we have experienced further market deterioration, which has impacted the short-term outlook into 2013."

The market did not swallow a sweetener about increased confidence for the medium-term outlook due to "success in securing a number of longer-term opportunities in growing sectors of the market" although the share fall stabilised after 20 November news of the group being awarded £42 million of new infrastructure projects in the rail and water sectors.

An 18 December pre-close update reaffirms this theme, with management confident from 2014 onwards due to "success in securing longer-term opportunities in growing sectors of the market including rail, energy and utilities and infrastructure".

Call me picky about words, but it is so easy to use "contracts" instead of "opportunities" which raises the question of what a lawyer may have judged passable. Management has previously referred to a forward order book standing at £3.0 billion "with a further £0.7 billion of projects at preferred bidder stage" compared with a £3.4 billion order book and £0.3 billion at preferred bidder stage at the start of 2012.

Amid concern over how UK public spending may affect some aspects of the group, analysts project a modestly declining earnings scenario with a forward price/earnings multiple of about eight times, in line with the last five years' annual average. Yet a prospective dividend yield over 8% - assuming a payout of 42p a share is maintained - has lent support and would be covered about 1.7 times by earnings forecasts.

Possibly the reason the market is uneasy enough about the dividend to have sent the shares so low is its security versus cash flow, which is a true test of dividend payments. The cash-flow statement in the first-half 2012 results shows a net cash outflow from operations of £104.4 million, compared with £66.8 million during the first half of 2011, which narrowed to £11.8 million for the year. In this context, the 42p a share dividend cost £17.8 million, being satisfied partly by a decrease in the cash balance from £148.6 million to £108.9 million over 2011.

The end-June 2012 balance sheet had cash of £35.9 million, so the 2012 dividend is probably secure, but the market already shows concern that the cash flow profile must improve in the longer run.

Elucidating this, the first-half 2012 operational review cited investment in regeneration (absorbing cash) and reduced levels of cash generated from construction amid downward pressure on prices and bidding margins. The financial review refers to a significant increase in working capital due to investment in receivables in construction, infrastructure and fit out, with the expectation that cash will inflow from reducing the level of working capital in the second half. This follows the form of 2011 and investors need to watch how it evolves.

Balance-sheet creditors also imply tight cash flow. While trade payables have fallen by 20% to £570 million, they substantially exceed £241 million trade receivables, as if the group has delayed payment to some creditors as the cash position deteriorated. Similarly Morgan Sindall has resorted to obtaining £47.9 million of short-term borrowings during the first half year to help finance more investment (in the context of £110 million committed bank facilities to mature in September 2015). Investors should note that the effect of this, and the fall in the cash balance, imply a higher net interest charge than £0.5 million in the first half, which was modest in the context of £19.3 million operating profit but every increment counts in today's challenged environment.

While on the balance sheet, I should mention just over 94% of £238.9 million net assets comprise goodwill and intangibles, hence net tangible assets of just 32p a share, which although an improvement on the last three years puts the valuation emphasis on earnings, cash flow and dividends.

So caution over the effects of UK public spending constraints and the cash flow profile help explain why the market has priced the shares lowly. In a four-year chart context this is nothing unusual; MGNS has previously hit 510p, 491p, 460p and 412p annually going back to end-2008. While the current price looks to be in a dependable low range for buyers, the overall sideways trend - with similarly recurring highs of about 730p - is a reminder of how this cyclical swinger needs trading.

On 16 November a non-executive director bought 2,000 shares at 556p, his total shareholding, although no others have added after the fall. The chief executive owns 10.4% of the group.

Bear in mind the cash flow profile, but all things considered the risk/reward profile favours upside - unless 2014 onwards sees more severe government spending cuts.

For more information see morgansindall.com.