Along the western coast of Saudi Arabia, strips of desert meet the Red Sea. Here in Tabuk province, excavation work for The Line has begun. The brainchild of Mohammed Bin Salman, the kingdom’s crown prince, The Line refers to a “vertical city” that will be 170 km long, 200 m wide and taller than the Empire State Building, enclosed in two walls of mirrors and home to 9 million people. according to plans at least.
The Line is gigantic, grand and, for many, completely impassable (the larger development, known as Neom, will also feature a year-round outdoor ski resort). However, the construction project will determine the future of an unlikely British small cap that manages the more mundane side of the fantasy: the foundations.
Keller (KLR) is a specialist geotechnical contractor. This means that he prepares the land for construction projects by grading the soil, building the foundation, and stabilizing the soil. In June of last year, Keller revealed that he had been chosen to contribute to the Neom project. The first stage of the work is expected to generate £45m in revenue and, according to Keller’s management team, has “the potential to generate contract revenue of hundreds of millions of pounds over the next few years”.
Artemis fund managers Mark Niznik and William Tamworth are cautious but say The Line has the power to transform Keller’s “good performance into a very good comeback.”
Placing the preparatory work
Niznik and Tamworth, who co-manage Artemis’ UK smaller company fund, look for companies that are market leaders in a particular niche. Keller fits the bill perfectly: It has a 10 percent share of the global foundation market, which in turn accounts for just 0.5 percent of the total construction market.
“When you are a market leader, you tend to have better pricing power than others in the market, which is especially important in times of inflation,” Niznik said. “You can more easily raise your prices and cover wage inflation or cost of goods inflation.”
This seems to be true for Keller. Group sales have grown steadily over the past five years, excluding a slight dip in 2020, with profits rising until Covid-19 hit. Keller’s order book is also extremely strong at £1.6bn, up from £1.04bn in 2019. Management noted a number of recent contracts in the energy and infrastructure sectors, as more countries seek alternatives to Russian hydrocarbons and begin natural gas projects.
Investors are often wary of contractors, and for good reason. The sector is littered with corporate disasters, including the collapse of Carillion in 2018 and the fall of Interserve a year later. However, there are some important differences between these companies and Keller. Keller is very much a subcontractor rather than a prime contractor, with higher margins and smaller projects. The group’s largest client accounts for just 3 per cent of total revenue, and projects are typically short, with an average value of £375,000.
“It is still a cyclical business, but it does not have very narrow margins in which, if it goes from 2% to -0.2%, it goes bankrupt. It’s a different model,” Tamworth said.
Cash is also high on the agenda for Niznik and Tamworth. This is particularly important when dealing with contractors, who often recognize revenue before the money has been received. “We look at the cash flow statement to take into account the profit and loss statement,” Niznik said. “Earnings can be easily manipulated, there are myriad tricks, but cash flow is harder to manipulate.”
Historically, Keller has been a very cash-generating company. Its operating cash flow has repeatedly exceeded its operating profit, and free cash flow, used to pay dividends and make acquisitions, has been strong. This has resulted in an average dividend yield of 5.3 percent over the past five years and 27 uninterrupted years of dividend increases.
Things got a bit out of control in the first half of 2022, when working capital skyrocketed by £93m, resulting in a free cash outflow of £48m. Higher steel prices and supply chain problems were partly to blame, and “operational challenges” in North America didn’t help matters, more of which later.
Tamworth conceded that working capital is “more volatile at Keller than at many companies,” but stressed that part of the problem was seasonal. “Typically, the construction sector is busiest during the summer and quieter during the winter period. It sees an outflow of working capital in the summer months, that is, in the middle of the year, and an inflow in the second half of the year. And that’s because of the weather, rather than them trying to budget at the end of the year.”
However, even the most diligent investor can get caught up. In January, a business update revealed financial reporting fraud at Keller’s Australian subsidiary, Austral. The “deliberate and sophisticated” scheme caused Austral’s performance to be exaggerated from 2019. Management estimated the impact of the fraud to be £6m in the first half of 2022 and £8m to £10m in the first half of 2022. previous years.
This is clearly not good news. However, it’s not necessarily disastrous, especially for investors who take a longer-term view. For starters, the fraud has not resulted in a massive undercut of profits. Management said overall performance in the second half of 2022 had been strong and only expects operating profit to be “slightly below” the low end of the market’s expectation range (analysts previously forecast underlying operating profit of between £109 million and £114 million). The group’s cash position has not been affected and the dividend is yet to rise 5 percent as planned.
Niznik and Tamworth were far from thrilled by the Keller revelation, saying they expected earnings improvements next year. Instead, the additional profits will be used to fill the void left by the fraud. However, they praised the group’s quick response and said the stock price reaction was tougher than they expected.
risk versus repavilion
The question for investors now is whether Keller is worth the risk. For one, there’s the lingering taint of the fraud problem and the possibility that the group’s full-year results will be delayed (after the scandal, Keller’s auditor will want to make sure he gets it right this time). The recession also poses a threat: About a fifth of Keller’s revenue comes from residential projects, which are likely to be affected by a housing slowdown.
“The risk of it going wrong is that there is a much more severe recession in the United States than people currently fear,” Niznik said. Margins have already come under pressure in North America as a result of inflation and supply chain delays.
However, Niznik is calmly confident. “When we talk to companies, they are much more bullish than investor ratings seem to suggest. We believe that much of the concern about the recession is already in the price. Keller herself also expects a “gradual recovery of the margin back to recent North American levels over the medium term.”
Recession fears plus fraud fears have sent Keller’s stock price down nearly 20 percent in the past 12 months. The group is currently trading at a price/earnings ratio of just 6.7, compared to a five-year average of 8.4. Artemis doesn’t think the group deserves a high rating, but “nor does it deserve the rating it has today.”
“This is a low-value company at about a 25 percent discount to their long-term average, generating margins that are below their long-term average, so upside potential if they can put their margins where they should be. Tamworth said.
“The icing on the cake is the huge opportunity possible in Neom, which no one is looking at right now. There are no forecasts for it. We own Keller because the valuation is attractive and there are margin advantages. We don’t own Keller for Neom, but that’s the part that could turn a good return into a very good return. And we own Keller even though there are cyclicality risks in the US.”
If The Line is ever fully completed, it doesn’t really matter, Niznik suggested. “The good thing is that because you have to dig the foundation first, Keller is there from the beginning.”
“Real money is being spent on it,” Tamworth said. “Will it be a $500 billion project 170 km long? Nobody knows. But it could be very significant and a tenth of that, yes, it could easily be. Nobody is going to value this at a long-term multiple and assume it is a 50-year project, but it should generate cash and be profitable throughout the project.”
This assumes that Saudi Arabia will pay for the work done. Some British contractors were trapped during a construction boom in 2014 when the price of oil fell and the kingdom subsequently delayed, canceled or renegotiated construction projects at much lower rates.
However, for investors who can control their nerves, this unloved UK small cap could be a golden opportunity.