Review of 2005

24 April 2008

Our Cet Index for the Whole construction industry spent most of 2005 out-performing the mainstream construction Indexes. It gained an impressive +36,8% in value over the course of the year to finish at an all-time high of 153,64 points. Only a year-end rally on the Japanese market stole the CET's glory, with the Topix 500 increasing +42,24% over the year.

But compared to other indexes, the CET's advance was market beating, and this was in a year that the major European benchmarks themselves enjoyed a dramatic improvement. The German DAX Composite Index rose +26,88% in 2005, compared to a meagre +6,86% the previous year. Similarly, France's CAC 40 rose +22,28% last year, a vast improvement on 2004's +6,63%. The UK's blue-chip FTSE 100 Index was more subdued than its European neighbours last year, but again, its +16,92% growth was much more heartening than 2004's +6,69%.

It is also interesting to note that for the second year running, the key European Indicators grew well ahead of the US markets. The Dow gained just +0,89% in 2005, for a second year of stagnation following an increase of just +2,12% in 2004. Other indicators like the S&P 500 and NASDAQ Composite were a little better with gains around the +5% mark last year, but there was clearly a big performance gap between these an Europe's double-digit gains.

Construction Shares

There were several reasons why the construction sector out-performed the mainstream markets last year, with different factors in play in the three individual sub-sectors. Improved profitability lifted both the equipment and contracting sectors, although the reasons for the rises were different. In the materials sector however, it was mergers and acquisitions that drove more moderate gains.

For all but the last few months of the year, it was the contracting sector that was the clear motor for the CET Index. Over the course of 2005, it gained +43,07%, building on the previous year's +32,77% rise to take it to and all-time high of 174 points.

The key driver behind this rise in valuations was a general improvement in profitability. Having hit a low in mid-2003, net profits in the sector have been rising steadily for 30 months. Although still low in comparison to other industries – the net margin is only around 3% to 4% on average – the relative improvement in profitability has been a major share price driver in both 2004 and 2005.

But it has not all been good news in the sector. The early part of the year saw Walter Bau, one of Germany's four largest construction groups, die a painful death amid insolvency proceedings. Other than this though, it was good news all-round for the sector.

Italy's Impregilo's market capitalisation grew strongest of all over 2005, although for not entirely positive reasons. The company ended 2004 with a weak share price, following news of an investigation into its accounting practices, and concerns over its debt burden. However, with no charges being pressed, and a complicated mid-year re-capitalisation, the company ended 2005 being worth +210,75% more than it had been at the start of the year.

Other big gainers in the sector included Ballast Nedam, which now seems to have recovered from its painful losses and subsequent controversial withdrawal from the UK market in late 2003, and Spain's OHL. Also worthy of mention are YIT, Bam and Veidekke, which all gained more than +90%.

The other end of the share price growth table is dominated by UK contractors. Amec is at the bottom of the heap with just a +13,75% rise over the year, followed by Balfour Beatty (+15,46%), Mowlem (+20,47%) and Carillion (+29,65%).

Mowlem's share price was of course hiked up considerably in November and December by a take-over offer from Carillion, the only major piece of consolidation news in the sector in 2005. Removing the effects of this, which also bolstered Carillion's share price highlights a clear gap between UK companies' market performance last year, and that of contractors elsewhere in Europe.

Bouygues is also low down the table, with a share price rise of +18,86% in 2005. However, the company paid a special one-off dividend of € 5 per share at the start of the year, and if this is added back onto the year-end share price, the increase would be +33,06%.

Overall it was a strong year for the European contracting sector, with all the companies in the CEC seeing their shares rise.

Overall it was a strong year for the European contracting sector, with all the companies in the CEC seeing their shares rise. There was growth in both sales and profits for the major players. The only source of concern is that the industry's overall order intake appears to be flat, compared to 2004, which could indicate a slowdown is on the way.

Equipment

As in the contracting sector, construction equipment manufacturers enjoyed a year of good sales and profit growth in 2005. Revenues have been growing since mid-2003, but a key factor in the last 12 months has been a marked improvement in profitability. Net margins in the equipment sector are now running at an average of 6,5% of sales, compared to around 4% a year ago.

Net margins in the equipment sector are now running at an average of 6,5% of sales, compared to around 4% a year ago.

This driver, along with some interesting regional factors pushed the CEE for equipment manufacturers' share prices up an impressive +47,56% in 2005, to take the Index to a record high of 170,52 points.

But unlike the contracting sector, not all companies in the CEE saw their share prices rise last year. Both Deere and CNH saw net losses over the course of 2005, and this seems to be a result of a downturn in demand for agricultural equipment. The two companies are by far the world's biggest players in this market, and their sales of agricultural machinery significantly outweigh construction equipment. It's not surprising then that their share prices fell, despite booming demand for construction equipment.

Pinguely-Haulotte enjoyed the most pronounced share price rise in the sector last year, with a +177,75% rise, and the other access platform specialist, JLG also performed extremely well with a +167,37% rise.

The other clear trend for high growth last year, was for Japanese companies. Komatsu lead the way with a +172,62% rise, while Kobe Steel, Hitachi CM and Kubota all enjoyed rises of the order of +100%. Metso's share price was also up in this territory, following a marked turn-around in profitability.

Japanese manufacturers clearly benefited from the general buoyancy on the stock market in the second half of the year. Japan's economy is finally showing signs of growth, following the 15 years of stagnation that came after the collapse of asset prices at the end of the 1980s. Improvements in the Chinese equipment market last year also helped these companies, along with Koreans like Doosan Infracore.

In the context of the wider markets, particularly benchmarks like the Dow, it was a positive year for the large US manufacturers, with Ingersoll-Rand gaining +8,53%, Caterpillar rising +24,33% and Terex putting on +34,59%. However, these were a little lacklustre compared to the rest of the equipment sector, and well below the overall gain of +47,56% enjoyed by the CEE.

European manufacturers dominated the middle ground of share price rises last year, with Volvo and Sandvik just below the CEE, and Palfinger and Atlas Copco, along with Metso, out-performing the Index.

But again, it was an up-beat year for the equipment sector in general, with generally strong share price rises across the board, and manufacturers in each region out-performing the local bench mark indexes.

There are clear signs that the rate of growth of both sales and profits are slowing now. However, robust demand for machines in large markets such as the US and China, and reasonable conditions in Europe and Japan, should mean that 2006 will start well for equipment manufacturers, even though the market may turn as the year develops.

Materials

While the contracting and equipment sectors were quiet last year as far as mergers and acquisitions were concerned, this was a major driver in the materials producing industry. It was this factor, rather than significant rises in profitability that drove the CEM Index up +23,98% to finish the year at a record high of 130,22 points.

The early part of the year saw Cemex reach financial close on its acquisition of RMC, a deal which was announced in late 2004. This was followed in week 2 of 2005 with Holcim offering a 32% premium to acquire Aggregate Industries, which added almost € 1 billion or about one point to the CEM Index.

Although the impact of this deal and the previous Cemex-RMC tie-up were in themselves relatively small, the sudden surge in mergers and acquisitions in the sector helped lift share prices in anticipation of further consolidation. The likely 'target' companies benefited from this the most, and over the course of 2005, the biggest share price gains were experienced by Heidelberg Cement (+69,15%) and BPB (+64,41%).

BPB ended the year as the subject of a Board-Approved take-over bid by Saint-Gobain, although reaching this point was a tortuous process. Saint-Gobain initially made an offer for the company in week 28, but this did not meet with BPB Board approval, as it was felt to be too low. A higher offer followed a few weeks later, but it was not until week 46, when Saint-Gobain offered £ 7,75 (€ 11,10) per share – +15% more than the original £ 6,75 (€ 9,65) per share bid – that BPB's Board endorsed the deal.

Heidelberg Cement's share price received a mid-year boost thanks to a € 60 per share offer from Spohn Cement – essentially a bid to take the company into the private ownership of one of Germany's richest men, Adolf Merckle. Although this eventually came to nothing, the company's shares retained and built upon this valuation.

Other high climbers in the sector last year included Hanson and Pilkington, again two potential acquisition targets. The were thought to be talks between Pilkington and its largest share holder, Japan's Nippon Sheet Glass (NSG) at the end of 2005, with NSG considering fully acquiring the company. However, like the Heidelberg deal, this did not transpire in 2005.

Hanson is also regarded as a potential takeover target, but the major hurdle here is the company's on-going liabilities in the US from former employees' litigation over asbestos-related illnesses. While this is not a 'bottomless pit', it is an unknown, and could run into hundreds of millions of Euros over several years. It is the difficulty in accurately pricing this risk into any take-over bid, rather than the size of the liability, that is the main barrier to any deal.

The worst performing shares in the sector last year were Lafarge (+3,11%) and Saint-Gobain (+11,39%), which of course under-performed the CEM, but were also poor in comparison to France's major indicator, the CAC 40 (+22,28%). Just as the high gains for many contractors' and equipment manufacturers' share prices have been driven by strong profits, these two lacklustre performances are a result of relatively weak margins and poor profitability.

Currencies

Having spent 2003 and 2004 generally appreciating, last year saw the Euro give up many of those gains – most notably against the US Dollar. It fell -9,32% against the US currency to finish the 2005 valued at US$ 1,196, from US$ 1,319 at the end of 2004. This change in valuation was due more to events in the US, namely 12 straight months of +0,25% interest rate rises, than any developments in Europe.

Although this was a big change in the value of the Euro – the only larger adjustment was a -13,77% fall against the Korean Won – the US Dollar is still much weaker than Euro-zone exporters would like. There is a general feeling in Europe at least that the natural level for the two currencies is around a one-to-one exchange rate.

Last year also saw the Euro lose ground to the majority of European currencies, including the British Pound, Czech Koruna, Norwegian Kroner and Polish Zloty. It did achieve some gains, most notably against the Japanese Yen and Swiss Franc, but these were only marginal.

All three components of the CET ended 2005 at the highest levels since the index was started in early 2002. However, the question as far as the construction sector is concerned, is how long will the growth continue?

Outlook

The key global economic drivers in 2005 were rising commodity prices, particularly oil, and rising interest rates in the US. Towards the end of the year it appeared that oil prices had peaked and stabilised around the US$ 60 (€ 50) per barrel mark, and there was also some sentiment that US interest rate rises would level-off in the first half of 2006.

At the same time, there was talk in Europe that the European Central Bank may start to raise interest rates as inflation threatens to pick-up in the Euro-zone. This could push the Dollar back down against the Euro, which would not be good for Europeans trying to export to the US.

But despite this concern, 2005 ended with a generally bright economic outlook. The bullish performance of stock market indicators shows there is plenty of confidence around, which was driven by steady improvements in corporate profitability.

All three components of the CET ended 2005 at the highest levels since the index was started in early 2002. However, the question as far as the construction sector is concerned, is how long will the growth continue? Broad market information from groups like Euroconstruct indicates that growth in European construction activity is slowing, but there is no expectation of a recession. Similarly, sales and profit growth in the equipment manufacturing sector is cooling-off, but again it looks set to stay positive for a few quarters at least.

Against this background, 2006 looks like it will start well, but there could be some nervousness as the year progresses, with investors looking for signs that the market may be turning.

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