Market Commentary - Housing, Infrastructure, Construction and Services - 19th January 2016
Workspace is the only sector related stock to provide news this morning with an IMS which informs us that it is seeing strong demand for its rental space in London and for its developed sites. The main move yesterday was at Mitie, as you might expect but the stock ended the day down just 4.9% to 195p.
Workspace is the only sector related stock to provide new this morning with an IMS which informs us that it is seeing strong demand for its rental space in London and for its developed sites. L4L rent roll in the final quarter of 2016 was up 3.5% and 9.3% in the nine months from 31st March. It exchanged on three mixed use developments in October last year and has planning permission on two refurbishments, one in Hackney and the other in Ladbroke Grove. Intuitively demand for space in London should be static or falling given Brexit uncertainty and the economic cycle. But the evidence is that demand from renters is rising. It may be that as leases end companies are opting to lease not buy. Savills most recent report on London showed that demand was down 7% on the prior year in London (sq ft ) but the 12 month rolling take up was 17% higher than the long term average. 46% of 2017’s development pipeline is already let. So the evidence from Workspace seems to match both the figures from the agents and the strong level of demand for fit-out reported by Morgan Sindall.
The main move yesterday was at Mitie, as you might expect but the stock ended the day down just 4.9% to 195p. Short positions on Mitie have increased and are now 14% according to Castellain Capital who monitor such numbers; that is the fifth highest in the UK market. The issue therefore is whether the company is on “The Spiral of Corporate Death” which we have seen many times in this sector with Jarvis, Connaught, Spice, Carter and Carter, Erinaceous and others.
That spiral starts with the trading performing less well than expected and management using accounting policies in unusual ways which the Auditors for some reason allow. By its very nature that phase is hard to detect initially in the numbers but aggressive responses to questions by management and evasive answers are usually a dead giveaway. The spiral continues through to loss of senior teams below the board, inability to win work on anything but price which inevitably leads to poor contract performance, irrational acquisitions to cover the tracks, disputes with customers about cash, lack of operating cash and so on. Mitie has had it fair share of such signals and glassdoor.com, a website for open employee feedback, has more than its fair share of disgruntled Mitie employees. Though you may say it’s only the complainers who might use such sites. Nevertheless at best it indicates there is a big morale lifting job for Phil Bentley and his team and at worst Mitie may struggle to attract the best and brightest.
Our sense is that Mitie’s decline in the spiral stands a good chance of being stopped. It was using some quite dangerous and unusual accounting interpretations which, some might argue, created a very false prospectus for investors and therefore on the market for the shares; Institutions and the FCA should consulting with lawyers about that as the senior team made many positive statements about current trading being positive when in fact it was being supported by expected future earnings improvements. The tendency has been to allow departing management to leave, sometimes with a big cheque, and not be pursued on an individual basis. Hence, the pattern is being often repeated, as there is no real deterrent. Just keep the plates spinning as long as possible is the tactic, and make best use of the other great numbers wheeze, fair value adjustments, so keep on acquiring! It also has the advantage that brokers, who are more than ever dependent on deal flow for income are disinclined to criticise or lift up the lid publicly. Keep buying independent research!
Our view that Mitie might escape the downwards spiral is based on a number of factors. Firstly, it is still winning work, £200m was won last month according to information on the call yesterday. Secondly, its customers do not seem to be discontent in the way it has happened elsewhere. There are many reports of Mitie staff, under pressure to deliver ticking, the box to say work has been done when it has not but in general we do not detect undue customer concern. There is a strong common pact between management who made a choice in a competitive process and the winner’s staff to make the outcome positive. In Mitie’s case the Lloyds contract is crucial due to its size. Thirdly, the balance sheet is being stretched but there is still wriggle room and cash flow should be strong in this sector. Fourthly, new management appears to be getting to grips with the simple operational fixes that are needed to manage the business in a better way and ensure that it gets paid.
We may be being overly optimistic but given enough time and with customer goodwill there are enough reasons to believe that Mitie will escape the spiral. But one more go at cleaning up the numbers is needed. Accountants have yet to be appointed to report on the impact of IFRS 15 on the company. The much needed changes in accounting policy needed at Mitie are likely to be wrapped up with the policy on IFRS 15. Best to wait no longer and get started. At 195p and with EPS of 18-20p likely in 2018 the stock is reasonable value. But you have to believe that the next warning will be manageable and not require an equity raise; we think those condutions can be satisfied. And do not be fooled by the new CEO buying £3.6m worth of shares; Connaught went bust after new Chairman Roy Gardner made a similar bold statement on becoming head man and immediately acquired £0.5m worth of shares. That turned out to be a tax efficient move in the end, unfortunately. The fundamentals are not all great but they are not that bad at present and the market is such that recovery is possible.
The best performers yesterday were Mears up 3.2% to 475p and Serco up 2.9% to 150p. Both are good examples of solid accounting treatment being applied to services situations that are getting good investors support. Serco clearly has had its moments in the distant past but in the last few years under Rupert Soames and Angus Cockburn’s leadership (and great humour and candour) investors clearly have a set of numbers they can trust and are improving and the business is winning work. These moves demonstrate it not the sector as such that is the issue but it’s about over ambitious management shifting revenue and cost between years in a way that is not sustainable. Stressed management, frequent and often unrelated acquisitions, lengthening long term receivables and deteriorating cash are not that hard to see. And they are often noticeable before the first warning. Who might be next then? Interserve still looks to be the most likely candidate.
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