Market Commentary - Housing, Infrastructure, Construction and Services 23rd February 2017
Morgan Sindall, Howden Joinery and Rentokil have released their 2016 Finals this morning. We did not expect to see Serco decline 20% yesterday to close at 119p. We attended the meeting which provided few reasons for such a dip, in our view.
Morgan Sindall, Howden Joinery and Rentokil have released their 2016 Finals this morning. Morgan Sindall has fulfilled its optimistic statements of reporting strong earnings and cash; operating profit grew 26% last year and year end net cash was over £200, average daily cash was £25m. The company delivered EPS of 85p last year, well ahead of estimates which were around 78p; the company has set targets for the mid-term, which in itself is a bit punchy for this top team and if achieved we could see EPS get to at least 150p on a 2-3 year view. Howden’s numbers are strong but the market may focus a bit more on the statement that the softness seen in its markets in 2H 2016 has continued into this year. That is not stopping its expansion however and it intends to add a further 30 branches this year to add to the current 643 branches of which 23 were opened in 2016. The company grew revenue by 6.5% to £1.3bn last year and operating profit grew by 6.7%; same store sales were up by 4.2%. Investors are likely to welcome the new £80m share buyback programme, easily affordable from the £226m net cash pile. Rentokil’s performance last year was as expected with revenue up 13.6% at CER and operating profit up by 11.8%. Organic revenue growth at 3% is said to be the best rate for 10 years and it was near 6% in pest control. EPS was 10.7p at AER were ahead of forecasts which should help to sustain the share price; at 236p at close last night the valuation is stretched in terms of UK stocks but not in terms of its main US rival. More below
We did not expect to see Serco decline 20% yesterday to close at 119p. We attended the meeting which provided few reasons for such a dip, in our view. The puzzle is not about why it fell 20% but how it got to 150p in the first place. We have said for some time that the valuation at 150p was based on a very rosy scenario of what might be possible in the mid-term, starting 2018 and it looks like a few pennies have dropped. The management has not altered its story in any substantial way so in our view, the market got ahead of itself. Also there might have been an expectation of an announcement of when dividends might restart. The story from the company has been consistent, from what we have heard, that they will restart dividends when the situation is robust enough to cope with a pay-out. Now some may think it has reached that point and arguably a small payment would have been helpful. The fear may be that there is some bad stuff out there we are not being told about. We doubt that is the case it’s simply that the news yesterday highlighted that previous management, so loved in many quarters of the City created some very large commitments to win work that were always going to unravel and require a long period of repair.
Some bits of the Serco story have got very much better, such as the potential future workload and the overhead cost base. Perhaps the news that alarmed some yesterday was that 2018 may see limited margin improvement. The latter bit is in truth a tad more cautious than earlier statements. But equally the 2018 outcome could be a lot better than new forecasts suggest, confounding yesterday’s realistic caution, if the company gets “lucky” in several the six big “Elephant “ contracts, in which it is in the final two or three bidders. The historic win rate suggests that it may get at least its fair share of activity, especially as some, such as Hades (MoD) is split into a number discreet segments which allow several parties get something. At 119p is Serco a buy for observant analysts even though the rating at around 17x 2018 earnings is high. If it gets its fair share of the Big Six and mobilises them early 2018 could be a great year!
The current level of volatility in stocks that are supposedly well covered by analysts is remarkable (e.g. Berendsen, Mitie, Interserve). It may be a “condition” of the market but our sense is that it also has something to do with a lack of independent thinking and a focus on levels of detail that cannot be known. From yesterday’s questions “Fake News” present from some questions about the situation with some large contracts and “when did you stop beating your wife” levels of questioning.
Following on from Serco’s “overbought” situation investors need to be a little wary of Mitie in the next few months. Not because it is a bad company or because it has substantial new shocks but, as with Serco investors may be ignoring the obvious. It has substantial accounting issues to unravel as previous management used the rules as much as possible to “flatter” short term earnings, in our view. The company management has made no promises about earnings and has highlighted the previous use of Percentage of Completion methods of pulling forward earnings that may happen in the future. Investors should not be fooled into thinking that unravelling that mess will be swift or cheap. Mitie will emerge as a strong company in our view and operationally has some great strengths but getting the accounting back to a situation where outsiders get a “true” picture of current trading will be painful this year. When it announces its 2016 results the impact of getting back to a more representative presentation of earnings may be tough.
Capita was the main riser yesterday, up 4.5% to 558p as the market is starting to believe that the radical rethink of strategy, funding and skills sets is not needed. Why? Because an analyst said so. Given it’s a close period how does he/she know? We showed above that there is a herd mentality that responds to guidance rather than leads the thinking. Mmmm. We stick with our view that Capita needs to “lift up the drains” and have a good rethink.
Morgan Sindall has gone through some pain to get to the confident position presented today. The main items to focus on today, in our view are the capacity for further margin improvement and the strong balance sheet (net cash and no pension issue). The company has achieved a small operating profit in Property Services which is real progress, the margin in Construction was 0.7% and the target is 2% (which is the industry average) in Partnership the margin is reported at 3.1% and peer group levels suggest it can improve and in Fit-Out the margin is back at over 4% (4.3%). The company can near double EPS by sustaining current levels of revenue and getting average margins in each sector! We are dashing to the meeting so will not go into too much detail. We expect to see target prices rise to 1500p on a two year horizon. Of course the dividend will help which is raised to 35p today for 2016; the board has resisted the temptation to get it back to 42p in one move which has not surprised us, it has to leave something to incentivise investors for this year!
Howden’s expansion has been remarkable and there is no sign that it is cannibalising its own market. There are some areas of concern in the statement however. The softness in its markets is not unexpected and is consistent with read across. The other issue is that it has passed through price rises as clearly the cost of imported raw materials is starting to be felt. One of the consistent themes of the current reporting round for distributors will be the impact of FX on purchases, especially as FX hedges expire. The increase in the number of accounts by 30,000 to 450,000 is substantial but it does start to raise questions about the average sales per client. The share price has been under pressure recently but closed last night at 425p against EPS last year of 29.5p and forecast of 32p for this year. Observers might say it’s up with events.
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