Market Commentary - Housing, Infrastructure, Construction and Services
Two pieces of news of interest in the sector this morning. Interserve has announced that it has won a project worth £81m to expand and extend a shopping mall in the UAE. SWP has received a recommended offer from a company comprising several of the existing management team, all of whom are existing shareholders, which will mean that, subject to acceptances, it will cancel its AiM registration and become a privately owned company.There were few risers in the sector with Mears, up 1.1% to 446.5p being the leader. It recovered a little from Monday’s wobble triggered by the Mitie warning
The conference call was a mix of the plausible and the implausible. It is plausible that the market issues have deteriorated a little more than foreshadowed in the last prelims. Most peer group stocks incorporated weak conditions into guidance and perhaps Mitie was less cautious and during the call even introduced the Referendum outcome as factor. The conditions in healthcare markets, which have triggered the company to wish to review the business are not new so perhaps it’s just that patience has run out. The £107m of assets tied up in that operation and any future restructure costs contain the possible seeds of the next warning, maybe. The current top team keeps buying into new areas (Energy services, welfare to work, healthcare) and gets unstuck.
It is, however, implausible that the company can spend £10m on cost savings (on a programme that appears to have started) and deliver a run rate gross cost savings of £30m a year, including £15m in the second half of this year. The cost will be contained within ordinary trading, we are told. Clearly not all of the cost saving will drop through, even if they are achieved and if the customer pressures are as described the proportion that hits earnings could be quite low. In the call the company indicated that a payback of four months is possible as most of the cost is laying off people but the usual payback is 12 months, so we can only guess that the redundancy cheques will be small or the ambition is too great.
The core argument from the company is really that it is about the markets. But much of what we heard about them was foreseeable. In Social Housing Mitie has a large number of contracts doing relatively low grade work, often painting and decorating which is clearly a little more discretionary than the essential repair work and more complex in-depth programmes on which Mears focuses. The capping of rent rises said to be affecting Social Housing budgets has some logic but as Housing Associations are reporting EBITDA margins of 40%+ in many cases affordability is not the issue. The rents have been capped as Social Housing is currently a very profitable business. Mitie’s issue in this space is that its core work is low quality so it needs higher grade discretionary work to make the numbers. Others have contracts that include high-grade work so the read across is limited.
In Healthcare it’s clear that the larger operators have a structural disadvantage due to overhead costs, which are yet to be balanced fully by operational advantages, in all cases. Mears has devised its solution and as a consequence announced recently solid plans for changes and is getting on with the job. That include losing 20% of existing work but also increasing the focus on client budget management and comprehensive programmes. Mitie’s release today indicates that it has only just started it review and the language includes the possibility of a sale which will not help customer confidence
The implications for the 2016/17 out-turn are opaque. The gross cost saving and the cost of achieving it probably net off this year. The overall result therefore is a significant decline in margins in Property Management business and in Healthcare which cannot be estimated with accuracy, at this stage. Updated forecasts will no doubt appear but the credibility cannot be high. Forecasts of EPS for this year will fall around 10-15% to around the 20p mark and at this stage the balance sheet should not be damaged. It also seems unlikely that mid-term forecast will show much growth. But the issues are as much about how the business is run not the short and mid-term numbers and it’s got to be more than just telling us its about the people.
The temptation to abandon the expensively bought Healthcare operations and focus exclusively on FM must be great. Given the track record with acquisitions long term holders will welcome that move and a commitment to stick with the knitting in FM would be even better. But even in doing that there is a concern that in some areas, such as catering and Security it may be too small to compete with the likes of Compass, Sodexo and G4S.
The absence of much comment from FD Suzanne Baxter, who was not introduced as being present on the call at the outset, save on very few occasions is open to interpretation. She was invited by Ruby to make comments on two occasions. The responses from her were short, single sentence remarks.
Looking ahead, the numbers will be under greater scrutiny than ever, internally and externally. Earnings forecast have shown only modest to zero growth in recent years and are now going backwards. Our sense is that this is probably not the end of the bad news. But we agree with the company that outsourcing can be a very good business and in the areas in which Mitie, Interserve, Kier, Serco and Carillion operate sustainable earnings equal to 5-6% of revenue are achievable. Mitie’s issue may be that it tried to squeeze more margin out of customers than was actually possible and along the way failed to invest in efficiencies and IT so now there is some catch up. Experience tells us though that more than one upheaval is the norm and the comments on some segments of the business contain the clues about the next stages of the process.
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