Interactive Investor

Stockwatch: is this mid-cap share at a turning point?

14th June 2022 10:57

Edmond Jackson from interactive investor

Our companies analyst Edmond Jackson examines this UK stock and whether he’d buy, sell or hold.

Can £900 million MITIE Group (LSE:MTO) resume a genuine growth path?

Over 20 years ago, it was feted as a growth company, despite its then quite basic services, such as cleaning and property maintenance. The 1990s outsourcing trend helped, as did strong control by David Telling and Ian Stewart, Mitie’s founders in 1987.

Regular acquisitions to pep earnings saw Mitie evolve into the UK’s leading facilities management company, offering a wide range of services to the public and private sector.

At the end of 2020, it acquired Interserve Facilities Management for £271 million to further strengthen government contracting with the Ministry of Defence (MoD) and the Department for Environment, Food and Rural Affairs (Defra).

Classic problems arose, from acquisitive development

A chief risk is becoming a sprawling entity with control issues, unless management is both structured and capable to cope. I believe such failings are the chief reason why Mitie’s chart of the last two decades has been a game of snakes and ladders.  

In the Noughties, the stock trebled near 150p, then after a drop below 100p with the 2008 financial crisis there was another bull run to test 160p by early 2014. Bears then took it down to a 30p range by the time Covid hit, with the CEO of 10 years replaced at the end of 2017.

There was also a material misstatement regarding Mitie’s healthcare operation in the 2016 accounts where a line has only just been drawn by way of the Financial Reporting Council (FRC) imposing a £1.5 million fine on auditor Deloitte.

In due credit to the current CEO, the table shows operating profitability restored in the March 2018 year, which recovered to £65 million before Covid hit the 2021 year. It has resumed rising in the latest financial year, reaching £72 million at the operating level with £51 million net profit – for normalised earnings per share (EPS), according to definition, of 8-9p.

This implies a trailing price/earnings ratio (PE) of only some 7x with the stock currently 63p, despite a near 20% jump to 66p after prelims were announced. Since late last summer, it had been in a volatile bear trend, I believe chiefly due to concerns at inflation versus Mitie’s low historic margins.

The interim results did, however, show “encouraging” performance to 30 September, plus “steady progress towards delivering our new margin-enhancing growth strategy”.

A 4%+ normalised operating margin has benefited from Covid contracts

Normalised annual operating profit has nearly trebled to £167 million on revenue up 58% close to £4 billion, if benefiting from higher-margin Covid-related contracts that appear transitory.

A sub-2% operating margin at the reported level shows the extent of work yet to do, given that you could argue re-positioning costs have a regular element when a group has reached the extent of services’ sprawl that Mitie has. All businesses have to adjust.

The CEO asserts: “good underlying growth…through our investment-led strategy, Mitie has reached an inflection point earlier than anticipated. The group is now able to leverage its capital base to focus on long-term value creation, accelerating investment in growth and delivering enhanced shareholder returns.”

Risks with the UK economy temper my enthusiasm

A cheap PE persists, probably because investors fear that despite Mitie’s strong aspect of essential services, public and private sectors alike will be under the cosh this year and next, to find savings.

Business leaders have this week downgraded UK growth expectations from over 5% sub 4%, and regarding 2023 from 3% to just 1% - chiefly due to an inflation squeeze on consumer spending. But can businesses and government maintain their spending levels?      

Mitie’s revenue is 96% exposed to the UK, and last year achieved a very respectable 90% renewal rates on contracts. Higher profits with reduced working capital meant a net £25 million cash outflow in 2021 became a £133 million free cash inflow.

Management says that the current financial year has started well, citing various new contracts, also renewals/extensions; although such is the group’s diversity there should be monthly examples.

“The impact of inflation on our business continues to be well-managed, and we will see further benefits this year from our margin enhancement initiatives.”

If you believe this is realistic on a one to two-year view, and Mitie will not be compromised by a reduction in demand – then yes, now is a decent time say to take a starter position in the equity, possibly averaging in according to news-flow.

Quite how tough things could get in the UK; meanwhile, other stocks offer more substantive yields for this risk than Mitie’s circa 3%,  assuming consensus for a rise from 1.8p to just over 2p by 2023.

Succumbs to the current fashion for stock buybacks

Even if 2022 free cash flow near 13p a share was a tad exceptional, management’s current optimism implies a 2p dividend should be covered at least three times by free cash flow – while also funding modest acquisitions.

The 31 March balance sheet had £178 million debt: principally 8-12 year, US private placement notes at sub-3% annual cost; and £123 million leases. Versus £345 million cash at end-March, the annual net interest charge was near £20 million but with zilch near-term debt it is tricky to envisage leases/notes being paid down incrementally.

To my mind, Mitie’s dividend should be re-rated both to improve shareholders’ real return and underline management’s professed confidence. Instead, the board has followed current fashion to commence a £50 million buyback programme.

The cynic inside me is unclear whether this reflects vested interest of corporate stockbrokers gaining fees; or flexibility for a board to scale back purchases more easily in tougher times, than talk up – then down – dividend guidance.

Mite Group - financial summary
Year-end 31 Mar

  2017 2018 2019 2020 2021 2022
Turnover (£ million) 2,126 2,031 2,085 2,174 2,560 3,903
Operating margin (%) -2.0 0.1 2.0 3.0 0.3 1.9
Operating profit (£m) -42.9 1.1 41.7 64.6 8.3 72.1
Net profit (£m) -184 -27.1 30.9 90.5 -7.3 50.7
EPS - reported (p) -7.6 -2.5 3.2 5.6 -0.9 2.0
EPS - normalised (p) -1.6 10.7 9.7 9.3 6.1 8.1
Operating cashflow/share (p) 18.0 -1.4 5.7 9.8 2.1 15.0
Capital expenditure/share (p) 4.0 3.6 3.3 2.7 2.1 2.3
Free cashflow/share (p) 14.0 -5.0 2.4 7.1 0.0 12.7
Dividends per share (p) 2.1 2.1 2.1 0.7 0.0 1.8
Covered by earnings (x) -3.7 -1.2 1.6 8.2 0.0 1.1
Return on total capital (%) -24.3 0.3 13.7 14.2 1.1 10.8
Cash (£m) 129 59.4 108 140 196 345
Net debt (£m) 184 200 157 181 82.6 -44.6
Net assets (£m) 88 -24.0 -12.4 80.5 362 426
Net assets per share (p) 12.4 -3.4 -1.7 11.2 25.5 29.8

Source: historic company REFS and company accounts. Past performance is not a guide to future performance.

New acquisition in solar power     

The stock jump may also reflect this new growth angle, which offers a better margin at least initially.

Mitie is paying an initial £8 million plus an earn-out up to £4.4 million for Custom Solar, and reckons there is a gap in the market for integrated solar solutions.

This business has recently made a £2 million annual pre-tax profit on £15 million revenue, as if its operating margin may be nearer 20% than Mitie’s weak average. 

Also in terms of something new, Mitie has launched “Science of Service” for customers requiring greater hygiene, security and asset monitoring. Technology including data analytics is said to be a key driver of new contract wins, if unclear the extent this reflects a necessary change (meeting health and safety updates) than potential new growth.

The proof will obviously lie in numbers some investors may prefer to see in due course.

A year ago, medium-term objectives were declared: mid-single-digit revenue growth, 4.5% to 5.5% operating margins and a return on invested capital over 20%. To what extent will management have the freedom to achieve such, or might they be constrained by the UK economy?

In due respect and regarding the £271 million acquisition of Interserve Facilities Management, relatively low contract renewal rates have re-rated to 90% - said due to integrating Mitie’s technology and customer service.

It does therefore appear fair to assert an “inflection point”, at least operationally. I could be over-cautious in wanting to see how facilities management firms’ updates fare in the months ahead. Mitie certainly looks more interesting than it has for some time. Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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