Interactive Investor

Stockwatch: is this mid-cap share’s positive surprise a cue to buy?

18th November 2022 11:35

Edmond Jackson from interactive investor

With a cost-of-living crisis in full swing and austerity looming, analyst Edmond Jackson looks at this company’s potential to prosper.

How significant is tougher fiscal policy on the various listed outsourcing companies? 

It is a pertinent question for MITIE Group (LSE:MTO), a £1 billion UK-oriented FTSE 250 share that has diversified from cleaning and security services back in the 1980s. 

Latest interim results have surprised on the upside, in a context of the CEO proclaiming “an inflection point”. 

The long-term context is one of stock rating contraction after Mitie’s 1990s and early 2000s record for growth – down from a price/earnings (PE) ratio in excess of 20x to modest single-digit multiples. Despite acquisitions causing the business to overstretch, plus a 2016 accounting fiasco, a new CEO is transforming group operations. 

Is the stock therefore on some extent of mean-reversion upwards, as its long-term chart implies? 

After a long decline from the 160p area in 2014/15, it looks increasingly as if a bottom was established around 30p in November 2020. Lockdowns impacted only the March 2021 financial year and operational updates have recently been sound.  

While Mitie’s prospective dividend yield of 3% (assuming forecasts) has looked nothing special, a recent forward PE around 7x tried to price in recession risks – yet made the stock sensitive to “better than expected” news.  

This I believe is why the stock jumped over 10% yesterday to near 82p after interim results cited 16% revenue growth (factoring out the past benefit of higher-margin Covid contracts).   

There is good momentum across all divisions, and management says it is coping with inflation and has raised both the interim dividend and guidance for its year to March 2023.  

Normalised operating profit of “at least” £145 million would double last year’s, although consensus already expected net profit to double slightly to over £99 million. This has now edged up to £102 million, implying earnings per share (EPS) of around 7.5p – but the market is having second thoughts as the stock eases to 75p, implying a circa 10x PE. 

Will management actions be enough to offset potentially softer demand? 

The stock volatility may reflect awareness of how tougher fiscal policy could affect both demand from public organisations, as well as the general level of UK economic demand in coming years.   

Despite a context also of rising costs, Mitie’s boss has doubled down on raising the operating margin from 3.5% (normalised) in the first half-year to end-September, to 4.5-5.5% - driving a return on invested capital over 20%.  

This compares with the six-year financial summary table showing paltry margins at the reported level – at best, 3% in 2020 – and a best return on capital employed of 14%. It is unclear whether “invested capital” will showcase returns from relatively recent projects/acquisitions, but it would be quite some operational re-rating that at least mitigates revenue risks. 

Mitie Group - financial summary
Year-end 31 Mar

 201720182019202020212022
Turnover (£ million)2,1262,0312,0852,1742,5603,903
Operating margin (%)-2.00.12.03.00.31.9
Operating profit (£m)-42.91.141.764.68.372.1
Net profit (£m)-184-27.130.990.5-7.350.7
EPS - reported (p)-7.6-2.53.25.6-0.92.0
EPS - normalised (p)-1.610.79.79.36.18.1
Operating cashflow/share (p)18.0-1.45.79.82.115.0
Capital expenditure/share (p)4.03.63.32.72.12.3
Free cashflow/share (p)14.0-5.02.47.10.012.7
Dividends per share (p)2.12.12.10.70.01.8
Covered by earnings (x)-3.7-1.21.68.20.01.1
Return on total capital (%)-24.30.313.714.21.110.8
Cash (£m)12959.4108140196345
Net debt (£m)18420015718182.6-44.6
Net assets (£m)88-24.0-12.480.5362426
Net assets per share (p)12.4-3.4-1.711.225.529.8

Source: historic company REFS and company accounts

Within a “margin accretive growth strategy”, the £190 million acquisition of Interserve’s facilities management side two years ago is said to offer ongoing (cost) synergies. Rolling out a digital supplier platform, eliminating loss-making contracts and overhead cost savings are also opportunities to raise margin. In due respect, synergies from Interserve have risen from £30 million to £50 million. 

Some £400 million new contracts were won in the first half-year and Mitie appears to be sustaining inflation-linked price increases. A renewal rate over 90% included the Department of Work and Pensions in a list of prominent private sector names. 

Only a quarter of group revenue is public sector work

Of £1,923 million interim revenue, £355 million constituted “central government and defence” on a 7.2% margin; and £254 million “communities” on a 4.4% margin, serving healthcare and education.  

The group mainstay is “business services” at £592 million on a 5.6% margin and chiefly private sector; but did include Covid-related contracts and “Afghan relocations” are cited. Barring a price war among outsourcers, it is hard to see security and cleaning contracts not being renewed. 

Encouragingly, the order book for this main division is up 29% to £1.8 billion. 

There is also the “technical services” side at £526 million on a 2.7% margin, predominantly serving private firms with telecoms, green energy and digitisation. 

Mitie’s record from the 2009/2010 recession is good: financial metrics actually progressed; the worst damage was near-flat EPS in the March 2010 year, yet the dividend rose 13%. Mind, the macro context was loose monetary policy, and the opposite now applies, also fiscally.  

Is an inflection point genuinely manifesting? 

I drew attention to Mitie last June at 63p when the CEO proclaimed this: 

“The group is now able to leverage its capital base to focus on long-term value creation, accelerate investment in growth and enhance shareholder returns.” 

He currently adds: “In the first-half-year we have invested £19 million in three fast-growing, high margin businesses, and continue to see opportunities to invest in future growth.” 

I lacked conviction, however. While suggesting it could be worth taking a starter position and average in according to news flow, I backed off a firm “buy” given Mitie’s sub-2% operating margin at the reported level – i.e. margins need to be substantive enough just to pace inflation. 

Yet despite a drop to 56p by end-June, the stock timing would indeed have been opportune. 

Director share buying was, in hindsight, a tell-tale: on 3 October, six of them spent a total £27,500 buying 44,350 shares around 62p.  

Perhaps it was a lesson not to be cynical about modest buying being a PR exercise, when this happens near entering the closed period on dealings before a company’s results. 

Or, like my own stance, it respected value that existed around this level, if warily. 

These interim results affirm management getting plenty of things right, to build margin and revenue. In that sense, Mitie is at an inflection point, hence its stock rise is rational. 

But it is unclear whether it continues to rise or swoons at some point in the next six months given the current macro situation.

Can balance sheet withstand a serious downturn? 

Government has made a circa £100 billion about-turn on fiscal policy – from around £50 billion loosening in September’s mini-budget, to £50 billion tightening yesterday – in a context where the central bank should be cutting interest rates to mitigate recession. 

Yet the Bank of England is behind with taming inflation, and I cannot recall a situation of rates rising as we go into recession – with fiscal policy simultaneously tightening. 

At least Mitie is well-prepared in the sense its interim net finance costs are down 26% to £7.4 million after renegotiating a £150 million revolving facility. They are expected to reduce further after refinancing US debt this December, also terminating the group’s invoice discounting facility. 

The group certainly needs to batten down the hatches. At end-September it had £191 million debt near-term and £127 million longer-term, albeit no leases and only a £2 million pension deficit. Yet its balance sheet context was £402 million net assets of which £312 million constituted goodwill and £263 million intangibles. 

If the UK gets trapped in stagflation, then such a balance sheet – the legacy of past years’ acquisitions – is liable to weigh on the stock’s medium-term recovery. 

Yes, Mitie has defensive qualities, but tighter monetary and fiscal policy has yet to bite, and the last six months or so may not be indicative. Progress to a 5% operating margin is respectable yet may be the minimum required, effectively for the group to stand still. Underlying revenue growth is also needed versus inflation well over 5%. 

Decide whether I am being over-cautious, but I think this outsourcer is fairly priced given its balance sheet and sub-3% yield are not strong props. Hold. 

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

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