Stockwatch: This turnaround wrong-foots short-sellers

Is this another case of irony, how a heavily-shorted stock has enhanced upside potential as a new management steadily delivers on turnaround targets, while upsets fade?

There have been various companies - Home Retail Group, now owned by Sainsbury's, and Tullow Oil - that attract hedge funds' herd behaviour on the short side. Maximum downside in the stock may be established well before evidence of recovery in the business and its markets, even as soon as bad news forces a change in CEO.

A conservative investor's sense is to wait for proof of turnaround, but such is the technical bias, the company may only need to establish a theme of "delivering in line" for short-sellers to start buying back - or initially for the market to anticipate this. By the time new management does declare real progress, the stock may already have risen sharply.

Mitie Group, the FTSE 250-listed outsourcing services group, is an interesting test of this hypothesis.

Shorters' favourite, but situation isn't desperate

Serial warnings in a challenged sector, topped with historically aggressive accounting, have helped make Mitie London's fourth most-shorted stock with 13.7% of equity on loan.

Its medium-term chart shows a price slump from about 340p at end-2015, slumping to a 180p low last September. That followed a trading update citing new contracts and a strong pipeline, albeit margin pressures e.g. due to changes in labour legislation, public sector budget constraints and Brexit uncertainties.

So, despite cost efficiency programmes, the financial year to end-March 2017 would be hit. Furthermore, the loss of higher-margin projects would mean "very significantly lower" operating profit despite revenue only modestly lower.

Contraction in property management (due to social housing rent cuts) and healthcare (lower care budgets) was expected to offset modest growth on the core facilities management side (84% of revenue). So the story is mixed if no disaster, part of the dilemma being that a circa 5% operating margin allows little comfort room.

A new broom

The new boss since December is Phil Bentley, chief executive of Cable & Wireless before it was acquired by Liberty Global, also at British Gas after senior roles at Centrica and Diageo . He is preparing the ground for "generating significant shareholder returns over the forthcoming years", a 3 May update concluded.

An accounting review has examined all balance sheet items alongside a review by KPMG, resulting in £14 million one-off charges also a £40-50 million write-down - albeit only £6 million of which involve cash outflows, the majority having no impact on profitability. Past accounting errors imply lower re-stated 2016 accounts with a commensurate £10-20 million boost for the 2017 results due. The charge for cost-cutting also rises by £5 million after 160 roles have been removed.

Essentially then, Mitie is being stabilised as a group well-established in its markets, whose financial summary shows a good record of cash generation and dividends - i.e. not illusory profits as has sometimes been the dilemma with support services groups' accounting.

The shares are unexciting, but can recover from their current low range: since last autumn the chart has effectively bumped along sideways e.g. as management issued a third profit warning in four months in January, indicating a range of £60-70 million underlying operating profit for its year to end-March 2017.

Significantly, however, the stock didn't test new lows on that news, and the story weighs positively with the latest update to "in line", hence the stock rising from 211p to 234p. Such a fundamental/technical balance looks increasingly risky for shorting; to maintain such a trade implies the UK entertaining financial crisis during Brexit. Assuming we muddle through, Mitie is more likely at an inflection point and the market senses this.

Debt covenant issues not a serious worry

Mitigating another risk is end-March net debt down from £178 million to £146 million, like-for-like, and covenants appearing manageable. Despite limited headroom, "the company intends to engage with its lenders with a view to negotiating an amendment of our banking covenants so as to permit further one-off charges and thereby remove the risk of a possible technical breach." In other words they are asking bankers to respect underlying business reality than turn pedantic over exceptional charges.

To short the stock implies they would be inflexible and debt costs will weigh in a downturn. Last November's interims showed £7.7 million net finance costs against £39.8 million underlying operating profit, which is not ideal, but hardly critical unless there's a serious recession.

Risk/reward tilting positively

The full-year results announcement has been pushed out to 12 June when a strategy update is promised. The stock will take its cue from (the outlook on) current trading, and "strategy PR exercises", which can be damage limitation for kitchen-sinked numbers. If well-received, this can help build a stock recovery.

At 234p, the price trades on about 20 times the latest year's earnings, anticipated to recover to 17.5p per share in the current financial year albeit below the 20p threshold previously.

A de-based dividend with 2 times earnings cover represents a modest yield of about 3% and, with £421.4 million goodwill/intangibles on the end-September 2016 balance sheet, versus £225.3 million net assets, shorters can argue there's no real prop if trading deteriorates.

If you believe that whoever wins the June election, the UK faces serious austerity in public finances and economic disaster ahead for the Brexit years - the Vince Cable rationale - then, yes, it is rational to short Mitie.

But, in a muddling-through economic scenario and a new boss getting to grips here, the stock is a steady recovery play, its upside potential enhanced by an excess of shorting. The positive case is supported by UK public spending likely to remain a strong influence on the economy despite pressures, such that capable outsourced services groups can flourish. A 275p medium-term target therefore looks more likely than another drop below 200p.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.