Description

Business description

(The company has a fiscal year end in March. FY 2017 ends in March 2017.)

MITIE is a facility management business in the UK. It operates three segments: Facility Management, Property Management, and Healthcare.

Facility Management (GBP 1.9 bn of revenue) is comprised of Soft FM and Hard FM. Soft FM (GBP 1.3 bn) offers services such as cleaning (end markets include transport, leisure, retail, manufacturing and healthcare), environmental services (such as waste management, pest control, landscaping), security (clients include harbors, nuclear sites, retailers, airports etc), catering, and call centers. The Hard FM business (GBP 600 mm) delivers a range of technical, building maintenance and energy services.

The UK facility management industry is a GBP 100 bn market, of which GBP 75 bn is outsourced. It’s a fairly fragmented industry, with the top 12 players having about 40% market share. Mitie’s addressable market, defined as contracts over GBP 500,000/year, is valued at GBP 45 bn, with Mitie having about 5% market share.

Facility management is often a good business with recurring revenue and strong cash flow generation. Mitie has ~95% retention rate in the facility management segment.

Property Management (GBP $260 mm) mainly does painting and repair work for social housing clients in the UK. It also does repair work for insurance companies.

The Healthcare segment (GBP 80 mm) is created from Mitie’s 2012 acquisition of Enara (a homecare service provider) for GBP 111 mm, and the 2014 acquisition of Complete Care (provider of nurse-led complex services) in for GBP 9 mm.

In 2016, Mitie came under pressure on all fronts.

On the labor cost front, the new National Living Wage became law in April 2016. The UK government mandates that minimum wage increases from GBP 6.7/hr in March 2016 to GBP 9.0 in March 2021.Mitie’s labor-intensive service offerings in cleaning, catering and security are most affected. Although Mitie is protected from 95% of the wage increases because its contracts are mostly written in a way that passes on labor costs to clients, Mitie nevertheless felt pain as clients cut scope of work in order to cope with cost increases.

The Healthcare business, which is mostly funded by local authorities and the NHS, also came under pressure. The government’s 2015 Spending Review and Autumn Statement set out how the government will cut the forecast deficit by 75% by 2016-2017 and eliminate deficit by 2019-2020. As a result, local authorities spending is now severely constrained. The fact that Mitie’s homecare business has been receiving low ratings from audits carried out by the Care Quality Commission (CQC) didn’t help either. In the fiscal year ended March 2016, healthcare revenue declined 14% and operating income declined from GBP 5 mm a year to a GBP 4 mm loss. Loss further widened in H1 2017 (ended Sept 2017) to GBP 4 mm for the half year.

The Property Management experienced revenue and margin decline in 2016 as well. In July 2015, the government announced that social housing rents would decline 1% a year for the next four years. Social landlords had previously been able to increase rents year by CPI+1%, so once this measure was implemented they started to cut back on maintenance spending. In the six months ended March 2016, Property Management revenue declined 5%, and in the six months ended September 2016 revenue declined 17%.

On top of these challenges, after Brexit Mitie’s clients cut discretionary spending. The Hard FM business is most affected, because about 40% of its revenue is discretionary vs 60% secured by contracts. The Soft FM side, on the other hand, is 90% secured work vs 10% discretionary. In September 2016, the company issued a profit warning for the 2017 fiscal year (ended in March 2017), issued another warning in November 2016, and gave a FY EBIT guidance below consensus in January 2017. For H1 2017, the company cut its dividend after 27 years of dividend growth. Ex-CEO Ruby McGregor-Smith stepped down in December 2016.

Contract accounting

There has always been a fair amount of concern around Mitie’s accounting. Skeptics point out that in the last five years, accrued income (part of receivables) has ballooned from ~GBP 50 mm in 2011 to GBP 236.2 mm as of September 2016, a GBP 186 mm increase.

The GBP 236.2 mm is made up by two figures: GBP 77.1 mm from accrued income on long-term contracts; and GBP 159.1 mm on other contracts. As described above, Facility Management is made up by Soft FM and Hard FM. In some cases, Mitie bundles these services (for example, catering, cleaning, HVAC repair) into a long-term Integrated Facility Management (IFM) contract. The value proposition for the customer (such as Lloyds Bank) is that Mitie would take away all the maintenance headache for a regular, periodic payment. Mitie would assume these responsibilities, which initially cost more than the customer’s contracted payment to Mitie, and try to achieve cost savings and profits over time. In other words, there’s a cash loss at the beginning of these contracts. IFM is about 40% of total FM revenue.

It is commonplace in the facility management business to have a contract that loses money initially but becomes profitable later. However, there are different ways to account for them. Mitie uses the percentage of completion (PoC) method, which requires management to make assumptions about total costs over the life of contract (typically 5 years). Each year, Mitie would recognize a proportion of revenue (which is the sum of all contracted customer payments) and costs, using costs incurred as a percentage of total expected costs as a measure of progress. This practice ensures that each year, Mitie is recognizing an accounting profit.

Since costs go down over time, Mitie recognizes more revenue initially than later in the contract. But customer payments are the same over the contract period. This creates a mismatch in revenue and cash receipts. Initially, revenue recognized exceeds cash receipts, creating Accrued Income. Later, cash receipts exceed revenue, reducing Accrued Income.

In 2012, the company signed its first Integrated FM contract, and as discussed above, as of last FY end accrued income from IFM contracts was GBP 77.1 mm, compared to 0 in 2011.

The other GBP 91.7 mm of increase in accrued income simply came from the reclassification of what was previously called “amounts recoverable on contracts to accrued income. In 2011, there was GBP 94.3 mm in this line item, compared to FY 2016’s GBP 2.6 mm. This item primarily relates to the Property Management’s unbilled work.

This leaves us with GBP 17 mm of increase related to the accrued income on other contracts. This item simply represents revenue recognized after sending monthly bills to the customer. As mentioned above, this line is GBP 159.1 mm as of FY 2016, which is a GBP 17 mm (12% increase) from 2011. During the same period, revenue grew 18%, so we view this increase as normal.

We are not fans of the percentage of completion accounting for IFM contracts because we would rather not rely on management’s forecasts costs. But we got comfort with Mitie’s underlying business because:

(1) We looked at A/R+Inventories-A/P from 2011 to H1 2017, which only increased from GBP 54.3 mm to GBP 68.5 mm. This is driven by a significant reduction in Trade Receivables (collecting money faster), increase in Deferred Income (getting advance payments from customers), and increase in Accrued Payables (delayed payments to suppliers).

(2) In the last four years, Mitie generated ~GBP 90 mm of CFFO and ~GBP 60 mm of FCF each year. In FY 2016, Mitie generated GBP 61 mm of FCF compared to GBP 55.4 mm in 2015, despite GBP 10 mm of lower profits in the Healthcare segment.

New management team & simpler accounting

In December 2016, new CEO Phil Bentley, who successfully sold Cable and Wireless to Liberty Global, joined Mitie. In January 2017, the company announced that long-time CFO would step down in 2017. Mr. Bentley announced a number of changes to be implemented at Mitie:

1. The company will adopt IFRS 15, a new revenue recognition method, as soon as possible (likely in 2018). IFRS 15 has a much higher hurdle for allowing PoC accounting for contracts. New management appears to really dislike PoC accounting, and will carry out a balance sheet review in the coming months to look at the accrued income assets. Mr. Bentley said that giving up PoC accounting will create more volatile margins but at least they are transparent.

2. Mr. Bentley is committed to creating a leaner organization, and we expect more cost saving measures will be announced. Previous management announced a restructuring program that will create GBP 20 mm (1% of revenue) of savings. We expect new management will be more aggressive in cutting costs.

3. Healthcare will be divested. Property management is also a divestiture candidate. Proceeds will be used to pay down debt.

4. The company will focus on growing the FM business.

We think these are all positives. We think Mr. Bentley will create a simpler, more efficient, and more transparent business. If he can achieve that, we suspect that Mitie will re-rate from a hairy situation to a company valued on a FCF yield basis.

Management further shared that the pace of contract wins has accelerated in the last three months. We think that clients can only delay discretionary/capex-like work for so long - at some time, the discretionary work will come back to Mitie.  

It’s also worth noting that on November 21, Mr. Bentley bought 1.9 mm shares at GBP 1.94 per share. This is before he formally joined the company, and in our view reflects his confidence in turning around the business.

Valuation

Given the headwinds in Healthcare and Property Management, we value Mitie on Facility Management alone.

We think this business will organically grow 2%~4% a year, driven by 1%~2% of pricing growth embedded in contracts and 1%~2% volume growth (new wins, higher penetration in existing customers). We model GBP 1.88 bn revenue next year (2% growth from LTM).

We assume 5% ~ 6% EBIT margins (compared to 3.8% in H1 2017, 6% in 2015 and 2016; Mr. Bentley guided north of 5%) , and GBP 20 mm/year of D&A, which gives us GBP 114 mm to 133 mm of EBITDA.

Facility management companies on average trade at 11~12x EBITDA 2017E EBITDA. Applying these multiples to our EBITDA range, we get 285p~380p per share of fair value, 40%~80% higher than the current stock price.

Note that corporate overhead is allocated to segments.

Another way to look at this is the company has a market cap of GBP 734 mm and EV of GBP 966 mm. Annualizing H1 2017 numbers, the FM business generated GBP 90 mm of EBITDA. H1 2017 EBIT margin of 3.8% is at least 120 bps lower than management target and more compared to historical margins. In other words, we are paying an average multiple for an EBITDA that will likely significantly improve under the new leadership.

Catalysts

1. Adoption of IFRS 15 to create simpler accounting

2. Sale of Healthcare and Property Management

3. Resumed growth in Facility Management

4. Cost saving measures and margin improvement

5. Resumed dividend growth

Risks

1. Material impairment of PoC assets following balance sheet review

2. Loss of Lloyds IFM contract (~8% of revenue)

3. Continued labor cost pressure, although we view this as a factor affecting all players

4. Economic slowdown which further reduces customer spending

Catalyst

1. Adoption of IFRS 15 to create simpler accounting

2. Sale of Healthcare and Property Management

3. Resumed growth in Facility Management

4. Cost saving measures and margin improvement

5. Resumed dividend growth