Description

Price: £0.84 (as of 9/19/’24)

# fully diluted shares: 24,370,000 (basic shares: 21,550,000)

MC: £20.47MM

FCF (2025E): £2.93MM (FY ’24 ends September 30, 2024)

MC/FCF: 6.99

Net cash: £0.69MM

Last 5-Yr Rev. CAGR: 36.7%
Last 5-Yr FCF CAGR: 55.6%

Last 5-Yr Average diluted shares CAGR: 19.2%

Last 5-Yr Rev. per share CAGR: 14.7%
Last 5-Yr FCF per share CAGR: 30.5%

Summary

React Group (LSE: REAT.L) is an extreme cleaning business that tackles cleaning problems that non-specialist cleaning companies do not cover.

Examples of work that REAT does is cleaning up after a person has been hit by a train, cleaning up violent crime scenes, cleaning up hospital rooms after they have been contaminated with MRSA, Swine Flu, C. difficile, E. coli or Norovirus, clearing illegal drug waste (used needles lying around in public spaces, dumped chemicals from drug labs, etc.), and decontamination after sewage damage/flooding.

It operates in the United Kingdom (UK), where it is the only specialist cleaning company that operates nationwide. REAT can do any cleaning job, anywhere in the UK, 24 hours a day, 365 days of the year, with a lead time of 2 to 4 hours.

Next to the extreme cleaning business REAT does more regular cleaning jobs (e.g., window cleaning, air duct cleaning, graffti removal) for companies that require nationwide coverage. Examples of companies relying on REAT more ordinary nationwide cleaning services are retailers such as Costa, Pret a Manger, LIDL, and B&M, facilities management companies like MT, OCS, Aletheia, and Sodexo, healthcare providers such as NHS Hospital Trusts, and educational institutions such as University College London and University College Birmingham. These organizations rely on REAT to clean their stores/properties all over the UK because they prefer to deal with one service provider that can do all types of cleaning and don’t want every store/property manager to spend time on organizing cleaning service on an individual basis. Additionally, for food retailers and healthcare providers the cleaning is often necessary to pass hygiene inspections, which is quite high stakes for them, and they therefore prefer to deal with REAT rather than with your local cleaning lady/lad.

REAT currently trades on a forward FCF multiple of 7.

Management has historically met guidance and has in April 2024 guided to achieving over £5MM in FCF in 2.5 to 5 years from now. If this goal is reached in 2.5 years from now it represents a 29.9% FCF CAGR from its LTM base of £2.6MM, and if it is reached in 4.5 years from now it represents a 14.0% FCF CAGR.

Assuming that these FCF CAGR targets are in fact achieved, and that the stock trades for a still well below market average multiple of 9 MC/FCF in several years from now, I believe that 18% to 38% (annualized) IRRs are very achievable at the current stock price of £0.84.

I don’t believe that REAT has an invincible moat that structurally shields it from effective competition. I nonetheless believe that REAT is trading cheap enough that only near-term cashflows must be ballparked to do well, and I do feel relatively confident that these near-term cashflows can be reasonably foreseen because:

1. Approximately 87% of revenues are recurring and on multi-year contracts with Grade A customers. The non-contracted business is slightly higher margin but even when one accounts for this you are essentially buying this business for less than 8x FCF even if all non-recurring revenue disappears tomorrow.

2. Much of REAT’s revenue is coming from cleaning activities that have greater barriers to entry and a lower price sensitivity on the part of customers than one may reasonably expect at first glance. Imagine being a rail company executive and someone is hit by a train on one of your lines, making it impossible for trains to drive between two major cities for several hours. This could potentially cost you hundreds of thousands of pounds. Compared to that the cleaning service of REAT that is reliable, fast, and nationwide (you in the end don’t know where in the entirety of the UK—not a small country—the next accident will happen) does not cost you very much. Reflecting this relative price insensitivity on the part of customers REAT’s gross margins have averaged 28.2% over the past 5 years (normalized current FCF margin is ~11%, and I expect this to increase modestly with scale because HQ overhead is likely to remain roughly stable while revenues/gross profit grows). Sure, competitors could also hire, train, equip, and license a team of cleaners across the UK to deal with anything that may come up at any time and at any place. But the UK is a big territory and there are economies of scale in this business because the cost of maintaining a nationwide network of cleaners is significantly lower for a business that already has much recurring revenue from all over the UK.

3. REAT’s management appears to be heavily overqualified for the company’ size, is economically aligned with shareholders, has a great capital allocation and operational record, and is up against a large number of relatively small and unsophisticated competitors in a very large and highly fragmented market.

Business history

When Executive Chairman Mark Braund got involved with REAT at the end of 2018, the business was a £3.5MM revenue business losing £600k. While it had a great reputation with customers it predominantly did only ad hoc extreme cleaning work (recurring revenue was only ~33%), which meant that after one cleaning job was finished, they had to immediately go out and find another cleaning job. In addition, the company before Braund simply didn’t have the right people, operational systems, and customer relationship management in place to maximize growth and margins.

Braund changed the situation by:

1. Focusing the business on more recurring and higher margin business, both organically through redirecting existing activities, and through the acquisition of Fidelis and LadersFree; and
2. By hiring Shaun Doak—a sales expert—as CEO. Since Doak has joined the business in 2019 organic revenue growth has average 24.8% per year, never dipping below 17% in any single year.

These two changes have led to a business that in FY’24 will do ~£20.83MM in revenue, ~£2.56MM in FCF, with 87% of its revenue being contract and recurring on long-term sustainable contracts.

REAT’s revenue and FCF is distributed across its three main segments as follows:

1. Contract maintenance: where they deliver scheduled cleaning services in sectors ranging from healthcare, education, retail, industrial, to public transport (~76% of revenue and ~84.9% of FCF).
2. Contract reactive: where they are first responder to on-call emergency response service operating under a formal contractor framework agreement, typically 24-hours, 7-days a week, 365-days of the year (~13.7% of revenue and ~9.6% of FCF).
3. Ad hoc: where they provide a solution to typically one-off situations outside a framework agreement, such as for fly-tipping, void clearance, and Covid-19 contaminations (~10.4% of revenue and ~5.5% of FCF). The ad hoc business is non-recurring but does provide the opportunity to showcase their service offerings and regularly leads to long-term contracts in the other two divisions.

Business strategy

REAT essentially exploits that there are no other UK cleaning companies that can provide all types of specialist and regular cleaning services nationwide, even though there is a demand for such a service:

1. On the extreme cleaning side there are a lot of smaller players that may focus, for example, on oil spillage contaminations or chemical decontaminations, but don’t do any of the other types of specialist cleaning jobs that may come up in, say, the rail and road network (e.g., fatalities), or the police detention system (e.g., contamination of police cars and prison cells by intoxicated inmates).
2. On the regular cleaning side there are many nationwide and regional companies/organizations—such as NHS Trusts and restaurant chains—that outsource their cleaning services to facilities management companies. But especially when it comes down to some of the more dirty and specialized cleaning work these facilities management companies don’t have the expertise and scale to have these cleaning capabilities in-house, and therefore tend to subcontract much of this work to other companies (including to REAT). This double subcontracting leads to the stacking of fees which REAT can undercut (while maintaining good margins) by offering their services directly to the customer.

REAT’s basic playbook to fill these two gaps in the large and highly fragmented UK cleaning market is to roll-up small, well-run, and profitable cleaning companies, professionalize their operations, and, importantly, layer on top a great sales and marketing team to cross-sell other services from REAT to existing customers of the acquired company, and vice versa, taking some of the services of the acquired company and cross-sell them to existing customers of REAT.

Taken together, the business model has several attractive features:

1. For many customers the service is non-discretionary. Healthcare providers and restaurant chains have to keep up hygiene standards for legal reasons. Even for others that don’t require the cleaning for licensing their properties are typically attached to their brand image (e.g., furniture stores like B&M) and customers will eventually bail if the places look filthy.
2. Cost advantage and reputation should increase with scale. The denser the nationwide network of cleaning jobs the less cleaners have to travel between jobs, and the more competitive REAT can price its services.
3. Many clients really appreciate having one point of contact, one invoice, and a centralized and standardized system of quality control.
4. The business essentially runs on negative working capital (because contract maintenance and contract reactive typically gets paid before the work is done) and is very capital light (CapEx as a % of revenue has averaged 0.9% over the past 5 years).
5. 87% of revenue is recurring on long-term contracts. With contract maintenance they generally have 1 to 5 year contracts. Contracts for contract reactive are generally more in the range of 3 to 7 years. Contracts generally have inflation-escalator clauses built in.

M&A and cross-selling track record

As mentioned above M&A is an important part of REAT’s strategy. 

The current management up to this point has made two acquisitions, which have turned out quite successful.

In March 2021 they bought Fidelis—a company that provides cleaning ranging from daily housekeeping and washroom hygiene services to kitchen and duct cleaning, industrial deep cleaning, and pest control, in England and Wales.

They bought Fidelis because:

1. It had a strong customer list in the non-cyclical public education and healthcare sectors.
2. 87% of its revenues were recurring in nature, on long-term contracts of 3 to 7 years, with a strong track record of contract renewals and long-term customer relationships.
3. A wide spread of customers, with no customer generating more than 8% of revenues, and the top 10 customers representing ~50% of revenues.
4. Higher than average margins for contract maintenance.
5. They perceived a lot of room for cross-selling other services already provides by REAT.
6. They perceived a lot of room for organic growth through better sales and marketing.

They eventually paid (including deferred consideration payments due to performance hurdles being met) £4.75MM for Fidelis, which represented less than 4.75x of Fidelis’ EBITDA during the first year that it was part of REAT (March 31, 2021 – March 31, 2022). Note that this EBITDA multiple is an upper bound estimate because the total payment was £4.75MM and the owners of Fidelis received the payment for the highest performance hurdle of £1MM EBITDA in the first year (EBITDA for Fidelis is not separately reported in REAT’s financial statements).

Their projections for cross-selling and organic growth through better sales and marketing certainly planned out.

At the time of purchase in March 2021 Fidelis LTM revenue was £4.8MM. From September 2022 to September 2023, it did £12MM in revenue. Assuming an EBITDA margin of 12% this would represent a 150% increase, suggesting that they bought Fidelis at an EBITDA-to-growth ratio (ala PEG ratio) of 0.03.

Importantly, and highlighting the cross-selling strategy, REAT was able to sign a number of new contracts with customers of Fidelis in the education, healthcare, and property service business, benefitting all three of REAT’s divisions outside of Fidelis (contract maintenance, contract reactive, and ad hoc).

In May 2022 REAT made their second and latest acquisition by buying LaddersFree—a commercial window, gutter and cladding cleaning business that operates in the UK and Ireland.

They bought LaddersFree because:

1. They had a particular strong customer list in the private sector with customers such as Topshop, Magnet, Lidl, Prezzo, Gourmet Burger Kitchen, Debenhams and numerous Hotel Chains including Holiday Inn Express Hotels, Marriot and Jury’s Hotels.
2. Revenue is 100% recurring on 1-to-3-year contracts.
3. Significantly higher margin than other businesses within REAT.
4. 86% of its business is with large nationwide customers.
5. LaddersFree had zero churn of customers in the five years before acquisition in that 86% nationwide part.
6. Working capital light business model in that they build a membership of businesses that deliver the services for them. They train them, they audit them, and then they find them their work.
7. They perceived a lot of room for cross-selling other services already provides by REAT.
8. They perceived a lot of room for organic growth through better sales and marketing.

Net of assets they eventually paid (including deferred consideration payments due to performance hurdles being met) £6.4MM for LaddersFree. This price represents a 2.1x revenue multiple, a 4.6x profit before tax multiple, and a 5.3 normalized adjusted EBITDA multiple.  

From May 2022 to June 2023 they achieved 25% organic growth in LaddersFree, and this growth rate has been continued into FY’24, suggesting that while the price paid was not dirt-cheap as with Fidelis, it was still quite a decent acquisition.

In addition, REAT has benefitted from a significant amount of cross-selling, the most important of which was a contract win to semi-annually deep clean 250 locations of one of the UK’s most well-known fast-food chains, which was a customer of LaddersFree.

Note that the last payment for both acquisitions was in June 2024. So, they are now fully paid off and the company has currently still £0.69MM in net cash on the balance sheet.

Future growth plans:

Management has committed to the following regarding future M&A:

1. Most likely pay with cash only. In the past they did issue shares for M&A (that is why it is very important to look at past growth figures on a per share basis).
2. Small bolt-on acquisitions, no moonshots, and no changes to business model. Near-term future acquisitions will probably be slightly smaller in price than Fidelis (i.e., £4.8MM).
3. After each acquisition they will first focus on proper integration into the company, rather than buying a lot of companies at once.
4. Only Executive Chairman Mark Braund is turning over rocks for acquisition targets, the rest of the company is solely focused on operational execution.

Regarding organic growth management has indicated the following:

1. There is still a long pipeline of potential customers that haven’t heard of REAT and to which they are reaching out to offer their services. They have partnered with Crmsquad to generate a comprehensive dataset of potential customers, and use this data to focus their sales and marketing resources.
2. They are investing ~£0.3MM in a digital platform through which customers can book and track all their cleaning services online.

Operational excellence

In the end, we shouldn’t make this more difficult than it is: the cleaning company that does a consistently good job against an attractive price will win out against competitor cleaning companies that do a worst job against a higher price.

Below are a number of anecdotes that I do believe indicate that REAT is doing an excellent operational job:

1. They have grown rapidly in a though macro environment with many UK corporations tightening their belt and the NHS—a major client of REAT—being structurally underfunded. Crucially, many customers have reduced their cleaning to the absolute minimum (e.g., cleaning store windows only once a month rather than once a week) but: (a) REAT has grown right through all of that; and (b) they have done so without lowering prices.
2. Their prices are typically significantly lower than all other companies that can provide nationwide cleaning services (e.g., facilities management companies), and even then they expect to reach 30% gross margins in the medium-term.
3. Several clients have testified that REAT has not missed a single phone call of them in years.
4. While doing a lot of contamination work during Covid-19 they have not had any case of Covid-19 infection on the job.

Management incentives

Mark Braund owns 442,469 shares, or approximately 2.05% of the company. This represents approximately £360K at current market price, or roughly 3x his annual compensation. 

Shaun Doak owns 150,560 shares, or approximately 0.70% of the company. This represents approximately £126K at current market price, a little more than 1x his annual compensation.

Senior management has received a significant number of stock options to increase their stake, and, crucially, these options vest at much higher prices than the stock trades for today:

• 20% of total vesting at £1.00.
• 20% of total vesting at £1.25.
• 20% of total vesting at £1.50.
• 20% of total vesting at £1.75.
• 20% of total vesting at £2.00.

Valuation

Management has previously guided for £1.8MM in FCF in 2023, £2.2MM in 2024, and £2.3MM in 2025. All these targets have already been well-exceeded and I therefore regard management guidance as credible in this case.

For the coming years management has guided to reach £5MM in FCF in 2.5 to 4.5 years from now (guidance was “in 3 to 5 years from now” in April 2024).

In the table below I calculate (annualized) IRRs assuming that:

1. £5MM in FCF is indeed reached in 2.5 or 4.5 years.
2. The stock trades on a p/fcf multiple ranging from 5 to 10 at the end of the two periods.
3. Shares outstanding remain constant (i.e., 24.37MM).

Focusing on a p/fcf multiple of 9 (which I find reasonable given the expected growth rates) I believe that IRRs in the range of 18% to 38% are achievable.

Possible reasons for undervaluation

1. Nanocap stock without analyst following in a highly unsexy business: This is a nanocap stock with a daily float of hardly £30k. Institutional investors can thus most definitely not play. In addition, the company does something boring and filthy – a lovely hunting ground to find overlooked bargains according to the great Peter Lynch.
2. Price-to-earnings multiple screens badly: the stock currently trades on a p/e ratio of 92.8. This may turn off the few retails investors that are actually poor enough to being able to purchase the stock. The stock screens so poorly because any purchased goodwill that is determined to be due to Fidelis’ and LaddersFree’ customer list is amortized in four years. This of course doesn’t make any economic sense. Note, for example, that LaddersFree didn’t lose any major customer in the 5 years prior to acquisition, and that in generally basically all the value of these businesses resides in the customer list and relationships (an asset that will not be worthless after 4 years). In addition, they classify all assets on the balance sheet as being impaired when the net present value in a DCF is lower than it is listed for on the book, when assuming a 15% discount rate and only 5% revenue growth in the first 5 years, and 0% growth thereafter. This again makes obviously little economic sense, as their own guidance implies a revenue growth of well above 10% in the coming years, and a discount rate of 15% seems way too high for such an accounting exercise. Of course management doesn’t say this out loud but it basically seems like they do everything they can to create paper tax loses to maximize near-term cash for investment in the business. You can argue about the morals but from a business perspective it is basically free float that will be very accretive if, and that is the big if, they use the cash wisely.
3. People may interpret results since 2020 as being a Covid-19 fluke rather than a fundamental business turnaround: Covid-19 was actually not a major direct boost to REAT’s business. It simply coincided with the turnaround orchestrated by Mark Braund. One can know this for certain as all Covid-related revenue and FCF has been classified in the “ad hoc” category from the beginning and one can track this over time in the annual reports. Yes, Covid generated decontamination business but it also took business away (e.g., restaurants did not need cleaning during lockdowns). The earnings that Covid did provide were actually of lower quality in nature, in the sense that it was all non-recurring. According to management Covid did have an important indirect and lasting positive effect in the sense that it allowed REAT to showcase its expertise and built its reputation with clients. But this reputation has now been established and, assuming continued operational execution, will remain now that Covid has moved to the background.
4. Working from home: they unfortunately don’t break down the percentage of revenue that comes from office cleaning. I nonetheless don’t see this as much of a risk. They grew revenue and FCF per share with 14.7% and 30.5%, respectively, right through the absolute heyday of remote working during Covid. From here I find it doubtful that the percentage of employees working from home will increase (management has mentioned that they actually see more of the reverse – i.e., people moving back to the office). Good to realize here that the UK is not the US – i.e., the houses are small (generally no home office room) and distances to work are shorter (average commuting time between the US and UK is both roughly 30 minutes across the entire population but working from home is 10% more prevalent in the US as compared to the UK).

 Risks

1. Overpaying for future acquisition: this I see as by-far the most important risk.
2. Competition: I would especially be worried if some of the nationwide facilities management and services businesses, like OSC, would enter REAT’s niche.
3. Key man risk: especially chairman but also CEO. This is largely a bet on management. If the chairman would leave, I would most probably sell. If the CEO leaves, I would most probably wait and see. My experience with nanocaps is that they are very fragile, and that while management and operational execution is always key, it is much more important in small caps as compared to large caps.
4. Customer concentration: They got a very broad cross-section of 1,200 companies and agencies that they work for, of which about 230 are of a material size. Top 10 customers represent about 40% of revenue. Ideally this number would come down significantly while they scale. Further concentration over time should certainly be monitored closely.
5. Macro-economic headwinds: the UK has kind of been in though economic waters for quite some years now and they have grown right through that… In the end major companies and organizations do need their stuff cleaned regularly to function. Nonetheless, the current company (which has really existed since 2020) hasn’t yet proven itself through a proper recession, so it is uncertain how they would perform through, for example, a 2008 GFC event.

Disclaimer

This writeup is for information purposes only, is not investment advice, and is not a recommendation, solicitation, or offer to buy any security. Information contained in this document may constitute forward-looking statements or reflect the opinion of the author as of the date written. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated herein. This material has been prepared from sources and data believed to be reliable and is subject to change without notice. No representations are made as to the accuracy or completeness of this material, and the author does not undertake any obligation to update or review any information or opinion contained herein. No person should make any investment decision on the basis of this material. Investors should seek expert legal, financial, tax, and other professional advice prior to making investments in securities.

Catalyst

Stability/growth in FCF per share.

The company is currently focused on using its cash to capitalize on its growth opportunity. It does, however, also have a share repurchase program authorized. Mark Braund has in interviews mentioned (in a non-promotional way) that he thinks the shares are heavily undervalued. You can imagine therefore that he will decide to start buying back shares in the future.