Description

Preamble

In his October 2009 investment presentation at the Value Investing Congress, entitled "Liquor before Beer...In the Clear," David Einhorn argued that investors cannot afford to ignore the macroeconomic environment in the investment analysis process, as the big picture oftentimes affects the little picture.  We couldn't agree more with Mr. Einhorn.  2007-2008 were disastrous years for all investors, never mind those of us that adhere to investing with a "margin of safety," or buying "fifty cent dollars."  But whereas Mr. Einhorn was referring to the macros with a cautionary tone, (buying MDC Holdings, a homebuilder, at the top of the housing bubble), we instead want to bring to light a solid fundamental "micro" story that lies within an attractive macro-economy.  The economy that we are referring to is Australia, one of the most resource-rich developed countries in the world and a stalwart performer during this economic downturn.  Of the 20 largest OECD countries, only Australia and Korea have avoided technical recession over the last year.  And, in November 2009, the Australian central bank increased 2010 GDP projections to 3.5% - more than double the 1.5% expected in the US, per the IMF.  Moreover, Australia's proximity to and advantaged trading relationships with China are fundamental short and long term drivers that have and will continue to boost Australia's standing among global economies. 

* * *

Business Summary

Spotless Group ("SPT, Spotless" or "the Company"), based in Melbourne, Australia, is an ASX-listed company that offers a broad range of outsourced services to businesses primarily in Australia and New Zealand.  SPT operates within two segments:  "Facilities Services" and "Braiform."  Facilities Services essentially provides services to businesses that includes building maintenance, catering, cleaning and laundry services, within Australia and some parts of New Zealand.  Braiform manufactures and distributes garment hanger and packaging solutions to retailers and garment manufacturers worldwide.  Facilities Services provides a boring but important and necessary function to businesses in Australia and NZ, and can therefore be characterized as a stable, recurring revenue business.  The Braiform business is not a good business, hence it has performed miserably over the last couple of years (EBIT has fallen from A$38m in 2006 to A$7m in 2009) primarily due to pricing pressure (commodity product) and higher input costs (resin).  Fortunately, Braiform now only comprises ~7% of EBIT.  In our valuation, we only attribute ~3% of value to this segment.  We believe the market is valuing this segment at zero so either it gets shut down with no effect to the stock, or the business somehow turns around which is all upside in our view.  Over the past few years, Spotless has underperformed the broader market, due to the disastrous results of Braiform (which, to reiterate, is fully reflected in the stock), and a number of one-off lost contracts which resulted from a lack of focus during headcount reductions and restructurings.  We believe "the bad news is out," and now is the time to own this stock.

Investment Opportunity

Spotless is an attractive investment for the following reasons:

• Recurring Revenue and Cash Flows: Facilities Services owns a defensive mix of recurring revenue stream businesses where the Company is either #1, #2 or #3 in terms of market share
  • o Managed Services: 70% of MS revenues from defensive sectors (government, defense, education, healthcare)
    • 5-7 year contracts
    • Potential short term benefit from government stimulus package
  • o Laundry Services: 55% from healthcare sector
• Low Capital Intensity: Other than Braiform and Laundry Services, capital expenditures are approximately 1% of sales
• Exposure to Australia's Resilient Economy (see Preamble)
  • o Australia has intrinsic wealth from natural resources
    • 31% of world's lead, 27% uranium, 18% zinc, 9% copper, 13% gold, 16% silver, 11% iron ore, 5% black coal
  • o Strategic trade relationship with China positions Australia as an economic derivative to China
    • 16% of exports to China, of which 86% are minerals (28% of China's minerals imports)
  • o Largest OECD country to not have been in technical recession during this global recession
  • o GDP has grown every quarter since Q1'1991
  • o According to the IMF, 0.7% real GDP growth for 2009 and 2.0% for 2010 versus -4.0% and 0.9% for G8
    • On November 6, 2009, the Australian central bank stated that the economy would grow at three times the rate forecasted in August 2009. The central bank increased estimates to 1.75% in 2009 and 3.25% in 2010 from 0.5% and 2.25%, respectively

• Opportunity to Consolidate Facilities Services Sector: The facilities services sector in Australia is highly fragmented. Spotless, as a market share leader, should be able to acquire and extract value from many of its smaller competitors
• Cheap Valuation: At today's $2.86 stock price, Spotless is trading at a blended 8.2x estimated 2011E EBIT, which offers adequate protection relative to the inherent stability of the Company's cash flows
  • o LTM, SPT is up 9%, underperforming the ASX-200 by 27%
  • o 5.6% dividend yield (assuming 16cent per year) versus 4% for ASX-200

Valuation

We believe SPT is trading cheap relative to its intrinsic value.  Below, we have laid out our valuation, along with our specific rationale behind our multiples.  Comparables trade in the 8-10x EBIT range, but frankly most comparables are exposed to the cyclical natural resources sector, as opposed to Spotless' client base which consists of defense, healthcare and generally less cyclical businesses.  The question is where should a defensive, market share leader trade?  We believe the 11-13x range on EBIT is a conservative assumption.  Therefore, we believe SPT could be worth between A$3.57 - $4.59 per share (25% - 60% increase) in a few years, excluding dividends.  Including dividends, total return would be 33% - 69%.

Company Overview

Facilities Services can be broken down into four sub-segments:  Cleaning Services, Food Services, Managed Services and Laundry Services.  Specific breakdown is as follows:

Cleaning Services

• 11% of FY'09 Revenue, 11% of FY'09 EBIT
• Provides cleaning services to retail, industrial, commercial, specialized and public facilities under brands "Spotless" and "Berkleys"
  • o General facilities cleaning: Floors, glass, carpet, offices, kitchens, bathrooms
  • o Housekeeping in hospital wards, hotels, boarding houses
  • o Sterile cleaning: operating theatres, clinics, hospital wards
  • o Ground and garden maintenance for government properties, including airports, hospitals, education campuses
  • o Waste management and recycling for sports stadiums, commercial facilities, healthcare
  • o Heavy and light industrial cleaning for government properties, food processing plants, manufacturing plants, refineries
  • o Hygiene and washroom services such as stocking soaps, toweling and sanitary unit removal
• ~A$3bn market size
  • o Fragmented market, with the Top 3 players comprising 26% of the market
  • o Tempo 12%, SPT 8%, Menzies 6%
• Financial characteristics: 4-5% EBIT margins with low capital expenditure requirements (1% of revenue)

Food Services

• 24% of FY'09 Revenue, 24% of FY'09 EBIT
• Provides catering services to businesses, education and aged care
  • o Cafeterias, cafes, retail food outlets, catering, truckstops
  • o Entertainment and hospitality: bars, corporate functions and corporate suites in stadia such as MCG, Suncorp Stadium and Subiaco Oval
  • o Manages ~85% food outlets at 10 airport terminals in Aust. And 6 in NZ
  • o Brands include Epicure, Mustard, Mode, Alliance, Expresso plus, Vezzuto
• ~A$1.6bn market size
  • o SPT owns #1 market share, with 35% of the market
  • o Key competitors include Compass and Sodhexo
• Financial characteristics: 3-4% EBIT margins with low capital expenditure requirements (<1% of revenue)
• Key Drivers:
  • o Macroeconomic fundamentals, food and labour prices

Managed Services

• 40% of FY'09 Revenue, 33% of FY'09 EBIT
• 70%: Facilities Management and Asset Maintenance
  • o Building maintenance, painting, elevator maintenance, grounds management
  • o Sectors: Defense and Government contracts -- maintenance to housing, education, defense projects and government administration assets
• 30%: Support Services
  • o Cleaning, catering, laundry, housekeeping, pest control
  • o Village and town management services to resources sector (10% of MS Revenues)
• Over 250 contracts
  • o Major contracts include defense, school/public housing maintenance, services for Rio Tinto
  • o Won $500m, 5yr housing contract in 2008
  • o 5- 10% of contracts up for renewal in FY'09 vs 20% in FY'07/08
• ~A$8bn market size
  • o Top 5 have 52% of market, top 10 have 70%
  • o SPT is #3 in Australia and #2 in New Zealand
• Financial characteristics: $6.9bn order book, 3-4% EBIT margins with low capital expenditure requirements (<1% of revenue)
• Key drivers: macroeconomic fundamentals

Laundry Services

• 10% of FY'09 Revenue, 26% of FY'09 EBIT
• Provides outsourced laundry services to healthcare (55%), food manufacturing (25%), manufacturing (8%), retail 6% and other industries
  • o Operates 19 plants (13 Australia, 6 in NZ) employing 2,500 staff
  • o Processes 90,000 tonnes pa or 13m garment pieces from 9,000 client locations
  • o Over 250 contracts
  • o Brands include Ensign (Australia) and Taylors (NZ)
• ~$842m market size
  • o SPT owns #1 market share in Australia, with 27% of the market
  • o Competitors include Alsco (Steiner is parent), Safecorp Group
• Financial characteristics: 12% EBIT margins with high capital expenditure requirements (14-15% of revenue) due to periodic replacement of laundry machines

Braiform, the garment hanger manufacturing segment, is the other main business segment:

Braiform

• 14% of FY'09 revenue, 7% of FY'09 EBIT
• Provides customized garment hanger and packaging solutions to retailers and garment manufacturers globally
  • o Offers one-off and re-use hangers (key focus)
  • o Formed from 3 different businesses: Plastiform in US, Braitrim in Europe, Asia business
  • o Up until 2008, run as separate segment
• #2 market share globally, behind Manetti (only 2 suppliers)
• Financial characteristics: 0-4% EBIT margins, medium-to-high capital expenditure requirements (5-6% of revenues)
• Key drivers: Revenue down 30% since 2006 due to weakening supplier power + weak macros, high operating leverage and resin prices hurting margins

Catalyst