Mitie Group: Cheap, But Large Headwinds Remain (OTCMKTS:MITFF)

Mitie Group: Cheap, But Large Headwinds Remain (OTCMKTS:MITFF)

Mitie Group (OTC:MITFF) is a British company that has grown from a traditional facilities management and property management business into a broader strategic outsourcing and energy services company. The company’s shares have had a very rocky time over the last 5 years, falling more than 75% over the period – with a 50% fall since March 2020. The company did remain resilient in the first quarter, but near-term headwinds must still be noted. Mitie may come across as relatively ‘cheap’ at current levels, but I believe it is cheap for a reason.

About Mitie | Mitie

Source: Mitie.com

Resilient in the first quarter

At the end of July, Mitie provided a Q1 (April to June) trading update to the market, where new contract wins in relation to COVID-19 testing helped to mitigate weaker performance from other areas of Mitie’s business. Overall, this meant that Mitie’s revenues totaled £458 million, down by just 11% from the same period in the prior year. Combined with the fact Mitie has secured a large amount of financial headroom, this puts off any near-term concerns of a liquidity crunch. To me, this minor decline in revenue overall shows that Mitie has done well to mitigate the effects of the crisis over the toughest three months that the company has faced in a long time. The board acted swiftly to cut costs and to take advantage of government schemes and furloughed 7,000 of its 37,500 employees to help weather the COVID-19 storm.

Mitie is largely a ‘people’ business where revenues are linked to Mitie employees providing facilities management services such as security, cleaning etc., and the company will have been able to claim 80% of these wages from the government under the UK furlough scheme. The money coming in from the furlough scheme will likely have counted as revenue, and this will flatter these numbers somewhat.

Breaking down Mitie’s revenues, the biggest hit was seen by the company’s technical services business, which saw a 24% revenue decline in comparison to the previous year. This is the segment that focuses on engineering project work and represents 35% of the company’s revenues. Discretionary projects have been paused and may be slow to return.

The core Business Services division represents 53% of group revenues and is responsible for the management and maintenance of facilities across the UK. While many of these buildings have been shut throughout lockdown and are still closed or lightly used, the customers will still have had to pay for much of Mitie’s contracts as these are generally longer term and not month-to-month. The UK government has taken a cautious approach in starting to relax COVID-19-related restrictions step by step, but the buildings that Mitie service will still require some level of management and maintenance, even before they are fully re-occupied. In many of these cases, Mitie has built strong, long-term relationships with customers that the company will maintain for years to come. The concern is not about Mitie losing business here. The big question is, “What level of business will they have going forward?”

The UK’s gradual return to work and requirement for building maintenance has already led to an improvement in demand for the company’s services, and Mitie says they have now brought back over 40% of their 7,000 furloughed colleagues to work, as customers have started to resume operations. Whilst this is positive the impact of the new ‘work from home’ culture in the UK, the government’s advice to avoid public transport as much as possible means the pickup in demand will continue to be slow. Many UK companies such as banks are planning to keep employees working from home for long periods, which means less use of their shared office facilities. This potential hit to Mitie could possibly be mitigated by the need for greater social distancing within the workplaces and a consequently greater need for floor space per person, but even so, it will take a fairly substantial period of time for this side of the business to reach pre-COVID-19 levels. Another potential risk for Mitie’s core business is that the UK government has announced a relaxation of the planning laws that would make it easier for building owners to convert unused office buildings into flats. This may lead to great changes in city centres where residential property may be in greater demand than commercial offices. That leads to a real concern that, if office buildings are not fully re-occupied, then revenues here may never reach the prior levels at all.

This ‘structural’ concern about Mitie’s core facilities management business, both short and long term, is the main reason for the company’s recent lackluster share price action. Many other firms have seen some sort of pickup in share price since the original market crash back in March, but Mitie’s share price has been stagnant. This share price action is linked to the lag in operations seen within Mitie’s core business. As the company highlighted in their first quarter update, performance in the month of June was only ‘slightly’ better than that of April and May. June was the period where the UK government had started to reopen certain facilities and kickstart the economy once again, but seemingly, Mitie has not benefited from that to any great extent.

Interserve acquisition

An area that should offer investors some form of optimism is the recent £271 million acquisition of Interserve, announced in June 2020. What is most appealing about the deal is how it will help to diversify Mitie’s offerings. Interserve has a greater focus on facilities management for industrial customers rather than offices, and this acquisition will increase the group’s overall footprint in this area and help to diversify the business.

Diving into Interserve’s performance shows a robust but low margin picture. In the most recent year, the company reported total revenues of over £1.3 billion and an EBITDA of £43 million. This represents a recovery from 2019 when the Interserve business was forced into administration in the face of some opposition from shareholders. The Interserve numbers are similar to that of Mitie in that they display extremely tight margins and the importance of controlling costs to achieve profitability. Improving these margins through cost synergies could allow Mitie to outperform consensus estimates and deliver strong numbers. Mitie indicates the potential impact of these synergies in their formal announcement of the deal to the market:

Proposed £271 million acquisition of Interserve Facilities Management to enhance Mitie’s position as a leading UK facilities management company. Implied transaction multiple of 6.3x FY19A EBITDA (excluding synergies) and 3.7x FY19A EBITDA (including recurring annualised pre-tax cost synergies).

However, during these uncertain times, and with overall reduced demand levels for both Mitie and Interserve’s core offering, it will prove extremely difficult to deliver any revenue growth, and any upside will have to come from cost savings. My greatest concern for Mitie is the risk that comes with these tight margins. As Mitie faces a lag on operations for the foreseeable future, the control on their operating margin will be paramount. A fall of 11% in overall revenues in the recent quarter may seem small on the face of it, but given the low overall margins, this will significantly affect Mitie’s profitability and could potentially push them into a loss. This could be the picture for the foreseeable future as Mitie operates in an industry which is facing some of the toughest headwinds across a number of fronts.

The company had a year-end 2020 net debt pile of £168 million which represents a reasonable position of twice its £86 million operating profit for full year 2020 (year end March 2020). The balance sheet has been further strengthened by a deeply discounted rights issue which raised £201m in new equity in June 2020. This raised the money to fund the acquisition of Interserve but was priced at a 69% discount to the prevailing share price of June 24th, 2020, delivering a large share dilution and undercutting current investors considerably. The rights issue was also linked to covenant waivers on some debts and an extension of its existing revolving credit facility (RCF) of £250 million to December 2022. This all buys time but suggests that access to further funding, either debt or new equity, must be extremely limited. Whilst recent director buying should be a greater sign of confidence, investors must also be concerned that the rights issue could only be achieved through offering such a large discount. The Interserve deal has promise, but acquisitions are risky and tend to increase fixed costs, potentially pushing Mitie into a far more dangerous zone.

For a business that has been relatively subdued over recent years with poor performance and a sliding share price, the Interserve acquisition could bring some ‘excitement’ into shares and give a catalyst for an improvement in Mitie’s business. Interserve has already established numerous relationships and links within their industry which Mitie will hope to build on, and the ‘upside plan’ will be to use these relationships to sell more services and expand overall operations.

Conclusion

Mitie is now trading off a forward P/E multiple of just over 3, and, while this may prove attractive to some, to me, this is a close call, and the low multiple is there for a reason. As an outsourcing entity which relies heavily on external demand from its business partners, the speed in pickup of demand is largely out of Mitie’s control. I am wary of the speed of this pickup and, as such, am avoiding this falling knife for now. Mitie has a manageable debt pile, but investors must watch carefully to see if the company can service this debt over the coming years. Even servicing the existing debt will likely eliminate the prospect of a shareholder dividend for several periods, and the Board declared no dividend for the year ended 2020. Access to future debt looks limited, and access to further equity would likely only be achieved at deeply discounted levels.

When the company releases its Q2 numbers, it will be important to see how core demand has changed, how well Mitie has controlled its costs, and whether it has delivered any post-acquisition synergies. Taken together, this will indicate whether it can mitigate the general business headwinds.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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