What to do when a leopard changes its spots?

And MITIE Group PLC

 

4th century BC Greek mosaic of a leopard and Dionysius, courtesy Wikipedia

Companies diverge from their main business for many reasons. Often they are defensive, which does not bode well for their shareholders.

Imperial Chemical Industries (ICI) was once the largest company in the British Empire. In 1984, it became the first British company to report more than 1 billion pounds in profit.

In 1993, under pressure from a corporate raider, ICI divested its thriving pharmaceutical and agrochemical businesses into Zeneca. Zeneca then merged with a Swedish pharmaceutical company to form AstraZeneca. ICI's remaining business was dependent on bulk chemicals. Competitors had moved production to low-cost areas and ICI found itself in a low margin and cyclical business with little prospect of growth.

A year after the divestment, ICI decided to sell its bulk chemical businesses and move to specialty chemical businesses and paints, where margins were higher. It imported a new CEO from Unilever, who between 1997 and 2002 sold and bought more than fifty businesses. These included concerns making flavours and fragrances, paints, electronic chemicals and starches. This strategy came at a high cost. Some analysts argued that ICI paid too much for some of the businesses it bought and received too little for some of the businesses it sold. To pay down the resulting debt, the company sold some of the ventures it had bought. Then because they needed to raise more capital, ICI made a deeply discounted rights issue. Management had lost control. ICI, once known for its technical skills, lost the direction and calculated  risk-taking required to innovate.

ICI's share price dropped from 788p in January 1994 to 220p in January 2005. Shareholders who stayed the course received 670p a share from Akzo Nobel, which acquired ICI in June 2008.

Today another large British company is losing its main thriving business. For years, Vodafone's 45% stake in Verizon Wireless has disguised the poor performance of its other businesses. See http://thejoyfulinvestor.blogspot.co.uk/2013/05/marriageand-divorce-corporate-style_15.html. The loss of Wireless will have great consequences for the company.

Investors will note that companies are in constant flux. Sometimes this can be sudden and dramatic, as in the case of ICI or Vodafone. More commonly, new management branch out into new businesses that change the nature of the company. At other times, the basic business is disrupted by competition or new technology. Sometimes they reflect the work of excellent management, as has been the case of Unilever.

While a buy and hold strategy has its merits, investors would be wise to monitor their investments regularly.

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MITIE Group PLC

MITIE slogan, courtesy MITIE 2013 Annual Report

The facilities management company, MITIE, once offered a unique business model for the industry. An acronym for Management Incentive Through Investment Equity, MITIE created a majority interest in many small businesses in its market via partial acquisition or co-financing. Its partners retained management autonomy with the incentive that, after five to ten years, MITIE would buy them out on a multiple of ten times post-tax profits, averaged over the previous  two or three years. Owner managers were encouraged to continue working for MITIE after selling their shares. As a result, MITIE's businesses were part owned by local management, the founders. The entrepreneurial spirit was kept alive. And this was its charm.

Between January 1999 and February 2008 MITIE's share price increased by 428%. Beginning in 2006, MITIE began to buy well-established companies. The first was the security business of Rentokil Initial. This enabled the company to continue its growth, but at the cost of changing its business model. The new companies were large and more complex and required substantial integration. And MITIE breached the entrepreneurial model on which it was founded. Net debt has soared from 11 million pounds in 2008 to 222 million at mid 2013. Management now refer to 'Headline' profits that exclude the considerable costs of its strategy, as if they are of no importance to the shareholder to whom they are reporting. The leopard has changed its spots.

As a result, over the last five years MITIE's share price (in blue) has increased by far less than the FTSE 250 (in green), of which it is a constituent.

Graph courtesy Yahoo, click to enlarge.

While MITIE might have fallen out of favour with investors, the company has prospered with its more conventional business model. Consider:

1. Earnings per share have increased by 9% per annum through the recession - from 2005-7 to 2012-14.

2. While return on equity has declined, the return on new equity is still a healthy 14%.

3. Management seem to have been successful in building up a new healthcare and homecare business, while winding down engineering services where it was not able to make a satisfactory profit.

4. Operating cash flow, net of capital expenditure, for the last five years has covered the dividend by 1.8 times, leaving 119 million pounds available for acquisitions.

5. The record order book at 9.2 billion pounds is 4 1/2 times annual sales, giving an idea of the momentum that this service company has generated. 2014 budgeted sales were 85% covered at the beginning of the year.

At the present price of 329p, MITIE shares are trading on a PE ratio of 30, reflecting 40 million pounds after tax reorganization costs that halved the 'headline' profit, and they yield 3.1%. A profit recovery is expected in 2014, which is supported by better results in the 6 months to September 2013. This would put the share on a prospective PE ratio of 14 (broker forecasts) and a yield of 3.3%. My valuation model values MITIE shares at 335p.* This assumes that reorganization costs will cease and that net operating cash flow is used to pay off debt. Less optimistic assumptions would lower the valuation to 228p a share.**

*Earnings per share growth of 9% on a base eps of 18p (average of 2012-14), an average PE ratio of 21.5, 14% return on equity, equity per share growth of 6%, dividend payout 50% of eps; using a discount rate of 10.8% (3.8% SLXX, 2% operating risk, 5% margin of safety) for the years 2015-2019.

**As above except eps growth of 2% and an average PE ratio of 16.5 for 2015-2019.

 

There are serious caveats:

 

The CEO uses the annual reports to sell the company rather than address the problems it faces. It is disappointing that the CEO does not indicate what will be the final cost or the time period of the reorganization she is managing or how she intends to pay off the large loans the company has taken out in recent years. Shareholders should be informed why the units MITIE is exiting from cannot be sold to other operators.

Remuneration benchmarks for the management team do not help. While the annual reports are not specific enough to explain precisely how bonuses are awarded, it seems that they are largely based on 'headline' earnings and the share price. Under this formula, earnings can be bought in by acquiring companies while their cost (amortization and integration) is excluded. 'Headline' earnings also exclude the costs of running down two of MITIE's divisions.

The seasoned investor will also note:

1. Three directors sold shares worth 1.4 million pounds at 290p in September 2013. There were no director purchases.

2. The defined benefit pension scheme is a drag on attributable profits with a charge of 14 million pounds in 2013 following a 16 million pound charge in 2012.

3. Receivables are 87 days sales, illustrating the slow conversion to cash. Fortunately, trade payables match receivables.

4. 97% of revenues are in the UK and 61% of these are in the private sector. While given that the UK is one of the stronger developed economies, this is positive, the company is in a very competitive market. MITIE has withdrawn from engineering services, and energy solutions, once highly touted, is loss making and shrinking. .