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Synergy Health constrained by capacity

Synergy Health's acquisitions give investors confidence in its long-term prospects, but the share rating is vulnerable to short-term shocks
February 7, 2013

Shares in cleaning and sterilisation specialist Synergy Health (SYR) have been notably strong performers lately, outpacing shares in similar companies by 20 per cent over the past quarter on the back of some promising deals in new markets. True, Synergy almost certainly has a solid future in its key markets, but, in the medium-term, the share rating has moved too far ahead of the group's growth prospects. Really brave punters might try 'short selling' the stock; meanwhile, shareholders might simply opt to sell.

IC TIP: Sell at 1,062p
Tip style
Sell
Risk rating
High
Timescale
Long Term
Bull points
  • Potential of US hospitals market
  • Austerity won't last forever
Bear points
  • Shares rated higher than sector average
  • US expansion may undermine profit margins
  • Business model demands high capital spending

The trigger for the big share-price move was Synergy's decisive entry into the US hospitals market. The acquisition of SRI/Surgical Express, in particular, for $25m (£17m) got the City's admiration, especially because the price paid looked good for a business generating sales of more than $100m.

However, it is not clear what effect the expansion will have on Synergy's underlying profit margins. These were more than 15 per cent in the first half of 2012-13, but there is a risk that the peculiarities of the US business could eat into them. This is because most US hospitals, unlike those in Synergy's core business with the NHS, have their own sterilising and cleansing facilities on-site. That means Synergy would be paid a fee as a service provider, rather than as a more lucrative full-facility operator.

There is no doubt that the US market is far larger than anything Synergy has entered so far and the opportunities are there. However, the question hanging over the States-side project is whether investors have taken into account the amount of investment needed over the next few years to bring the service up to Synergy's standards. That could generate big one-off costs that may not be adequately priced in.

 

SYNERGY HEALTH

ORD PRICE:1,062pMARKET VALUE:£620m
TOUCH:1,062-1,065p12-MONTH HIGH:1,136pLOW: 758p
DIVIDEND YIELD:2.2%PE RATIO:21
NET ASSET VALUE:539pNET DEBT:57%

Year to 1 AprTurnover (£m)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
201028624.540.613.2
201128736.752.115.8
201231232.544.518.0
2013*36337.549.120.4
2014*40942.349.423.0
% change+13+13+1+13

Normal market size: 500

Matched bargain trading

Beta: 0.4

*CanaccordGenuity forecasts

As support services businesses go, Synergy is unusual because a lot of its capital is tied up in tangible assets. That's because often it has to fund and build hospital cleaning facilities itself for the contracts it wins. That means lots of upfront spending in order to grow sales, as each new contract can mean another round of construction.

Analysts at broker CanaccordGenuity estimate that to achieve an adequate cashflow return on its capital of around 8 per cent, the company must invest between £15m and £30m annually to generate the required income. This inhibits shareholders' returns as the lead time between winning a contract and starting operations is between 18 months to two years. CanaccordGenuity estimates that the company will clock up capital spending of £75m over the next three years. Given the lag between spending and revenue-generation, sales growth will be deferred, making Synergy much more cyclical than is generally perceived.

Synergy also has its share of immediate problems resulting from austerity in the European Union. This affects its Dutch business supplying hospital linen, in particular. Meanwhile, a spending squeeze in the NHS, while not affecting existing contracts due to the importance for patient care, could slow the pipeline of new work that Synergy could bid for.