Of course the market in which a company operates is a big factor. It is surely relevant that the world’s most successful companies of the past 100 years or so mostly operate within industries that cannot disappear - people will always need to eat, drink and wash. Thus the likes of Nestlé (SWX:NESN), Procter & Gamble (NYSE:PG) and Heineken (ENXTAM:HEIA), all of which trace their roots to the 19th century, chanced upon built-in advantages.
True, people have an equal need for shelter, which prompts the thought: why aren't major housebuilders such as Persimmon (PSN) and Taylor Wimpey (TW.) among the global greats? Probably because building houses lacks the economies of scale that accrue to making chocolate bars, soap powder and beer, where a single production plant can supply a whole country. Housebuilders must necessarily scatter their activity across many building sites and source their low added-value raw materials regionally if not locally.
So the constraints of a market are important. Companies have some wiggle room. They can tweak their products and services - exiting here and focusing there - but only so much. Sooner or later they find out that the dynamics of their market place are the biggest obstacles in their path to renewal.
Outsourced services provider Mitie (MTO) may be in the process of discovering this. For more than 20 years Mitie, which was founded in 1988, expanded quickly through a combination of an acquisition-driven business plan that could barely fail to increase earnings per share and the good fortune of being close to service industries undergoing profound change.
Thus doing low-value tasks, such as cleaning offices and looking after security, became a growth business as organisations rushed to save money by offloading those peripheral chores on to specialists. Mitie's turnover was only £200m in 1996-97, but had crossed the £1bn threshold 10 years later and £2bn just five years after that. However, the pace is clearly slowing. Soon it will be five years since the percentage growth in revenues was in double figures and City analysts expect this year to produce barely 2.5 per cent.
Consequently, profit margins are under pressure. Given their low value-added activities, Mitie and its lookalikes - Rentokil Initial (RTO), Serco (SRP) and Mears (MER) - generate lowish margins anyway. Even so, Mitie's have halved in the past four years - for example, from 6.5 per cent at the level of gross cash profits (so-called 'ebitda') to 2.9 per cent for the latest rolling 12 months. Some of that should be clawed back now that Mitie has shut some lossmaking activities. Yet simultaneously - and in pursuit of lost growth - Mitie's bosses are taking the company into some risky areas.
In particular, Mitie is looking to build in the so-called 'care and custody' sector - a euphemism for running the UK's overcrowded prisons and centres for detained immigrants. For example, it has recently won an eight-year £180m contract to consolidate two centres in west London that hold 900 detained immigrants into one. The trouble is - as Serco's bosses might testify - running anything to do with prisons and detention centres is a hiding to nothing. It's an area where politicians and civil servants can't keep the public happy and, consequently, service providers can't keep their state paymasters happy.
Meanwhile, Mitie is struggling to produce the accounting profits or the cash to justify its share price. On average, in the past five years, Mitie has made £87m a year operating profit (a figure that's 8 per cent more than it made last year). The amount of value that generates depends on the assumptions used, but, on Bearbull's, it works out at about 200p per share, well short of the current price. From the perspective of cash flow the picture looks worse. Free cash flow per share has averaged just 9.3p a year in the past five; this despite minimal levels of capital spending, which has always been less than the depreciation and amortisation that Mitie charges. That won't generate much more than £1 per share of value.
True, Mitie is hardly a basket case. Its notional post-tax operating profits are enough to cover its equally notional cost of capital (including cost of equity). Its return on equity - about 12.5 per cent based on average profits - is acceptable though insufficient to justify a price-to-book ratio of 2.2 times. Its ability to turn accounting profits into cash - 72 per cent cash conversion on average in the past six years - is okay, although it should be higher for a company that does so little capital spending.
In short, Mitie's shares - despite being 21 per cent below the all-time high they hit early last year - look overpriced at 271p. So much so that I have tightened the stop-loss level on my holding in the Bearbull Income Portfolio and will jettison the holding if I can find a better alternative. It would be nice if Mitie wins the challenge to renew itself, but I don't think I want to bet on it.
