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Pressures crowd in on Mitie

A recent acquisition at this support services stalwart has prompted us to turn bearish
Pressures crowd in on Mitie

Shares in outsourcing operator Mitie (MTO) have been a long-running Investors Chronicle favourite. But its most ambitious acquisition to date has changed all that. The £111m deal in October to acquire Enara takes Mitie away from its core business of looking after property and into the field of looking after people. Add in the facts that Mitie's profit margins are under pressure and its share price is close to an all-time high, and the shares look like a 'sell'.

IC TIP: Sell at 294p
Tip style
Sell
Risk rating
High
Timescale
Long Term
Bull points
  • Lots of contracted revenues
  • Solid core business
Bear points
  • Falling cash generation
  • Question marks over Enara deal
  • Winning new business is getting tougher

True, Mitie is still winning contracts and organic revenues grew 4 per cent in the first half of 2012-13. But analysts at broker Liberum Capital fear this is coming at a price. Liberum thinks gross profit margins on the single service contracts - such as contracts to clean buildings - that make up 41 per cent of Mitie's revenues are coming under pressure. In order to win business, Liberum analysts suspect that Mitie is taking on risks by guaranteeing its customers savings and by accepting extended payment terms. This is manifesting itself in a strain on working capital that has meant steadily declining cash flow over the past four years.

Conversion of earnings before interest, tax and depreciation into cash has fallen from 97.5 per cent in 2009 to 83.7 per cent in the latest results. And Liberum thinks it could dip below management's target of 80 per cent to 78 per cent in the year to end-March. As cash collection has been falling, debts have risen. In 2009, Mitie had net cash of £10.3m. By the end of September it had net debt of £133m. Following the Enara deal, Liberum analysts forecast this will have risen to £219m by the end of 2012-13.

The Enara acquisition brought expansion into a high-growth and high-margin market: caring for people at home. The UK's ageing population gives home care compelling fundamentals and the government is keen to reduce care costs by keeping the frail in their own homes for as long as possible. Mitie's own estimates are that the home care market is worth some £8bn. The worry is that expressed by broker Peel Hunt: Mitie may have paid too much for Enara.

MITIE (MTO)

ORD PRICE:294pMARKET VALUE:£1.09bn
TOUCH:294p-294.5p12M HIGH:303pLOW: 252p
DIVIDEND YIELD:4.0%PE RATIO:11
NET ASSET VALUE:112pNET DEBT:32%

Year to 31 Mar Turnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20101.728016.97.8
20111.898718.69.0
20122.009520.59.6
2013*2.1911223.510.2
2014*2.3512726.811.7
% change+7+13+14+15

Normal market size: 9,000

Matched bargain trading

Beta: 0.8

*Liberum Capital forecasts (profits & earnings not comparable with historic forecasts)

Enara brings £93m in revenue and £10.1m in full-year profits. But Peel Hunt points out that Enara was purchased for 10.5 times Ebitda (cash profits before tax), which is well above Mitie's own rating of 8.5 times Ebitda. This is partly because Enara generated operating profit margins of 10.8 per cent. That's almost double Mitie's 5-6 per cent operating margin and well ahead of the 8.4 per cent operating margin achieved by the home care division of Mears, another support services company. But Enara's profit margins have been declining for the past three years, and its growth has largely come via acquisitions. Enara was created by a private equity group through more than 30 deals in four years that doubled its size. So it's fair to say that Mitie's acquisition is an integration within an integration in a market in which Mitie has no experience; although Mitie says integrating Enara is progressing well.

Meanwhile, Mitie is also grappling with the impact a sluggish economy and construction downturn is having on its more cyclical operations. Management are still extricating themselves from its underperforming mechanical and electrical engineering business, and group restructuring costs came to £4.8m in the first half and operating profit in the property division fell 31 per cent to £7.9m.

That said, Mitie has a solid core to fall back on. In January, Mitie said facilities management operations, which contribute half of the group's revenue and two-thirds of operating profit, were performing "exceptionally well" buoyed by the deployment of a major contract with Lloyds Banking Group - in the first half, its margins edged up to 6.8 per cent and operating profits were ahead by 30 per cent to £35.3m. The order book was ahead by 4.7 per cent at the halfway stage to £9bn, with 72 per cent of 2013-14's targeted revenue already secured.