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Spotless cleans up on outsourcing trend

Spotless cleans up on outsourcing trend

By Tony Featherstone 28.09.2015

The outsourcing trend shows no sign of slowing as companies look for further cost savings and efficiency gains as staff numbers are cut. Spotless Group Holdings’ solid profit result and its improving outlook show the potential.

Spotless provides outsourced facility, laundry and linen services to companies and government departments in Australia and New Zealand. Catering and cleaning are not glamorous, but there’s a lot to like about Spotless’ position in a growth industry.

Spotless returned to the Australian sharemarket in May 2014 through an Initial Public Offering (IPO), raising $994 million at $1.60 a share. Private equity firm Pacific Equity Partners had bought Spotless in 2012, sold its international operations, delisted and restructured it. The turnaround was swift and Spotless returned to ASX much improved.

The market initially cheered Spotless’ return. It rallied to $2.52 in March 2015 – a 57 per cent paper gain in less than a year for those who bought in the IPO. But it fell to $1.75 in late August as the market correction intensified and now trades at $2.03.

Chart 1: Spotless Group Holdings

Source: The Bull

There was no operational news to warrant such a fall. A partial selldown of Spotless stock by PEP, after escrow (restricted share) provisions expired, and board and management changes, weighed on the price.  The market correction did the rest.

Spotless’ maiden full-year result, released in late August, impressed. Revenue of $2.8 billion in 2014-15 beat prospectus forecasts by 6.6 per cent and underlying earnings (EBITDA) bettered forecasts by 5 per cent. It’s a good sign when IPOs comfortably beat prospectus forecasts, particularly when they are vended by private equity firms that, generally, are known for maximising as much value as possible during the IPO.

Spotless announced more than $350 million in new contract wins, and $950 million in contract renewals. It has a strong pipeline of opportunities and plenty of operational momentum heading into FY16. The result boosted Spotless’ flagging share price.

Other highlights included a higher EBITDA margin than the market expected and a 20 per cent gain in revenue from its Health, Education and Government division.

PEP’s work to restructure, streamline and improve Spotless’ organisational culture and decision making is paying off. It is winning contracts, becoming more efficient and laying a stronger platform for incoming CEO Martin Sheppard.

It’s always interesting watching companies after restructures. Years of cost cutting, asset divestments and operational streamlining can take a toll on staff. But profits can grow rapidly when the “heavy lifting” of restructuring is over and management can focus on what it does best: winning contracts and making higher profit from each dollar of revenue.

Longer term, Spotless is superbly positioned to benefit from growth in the booming aged-care sector by providing catering and linen services to the many retirement and care facilities under construction.

The key question is valuation. Spotless trades at a 19 per cent discount to its closest global peers on a Price/Earnings (PE) basis, estimates Macquarie Equities Research. Its $2.25 target price is based on Spotless trading at a 5 per cent discount to global peers.

It’s an interesting piece of research, but comparing Spotless with its global peers is tricky. Offshore service/contract companies tend to have more diverse operations, are much larger, and have been listed for a lot longer. Spotless should trade at a discount.

Nevertheless, a forecast PE of 13.1 times FY16 earnings is undemanding and an expected 4.9 per cent dividend yield, unfranked, is another attraction.

Local analysts are bullish on Spotless after recent price falls. All five broking firms that cover it have a buy or strong buy recommendation. Price targets range from $2,17 to $2.45; the mean target is $2.28. That suggests Spotless is trading slightly below fair value and does not offer a sufficient margin of safety to warrant aggressive buying.

I expect it to beat market expectations in the next 12 months. It has several levers to quicken profit growth: more work in the healthcare and infastructure sectors, and a reduction in third-party suppliers (which lifts its margins), for example.

Spotless’ customer-value proposition has real strength, judging by its high contract renewal and win rates, and growth in key sectors. One senses the restructure and streamlined management have made Spotless more dynamic than its previous incarnation.

It’s a great business model when it works: 5-10-year contracts, a high proportion of recurring revenue, good earnings visibility, and increased economies of scale as the business grows. As the dominant player, Spotless has a reasonable, though not impenetrable, competitive advantage.

There’s still a lot of value to unlock within Spotless. Gains may be slower from here, but it deserves a spot on portfolio watchlists and serious consideration if ongoing sharemarket volatility drives its price back towards the 52-week low of $1.73.

>> BACK TO THE NEWSLETTER: Click here to read other articles from this week's newsletter


Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at September 24, 2015.


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