Description

COOR SERVICE MANAGEMENT AB (COOR SS Equity, 38 SEK)

…Serious investors should understand the disparate nature of intangible assets. Some truly deplete over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses.  The concept of making charges against other intangibles, such as the amortization of customer relationships, however, arises through purchase-accounting rules and clearly does not reflect reality. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated – even though from an investor’s viewpoint they could not be more different.

Warren Buffett

We’re looking to pay 10x free cash flow or less, period. If you find those opportunities and you can’t kill the business, you should be buying all day long.

Bruce Berkowitz

Thesis summary

·        Coor is a safe, boring property services company trading at a discounted valuation due to relatively low liquidity, limited relevant historical financial data, limited analyst coverage and (perhaps most importantly) a large discrepancy between reported earnings and actual cash earnings. This makes it look expensive on a first glance and screen badly. The reason for the discrepancy is amortization charges taken against customer contracts capitalized after previously completed M&A activity which distorts the market’s perception of the actual economics of Coor’s business.

·        Negative working capital and low capex needs (<1% of sales) means the company is highly cash generative (Coor targets cash conversion>90%) and long term contracts ensure that earnings visibility is very good. The company is shareholder friendly and pays substantial dividends (est. 50% of EBITA in 2016, implying a 5.5% dividend yield).

·        While customer concentration is still relatively high with the top 5 customers constituting about 30% of revenues, the company is diversified in terms of industrial exposure, with no industry making up more than roughly 20% of revenue.

·        Coor’s growth potential is quite decent due to only moderate penetration of outsourcing of facility management in the Nordic region so far, and an increasing trend toward integrated facility management (IFM) which is Coor’s specialty. Mid-single digit revenue growth looks feasible in the medium to long term. Bolt-on M&A could add to that figure.

·        The company is conservatively financed, with NIBD/EBITDA of about 1.7x, which seems low given the stickiness of the customers (long contracts, typically > 5yrs, and high net retention rates). There’s clearly room to take on more debt which could allow the company to make bolt-on aquisitions to boost growth and/or pay out extraordinary dividends to shareholders. Management targets a long term NIBD/EBITDA ratio of <3x.

·        Coor is clearly too cheap, trading at 11x 2017 adjusted EPS despite high cash generation and dividend potential and stable, safe business characteristics. A conservative DCF shows the company is worth 61 SEK, 66% above today’s price. My price target is 63 NOK. Neither my base case nor my bull case assumes much margin expansion or favorable M&A. However, should either of these materialize, the upside in COOR is far larger than my base case implies. Given its conservative balance sheet, great cash flow visibility I think the company is also an interesting company for private equity players.

·        Risks include (but are certainly not limited to): loss of key personell, loss of big clients, stricter labor regulation, entering large contracts on unfavorable terms, unfavorable future M&A and increasing competitive pressures in the industry reducing margins.

Relative performance vs peers since listing

Brief company history

Coor AB was originally part of Skanska AB (SKAB SS Equity) and was formed in 1998. It is headquartered in Kista, Sweden. It offers a wide variety of facility management services:

Over the years, Coor has built a large portfolio of private and public customers including Statoil, the Danish Police Force, Volvo and Ericsson both through organic growth and M&A. It operates mostly in the Nordic countries, but will follow Nordic clients to other European countries as they expand operations there. Sweden is its largest and most profitable market, followed by Norway.

In 2004 Skanska Facilities Management was acquired by the private equity firm 3i and renamed Coor Service Management in 2005. In 2007, the buyout firm Cinven Ltd bought out 3i at a deal size of 536m EUR (EV). In 2013, Coor acquired service company Addici with Nordic-wide operations. Coor was IPO’ed in 2015 at a price of 38 SEK per share, the same as the current market price. The company raised about 1675m SEK in total before costs, and demerged the industrial services division. Cinven (Cinoor) remains the largest owner with 12.6% of the stock outstanding, but sold about 18m shares in the IPO and has sold more this february (placed 17m shares at 36 SEK). The firm is no longer bound by any lock-up on its remaining shares (this expired 180 days after listing). Most of the management and board, including CEO M. Stohr, added to their holdings during the IPO.

Characteristics of Coor’s business:

Facility management is an attractive business when done right as capital expenditure needs are low (<1% of sales) and long term contracts (typically at least five years) provide great cash flow visibility. FM services are categorized as hard FM and soft FM which refers to maintenance / repairs / operations and workplace related services, respectively. The latter category can be subdivided into 4 main categories: cleaning, food & beverages, security and other office services.

One of the things I like about this business is that it is easy to understand, and that the risk of technological disruption is low. That said, technology is playing an increasingly important role according to the company. Increasing use of technology in FM services means there might be larger cost savings to be had for customers (as well as fatter margins for Coor) in the future than what has been the case in the past, and is constructive in terms of getting companies to consider outsourcing their facility management. As an example, Coor has launched a smart ID card management system, a digital archiving solution, a virtual receptionist service and intelligent sensors that help monitor customers maintenance needs (higher degree of automation in waste and cleaning services, climate control, energy use monitoring and optimization). Customers appear sticky. At year-end 2015, more than 75% of customers had maintained a relationship with Coor for 6 years or longer. Based on past retention statistics and management communication I think 85% net contract retention is realistic going forward, this is also supported by the fact that the two major rivals in the Nordic market, ISS and Sodexo, do not seem aggressive in their bidding currently (that may change, industry conditions have not always been as mellow).

Most of Coor’s business (65%) is structured as integrated facility management contracts which specifies what services are to be provided, where about 70% of the revenue stems from monthly subscription fees, usually with an inflation adjustment clause (especially for second or third generation contracts). Coor is paid these monthly fees one month in advance, which is obviously excellent from a working capital point of view (explains how Coor can have negative working capital). On top of those 70% there is a variable element which can consist of more ad hoc services like a catered event e.g. or moving assistance. Prices are set based on how comprehensive the service agreement is and based on specifics of the facilities (size, number of employees) and what exact services are provided. Generally it seems like more complex services give less price transparency for the customers and better margin potential for Coor. IFM appears to have better margin potential than bundled services which again has better margin potential than single service contracts. Another attractive feature of this business is that the cost structure is quite flexible - all employees on a specific contract are typically given notice before a contract renewal. That way, Coor is not stuck with a large number of excess employees should they not get a renewed contract with the customer. The norm in the Nordic FM market is that the winning bidder for a contract takes over (most of) the relevant employees at a given facility, a practice which serves both employees and employers well.

The industry has exiosted in its current form for a fairly short period of time, so it is not easy to say how it will react to another economic downturn of some magnitude. While one would imagine margins come under pressure if commercial real estate values fall e.g. since lower rent levels would probably increase customer’s price sensitivity, one must also consider that outsourcing facility management in the vast majority of cases increases efficiency and lowers cost for the customer. So the net effect is kind of hard to anticipate. In any case, it appears the industry fared rather well during the global financial crisis of 2007-2009:

Source: Coor IPO prospectus

Brief market overview

The market for outsourced FM services has developed from mostly single-service to more multi-service over time. When one supplier provides several services under a single contract, it is called an integrated facility management contract (IFM). According to Coor, the main benefit of IFM structured contracts is that it allows for maximizing the local synergies between various services at a single location, which can reduce cost on the order of 20% for the customer and increase efficiency.. The IFM market is expected to grow at a 6% pace in 2016 and 2017 according to Coor. The outsourced FM market in the Nordics is about 215 Bn SEK (the total value of Nordic FM activities is much higher at 380 Bn) and still fragmented as a whole, with the largest 10 suppliers accounting for only about 30% of the market. Compared to other European countries like e.g. the UK, the Nordic market for outsourced FM services should still offer plenty of room for Coor to grow revenues. This is true both for the private and the public market.

However, the IFM market looks a bit more oligopolistic, with COOR as the strongest player according to the company at least. I am a little bit skeptical of this assertion as I believe the small size of COOR relative to e.g. ISS means ISS can bid for contracts that Coor simply cannot fulfill. But it seems pretty clear that it’s a strong player, and that 3 players dominate. Coor’s market share in IFM services is 36% while ISS is a close second at 32% and Sodexo a distant third at 14% or thereabouts (source; companies, DNB Markets). In FM services overall, the numbers are 9%, 3% and 3%, respectively.

Source: COOR AB

Management and board, COOR AB

Both management and board seems capable and trustworthy. Ownership in parentheses.

Mikael Stöhr (78 947)

Member of the Board of Directors, President and CEO of the Group since 2013

Born: 1970

Education: L.L.M, Major in Business Law, Lund University.

Professional experience: President and CEO, Green Cargo AB and Axindustries AB. Vice President, Axel Johnson International AB. Trade Commissioner to Russia, Swedish Trade Council in Russia. Junior Engagement Manager, McKinsey & Company, Associate, Mannheimer Swartling Advokatbyrå.

Rikard Wannerholt (22 746)

Senior Vice President, Operations Development since 2013

Born: 1962

Education: B. Sc. in Business Administration, Lund University. Advanced Management Program, Stockholm School of Economics. International Executive Program, IESE Business School, University of Navarra, Barcelona.

Professional experience: CEO, Sun Microsystems Sweden, President and CEO, Addici. Executive Vice President, EDB Business Partner.

Jens Ebbe Rasmussen (73 213)

Senior Vice President, Business Development since 2009

Born: 1968

Education: M. Sc. in Business Administration and Economics, Lund University.Finance, École supérieure de commerce de Paris. Sub-lieutenant, Land WarfareCenter, Skövde.

Professional experience: Management Consultant, McKinsey & Company. Fixed Income Department, Unibank Markets (Nordea). Consultant/External Advisor, Fruktbudet.

Olof Stålnacke (82 929)

CFO of the Group since 2009

Born: 1965

Education: M. Sc. in Financial Economics and International Business, Stockholm School of Economics.

Professional experience: CFO, The Absolut Company, V&S Group. Various CFO positions and Management Consultant, McKinsey & Company.

Board:

Anders Narvinger (Former CEO of ABB Sweden, 55 701), Søren Christensen (Cinven’s representative), Mats Jonsson (Previous CEO of Coor AB, 565 155), Monica Lindstedt (10 000).

Valuation

Revenue, COGS and opex are assumed to grow roughly in line from 2017 onwards. I expect a slightly higher growth rate in revenue in 2017 as the 300m/yr contract with Karolinska (a Stockholm hospital) is fully ramped up in 2017. The resulting medium term EBITA margins of 5-5.3% looks realistic IMO. This is supported by management target over the cycle of 5.5% EBITA margins and 4-5% organic growth (I choose to be somewhat more conservative in the short term). This is somewhat lower than the peer group avg EBITA margin, largely due to smaller economies of scale. Over time, I think COOR could approach the peer group average of 6%+, as it builds scale outside of Sweden. It is obvious that margins follow scale and percentage of IFM business: Today, Sweden has an EBITA margin of 8.6% (superior even to Compass Group average margins, a company with a 30 Bn USD market cap), while Finland, where Coor does the least business and has more single service business, has a much weaker -0.4% EBITA margin. There are also ongoing efforts to increase the share of self-delivery in certain service areas which should increase efficiency and improve contract economics further.Note that the significant opex reduction from 2015 to 2016 is due to adjustments for non-recurring items due to listing on the Stockholm stock exchange, an unusually high level of renegotiated and new contracts and cutbacks at a couple of major customers that have new been completed (for now anyway, I view Statoil as a risky customer in this regard).

NB: The reason I adjust for amortization cost here is that this amortization is 100% the product of the change in intangible assets in the balance sheet pertaining to writedowns of capitalized customer contracts from previous M&A. See notes 3.2 and 18 in the annual report for 2015. No new customer contracts from organic growth initatives are capitalized. http://www.coor.com/Documents/In%20English/Investors/Coor_Annual_Report2015.pdf

P&L

DCF

Assumptions not shown explicitly include: no share issuance/other dilution, paid taxes at 10% through 2019 because of past accumulated losses (maybe even lower) vs a 24% normalized tax rate. From 2020 onwards, I use the normalized tax rate of 24%. Note that I use a 10% discount rate instead of the calculated WACC of about 8.4% for the sake of conservatism.

As shown in the table above, I sketch out 3 scenarios and probability weight them (subjectively, obviously) to arrive at a p-weighted fair value estimate. The base case is my DCF value, the bear case is a 2020 market valuation of 10x my estimate for 2016 adjusted EPS plus half of my estimate for dividends received in the interim, discounted back at 10%. The bull case assumes all DCF assumptions steady except revenue growth, which is increased to 4%/yr. The p-weighted average is 63 NOK.

NB - there is another, more aggressive bull case possibility that I am not including here:                                   

If we assume higher EBITA margins from increased scale and operational density – a company wide EBITA margin in line with Sweden today in 2020 for example - and apply a 15x FCF multiple to that figure (the resulting 6.7% FCF yield figure is actually in line with the current sector average), the fair value of COOR is in the mid-90s. It doesn’t take a miracle for this to happen, but I’m not willing to bet on it. Fortunately I don’t have to for this to be a good investment.

Key risk factors

In addition to general risk factors like FX volatility and macroeconomic pressures and liquidity issues, I believe these are the most important risk factors for Coor going forward:

Competitive pressures may change

In 2013, price pressure was much higher than it is today as one of Coor’s competitors engaged in what Coor management has called irrational bidding behavior. This caused Coor to both lose a few existing customers and precluded Coor from several new bidding processes (economics no longer interesting). As the numbers above indicate, Coor’s niche is attractive, new players could emerge. While technology is playing a more important part now than in the past, this isn’t rocket science.

Client concentration

Losing major contracts obviously impacts Coor directly. For example, Ericsson and Statoil constitute about 10% of revenues each. Additionally, when customers perform large headcount reductions Coor may suffer as many contracts are structured according to number of employees served. We have seen this in the past year with both Ericsson and Statoil. Given the state of the oil & gas industry currently, further cuts in STL or other energy industry clients like Aibel can not be ruled out. Over time, Coor can make adjustments to its cost base but this may not be enough to compensate.

Labor regulation changes

Labor regulation changes could end the favorable dynamic described above where Coor can give notice before major renewals come due. This could be a major negative as it would mean Coor is stuck with a much larger cost base for longer after losing contracts.

Weaker commercial real estate market in the Nordic region

The Nordic commercial real estate markets are faily expensive. Rapidly falling asset values and rent levels could impact Coor revenues when contracts are renewed and pressure margins on new deals. On the other hand, outsourcing might look attractive as it usually provides significant cost savings for the client. Since this industry didn’t really exist in the same form during the last downturn in Nordic commercial real estate, it is hard to predict exactly what the net effect of a downturn would be.

Losing key personell

A lot of key employees at Coor have been with the company for a long time and are probably integral to operating as efficiently as possible. Losing these people could be a major negative.

Appendix: shareholders, consensus, revenue, breakdown of margins and growth by country

Largest shareholders (as of April 2016):

Value-oriented shareholders of note: Taiga Funds, Didner & Gerge, Schroder.

Relative valuation

Coor country by country (source: Q4 presentation, annual report)

PS: My apologies for the poor formatting.

Catalyst

Increased analyst coverage

M&A