Description

Note: Table above is for FY22 (March) and FY23 (March) in pounds.

Investment Thesis

Mitie Group (LSE: MTO) has 50-100% appreciation potential over the next 12-24 months and several near-term events could jumpstart the process. Driving the performance is accelerating earnings growth, strong cash generation, and the potential for a dividend reinstatement, which would significantly change the narrative on the stock. The stock’s success is dependent on execution, mainly in the form of margin improvement, and there is a clear self-help path forward through cost restructuring and IFM acquisition integration. While this is a longer-term thesis, upcoming catalysts could make the next several months mighty for Mitie including 1) upside to FY21 (March) and FY22 earnings estimates, 2) release of overhang from IFM shareholders, 3) increased index inclusion and investor attention, and 4) a dividend reinstatement.

Overview

Mitie is the UK’s largest facilities management company – a mature industry that has long duration contracts (3-5 years) and high retention rates (90%+). While EBITDA margins are low (MSD), so too is capex, which leads to good cash flow generation with proper execution. This is a competitive industry where scale and technology are a competitive advantage to servicing large national customers. Business services is an altogether out-of-favor sector in the UK due to lower-than-average business quality and work from home requirements.

Mitie had been in transition well before the onset of COVID. The company was built through acquisition over years but never integrated, which led to significant margin contraction. Management laid out their transformation vision during the 2019 Capital Markets Day, however, most of the projects were postponed or diverted once COVID hit. The stock peaked near 170p in 2014 when forward EBIT was £128mm (5.8% margin) and EPS was 24.7p. Fundamentals and the stock price have been on a steady descent ever since. Consensus estimates for FY21E (March) EBIT and EPS are £58mm (2.3% margin) and 3.0p, respectively. The stock hovers just above 60p.

Why Does the Opportunity Exist

Mitie is an under-earning UK business services company going through significant transition. Prior to COVID, sentiment for Mitie was abysmal due to a history of poor execution, minimal free cash flow generation, and balance sheet risk. COVID took a heavy toll on the business and management eliminated the dividend. During the height of COVID, Mitie made a transformative acquisition (IFM) accompanied with a large rights offering. These factors have caused many investors to socially distance from the stock, ascribing a 40%+ valuation discount to peers. While the “re-opening” trade has been prevalent in the US since Q3 2020, it is significantly lagging in the UK leaving many beaten down stocks trading at a fraction of pre-COVID levels.

10%+ Earnings Beat Could Jumpstart The Re-Rating

This is mostly a longer-term thesis as we believe FY23 (March) estimates could be 30% than consensus. However, we also believe that near-term estimates need to come up 10%+ and the trend of positive earnings revisions would provide early support for multiple re-rating. There are three items to keep in mind as it relates to FY21 results:

1.       Company guidance is likely conservative.

2.       Guidance was given during the height of the UK’s 2^nd lockdown.

3.       Analysts do not appear to be modeling incremental margins correctly.

To put guidance/estimates in perspective, this is a company that had chronically under-delivered for shareholders.  We believe with the advent of new management (CFO and IR in 2020) the company was going to take a new approach to managing expectations and addressing investor concerns. This has already begun to play out regarding additional disclosures (such as intra-period debt balances) and a new long-term incentive plan that focuses on cash generation. Like many companies during COVID, Mitie did not provide guidance during the height of COVID. 

On 11/19/20, MTO released 1H20 results. Organic growth was -8% in Q2 (-9% in 1H) and the company did not issue guidance given uncertainty with COVID. The interesting part to note is that results for the December quarter were getting materially better at the time of the release and the company still did not want to put out guidance (we believe given their conservatism).

On 1/28/21, MTO released a Q3 trading update. Organic growth accelerated to 6.7% Q3 (vs. -8% in Q2). At the time of the release, the UK was going back into lockdown, which caused the company to guide to flat organic growth in Q4 and £57-61mm of full year operating profit. Since there were only two months left in the FY, the company likely had decent visibility to give guidance, but their framework was based on a fairly draconian operating environment.

The January 28, 2021 trading update on Q3 results was an inflection point for the company that caused significant revenue revisions but minimal profit revisions. Revenues for FY21 and FY22 were revised upwards by 8% and 18% while operating profit was only revised upwards by 5% and 3%. These businesses typically have 15% incremental operating margin. Using that assumption, it is easy to derive a significantly higher profit estimate. We will note that there are some offsets, such as bonus accruals and share based comp. However, there are also some more favorable dynamics such as organic revenue that is likely to exceed 0% as well as IFM synergies that were increased by £5mm in the November 2020 trading update that were not factored into consensus. Needless to say, it is difficult to reconcile the estimates and we believe they will have to come up.

We want to emphasize this is not a “beat and raise” thesis, although that dynamic would help given Mitie’s poor sentiment. The crux of the thesis resides in FY23 earnings power that we believe could be 30% higher than estimates.

IFM Acquisition a Big Positive

On June 25, 2020, Mitie announced the acquisition of Interserve for £268mm, representing 3.7x 2019 EBITDA including synergies. The IFM acquisition made investors quite nervous given its size (£268mm at announcement which was nearly identical to MTO’s market cap), timing (June 2020 at the height of COVID uncertainty), accompanying rights issue (40% increase in share count), and overhang from new shareholders (primarily distressed debt investors who would likely sell and pressure the stock). The price was further negotiated down to £190mm (2.5x EBITDA) based on MTO’s rate of improvement and some IFM contract losses. 

While the market has collectively viewed these as risks, we view them as significant opportunities for the following reasons: 1) the acquisition made strategic sense by providing MTO public sector exposure and greater scale, 2) the rights issue de-levered the balance sheet (a key investor sticking point), 3) the increase in market cap makes MTO a larger constituent of an important UK stock index, garnering greater investor attention, 4) the timing of the transaction enabled MTO to negotiate a tremendous price of 2.5x EBITDA, 5) overhang from the new shareholders has mostly been released, 6) significant cost synergies provide a road map for margin expansion, and 7) IFM has a more favorable cash collection cycle and will help improve Mitie’s cash generation.

Mitie identified £30mm of cost synergies at the time of the acquisition and increased those to £35mm in November 2020. If the company is able to realize those synergy targets, the deal will be highly accretive. It is important to note there are two opportunities for further upside we believe the company has a good shot of achieving. First, Mitie did not assume any revenue synergies in its original target. Second, Mitie took a very conservative approach in estimating its win rate on IFM contract renewals (25% in year 1 and 50% in year 2). We believe these offer significant upside if achieved.

We would also note that up until recently, Interserve vendors held 17.5% (248mm) of Mitie’s shares. Since they were not traditional equity investors, there was a perceived overhang in the stock. On March 4, a block of 149 million shares traded at 51p and the stock has been fairly strong since the block traded. There are about 100 million shares remaining that could be serving as a slight overhang on the stock.

Margin Improvement Will Drive Stock Performance

MTO historically earned a 5.5-6.0% profit margin compared to the current run-rate of 2.3%. Bridging this gap is key for stock performance, and much of it is within management’s control through self-help initiatives. Aside from IFM synergies, Project Forte, a program designed to create the “Amazon of Facilities Management” is set to produce £23mm of net savings and a 33% increase to £58mm EBIT in the most recent fiscal year. Additionally, as the UK reopens from COVID, MTO will reap the benefits of improved utilization and higher margin project work, further driving margin expansion. In 2019, the company instituted a mid-term profit margin target of 4.5%, which did not contemplate Project Forte at the time, providing ample opportunity to reach historic levels.

Below we provide a bridge from run-rate EBIT to FY23.

Valuation

We believe EPS and FCF yield are the most important metrics to valuing MTO. Based on consensus FY23 (March) estimates, MTO trades at 9.6x EPS (6.6p) and a 6.7% FCF yield (£61mm), which is a slight discount to its historic averages. If MTO executes, we believe FY23 EPS of 8.5p and £90mm of FCF are achievable, putting the stock at

Serco (SRP LN) is the closest comp and is also a valuable case study as it went through a similar restructuring 2-3 years ago. On 2022 estimates, SRP LN trades at 15.2x EPS and a 4.8% FCF yield (similar to multiples of ISS DC and a discount to SW FR). Should MTO be successful in its initiatives, we could foresee upwards of 8.5p and £90mm of FCF. At 15x EPS and a 6% FCF yield, the stock would be worth 110-130p.

Risks

The biggest risks here are execution and dis-synergies from IFM. IFM customers have clauses in their contracts that allow for termination due to change in control, which poses retention risk to MTO. Management took a conservative approach in assuming the cancellation rate (they even renegotiated the purchase price down by £78mm during their due diligence based on this) which gives us some comfort.

Catalyst

Catalysts

1.       Positive earnings revisions

2.       Achieving/raising synergy targets

3.       Dividend re-instatement

4.       Release of final shares from IFM acquisition