Australia | Jul 09 2014
-Quality base, low churn
-High revenue visibility
-Potential capital return
-Large scale opportunities
By Eva Brocklehurst
Spotless Group ((SPO)) is a reformed child, returning to the ASX fold after a 2-year absence. The company is streamlined, having undergone significant restructuring with the divestment of problematic businesses and unprofitable contracts. Spotless provides outsourced facilities management and laundry & linen services across Australia and New Zealand and three brokers on FNArena's database have initiated coverage of the new stock, all with Buy ratings. The consensus target is $2.00, which suggests 15.3% upside to the last share price.
Revenue visibility is high and UBS attributes this to low contract churn, long-term contract structures and a high quality, diversified customer base. The company looks well positioned to benefit from the ongoing growth in outsourcing. UBS finds the valuation compelling and does not believe current multiples reflect the potential. Delivering on prospectus forecast will be the key to developing a track record and achieving a potential re-rating, in the broker's opinion.
Citi spies potential for capital management and/or special dividends from FY16. Debate over the sustainability of margins should be mitigated by the company delivering on expectations. The broker observes a lack of reliable third party data to test top line growth assumptions. Down the track, the market should be more confident. Margins may have benefitted from the period in private hands but sustainability is the key word, in Citi's view. The industry drivers look supportive for outsourcing, particularly in resources and government, where cost efficiency is the prime motive. Scale and experience should therefore favour Spotless. Citi thinks domestic comparisons alone are flawed. The company's competitors are predominantly multinationals and trade at a price/earnings premium on FY15 estimates around 29% above Spotless. A material contract win in the next few months could be a significant catalyst.
Deutsche Bank also thinks Spotless could begin returning capital from FY16 onwards and, while pro-forma FY14 leverage appears high at 2.48 times, cash flow should help the ratio decline to 1.7 times in FY15 and 1.3 times in FY16. Facility services earnings margins have been historically well below global peers. Deutsche Bank observes the restructuring has enabled an increase in these margins to 7.6% from 3.8% back in FY11. Further initiatives are expected to increase margins in FY15, taking the company to the lower end of Australian and upper end of group, relative to global peers. The stock is trading at an 11% discount to Deutsche Bank's valuation and the Buy thesis is based on forecast earnings growth of 14% compound over the next three years. The market position is strong, Spotless being the largest provider of facility services in Australasia by revenue, scale and breadth.
Spotless derived 99% of FY13 revenues from recurring activities and Deutsche Bank observes a high contract retention rate. There are price escalators in almost all the contracts and 57% of contracts are of five years or more duration. Another number that gives heart to the broker – 54% of revenue comes from government-backed agencies. Despite the federal government's rationalisation of departments and the weak retailing sector, Spotless is protected via low exposure to federal business outside of defense and only an indirect exposure to the retail sector, through shopping centre property developers and airport food outlets.
Meanwhile, there are myriad opportunities. Spotless has identified $1.5bn in annual revenue opportunities and a further $2.6bn in near-term large resource and immigration contracts. Deutsche Bank's forecasts do not assume the awarding of any of these contracts, but analysis suggests up to 39% upside to FY16 forecasts could be on the cards if Spotless is successful.
Spotless started life as a dry cleaner in 1946. In May Spotless re-listed on the ASX, following a partial sell-down by Pacific Equity Partners, which took Spotless private in August 2012. In 2013, Spotless derived around 37% of revenue from facilities management, 34% from catering, 19% from cleaning and 11% from laundry & linen services.
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