Room for improvement

PORTFOLIO POINT: Virtual officer provider Servcorp has been expanding aggressively. For investors, the question is whether it has moved too fast, too soon, in the current environment.

Two analysts, presented with the same set of facts, can and often do arrive at entirely different conclusions.

Indeed, every day and every time a stock trades, the buyer and seller are arriving at vastly different conclusions.

On the one hand a renewed interest in cyclical stocks does not make it difficult to imagine Servcorp shares racing higher – the company having boldly positioned itself for an economic upturn by doubling its floor portfolio and expanding in the United States in anticipation of a strengthening global economy.

But on the other hand I can also see Servcorp shares limping for another few years because it mistimed its aggressive expansion amid a global economy panicked into unlimited money printing and tried to enter too many markets at once while not generating enough traction with its virtual office strategy.

It is too early to say which scenario will take hold at Servcorp. Run by founder and major shareholder Alf Moufarrige, Servcorp has a history of buying office space at the depths of recessions – when rents are cheap – and benefiting when demand for serviced accommodation recovers. And few small-cap Australian companies have demonstrated such global ambition. With 124 serviced accommodation floors in 21 countries, smaller enterprises employ Servcorp’s cost-effective city office space, access to receptionists and meeting rooms.

2012 Results

Servcorp’s latest full-year profit result showed the growth strategy, especially in the US, is behind expectation. The overall result was reasonable: revenue rose 10% to $200.7 million and net profit before tax from the mature floors gained 20% to $37.3 million.

But there were two main disappointments. First, Servcorp’s FY13 guidance of $27 million in net profit before tax, up about 50% on the previous year, was below consensus analyst expectations. Second, growth in Servcorp’s immature floors is increasing only modestly each month.

To its credit, Servcorp splits out earnings for mature floors, and immature floors that are not profitable or have been held for less than two-and-a-half years. The losses from Servcorp’s immature floors fell 32%, from $27.9 million to $18.9 million.

Servcorp is satisfied with overall growth in its immature floors, except for the US where revenue is approximately 12 months behind original projections. However, it says “growth [in the US immature floors] is now on the right trajectory” and that US revenue is lifting each month.

The Big Picture

This is a company that is rebuilding. In 2010 tough global economic conditions depressed business sentiment and revenues fell 26%. This combined with continued expansion, which ensured ongoing costs, also contributed to profits falling 94%. So the company raised $78 million that year, and cash in the bank rose by $47 million, suggesting that after dividends were paid the company did indeed fund expansion into 17 new cities and seven new countries. Nevertheless, Servcorp will be perceived as being cyclical for some time, and that will ensure a broadly oscillating share price despite growth off a small base. But Servcorp has no debt and $104 million in cash in FY12.

While the cash dampens Servcorp’s return on equity (a mark against it in my eyes), it allows the company to now self-fund aggressive growth without borrowing or issuing new stock and further diluting shareholders.

Skaffold rates Servcorp an A3 for quality, which is near the top of its range, but gives its latest performance a score of 3-Average. It achieved a performance score of 1 in 2009.

Servcorp’s poor return on equity (ROE) in recent years weighs on its Skaffold rating. From 28.6% in FY08, Servcorp’s ROE plunged to 2.64% in FY10, 1.9% in FY11, and 8% in FY12. The investment in offshore growth has taken a heavy toll on net profit.

Prospective investors in Servcorp must believe the offshore expansion will lead to sharply higher ROE in coming years, and a rising intrinsic value that is ultimately accompanied by a rising share price.

Skaffold has Servcorp’s current intrinsic value of $2.29 rising to $2.83 in June 2013. A $3.15 share price suggests there is no safety margin with Servcorp and that it is overvalued and this is simply a function of the fact that the market has an appetite for the aforementioned cyclical exposure.

The Good, the Bad and the Ugly

The key question, however, is whether Servcorp can grow faster than the market expects. With 52 of its 124 floors in the struggling US, Japanese and European economies, and 27 floors in the slowing Australian and New Zealand markets, it is hard to see overall demand recovering strongly anytime soon.

Forty-five floors of service accommodation in the Middle East, South-East Asia, China and India might however have potential for stronger growth.

Rising white-collar unemployment can also create demand for serviced office accommodation as retrenched corporate workers start consultancies or other businesses. But this trend is not enough to offset subdued overall business sentiment and activity.

Rising competition in developed markets is another threat. Servcorp said “competition in many markets continues to be aggressive, largely as a result of the prolonged downturn in the US, Europe and Japan”. Lower pricing power and profit margins under continued pressure seems a likely outcome in at least the Japanese and US markets.

Floor expansion is also slowing. Servcorp scaled back floor openings from 15 to nine floors in FY12 and expects only 11 new floors in FY13. Virtual office revenue in FY12, about a quarter of total revenue, grew faster than its serviced office revenue, yet Servcorp seems to have gone a little quiet on its virtual office strategy, which was touted more aggressively a few years back.

Another risk is a higher Australian dollar. The third round of quantitative easing in the US has lifted risk appetite and put renewed upward pressure on an already overvalued Australian dollar. This suggests more pain for companies, such as Servcorp, with significant offshore earnings.

Click to enlarge

But even with these risks, Servcorp is worth putting on a ‘turnaround watchlist’. With the biggest chunk of its expansion strategy implemented, management will have greater scope to lift performance from its mature floors, speed up the profitability of its immature floors, and get more of them to mature floor status.

Servcorp also has plenty of room to improve performance through capital-management initiatives. It has always held a lot of cash for its size, and the current bank balance of $104 million is roughly double the average cash holding for much of its listed life.

With fewer floors being opened, Servcorp could look at higher dividends or giving some cash back to shareholders through a special dividend. It announced a buyback of about 5 million shares in August to utilise surplus cash and reduce the number of issued shares, which would help boost earnings per share.

The market has given Servcorp a tick in recent months. After touching $2.60 in late June, its shares rallied as high as $3.48 before retreating to $3.15. The sharemarket rally and improving global risk appetite was good news for beaten-up small-cap cyclical growth stocks such as Servcorp.

Despite these gains, the shares remain at a tantalising 10% premium to Skaffold’s 2013 intrinsic value.

Intrinsic value is forecast to rise by as much as 23% per annum (See Fig. 1) for the next two years. This, along with zero debt and recovering returns on equity – thanks to a largely implemented capital expenditure program – justifies inclusion in a ‘turnaround watchlist’ while waiting for the 10% premium to intrinsic value to narrow.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.