Servcorp sends in the family

‘Anybody that doesn't meet their numbers gets fairly well punished' said Servcorp founder and chief executive Alf Moufarrige last week after a profit warning from the serviced office provider knocked 20% off its share price.

Servcorp now expects profit before tax for the year to June 2017 to be around $47m rather than its previous guidance of ‘not less than $56m'. Certainly it's a big miss and a correspondingly big reaction, but the issues behind the downgrade are not so surprising; indeed the company has been grappling with them for years.

Empire-sized headache

At the heart of the downgrade was the American business, from which management expected a first-half profit of around $2m, but which instead lost around $2.5m –mainly due to its operations in New York.

The main problem is the competitive nature of the US market, which management has previously described as being far more ‘competitive and vicious' than any other they have encountered.

Chief financial officer Anton Clowes told us on the phone last week that competitors in the US were doing a better job of getting the word out about shared workspaces, and that Servcorp needed to improve its brand recognition. 

In addition to the US, the company's operations in South-East Asia have also been underperforming, most notably in Singapore and Malaysia.

Sending in the big guns

Servcorp's experience is that most problems can be solved with some extra care and attention, so the plan is to send in its two most senior managers.

The company has removed the general manager of the US business and will now be headed up by chief operating officer Marcus Moufarrige for the remainder of 2017. His father, founder and chief executive Alf Moufarrige, will take the reins of the South-East Asian business.

This, then, will be the acid test of management's faith in (err) management. It has the ring of a self-serving argument, but we have high regard for Servcorp's management and culture. It has performed well in many regions over long periods, and it's done so mostly against the same companies that it must compete against now in its problem regions. The fear, though, is that with the US and South-East Asia being recurring problems, there may be bigger issues at play.

Buy-cycle

Overlaid onto all this is Servcorp's inherent cyclicality.

Historically the company's performance and share price (see Chart 1) have performed in line with – perhaps slightly ahead of – prevailing economic conditions. In the eight or so years since the global financial crisis, Servcorp's share price has almost tripled, with last week's trading update being the first major hiccup.

This could be a sign that we are closer to the top of the cycle than the bottom, in which case history suggests that it could pay to be patient.

Despite the reduced profit guidance, the company also announced that its cash position remains strong with unencumbered cash of around $100m. With no future expansion planned for 2017, the company expects this balance to rise even after paying an expected 26 cents per share in dividends for 2017, up from 22 cents per share in 2016.

While that is good news for Servcorp investors desiring income, it also shows that the company is finding it difficult to find attractive leases to grow its total floors. However, the cash balance should provide a useful war chest to expand when any future downturn arrives and low occupancy leads to cheap leases.

Treading cautiously

Alf Moufarrige has said that he'd buy Servcorp shares if the company was not in a blackout period, but we're not inclined to take his lead at the moment.

We're in no doubt that this is a good business, but it's a good cyclical business and we're therefore inclined to demand a wide margin of safety. With the share price still having more than doubled since our last Buy recommendation on 25 Jun 13 (Buy – $3.08), it's an approach that has served us well in the past.

We'll be watching the half-year results on 22 February, but in the meantime we're reducing our Buy price to $5.50 and our Sell price to $9. HOLD.