Spotless misses the mark

Someone somewhere must be happy to buy shares in Spotless Group – or at least its bankers think they will be – but it isn’t us and we have no idea why they would.

Spotless was taken private by Pacific Equity Partners (PEP) in 2012 and already they’re back trying to offload half the company. You might think that two years isn’t enough to turn a business around and you’d be right, but more on that in a moment.

Spotless is Australia’s largest provider of outsourced business services, taking care of the fiddly jobs that companies would rather not bother with themselves. In 2013, the prospectus proudly proclaims, the company served food to 76m people, laundered 36m sheets and 22m industrial garments and maintained 80,000 homes in public housing estates.

All this hints at the main problem with this business. It does a lot of stuff, and it’s all stuff companies would do themselves if they couldn’t get it done cheaply by someone else, so there’s not a lot of margin in it. What’s more, since costs tend to tick up each year, particularly in a company with such a large wage bill (about two-thirds of total costs), if you don’t keep the revenue line moving, then your profits will go backwards.

This is exactly what happened in the five years leading up to Spotless’s delisting: revenues rose by only 10%, which meant that a 12% rise in costs led to a margin contraction from 4.3% to 3.2% and an 18% fall in earnings before interest and tax. This was despite a 22% increase in shares on issue, so that earnings per share very nearly halved.

With such fine margins, small differences can count for a lot – and this may be just what attracted private equity. Although there’s been precious little growth in the past two years, with revenues ticking up by just 4%, a slightly smaller increase in costs (of 2%) has pushed the operating margin back up to 4.0% and sent the EBIT up 21% to $103m. But that’s only half the story (if that).

Job half done

Over the next couple of years, the company is forecasting another 4% increase in revenue, while a 1% fall in costs is expected to more than double the operating margin, to 8.4%, and the EBIT to $227m.

To put that into context, the EBIT margin hasn’t been over 5% since it hit 6.3% in 1999. Even if they pulled it off, you’d have to wonder if it had more to do with underinvestment than genuine efficiency gains; it would not be the first time private equity had played that game.

And even if after two years we have a thriving company producing double its current margin, new shareholders are being asked to pay about 13 times those suped-up earnings. The less said about the 32–35 multiple range for 2013 earnings the better.

All in all, this float has the look of private equity trying get half their money out before the job is finished, transferring that part of the execution risk onto the new shareholders. If they were really confident of delivering the planned improvements over the next couple of years then they’d surely wait until then to sell their investment.

We’ll be very happy to watch this one from a (considerable) distance. AVOID.