Spotless set to sparkle

Spotless was riding a wave, tapping into the trend of governments and industry to outsource their dirty work in fields such as hospital cleaning, catering, property maintenance and linen services.

Then it all turned sour. Like so many other Australian companies, the gloss started to come off when the company expanded into the UK with the acquisition of plastic coat hanger manufacturer Braitrim. The share price duly plunged to a low of around $4 as fund managers sold out.

Well-managed

Despite this, we've liked Spotless in the past, having first recommended it way back in issue 3/Apr 98  (Buy closer to $3.50 - $3.70). It's well-managed and, whilst many of its businesses are low margin, is largely recession proof.

What we've been waiting for is an attractive entry price and a sign that the company's UK problems are behind it. Before assessing whether that's the case, some background.

Plastic coat hangers represent less than 20% of group sales but have been the source of the recent troubles. Spotless does for garment manufacturers and retailers what Brambles does (or tries to) for warehousing and transportation companies – helping to get a product from A to B. The difference is that Spotless doesn't want its coat hangers back (no jokes about Brambles please).

After entering this niche sector in Australia in 1971 Spotless expanded into the US in the mid-eighties, securing contracts with big retailers such as Sears and Kmart. This successful expansion provided the rationale to acquire Braitrim, a similar business based in the UK and Europe.

Whilst the strategy appeared sound, the price paid to execute it was not. Spotless bought at the top of the market and, to compound the problem, it financed the purchase largely with debt.

Braitrim is now struggling due to the weak European retail environment and the higher price of oil (a major manufacturing cost). Meantime, the interest bill is eating into group profits.

Upgrading

So why are we upgrading? For two reasons.

First, we believe the share price has fallen sufficiently to reflect these problems. Second, the recent half-year results show a moderate change in fortunes. Sales rose by 7% and earnings, after adding back the goodwill amortisation (see article in Investor's College on page 13), by 15%.

There are also signs that the UK business is recovering with improved sales levels and margins. Still, the gearing remains high, with net debt-to-equity of around 77%, although with interest cover a comfortable six times, this shouldn't pose too many problems.

So is it good value? The raw numbers give an expensive looking PER of 25 but after adding back amortised goodwill, it's a more reasonable 13. What swings the argument is that prior to the UK acquisition, management's track record was exceptional.

Such confidence is apparently shared by management itself which, along with one of the fund managers we do respect - value managers Maple-Brown Abbott - have been buying over the past 12 months.

With a fully-franked dividend yield of 5.5%, the balance swings in favour of an upgrade from issue 118/Dec 02 (Hold for Yield - $5.08) to LONG TERM BUY.