Edmond Jackson's Stockwatch: Keep an eye out for Mears Group dips

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Wherefore support services shares? A series of blow-ups and disappointments among high flyers helps explain why price/earnings (P/E) multiples moderated from over 20 times, multiples some of these shares once enjoyed.

"Outsourcing" also became fashionable to an extent it was fair to question if the trend had peaked; and with local authorities facing financial pressures this was possibly why the FTSE SmallCap shares in Mears Group, which mainly provides repairs and maintenance services for council housing, drifted down in a volatile trend between 300p and 200p over 2010/11.

Mears Group has since enjoyed a much firmer upward trend, breaching 500p this year, partly as stockmarkets rose from early 2012 but I think also due to a re-appraisal. Financial constraints on local authorities can apply various ways as to whether sub-contracting is awarded, but logistics often dictate there is no real alternative but to involve the private sector.

Well-run support services shares therefore enjoy high-quality earnings with good visibility. The chief risk is these companies resorting to acquisitions to bolster earnings because the kind of services involved do not offer as high margins/growth that you can find elsewhere in the stockmarket (at a price).

Private companies introduced to a listed group may not have the same disciplines as public limited companies and the expected benefits of combining operations may not arise.

Advantages

Yet on a macro view, this kind of share looks relatively advantageous. We are told, UK recovery is the most impressive among G7 nations, although doubts linger it is largely the result of a consumer boom while the debt position and trade deficit deteriorate.

But council houses - nowadays "social housing" - continue to need maintenance and Mears has diversified into care for people at home which is a growth opportunity given the ageing population, people's general preference to stay in their own homes and the fact that councils are not geared up to provide this.

The latest 2013 results have benefited from the £24 million acquisition of Morrison Facilities Services in November 2012, also the £22 million acquisition of Scottish-based ILS Group last April, which cares for seriously ill people.

Revenue for social housing services has jumped by 47% to £742.5 million and in the care division by 9% to £123.1 million, enabling group revenue growth of 32% to £898.2 million and pre-tax profit up 26% to £36.6 million. Normalised of acquisition issues, earnings per share grew 10% to 28.06p and the dividend likewise to 8.8p.

Scope for variations in normalising means some discrepancy between the company's presentation and information sources such as Company REFS (table); and valuation is essentially about earnings and cash flow, for at about 500p a share the yield is barely 2% and there is no real asset backing beyond its reputation.

Long-term nature of the business

Mears Group may have slipped from over 520p shortly before the results on consideration the group's order book is flat at £3.8 billion, despite visibility of 92% of the £908 million consensus revenue forecast for 2014 and 70% for 2015 "which demonstrates both the long-term nature of our business and our leading market position."

Elsewhere for example, oil & gas industry support services shares have been sensitive to trends in the "backlog" or order book.

A prospective P/E of about 15 times currently appears full but notice how the trend in cash flow per share often well ahead of earnings per share, so the cash flow multiple should be lower.

Cash generation has recently represented over 90% of normalised pre-tax profit and the stockmarket usually warms to this as a form of financial security. Consequently net debt is low if variable, averaging £70 million over 2013 after the acquisition of Morrison. Year-end cash has risen from £57.6 million to £79.6 million.

Keep an eye on a tribunal claim

As regards negatives, there was an £18.6 million loss on disposal of a mechanical and electrical business, if in line with expectations and now history. Currently I would keep an eye on a tribunal claim underway in which a former regional manager is suing for constructive dismissal claiming victimisation after bringing to Mears' attention, "over-claiming and over-charging" at Morrison.

Mears has strongly denied this saying it necessary to challenge the claims than settle out of court.

I may be alert to this kind of thing as I have been on the receiving end of it myself, it can be very subtle and you are appalled when it happens, resolved to court action otherwise regret.

So best see if any evidence emerges. While potentially damaging in the short term it is something Mears should be able to move on from, so I quite draw the risk to your attention lest revelations dent the shares for a buying opportunity.

Enhancing UK coverage

Besides enhancing its housing services and their UK coverage, the care business is seeking bolt-on acquisitions which "will increase our ability to respond to growing opportunities from health and social care outsourcing and the implementation of new localised services."

Development-wise the group therefore looks to have at least two years worth of expansion to be busy with, supported by cash flow and a two-year extension to its £120 million unsecured revolving credit facility.

Mears Group appears fairly priced but if the debt-driven consumer boom eases and/or international risks take the shine off equities then its business offers both defensive and growth prospects. On a two-year view the shares likely offer useful upside from 500p so are worth watching for dips.

For more information see mearsgroup.co.uk.