Stockwatch: A risky recovery 'buy' emerges

Following my points last week about profit warnings, it is useful to consider the latest - from Lakehouse - which continues the trend and shows how price pressures are crimping profits.

Admittedly, this FTSE Small-Cap stock is more sensitive, operating on low margins, but it's a sharp illustration - especially for firms serving the public sector - of how austerity, in response to high debt, begets cost-cutting, leading to contract delays and losses.

After floating at around 89p only last March, Lakehouse may also be a classic indicator of a market top: "acquisitive smaller company floats with high expectations, subsequently slashed". Furthermore, this business seems to be feeling the pinch quite suddenly, as I noted with Creston, the marketing communications group. They are isolated examples - albeit serving both the public and private sectors - and they are squealing.

Another support services group under pressure

Lakehouse is an asset and energy support services group, involved in regeneration and construction of homes, schools, and public and commercial buildings. Its mainly public sector context is similar to that of Mears Group, with both firms assembled largely by takeovers to exploit local government subcontracting - Lakehouse made five last year.

Forecasts were massively over-optimistic pre-profit warning

On 10 December it reported prelims to end-September, showing underlying pre-tax profit up 114% to £21.6 million, on revenue up 11.3% to £336.6 million, the board "confident of its expectations for the current year and the future". High bidding success rates and long-term frameworks were cited, also a £595 million order book and growing sales pipeline of £2.8 billion. A casual reading would have seen no warning signs. Indeed, various "cheap" ratios looked inviting (see table below).

Barely six weeks later, a fourth-quarter trading statement cites a 22% advance in framework contracts, but also landlords' needs to reduce rents by 1% annually for the next four years. That means less work for the main Regeneration side (48% of turnover and 36% of profit in 2014/15), hence lower expectations in the current financial year. Energy services (20% of turnover, 33% of profit) are similarly running into landlords' constraints, hence lower margins for insulation contracts and delays installing smart meters.

At least Compliance and Construction are in line, but the net effect is a knife to profit estimates, with the outcome to be even lower than the year to end-September 2015. Those results showed operating margins of just 1.4% and 0.4% for the year before, i.e. changes to the cost profile will impact value.

Forecasts in disarray

The table shows forecasts (pre-warning) were massively over-optimistic. Indeed, management were, too, because the numbers came from Peel Hunt (Lakehouse's broker), and the finance director at least would have signed them off near their publication with the prelim results.

Lakehouse is a blunt example of how you need to beware the PEG ratio

An inconsistency is the broker reducing its 2016 profit estimate only to £20.0 million and earnings per share (EPS) to 9.9p, but the update refers specifically to a reduction in last year's profit. The stock has plunged to around 35p, putting the shares on a price/earnings (PE) ratio of about 3.5 times on the revised broker forecast, emphasising the market's disbelief. It also doubts the 2016 dividend estimate, trimmed only to 3.5p, giving a prospective yield of 7.5%.

By way of comparison, Mears' 12 January update cited progress and profits in line with expectations, also strong progress made in new contract bidding, although this was essentially covering 2015.

It remains to be seen to what extent the issues facing Lakehouse may spread to Mears, as chancellor George Osborne's renewed austerity means another turn of the deflationary screw. While he is trying to constrain landlords in renters' interests, action against their indebtedness is leading to reduced activity and prices for service groups, helping explain why they topped Ernst and Young's survey of profit warnings.

Mind the PEG gap

Lakehouse is a blunt example of how you need to beware the PE multiple divided by the earnings growth rate - the PEG ratio - highlighting how it can be just a snapshot in time and depend heavily on forecasts. Numbers in the table are based on a stock price of 84p before the warning, and showed a highly attractive PEG of 0.1 to 0.4 (less than 1.0 implies value).

Disciplined investors will watch how insider buying evolves

PEGs can work well for consistent growth businesses, but Lakehouse is low-margin and enough of its services appear easy enough to postpone. A seemingly attractive PEG has proved a value trap, and this needs bearing in mind more widely. The forecasts have also looked ambitious - based largely on acquisitions - with little regard to possible risks for a low-margin service group. This is all very typical of smaller companies and stock promoters as a bull market expires.

It's possible the stock does now represent a long-term recovery play, with risks largely priced in, especially if a worthwhile dividend policy can evolve. The group has no bank debt, just a total £743,000 finance lease obligations versus £6.9 million cash at end-September.

The balance sheet won't impress conservative investors, given that its 54p per share net asset value is virtually all goodwill- and intangibles-based. This is another reason the stock has fallen so far, in response to the warning, and applies to other companies that may warn in future.

But despite Lakehouse having made acquisitions, its balance sheet has not ended up over-stretched for a more challenging environment. Bear in mind that, since the 30 September year-end, £12.2 million of cash has been committed to acquisitions.

A cheap recovery play

Another aspect of the de-rating is an inevitable clearance process, where those institutions who feel they were sold a pup get cleared of the stock so they no longer have to justify holding it - on a rationale that this is profit warning number one and others could follow.

Management has resorted to the familiar cliché of facing "headwinds" and the broader question is whether such examples could conflate into a storm. If the group is commercially viable, however, its stock can recover from here, even if the latest Peel Hunt numbers remain over-optimistic. Though not yet a firm 'buy', disciplined investors will watch to see what extent of insider buying may evolve.

For more information see their website.

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.