Stockwatch: Third profit warning reveals cheap buy

So is it time to accumulate the FTSE Fledgling shares in property and energy support services group Lakehouse?

The price initially dropped from 33p to 26p after its third profit warning since the group floated at about 90p in March 2015; yet buyers dominated and the stock clawed back within hours.

It may reflect a sense that a new executive chairman is clearing out exceptional costs and unless the business faces tougher markets, forecasts make the stock look cheap. Company broker Peel Hunt projects normalised profit of £16.0 million and £17.5 million (i.e. before the bad stuff) for the current/next financial year.

They'll likely get trimmed but the gist is that exceptional costs have hit profit. While there is a weight behind selling its past, holders are looking to a better future.

A mixed acquisition bag

Lakehouse comes across as a classic case of "buy to build" development over-doing it, if mainly by losing operational control than the wheels completely coming off. Debt is rising, if not overbearing.

The group is quite like Mears in the sense of exploiting councils/housing associations' outsourcing - e.g. regeneration of kitchens and bathrooms represented 36% of last year's profit.

Managerial shortcomings meant margins were below target; contracts written downEnergy services accounted for a third of profit, while construction generated 16% and compliance 15%. After issues became manifest I drew attention at 45p as "a candidate to buy" and watch, "assuming a capable board can get a grip and re-position as necessary...mind that would also mean exceptional costs continue".

This is now happening with the appointment of Bob Holt as executive chairman from 21 July, who is effectively Mears's founder and seen as capable hands. The question is whether Lakehouse can prosper when social landlords reduce rents by 1% each year for four.

Interims to end-March 2016 cited lower client budgets and changes in procurement hurting regeneration, where roofing services were expanded to compensate. But managerial shortcomings meant margins were below target and a number of contracts had been written down.

Debt rising

The stock has likely fallen so low because investors are wary that a string of acquisitive support service groups have collapsed, if usually tipped over the edge by excess debt. It isn't the case here, but mind the balance sheet has gone from £21.1 million net cash at end-March 2015 to £6.6 million net cash end-September, then net debt of £22.6 million at end-March 2016.

The latest update cites £30.6 million net debt at end-June, comprising £28 million drawn from a £45 million revolving credit facility, together with a £2.6 million overdraft from a £5 million facility.

The cash flow profile going forward must turn positiveExact reasons weren't provided for this latest increase, nor was there any assurance on cash flow except to cite "issues within the Regeneration division" where contract settlements have a range of potential outcomes both in terms of cash flow and impact on the income statement.

Most likely this means contract write-downs/exit costs are being met with debt funding, e.g. a £4 million adverse impact cited for the current financial year to end-September. The trend may be peaking but the cash flow profile going forward must turn positive.

The end-March cash flow statement (within interims) showed an £11.4 million outflow from operations versus £11.3 million inflow in the six months to March 2015, and £15.6 million spent on acquisitions - funded by £25 million from a revolving credit facility.

Recent buyers of the stock are therefore banking that Bob Holt has examined all this as part of agreeing to join the board, and reckons it can be improved.

Mind he has full hands as non-executive chairman of five other companies, and they aren't all success stories for shareholders. He's chaired DX, an AIM-listed parcels and mail group, since July 2014, while its stock has plunged from 145p to a 15p all-time low amid highly volatile earnings.

They could well reflect industry conditions but even so, buyers of Lakehouse equity are betting on his appointment "in order that he can deliver a proactive strategy to restore value in the short term as well as establishing a clear framework to deliver sustainable growth over the longer term."

The economics are not proven bad; they have shifted - Lakehouse must improve its actAlso, on the prospect of his getting 4,615,384 shares if the stock is at least 98.4p by end-September 2018, although he will be awarded 2,307,692 shares anyway, additional to a £75,000 salary and an estimated £150,000 paid to his consultancy company for a two-day week.

Warren Buffett has cautioned: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

Well, the economics here are not proven bad, they have shifted - hence Lakehouse must improve its act and take some cost.

Restore medium-term value

The 2 August update cited a stable £633 million order book including a £37 million Scottish Power contract win for installation of domestic smart meters - it doesn't say how profitable but that hardly ever happens for commercial reasons.

Other domestic meter installation contracts have been concluded or are progressing, and metering "is expected to contribute an important element to the group's future growth agenda" after costing £1 million for staff training in the 2016/17 year.

The stock's rebound shows investors see the update as a new broom tidying upWhile results for the current year will be "significantly below previous expectations" this reflects one-off and non-recurring items than underlying issues.

"The actions are expected to help restore shareholder value in the medium term and the board remains confident in the opportunities and prospects for the group".

There is a caution about government consultation on energy services being "crucial to the levels of funding and types of works that will be funded" but trading/visibility remains strong in construction and compliance.

Speculative but getting on track

The stock's rebound therefore shows investors regarding this latest update as a new broom tidying up, the situation manageable and a worthwhile set of businesses to emerge.

Lakehouse has plenty to prove, but fundamental and technical (supply demand) aspects of its stock look to favour upside.

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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.