Stockwatch: Scope to double in two years

So is the vibrant risk/reward profile at this FTSE Fledgling, asset and energy support services group now upwards?

I drew attention around 30p last August as a 'speculative buy' after the classic third (i.e. final?) profit warning and the arrival of Mears Group founder, Bob Holt, as executive chairman.

Sentiment was jaundiced after Lakehouse had infuriated investors, floating at 89p in March 2015 and continuing to talk positively on prospects e.g. at the December 2015 prelims after rent rises had been pushed through for social landlords, only to have to issue a stark profit warning on 1 February 2016 with the group's property services side (responsible for over a third of 2015 profit) impacted.

I felt crocodile tears because angry investors were effectively complaining they weren't put on notice to sell in time, whereas forced rent rises were national news in late 2015. The affected businesses provide maintenance services for council housing in London and the South East, also East Anglia, for local authorities and housing associations.

Risk and reward

Despite Lakehouse's flotation coming late in the public sector support services bonanza, investors bid its stock to an average 30.3 times historic earnings (see table) during 2015: a good example how flotations can be timed better for vendors than new investors, and institutions should have negotiated a better price.

Yet the restructured group looks to have useful businesses: support services are presently unloved due to plc disappointments and blow-ups, but the UK will always be a mixed economy and the private sector is well-established in public services.

Chief risks I see, are a balance sheet still showing the strain of an acquisitive support services group - i.e. debt and goodwill/intangibles - in a context where ongoing public sector spending disciplines keep this sector exposed to potential upsets.

Lakehouse does at least offer some diversity - servicing and building homes, schools, public and commercial buildings - and the board has declared a progressive dividend policy such that at about 42p, the stock yields 5-6% (forecasts by Peel Hunt, company broker). So, unless the UK economy and public sector spending become seriously compromised, Lakehouse shares can grind higher on a two-year view and you are also locking in a useful yield.

Good progress in a transition period

Results for the year to end-September 2016 are titled: "Restructured business positions group for turnaround transition period", an elaborate euphemism for the typical phrase "much remains to be done" at turnarounds. Operations have been stabilised and costs taken out via restructuring, and some aspects of property services exited.

"The core businesses of compliance, energy services and construction are well-established, excellent businesses with a clear vision of what needs to be delivered", and the new financial year has started satisfactorily in line with expectations.

The impact of a total £43.2 million exceptional costs, of which £19.2 million were goodwill/intangibles' impairment, help explain a £33.3 million statutory pre-tax loss, while underlying pre-tax profit has more than halved to £9.9 million on underlying revenues down 9.2% to £305.8 million (these numbers being ex businesses exited).

Similarly, the group order book has slipped 8.7% to £543 million albeit with management contending forward visibility of revenues has improved from 77% to 87%.

Regarding the spread of activities, property services have reduced from 48% to 32% of group revenues due to lower activity and exiting problem businesses such as roofing. Similarly, uneconomic contracts have been replaced with thise offering an acceptable return. Staff have been cut and new leadership installed, leaving "a smaller, leaner and more focused business."

The operational review is worth reading in full, reflecting how variable contracting can be, the Foster business was hit particularly hard by clients cutting budgets, with a de-rating of its profitability accounting for a £17.4 million goodwill write-off. Yet, under new management, strong operational control and selective bidding, property "should be capable of delivering a consistent mid to high single-digit return."

The compliance side - maintenance and repair services e.g. for gas, fire and electrics - has jumped from 11% to 29% of group revenue, boosted by acquisitions, and margins/prospects look overall encouraging: "we believe we have created a market-leading business...specialist services driven by regulation...the board expects to deliver attractive returns relative to the group average, over time."

Energy services are 22% of group revenue, similarly driven by regulation/efficiency needs, though this slipped 0.9% despite a modest acquisition. Its outlook appears mixed if fair. Construction is the fourth division, 17% of revenue with a particular focus on schools, on a slightly better margin, but with revenue down 29.1% as contract procurement became a longer process - supposedly "good from a risk management perspective, but very frustrating when reporting performance", with 17 projects delayed. "We remain excited about the prospects for construction in a market with strong underlying growth fundamentals."

So operations are a contorted read, reflecting inherent risks of public sector contracting, but if management's guidance to its broker is fair then they're priced in on a forward PE around 9 times.

Balance sheet not ideal

It's the typical hangover from a support services acquisition spree: goodwill/intangibles representing 136% of £51 million net assets, and the liquidity profile changing from £6.6 million net cash to £20.6 million net debt. That profiles as £20.6 million long-term loans versus nil debt in 2015, and nil cash declared last September versus £6.9 million at end-September 2015. The ratio of current assets to current liabilities is 1.1 times, with trade payables/receivables evenly balanced.

A final dividend of 0.5p per share will be paid on 6 April, so cash is (expected) in place even so. Looking at deferred considerations due, there will be some £4.5 million next December.

Lakehouse is not out of the woods if there is a material adverse change to trading as 2017 evolves, which is why its equity remains "speculative". More positively, cash conversion has a strong profile, up from 115% to 121%, despite underlying operating cash flow down from £25.6 million to £13.2 million.

So there is intrinsic reason for balance sheet liquidity to improve, which it needs to do visibly to trust in a progressive payout policy.

True, Lakehouse may appear pretty unappealing relative to key financial tests, versus huge choice among stocks. Yet, in a turnaround context, executive chairman Bob Holt is ticking off the boxes and honing the group towards "investment grade".

It's still quite high risk/reward. However, I believe its stock can double on a two-year view, with a circa 10% dividend return also, if the new management can navigate through choppy UK public services.

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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.