Investment Case Spotless Group
Date: 21 Oktober 2016
Is this the right time to be investing in small caps – or in equities at all? Are equities generally too expensive now? KCM is frequently asked these questions. Luckily, as portfolio managers we have a wide pool of investment opportunities from which we can select equities for the Kempen Global Small-cap Fund. We start by applying an automated filter to identify attractive small caps.
We regularly come across companies that have been punished by the equity markets because they have been unable to meet expectations. Yet some of these companies have solid business models and strong positions within the value chain. If thourough fundamental analysis confirms this combination of factors, this will provide us with opportunities. As long as we can see and understand the path to recovery, in these cases we can afford to be very patient thanks to our long-term investment horizon.
One good example is the Spotless Group. This article looks at why we believe Spotless to be an attractive investment.
Spotless GroupSpotless, which started life as a dry cleaning business in 1946, has since grown into the largest facility service provider in Australia and New Zealand. Spotless provides a wide range of services, such as cleaning, security or the exploiting of canteens in schools, hospitals and prisons. It also offers professional laundry and linen services. Spotless Group is one of the largest employers in Australia and New Zealand, employing 39,000 staff members.
Long-term contractsSpotless has a fragmented client base. About half of Spotless’ customers is government-related, such as ministries, schools, hospitals and prisons (source: Spotless presentation, 24 August 2016). These are creditworthy customers not immediately affected by a downward economy.
Because of the cost savings it creates, outsourcing facility services is an ongoing trend amongst customers. In today’s era of tight government budgets, Spotless could probably profit from this: running a canteen is seldom an area of expertise for a school, Spotless excels in it. This trend of outsourcing facility services applies not just to the public but also the private sector.
Moreover, Spotless enters into long-term contracts with its customers. The average duration of its current contracts is five years, but occasionally contracts are signed for periods of 15 or even 25 years. This means that Spotless has good visibility on stable future cashflows, something highly valued by many investors.
What went wrong?Over the course of the past year, the equity price of Spotless has halved (as of 21 October 2016 it stood at AUD0.99). The focus of the previous management was on growth. Spotless made several acquisitions with a view to accelerating revenue growth. In addition to the fact that the equity market had high expectations of its future growth, within the company there was less focus on the profitability of projects.
A new management team was installed at the end of last year. Its first act was to reduce expectations with respect to growth and margins. The equity market received this news as a shock – hence the sharp negative reaction in the share price. The new team has subsequently been working hard on analysing the company and integrating the newly-acquired businesses.
Our approachPrior to our investment decision at the end of March 2016, we spoke to the new CFO on several occasions.These talks gave us improved insight into the company, its situation and plans. At that time the new management was still working hard on the strategic reorientation and analysis of the company. Although we recognised the attractiveness of the business model and the valuation of the company, we also identified risks relating to potential disappointments. For this reason, we initially took a relatively small position in Spotless.
After the company published its annual figures and strategic plan in August 2016, we held talks with both the CEO and CFO. These revealed that they had only identified a small number of loss-making or problematic contracts. Furthermore, following substantial investments over the past few years the company’s IT systems are now in good shape. The outcome of the strategic update is also clear: greater focus on those segments in which the highest returns are to be earned. We believe this will curb the company’s tendency to operate in too many industries simultaneously or to grow via acquisitions.
After the abovementioned talks at the end of August, we decided to increase our holding in Spotless to the maximum weight of 3% of the portfolio. Spotless is therefore one of the largest names in the Kempen (Lux) Global Small-cap Fund at the moment.
We believe Spotless to be attractively valued at its current share price (A$0.99 at 21 October 2016); not just when you look at the cashflows that the company can generate annually, but also if you compare the valuation to similar international players such as Compass and Sodexo (see graph below). Yet we are aware that it may take some time before Spotless has regained the confidence of the equity market. By focusing on execution, we expect the company to achieve better results over the next few quarters. We expect there to come a time when the market revises its valuation of Spotless. In the meantime, we will continue our dialogue with the company in order to monitor the progress on its strategic plan.
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This document is prepared by the fund managers of Kempen (Lux) Global Small-cap Fund (‘the Fund’), managed by Kempen Capital Management N.V. (‘KCM’). The Fund currently holds shares in the subject company. The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments. The information in this document is solely for your information. This document should not be considered to constitute an investment recommendation and it is not intended as an offer or a solicitation to buy or sell any financial instrument mentioned in this document. This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of KCM.