Stockwatch: A steady turnaround backed by 6% yield

Is this AIM-listed asset/energy support services group Lakehouse (LAKE) a genuinely evolving turnaround, or does a 6% prospective yield imply the market has justifiable doubts?

I initially drew attention as a potential recovery play in January 2016 after Lakehouse had plunged below 40p from a 90p flotation price in March 2015, its property-related sub-contractor services hit by a diktat to landlords to reduce rents by 1% annually for the next four years.

Energy services were also running into landlord constraints, hence lower margins for insulation contracts and delays installing smart meters. Investors dumped stock in a sense they had been misled by an early January 2016 update that things were in line.

The drop below 40p implied a price/earnings (PE) of 4 based on revised forecasts by Peel Hunt, Lakehouse’s broker, and a prospective yield of 7.5%, yet the table shows how the year to end-September 2016 actually resulted in big losses.

That August, with the stock down to 26p after a third profit warning – an old adage suggests is the trigger to “buy” – I was encouraged how Bob Holt, the founder of Mears Group (MER), a successful support services group, had decided to become executive chairman. I thought the stock “still speculative but favouring upside” amid a challenge to reduce £30.6 million net debt.

Those results seemed a classic clear-out and, although profit/earnings have been downgraded by 18% for the latest financial year, and by 12% in respect of 2018, it appears to mainly reflect a disposal.

The proceeds mean expectations for the dividend remain at 2p and 2.5p per share, hence a 6% yield with the stock currently at 40.5p. Its fall from 52p mid-year suggests the market perceives risks given Lakehouse’s orientation towards local authorities and housing associations; both of which face spending constraints, also Labour party rhetoric tending against private sub-contractors.

Disposal, debt reduction and cash flow should support dividends

Interims to end-March 2017 showed net debt of £24.7 million, having blipped up and down e.g. with deferred consideration payments for acquisitions, a legacy of rapid expansion.

Holt asserted last June that, after a strategic review, the group’s core businesses of compliance, energy services and construction were performing well, although property services had declined from 37% to 20% of group revenue, like-for-like, hence interim group revenue was 11% lower at £149.8 million, despite the three other divisions advancing 14% overall.

The market had been concerned about operational cash flow conversion but this had mitigated to a 12% outflow versus 170% in first-half 2016 year.

Since an April 2017 dividend payment the board has opted to defer an interim payout, but “we maintain our policy of paying a progressive dividend, so the subject will continue to be reviewed during the second half.”

This is crucial because dividends are the prime support until earnings recovery is established, also considering £64.3 million goodwill/intangibles within £47.9 million net assets. The end-March 2017 balance sheet had only £0.3 million cash versus the cash flow statement, showing £4.6 million paid as dividends during the 2016 financial year, also £4 million proceeds from bank borrowings during first-half 2017.

The current sale of Orchard, a consultancy business helping companies with energy procurement and usage, for £12.4 million with an estimated £5 million gain on book value is said to help reduce debt, but also looks welcome to secure payouts.

Medium-term sale of property services also?

Strategically, the sale of Orchard is said to enable focus “on the group’s operative-focused activities within its compliance and energy services divisions”, which sounds a bit odd not to mention property services.

You quite wonder if the board is open to offers for the property services side; cited as “a significant operational turnaround, given the challenges in roofing in 2016”, currently stabilised albeit with some risk of further write-downs until legacy contracts are closed out in the current second half.

My reading is that management will continue to pursue a turnaround, but if property services lag other divisions to dirty results reporting then a sale looks possible.

Given net debt of £24.7 million at end-March, further debt reduction and cash-resource to develop the better-performing activities also make returns to shareholders, might improve the stock’s rating. The group does have a £35 million bank facility so there is no near-term pressure to cut debt.

Income statement is no great shakes

Looking back at June’s interims to end-March 2017, cost of sales marginally increased like-for-like from 8.79% to 8.96% of revenue, and “other operating expenses” from 7.47% to 8.38% of gross profit; which to an extent may reflect operational gearing with the fall in turnover, i.e. some costs being difficult to cut proportionally.

Yet like-for-like interim operating profit slumped 49.1% versus turnover down 10.7% to £149.8 million, so cost control should be a priority. A bit further down the statement, exceptional costs jumped from £0.6 million to £1.1 million, not massive in context but higher even so. Amortisation of intangibles edged down 5.4%, albeit a substantial £5.3 million in context, hence a £2.8 million operating loss on an IFRS3 basis then £0.8 million net finance costs extended the pre-tax loss to £3.6 million versus £1.8 million like-for-like.

So, even setting aside the discrepancy between statutory and normalised profits, the income statement conveys there is “plenty yet to do”, part-explaining why the stock has been a roller-coaster back to its level a year ago. As proclaimed in the interim results highlights, cash flow has at least levelled from a £10.6 million outflow on operations.

Lakehouse – financial summary           Broker forecasts year ended 30 Sep 2012 2013 2014 2015 2016 2017 2018                 Turnover (£ million) 152 192 302 340 334     IFRS3 pre-tax profit (£m) 3.9 4.1 0.1 3.2 -33.3     Normalised pre-tax profit (£m) 4.2 4.6 4.4 11.8 -9.9 5.5 8.6 Operating margin (%) 2.9 2.5 1.8 3.9 -2.8     IFRS3 earnings/share (p) 1.8 1.9 -0.2 1.7 -18.6     Normalised earnings/share (p) 2.0 2.2 2.5 8.2 -4.0 2.7 4.3 Earnings per share growth (%)   10.2 15.2 228     56.4 Price/earnings multiple (x)         -10.2 14.9 9.5 Cash flow/share (p) 2.1 2.3 3.7 13.1 -2.6     Capex/share (p)       1.0 0.6     Dividend per share (p)         2.9 2.0 2.5 Yield (%)         7.2 4.9 6.2 Covered by earnings (x)           1.4 1.7 Net tangible assets per share (p)       1.3 -11.6                     Source: Company REFS               Funds raise exposure

Between March and July this year, announcements show funds such as Oryx International Growth (OIG), North Atlantic Smaller Companies Investment Trust (NAS) and Harwood Capital – all operated by Christopher Mills, a US/UK smaller companies specialist – increasing exposure through 10% to 15.24% as of last July; which is encouraging because these funds are effectively locked in – selling would drive the price down against their interests – thus demonstrating conviction.

So, although Lakehouse appears unloved by the market and its updates convey a sense of “plenty remains to be done”, the long-term case looks intact and a 6% prospective yield fair compensation for the holding risks.

Fears of a Conservative party leadership contest and a Labour government before 2022 appear overdone. Thus, Lakehouse merits accumulating by patient investors: a chance to lock in attractive yield with capital upside as progress with the turnaround reduces risk.

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.