Mears has turned a corner
Mears Group Plc (MER) is a different company to what it was a few years ago. Following years of misguided capital allocation, it has exited non-core businesses to return to its roots as the market leader in social housing maintenance, a non-cyclical, high-return and cash-generative business underpinned by long term contracts with government counterparties for mandatory services. This is now 75% of Mears’ business with the remainder coming from housing management contracts. In the process, Mears has made positive management changes, become debt free, reduced structural working capital requirements, and improved its quality of earnings. Furthermore, Mears is well positioned an inflationary environment, with the ability to pass through cost increases. The company for the first time has also articulated a sensible capital allocation policy.
Mears was taken public in 1996 by its controlling shareholder, Bob Holt. Despite having sold down his stake by 2005, Holt remained executive chairman and then solely chairman until finally being forced out in 2018 following shareholder pressure. Capital allocation had been poor under Holt. In particular, in 2007 Mears began building a domiciliary care business with a string of acquisitions that continued until 2015 but failed to produce a profitable business. In 2016, the company also began using its own capital to fund housing development projects, which was outside its capability and ultimately produced low returns.
Following the appointment in late 2018 of the new chairman, Kieran Murphy (ex-Gleacher Shacklock and Citi), Mears committed to refreshing the Board, selling non-core businesses, exit capital-consuming development activities, and reducing net debt. Tangible results of this restructuring were just beginning to manifest themselves when Covid struck. However, since then the company has accomplished the following:
· It has exited the loss-making domiciliary care business
· It sold Terraquest, a digital platform for building planning permissions, for £70m
· It has ceased funding new housing development, releasing working capital as remaining inventory is sold down.
· It has reduced average net debt from £113m in 2018 to £24m net cash now
Retained business
Social housing maintenance and repairs (75% of revenue and profit)
Mears was founded in 1988 as a provider of maintenance services to social housing landlords. Mears has the largest market share at 14% and it has maintained a fairly consistent operating margin of 5% over time. Revenue grew from £12m at IPO in 1996 to approximately £550m today, helped by the acquisitions of two large competitors in 2012 and 2018 with £300m revenue in total. Mears customer satisfaction and complaint scores are consistently good and have improved over time, and it seeks to protect margins by maintaining high service standards that enables it to avoid bidding at unattractive prices.
Social housing – rented accommodation provided to low income tenants - is provided in the UK by regional governments and non-profit ‘housing associations’, who largely outsource maintenance. By law, rent can only be used for maintenance and landlords are required to undertake repairs, so this is a non-discretionary service. Earnings visibility is very good in this business, with average contract length at 7 years and revenue and profitability unaffected economic cycles (for eg. revenue and profit grew by 34% between 2008 and 2010).
Mears typically bids for £1bn+ of new business per year and targets a win ratio of 33%. Prior to 2017 it had been hitting or exceeding this target but its win ratio dipped into the teens in 2017 and 2018, which Management put down to more intense price competition on tenders. The win rate was 40% as of H1 2022 and Management said on the earnings call that competition is at the lowest point for years following the exit especially of larger contractors like Kier and Interserve.
Management
Housing management accounts for the remainder of Mears' revenues. Within this, Mears has had a particular focus on contracting with local authorities to house homeless people and, latterly, asylum seekers. In 2019, Mears and Serco were awarded 7-year contracts by the UK government to house asylum seekers.
What I like about Mears
1. The core maintenance business is providing an essential service, has steady inflation-protected margins and is non-cyclical.
2. Social and affordable housing continues to be a priority for Government. Mears is the largest provider at 14% market share. Mears is seeing less competition now and as 40% of the market remains insourced by housing associations and registered providers, there is scope for Mears to continue growing its core maintenance business.
3. Mears' quality as a defensive, cash generative business has been restored. Kieran Murphy did a good, understated job of resetting Mears after years of mismanagement under Bob Holt. Activist Primestone threw in the towel in 2021 but wrote this letter before doing so, detailing the progress they saw. Murphy's final stroke was to facilitate the retirement of David Miles - a substandard CEO - and promote Lucas Critchley. The latter's roots are as an MD in the core maintenance business before in recent years serving as group operations director and then taking the day-to-day lead on much of the transformation work of the last few years. His welcomed focus appears to be incrementally improving the core business and using excess cash to restore the dividend and buy back shares.
What is Mears worth?
My valuation is 280p, including approximately 20p of net cash, and uses a 12 P/E for the core maintenance business. This compares to current share price of 215p.
At +30%, the valuation is not much above the current share price, but I am assuming no growth in the core maintenance business and that margins stay at 4.5%, below historical levels, and also that the Asylum contract will not be extended.
I think any of these could prove to be conservative assumptions. For example, Mears is bidding on £500m of new revenue in 2023 and also an enlarged contract for 2024 with North Lanarkshire that I estimate would generate an incremental £100m revenue p.a. over 12 years. If Mears hits its historical success rate of 33% on the £500m and wins North Lanarkshire, this would add an extra 50p to the share price.
As for margins, Lucas Critchley noted on the most recent earnings call that the whole Mears organisation and its customers know that 5% is the target, and it has recently exited some low margin contracts. 5% margin adds 22p to share price.
Mears has also traded at mutliples above 12x in the past and so there is a possibility of a rerating, especially if it starts to convert its pipeline into revenue growth and as the market begins to appreciate the restoration of Mears’ earnings quality.
In the meantime, if Mears' share price remains at current levels, any buybacks will be accretive.
So assumptions as follows:
1. Current maintenance revenue is £550m, no growth. Operating margin of 4.5%, below 5% historical average.
2. Current management revenue, excluding Asylum, is £130m with 5.5% operating margins, in line with historicals. 8x multiple reflecting lower quality of this business.
3. Asylum annual revenue of £150m for the remaining 5 years at 5.5% margin, discounted at 10%. Revenue has been higher than this recently owing to high levels of asylum seekers so assumes a moderation. No extension assumed.
4. 25% tax rate
5. £24m net cash. 8 December 2022 trading update disclosed £40m average net cash position however H1 statement indicated £20m of payments on account will reverse. Also includes £4m, 10% loan note receivable from Terraquest disposal maturing 2028.
Great write up! - I see Investors Chronicle had brief but positive articles (buy in each case) on 4 August and 31 March 2022 - I like the slow fuse and intended progressive dividend. Many thanks and I look forward to the next one!!