Spotless Version 2.0?

Spotless blind sided the market in December 2015 when it released a trading update where EBITDA was downgraded to “flat year-on-year” and NPAT downgraded to “10% below last year”. This is despite Spotless having affirmed “FY16 results to materially exceed the FY15 results” merely 6 weeks before.

Its share price plummeted more than 50% in response.

Was this a massive overreaction by a schizophrenic Mr. Market in response to a mere 10% earnings downgrade, or is there more to the story?

The real story here, in my view, is what this trading update tells us in context of the single most important question for Spotless today – and that is, whether the massive EBITDA margin uplift (doubling from c.5% to c.10%) after 21 months of ownership by Pacific Equity Partners is maintainable and the “new normal”.

As Spotless’ new CEO, Martin Shephard defiantly describes the situation:

The market has been talking over the past week since we put out the update that our margins are going to get eroded to 5-6 per cent, and we are just not seeing that.

How was Spotless’ margin expansion achieved?

Increasing short-term profitability is actually not too difficult for a company like Spotless with locked-in multi-year customer contracts. Amidst all the fluffy Prospectus narrative about “Increased customer focus” and “Refocused organisational structure”, you simply slash overhead costs you deem non-essential to customer delivery. Every dollar of cost saving flows straight down to the bottom line as another dollar of profit.

To this end, we know that approximately 790 FTEs in administrative or management roles were reduced equivalent to 50% of the FY2012 total overhead expenses. We also know that occupancy costs were drastically reduced from $70m in FY2011 to $11m in FY2015.

So what happened in December 2015?

The starting point for FY2016 was a great one, Spotless’ FY2015 results comfortably beat Prospectus forecasts on all accounts, and EBITDA margin continued to expand:

So what happened in December 2015? Why has a blue chip company with a blue chip Board been caught so off guard so quickly? Why did EBITDA margin drop from 11.8% to 8.5% in less than 6 months?

I will attempt to provide some clues here.

Capitalisation of Pre Contract Costs

Firstly, let’s dig into Spotless’ FY2015 Annual Report. Buried deep in the Revenue Recognition section we see that the concept of “Pre contract costs” was introduced for the first time during FY2015:

This is booked under “Other non-current assets“, which increased by $33m between FY2014 and FY2015:

So we know possibly up to $33m of “pre contract costs” was capitalised on the Balance Sheet during FY2015 as “Other non-current asset“.

Note “Other non-current asset” item is relatively insignificant relative to Spotless’ total Assets (so likely to be ignored in tops-down analysis of the Balance Sheet), but is actually very material relative to Spotless’ EBITDA.

This effectively answer the question as to why 1H FY2016 EBITDA was flat but NPAT dropped by 20%.

Depreciation can usually be budgeted to a very high degree of accuracy so there should never really be any surprises here – Unless it was because previously capitalised Pre Contract Costs had to be written off because Spotless lost contracts previously deemed “probable”.

The implication here goes a lot further than profitability having been front-loaded into FY2015. Pre contract costs now sit beneath the EBITDA line as part of depreciation. By capitalising Pre contract costs, Spotless is given a significant “free-kick” at the EBITDA line.

We see that, under new management, for the first time Spotless have explicitly identified “pre-contract costs” along with property, plant, equipment in its 1H FY2016 financials:

Note that new management have partially reversed this treatment of pre contract costs, where there is now a “Treatment change from capitalising smaller bid costs at balance date for tenders yet to conclude. Only costs associated with very large contracts where Spotless is the preferred bidder capitalised at balance date.” Meanwhile, “Other non-current asset” have continued to increase to $60m as at the end of 1H FY2016.

More aggressive Revenue Recognition?

In attempting to explain a large decline in operating cashflow, Spotless highlighted that this was partially attributable to $32m of “Work in progress relating to major contract, expecting to be invoiced in 2H16”:

In other words, $32m of work completed but “not invoiced due to contractual obligations” had apparently been recognised as revenue.

Companies with complex long term contracts using stage of completion method of revenue recognition do indeed have room for subjectivity as to when revenue is recognised. Again, $32m is a tiny portion of Spotless’ revenue of $1,606m for the half, but very meaningful relative to Spotless’ EBITDA of $137m (without which 1H FY2016 EBITDA would actually be down 23% on previous year).

I do also query whether this lever had been pulled during 2H FY2015 when Trade Receivables jumped from $321m to $391m and where we coincidentally saw “peak” EBITDA margin at close to 12%:

And FY2015 EBITDA extremely skewed to the second half of the year…

To be clear, capitalising your bid costs and recognising uninvoiced WIP as revenue do not contravene accounting standards. However, I want to highlight that (1) there is a high degree of subjectivity involved; and (2) there is an effective transfer of accounting profitability between periods if they are not applied consistently.

Hypothetically, if one were to add back the capitalised “Pre contract costs” and not recognise the $32m in WIP revenue until it’s invoiced, then Spotless’ “flat” 1H FY2016 EBITDA of $137m would suddenly look very different. Incidentally, actual operating cashflow for the period was $18m – and this figure excludes capex and pre contract costs, the inclusion of which results in negative cashflow of $57m.

Note I would disregard the “one-off adjustments” put forward by management to arrive at an “underlying” EBITDA / cashflow. Can you really run Spotless without incurring bid costs? And isn’t not incurring cost blow-outs fairly core to running a labour-intensive services business?

What if margin reverts to historical norms?

Industry structures and competitive landscapes have the ability to dictate terms to an industry participant much more so than any great management team can actively push back and reshape them.

The venerable late Simon Marais of Allan Gray gave this assessment of Spotless’ prospects prior to their 2014 IPO:

With better management it is a better business but the industry challenges Spotless faces now are much the same,” he said. “In the maintenance and cleaning services industry the only things you can dramatically change to improve competitiveness are cut costs and squeeze margins, there is not a lot of pricing power to be won from brand recognition.

With $802m of net debt on its balance sheet, Spotless’ EBITDA margin only has to revert back to around 7-7.5% (still well above historical norms) for debt covenants to be breached.

To be fair, Spotless has the option of paying down debt with cashflow before any breach of covenant. However, on current cashflow trends, Spotless’ supposedly “juicy” dividend yield will have to be sacrificed (and let’s face it, Spotless’ 1H FY2016 yield was paid 100% out of additional debt and not cashflow generated during the half).

For those with the tendency to anchor towards Spotless’ pre-trading update high of $2.52, please note that at PEP’s original acquisition enterprise valuation (c.$1.1bn), Spotless is worth effective $0.25 per share. The question to ask then is – how fundamentally different is Spotless today compared to its previous ASX listed incarnation?

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post.