Lakehouse — Good potential, turnaround well advanced

Lakehouse has attractive exposure to the gas and buildings compliance markets (eg boiler, fire, lift, electricity and water certification) and the energy services market (eg installing more efficient heating, insulation and renewable energy solutions) that are underpinned by regulatory requirements. Lakehouse’s scale, national footprint, cost and pricing and reputation position it well to tender for contracts awarded by local authorities and housing associations. Increasingly, post the recent acquisition of Just Energy, the proportion of private sector work is likely to rise but the main customers will continue to be public sector.

Weak performance in the group’s property services and construction divisions can be traced back to a rapid expansion pre- and post-IPO that led to higher-risk contracts being taken on. This has overshadowed the opportunities in the compliance and energy services divisions. The intended disposal of the areas of substantial underperformance is welcome news.

Experienced observers know it takes time to effect change and there are always bumps in the road. We therefore focus on the potential in the medium term. Given the work done so far, we believe operating profit can expand from £7.4m in FY17 to our base case of £9.4m in 2020. There is a case for more aggressive profit growth; our current forecasts only allow modest operational gearing, with c 9% of revenue growth to flow through to profits. If this were to be increased to 25%, it would lead to 2020e operating profit at c £14.2m. In our view, the critical drivers to this growth and share price recovery are the following:

We highlight the following areas of risk to investors:

The half-year results to March 2018, published 26 June 2018, showed the continued turnaround in the company.

At £396m the order book provides a good backdrop for future revenue and the participation in frameworks with a value of £1.1bn shows the business has good demand. The profile of the orders is shown in Exhibit 1 below. The data excludes Arbed 3 as that was awarded after the period ended. It demonstrates that underpinning of revenue for the next two years and beyond.

Since 2010 the company’s corporate strategy has been to grow organically and through acquisition in the provision of compliance, energy, property and construction services, serving mainly the UK public sector. This strategy was the result of a strategic review under former executive chair and latterly CEO Stuart Black, who wanted to reduce the group’s reliance on construction activity and move into higher-growth, higher-margin and lower-risk service activities.

Following the strategic review, the group focused its resources and capital mainly on increasing organic sales growth opportunities and acquisitions in compliance and energy services. The logic was, and remains, to create a national presence in areas of essential services provision mainly through long-term framework contracts with core public sector customers. The strategy was underpinned by strengthening the group’s management team and the introduction of additional expertise and experience in these new areas of focus.

A number of acquisitions (detailed in Exhibit 3) were made between 2011 and 2014. In 2014, the board committed to further expansion and prepared for a flotation that would provide further capital for growth.

The underperformance was mainly operational and principally in one part of the business, property services, but there were issues elsewhere that needed to be resolved to create the right platform for the future.

The IPO took place in early 2015, with Lakehouse listing at 89p. The capital raised from the IPO was used to fund further acquisitions between May and December 2015 (see Exhibit 3).

By early 2016 it was becoming clear that group financial performance was below target and the growth objectives were difficult to achieve. The problems were partly created by the speed of the expansion causing management to accept excessive risk in some areas of the business, most notably property services and construction.

A profits warning in February 2016 led to shareholders requisitioning an EGM, looking to replace most of the board. The April 2016 EGM was cancelled as investor support for the resolutions was strong enough for the existing board to concede to most of the demands. On 18 April 2016 the board brought back the original founder of Lakehouse, Steve Rawlings, who had stepped down four years earlier but remained a substantial shareholder. Mr Rawlings was reappointed as a non-executive director. On 21 April 2016 Stuart Black resigned as CEO. Steve Rawlings who had been ill for some time unexpectedly passed away in July 2016.

Continuity and stability was re-established when Bob Holt was appointed to the permanent role of executive chair in July 2016, following Ric Piper who took the role on an interim basis in mid-April, and Michael McMahon, who came into the business via the Everwarm deal, as chief operating officer. Jeremy Simpson remained CFO throughout the period, having taken the role in April 2014.

The growth strategy that was present at listing remains intact and is valid. The key problems were in its implementation and a high level of risk being assumed in certain contracts, especially in roofing in property services, which drained the company’s cash. That remains exacerbated by an increasingly adversarial climate in construction.

Since mid-2016 management’s efforts have been focused on getting the operations in good shape and building a robust business ready to resume growth, initially organic but also through acquisition in due course.

There is a greater emphasis on organic development than there was from 2010 to 2016 but the option to buy and build remains. The sale of the non-core energy consultancy, Orchard, in September 2017 was the only completed deal under the new top team, until the recent acquisition of Just Energy.

The group’s current strategy is based on:

The SWOT analysis of the group shown in Exhibit 4 summarises the picture we see of the business. Within these, we would place emphasis as follows:

For the purposes of analysis, we split the compliance division into gas and building services. The addressable market for Lakehouse’s compliance services is estimated to have a current annual value of at least £1.6bn (2014 data, based on the Lakehouse prospectus, post Grenfell we would expect this to have expanded). The largest element of that is gas, comprising around £1.3bn, split broadly 50/50 between the annual servicing of boilers and the safety certification, which is needed for each boiler, annually. Building services includes the other market areas of lifts, water, electricity and fire.

The main driver of demand are regulations that require, in many cases, annual inspection and certification of equipment; this particularly applies to gas boilers but also to lifts, fire and safety equipment.

The backbone of revenue in the gas division is the annual gas safety certificate required by all UK rented properties that use gas as fuel. The main tasks are inspecting domestic boilers, issuing the required certificate and, usually, conducting a boiler service; this also provides an opportunity for additional revenue via boiler replacement where needed.

The market for compliance within buildings is characterised with increased legislative demands, especially since the Grenfell fire, which has raised awareness of compliance.

These services operate in social housing markets and on public building assets, as well as on some industrial and commercial properties. The workload is in planned and responsive maintenance, installation and repair services in the areas of gas, fire and electrical, water and air hygiene and lifts. The customers will usually have several items that are covered by regulations, on the same premises, which provides an opportunity for cross-selling.

Compliance now includes 204 frameworks (end September 2017), up from 108 a year earlier, with an aggregate potential value of £608m (30 September 2016: £447m). We expect to see Lakehouse expand further in this area, given its market position and the likely rise in demand as legislation becomes increasingly tight and onerous for building owners.

The main competitors in compliance are local operators, working mostly on a regional basis. The market remains highly fragmented, and while there is evidence of consolidation, in our view this is at a very early stage. Lakehouse benefits from being larger than many rivals, especially in procurement. Scale also brings higher than average overhead recovery and resources to maintain knowledge of the frequent changes in legislation, and enables the company to be more competitive as it has a broad geographic presence.

In the South of England, Bilby competes against Lakehouse. It has been operating a buy-and-build strategy and competes via its branded subsidiaries, P&R Installations, Spokemead and Purdy. Its offering extends to building services as well as the core gas compliance operations. It works both directly for the client (as what is known as a tier one contractor) and through larger organisations (which are the tier one), such as Mitie and Mears and on the Ministry of Defence housing contract via Amey.

In the North West, Liberty Gas provides some competition to the Lakehouse subsidiary Sure. Competition is through quality and price for the core compliance business, which is important to win, as it provides access to cross selling opportunities and higher margin installation projects.

Edison expects that the events at Grenfell in June 2017 to trigger an increase in the market, especially in fire compliance and that is reported to be happening by industry participants but is not yet quantified. The procurement process usually involves a formal tendering period and the appointment of one or a small number of suppliers to a framework contract that can last up to 10 years, but usually have a smaller contractual period.

We note the key elements of the expansion strategy and evidence of recent wins as follows:

Lakehouse energy services delivers energy efficiency projects. These include installing heating and renewable technologies and insulation measures for social housing and private homes, through its Everwarm subsidiary. Everwarm uses these services to deliver carbon emissions savings for energy companies, enabling them to meet their legislative targets. Providor offers smart metering services and has a small presence in the installation of electrical vehicle charging points, which is growing. As outlined, the business obtains its work mainly through framework agreements and it is on 54 such arrangements (as at end September 2017) worth £466m.

At the time of the flotation, the company estimated its addressable market in Scotland had an annual value of around £1bn and in South East England was around £1.1bn. In our view, these markets will not have grown but the need for measures remain high. There is a large market worth £3bn per year for gas boiler replacement in private homes but that is not a target at present.

The vehicle charging point installation programme is still in an early phase so a market value is not wholly relevant. Lakehouse is an approved installer for vehicle charging point manufacturers, such as Schneider and Chargemaster. The smart meter installation market has considerable potential over the five-year initial installation period as there are around 27m dwellings in the UK, most of which will require two new meters at a cost of £300-350 per installation.

The markets for the energy services operation are driven mainly by government policy and direction. Of the three key areas for the division, energy efficiency, smart metering and the emerging charging points for electric vehicles, only the latter is funded by private sources.

In energy efficiency there are many funding schemes. The main ones are:

One of the core contracts is the Scottish government’s flagship HEEPS. Lakehouse has a 33.3% share in Warmworks along with its JV partners Energy Saving Trust and Changeworks.

Everwarm’s competition comes from several areas. In the recent bid for Arbed 3, the social housing maintenance provider Fortem and a consortium of local housing associations provided the competition. British Gas is focused mainly on compliance and boiler maintenance but also has offerings in the energy services area. Providor is in competition with several meter installers such as Nexus, Fulcrum, Actavo, M Group Services (Morrison Data Services), Orion, Ganymede, Lowri Beck and Amey. Lakehouse, via Providor, has the largest number of trained engineers and a true national presence, unlike most rivals.

In addition to Arbed 3, Everwarm has recently won a £44m Housing Investment Programme (HIP) framework in Aberdeenshire with an existing partner, and significant External Wall wins for West Dunbartonshire (£2.1m) as a new client, West Lothian Council (£2m) and Almond Housing Association (£1.4m). Everwarm secured a first ranked place in 28 out of 32 areas on the multi-million-pound Scotland Excel framework in 2017, from which it has obtained works orders. In May 2018 the company secured the Arbed 3 contract in Wales, a three-year £55m contract for delivering energy efficiency to 6,000 homes in Wales. On the back of this, in May 2018 the group also announced the acquisition of St Albans-based Just Energy Services with an aim of delivering similar services in other geographies.

Providor is at the forefront of the efforts to install smart meters throughout the UK. It is one of the few operators capable of managing a national roll-out of smart meter installations. As noted above, the hiatus in sorting out the technology has been unhelpful for Providor. Given the government’s push to install SMETS2 meters, it is anticipated to create a difficult position for installers as meters will be installed at a rate that is faster than the conventional replacement rate. Providor is one of a small number of companies with the relevant capabilities. Lakehouse has persevered with Providor, given the strong political drive to implement the smart meter project, it could be justified. But the results will not be evident until FY19, when the roll-out gets into full swing.

The management team at Lakehouse has substantial experience in the sector (see page 15).There are also two NEDs: Robert Legget came onto the board in April 2016; he is chair at Progressive Value Management, which specialises in creating value for investors in poorly performing entities with illiquid shareholdings. Derek Zissman was appointed in November 2017 having spent much of his career at KPMG; he is chair of the audit committee and director of several private companies.

Management is incentivised to perform well through cash bonuses and shares. In addition to the usual performance incentives, the company introduced a special incentive award plan that covers the period up to January 2019, or earlier should the results for the year to September 2018 be announced before then. The chair, Bob Holt, can be awarded up to 2.3m Lakehouse shares at nil cost, with the amount on a sliding scale based on absolute total shareholder return (TSR). An award can be made at a minimum TSR of 78.48p and the maximum is reached at 98.4p. The other executive directors are eligible to participate in this scheme It was designed to provide a strong incentive for management that aligned with those of the shareholders and have simple criteria for calculation. It has just over nine months to run and, with the share price near 40p, it seems unlikely the criteria will be met.

We expect that the remuneration committee will extend the period, given the ongoing need to lock-in management and the potential achievability of the goals. Our experience suggests that turnarounds in the broader sector often take longer than expected.

In making our forecasts, we assume broadly unchanged circumstances. There are risks to this assumption so below we outline some of the key issues.

We use comparative valuations focused on P/Es given the UK focus of direct peers to provide an indication of valuation. The peer group can be split in two. Close valuation comparators involved in similar businesses include Marlow, Bilby, Premier Technical Service Group and T Clarke.

A broader group of support service companies also provides a sense check around these multiples and we include larger groups such as Mears and Mitie

Based on our forecasts Lakehouse has a prospective P/E of 11.6x. This compares to the closely aligned set of peers who trade on an average prospective P/E of 14.9x.

The whole sector has been suffering from negative investor sentiment after the collapse of Carillion. In the near term we believe this is reasonable. Lakehouse itself noted the collapse added uncertainty to the sector and clients are taking a tougher negotiating stance on contracts.

The key actions since July 2016 have been to get stability in the operations and start a performance improvement plan, strengthen the balance sheet and resolve the legacy issues. We have altered our forecasts for FY18 onwards to reflect the new situation of the discontinued areas.

In our main forecasts, we have assumed modest revenue development and that Lakehouse will expand its compliance and energy services as swiftly as possible while assuming low risk. The company is seeking to balance risk and reward, so we expect it will be cautious in expanding.

Our forecasts for revenue show it rising in total from £182m in 2017 to £204m by 2020 with growth of 13.0% and 11.8% in compliance and energy services respectively over this period.

Forecast operating margins are only slightly higher than current levels as we expect the framework pricing will not be substantially different from present levels, which are competitive. But with the benefit of lower central overheads and their absorption over greater revenue, there are margin gains.

It is possible we are being overly cautious in our approach. Our margin assumptions of compliance effectively maintaining a 7.5% operating margin in 2020 and energy services increasing its margins from 5.1% in 2017 to 6.8% assume an additional £5.0m and £5.8m of costs above inflation increases. Consequently, only c 9% of the additional revenues are flowing through to operating profit. If management can continue to show strong cost control and discipline and start to leverage the group’s scale, and if we see a more traditional c 25% of revenues flowing through to the operating profit line, it would lead to an operating profit of £14.2m.

In mid-July 2016 the balance sheet was an issue given the deterioration in trading and the £21m net debt at end 2016. The sale of Orchard provided a £12.4m boost to the position that, along with favourable working capital movements in September, caused net debt of just £1.3m at the year end. Our forecast net debt position at year end 2018 is £14.4m, still higher than 1x EBITDA, which is regarded as a ‘safe’ level within the industry but an improvement on 2016 and we expect it to fall to 1x by 2020.

With the sale of Orchard, the company also reduced its revolving credit facility from £35m to £25m with RBS. The company has a £5m overdraft facility in addition to the credit facility; these are being renegotiated.

A strong balance sheet is important when tendering for public sector contracts as many customers need it as evidence of ability to fund work. It also allows the company to be more selective about projects as it is not chasing cash and often paid up front, which works well in the growth phase but can be negative if the company downsizes.

Operating cash flow before working capital movements is expected to exceed operating profit in our forecasts. The working capital used in this year and next is higher than usual, partly due to the downsizing of parts of the business creating negative working capital for the group and partly due to growth in the services area. The company is targeting 80%+ operating cash flow conversion. We expect a large cash outflow this year as legacy contracts are settled and a normal position to be achieved in 2019 when operating cash flow will equal 92% of adjusted operating profit.