I’m often on the hunt for contrarian plays, where the City has over-reacted to bad news and marked down shareprices. These high-risk situations offer substantial upside if executed properly. And this week’s gamble has recently fallen into that camp…
Gamble of the week: Johnson Service Group (JSG)
Johnson issued a shock profit warning last week, triggering earnings per share downgrades and denting City confidence.
Johnson Service Group provides industrial laundry, dry cleaning and facilities to management services in the UK. Its core business-to-business services generated turnover and underlying operating profit in the first half of this year. Importantly, trading at these divisions remains solid, delivering good earnings streams, strong cash flows and high barriers to entry. As such I’d value them at around £200m. The main culprit behind the earnings miss, then, was not the core business but non-core elements, most of which are for sale anyway.
Here, retail dry-cleaning achieved H1’07 sales and earnings before interest and taxes of £40.9m and £2.7m and should be worth another £50m. The rest of the activities up for sale should realise £25m on disposal, generating an enterprise value of circa £275m for the whole group.
Deducting net debt of £150m and a £15m pension deficit and Johnson Service Group should be worth £110m or 180p a share. Following the poor trading update, house broker Investec trimmed its forecasts, and is now expecting 2007 earnings per share to be 21.8p, rising to 27.3p in 2008. As such, at current levels the shares presently trade on an undemanding 2007 price/earnings ratio of 4.3 and pay a nice 15% dividend yield – although the latter is in danger of further cuts in order to conserve funds.
Obviously these shares are not for the risk-adverse. Indeed, if conditions deteriorate further, there is a chance that Johnson Service Group could breach its banking covenants, and hence be forced into an emergency rights issue. However, interest payments are presently covered over 2.5 times, while the group has a committed bank facility of £200m.
It should also be pointed out that dry cleaning is in structural decline. Because fewer people wear suits to work, suits are cheaper and, no longer being regarded as precious items, are discarded more frequently. At the same time, fewer people smoking indoors is generating a lower frequency of washes.
However, given Johnson Service Group’s strong positions in its core markets, I believe that the recent sell-off has been overdone and the shares now rate as a high-risk buy for the more adventurous investor. Lastly, at such down-trodden levels, I would not be surprised to see the stock attracting some opportunistic trade buyers, or perhaps even a private-equity bid.
Recommendation: SPECULATIVE BUY at 97.5p (market capitalisation £57.9m)
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments