What do results at Mitie Group plc mean for the service sector?

Shares in embattled facilities management and professional services group Mitie (LSE: MTO) rose 10% today despite a swing from £75.7m profit in FY2106 to a £184m loss in 2017.

The losses were largely caused by one-off costs and the market seemed impressed with the underlying performance at the recovering business.

Adjusted operating profits fell only 13.9% to £82m, after overheads grew and revenues largely remained flat. More importantly, cash generated by operations ballooned from £85.2m to £122.8m and was used to take a chunk out of the debt pile, reducing net debt to £147.2m (FY16: £178.3m). In my opinion, these figures form the best picture of how business is proceeding at Mitie.

The board did not recommend a final dividend, bringing the total dividend for the year to 4p, compared to 12p last year. 

Sliding service shares

The company has reported a string of profit warnings over the last couple of years. On top of that, an accounting review found “material errors” back in May, knocking £50m profit off of 2016/17 results. Advisor KGM said the overstatement was caused by aggressive customer contract accounting compared to sector peers. The balance sheet will also be hit by a writedown of between £40m and £50m.

When combined with a £14m one-off charge in January, these adjustments will significantly impact results and valuations given the group made only £76m last year.  The company has lined up Derek Mapp as the next chairman, alongside new CEO and CFO Phil Bentley and Sandip Mahajan respectively in a bid to turn performance around. 

Mitie has also sold its lossmaking healthcare business in an effort to focus on core, profitable areas. Its strategy is solid, if not compelling, and consists of a focus on culture and advanced technological solutions. The company has also launched a programme dubbed Project Helix that aims to generate £45m in savings a year.

Given the wholesale replacement of management, I’m expecting the kitchen sink to come flying out the HQ window soon, so investors who hold the shares would do well to prepare for writedowns, in my view.

Despite steady trading, I’d avoid Mitie and the entire service sector.  You see, multiple companies will bid for a service contract, resulting in a race to bottom on price and profitability. Often, the job goes to the lowest bidder, resulting in poor services and a disadvantage in the renewal process. This, combined with paper-thin margins and an austerity-focused Tory party puts me off of service companies in general.

Locked into long-term losses

Serco too is on a long and winding road to recovery, according to CEO Rupert Soames. The company has suffered a number of contract issues, scandals and profit warnings in recent years.

Mistakes were made operating the Compass UK asylum seeker support contract alongside G4S. The contracts, which were signed in 2012, have been extended until 2019. Costs have risen far beyond expectations and Serco has been unable to negotiate significant pay increases. When the deal expires, Serco expects to have lost £112m overall.

G4S is set to lose £107m for similar reasons. This contract perfectly demonstrates the dangers of working in a competitive, low-margin industry. Dividend investors would do well avoiding service companies altogether.

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Zach Coffell has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.