Between 2003 and 2007 the shares of Synergy Health (SYR), the provider of cleaning and sterilisation services to hospitals, were star performers. The stock shot up from 100p to 900p a share. But since then the ride for shareholders has been hard, with a trading update alone in the autumn knocking 62% off the price. The shares have since recovered, but at 430p and a multiple of 11 times earnings this previous high flier still languishes.
Chief executive Richard Steeves says part of the problem has been the high expectations placed on the company. ‘Since becoming a public company in 2001 until the trading update we had always met or exceeded expectations. On 12 out of 14 occasions we had been able to beat forecasts, and on the other two we met them. I think there was an expectation we would go on defying gravity.’ Steeves hopes to be able to convince the market the company is back on track.
The £230 million cap is divided into three divisions: Sterilisation Services, Decontamination Services and Healthcare Solutions. Sterilisation revolves around one-use, disposable medical devices but includes services such as food decontamination and the packaging of medicines. Decontamination is principally concerned with the cleaning of re-usable surgical instruments for the UK and European markets. Healthcare solutions provides linen services, infection control and laboratory services to hospitals, and is the largest of the three, accounting for almost 65% of sales. In spite of the diversity of the services the key purchasers within hospitals tend to be the same people, making the various parts a natural business fit. End markets are regulated, and present potential competitors with high barriers to entry.
The contracts are with individual hospitals rather than with health authorities and should be nearly recession-proof. The foundation trusts are independently run, with commitments of 4% real growth in budgets for the next three years. In addition Steeves points to the general background of expanding government expenditure as being supportive.
The benefit of Synergy to the NHS is it can provide services at around half the cost the NHS itself would face if it kept them in-house. Outside contractors have one huge advantage: unlike the NHS itself they can claim back VAT from the government. Beyond that, Steeves points to the greater efficiencies of the private sector, partly in scale, in providing a one-stop source of services, but also through much greater flexibility in the buying process. Synergy sources its inputs directly from a diverse range of suppliers around the world, while the NHS in the past has relied on intermediaries. Having moved to outsourcing, Steeves sees the NHS as wanting to concentrate on the provision of clinical services from now on. ‘We are able to buy cheaper across the board. Everything we buy, we buy better.’
Fall from grace
The autumnal tumble in the share price was prompted by a trading statement in which the company said operating margins would be lower due to high energy and transport costs and problems with contracts in the decontamination area. A recent interim management statement (2 February) emphasised the company had made good progress in resolving these issues.
On the subject of costs Steeves says the oil price has retreated but gas and electricity prices remain elevated so the problem has not gone away. But it was the spike in oil to $147 that caused the damage, and so should not occur again.
On the decontamination contracts Steeves points to the complexity of the business and a lack of precision in some of the early deals on what was expected on behalf of customer and supplier. He is reluctant to go into detail, due the nature of Synergy’s relationship with the NHS, but asserts these issues will not be repeated. One part of the contractual misunderstandings was the volumes were not as great as originally advertised. Consequently Synergy had to absorb the costs of the gearing up. Since then the company has won new orders and costs have come under control.
‘In the recent update we gave we said we were categorically on course to have those margins restored by the end of the year, and that has pretty much already happened.’
Net debt stands at £167 million, having increased due to translation effects on the foreign currency part. Synergy has an internal target to keep net debt to around 2.5 times earnings before interest tax depreciation and amortisation (EBITDA) and it was just slightly over that at the end of the third quarter, due to the translation of euro-denominated debt, which accounted for around £10 million. Synergy is also completing three facilities in China, Lancashire and a new sterilisation facility in Ireland, which pushes up the net debt a little. Steeves anticipates getting back on target within a few months once these are out of the way. The debt covenants come in at 3.5 times EBITDA, declining to three times at the end of June. The current facility is in place until 2012.
Sterling weakness is marginally advantageous for the £228 million cap. Around 45% of earnings come from Europe, although Synergy has to contend with the negative impact of the euro’s strength on its debts. The group also sources a lot of its inputs from Europe, so the cost base for the UK services has gone up. The weakness against the dollar puts greater pressure on margins, as Synergy has little in the way of sales revenue from the US, so once the hedging runs out toward the end of this financial year, Steeves says Synergy will either have to raise prices or find other ways to restore margins.
Growth and resilience
Synergy’s capital expenditure plans, which are bringing new capacity on line in a difficult economic time could be seen as a risk. The company has three new plants on the way and one in Holland that has already started producing. The three new ones are due to come on stream this year. Contracts are already signed up for China, a facility split between hospital services and sterilisation. Ireland comes on stream toward the end of April. As for the decontamination facility in the north west of England, Synergy already has enough contracts to fill the site. ‘Everything has customers earmarked or actually contracted for them already.’ The decisions to invest were made a couple of years ago when the economic future looked a lot brighter, but Synergy has not seen any let-up in demand and is not worried about the timing of the new plants.
The third-quarter trading update released last month pointed to strong sales growth of 15.5%, of which around 8% was underlying. Steeves sees this growth as being resilient in the face of the downturn. Synergy does have some activities that have suffered but these are small. It has used its sterilisation know-how for industrial products, much used by the automotive industry. This accounted for £4 million in revenues at its peak, and this has declined, with the automotive share almost disappearing. Industrial sales have fallen by between £1 million and £1.5 million. However, work the company does for silicon chips and gemstones is holding up well. The other area that has seen a decline is laboratory testing for occupational health, which involves testing for alcohol and drugs, and is vulnerable to companies cutting back costs. Here the revenues have held up, but there has been no growth. This contributes about £3 million. Consequently, according to Steeves, only about £7 million of the business is affected by the downturn, compared with the annual consensus sales forecast of about £273 million. There has been much discussion about elective surgical procedures being reduced in the US but Synergy, with exposure limited to the manufacture of devices used in the American market, has not seen any downturn, and indeed continued growth.
The way back
When Steeves is asked what catalyst might get the market to re-rate the company he replies: ‘It will be certain that the management has sorted out the the margin dilution that we saw earlier in the year. The market is difficult at the moment and there is a tendency for profit warnings to come in twos or threes rather than singly. The market will want to see we have done the job we said we would do in terms of tackling those issues. Once people have seen the evidence then I think we will see a correction in the share price.’
If Synergy’s share price can hold above 425p, the recent highs of its post-autumnal range, technical analysts will take heart a double-bottom will be in place. The present multiple of 11 times earnings certainly looks cheap from a historical perspective. At its height Synergy traded at 30 times, suggesting now is a good time to buy.
