Shares in textile services company Berendsen(LSE: BRSN) dived as much as 17% this morning after operational instability in its UK Flat Linen business prompted a full-year profit warning.
Revenue increased 10.1% in the period, although most growth was driven by acquisitions. The company's 2.8% organic growth is unsurprising given the mature nature of its operations.
All's well at the top line then, but Berendsen's problem lies in the execution of those services. Costs were higher than expected in UK Flat Linen, which serves the hotel and healthcare industries. A number of changes have already been made to improve performance, including a rollout of tracking chips that should improve the identification and sorting of linen.
The first question facing long-term investors analysing these results will be, "are these problems fixable?"
The company is currently conducting a review of UK operations, and while its issues can likely be curtailed by cost-cutting, it's impossible to know for sure until the root cause of the underperformance is exposed.
The business plan
The company's other businesses are performing in line with expectations. The upshot of this is a flat year. Management expects operating profit to clock in at £160m, compared to £153.8m in 2015.
The market might be blue on Berendsen today, but if it can turn around Flat Linen, investor attention will quickly turn to how it can expand.
The company has prioritised investments into the Workwear and Cleanroom businesses where superior operating models exist to deliver higher margins and returns, largely due to the more complex nature of operations.
For example, specialised workwear like firemen's outfits need to be handled with care to ensure it remains functional. The mission critical nature of these services means companies are often willing to pay for the best.
The Workwear and Cleanroom business achieved operating margins of 21.3% and 26% last year, compared to Flat Linen's 10.8%. Focusing on these businesses seems sensible, although it's possible management spent less time on the Flat Linen business to facilitate the expansion. If this is the case, hopefully this is a mistake that won't be repeated.
The company also uses some rather Foolish (capital F!) metrics to assess long-term performance, with an emphasis on cash conversion and return on invested capital (ROIC) when analysing the success or failure of the business. The former ensures there are no accounting gimmicks (it can be easy to massage paper earnings that appear on the income statement, but harder to manipulate cash) while the latter metric is one of the single most important factors in driving long-term returns.
A high return on capital implies that a business needs to invest less to increase profits - and we Fools will almost always pick a business that only needs to invest £5 to make £1, over a company that requires £8. Simply put, a high ROIC allows compounding to work its magic.
The company has performed admirably in the past, with strong cash conversion and ROIC jumping from 6% in 2011 to 8.6% last year. These figures seem likely to fall in the short term, but this impressive track record and the repeat nature of revenues should be enough for investors to hold the shares. After the fall, the shares only offer a yield of 3.1%, lower than the FTSE 100's payout. But one positive is that most of Berendsen's business is repeatable and predictable income should help protect that dividend.
With the shares changing hands for 18 times last year's free cash flow Berendsen is no obvious bargain, in my opinion. If you're looking for a dividend paying stock with a stable business model, but don't trust Berendsen after today's update, I'd urge you consider The Motley Fool's top income stock.
This company increased its dividend by 45% in 2015, facilitated by pre-tax profits nearly doubling over the last four years. Click here to find out if this fast-growing dividend could boost your income.
Zach Coffell has no position in any shares mentioned. The Motley Fool UK has recommended Berendsen. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.