Board Review
Improving profitability
We entered 2007 expecting to make good progress in Pest Control, Parcel Delivery and Asia Pacific while knowing that market conditions in continental Europe would continue to impact Textiles and Washroom Services. Our expectation was that profit for the year would be in line with 2006, but that there would be some regression in the first quarter of 2007, due to a number of factors including the declining trends in Textiles and Washroom Services, still apparent as we exited 2006.
Our first quarter results were in line with our expectations – adjusted operating profit from continuing operations was down 4.3% at £53.9 million and adjusted profit before income tax was down 23.2% at £35.5 million. As anticipated, profit was affected by the restructuring underway in UK Pest Control and UK Washroom, seasonally weak trading in North America Pest Control and trading in our European Textiles and Washroom business.
The second and third quarters developed in line with our plans, with the regression in adjusted profit before income tax reduced to 4.3% in the second quarter and up 21.1% in the third quarter, a continuation of positive quarterly trends. The third quarter results were flattered by interest received on the sale proceeds from Electronic Security, but even without these would have been some 5.7% ahead of the prior year. At this stage it seemed the group had reached an inflection point and we expected that in 2008 profit before tax and amortisation would show mid to high single-digit growth over 2007, again after excluding the interest benefit from the sale of Electronic Security (estimated at the time to be around £15 million in the second half of 2007 and £30 million for the whole of 2008).
In each of the first three quarterly trading statements in 2007, we commented that business-to-consumer trading in City Link was a little softer than expected, although this was offset by stronger business-to-business trading but that overall the division was performing in line with budget. As we entered quarter four, City Link’s performance began to fall short of budget and in December we issued a trading statement saying that poor business-to-consumer trading in the run up to Christmas meant that City Link’s profit would be up to £10 million short of expectations and that this would have a similar impact on overall group profitability. This announcement had a severe and adverse impact on the share price which fell 22% on the day of the announcement, reducing the group’s market capitalisation by some £588 million.
An investigation into the causes of the profit shortfall revealed that:
- The trading downturn was not just driven by a shortfall in market related business-to-consumer volumes;
- The foundation for the integration of City Link, its franchises and Target Express (acquired at the end of 2006) had not been solid enough to cope with the degree and scale of changes that were being implemented. This had resulted in an adverse impact on account management, service and new business generation and, as a consequence;
- City Link’s profitability in 2008 was and remains unclear with the risk that the business may not trade better than breakeven in 2008.
Actions have been taken to improve the situation, including the appointment of a new management team, a pause in and review of the depot integration programme, a programme to improve customer service and strengthen account management where required and a restructuring of the sales team, already generating a strong new business pipeline.
Further details of the problems at City Link and the actions that have been taken to address them are set out in the Review of Performance contained within the Business Review.
City Link’s performance is clearly unacceptable and we are working urgently to address the issues. With hindsight, it is now clear that the problem which we had originally diagnosed as a shortfall in business-to-consumer trading was, in fact, a shortfall in the legacy City Link operations. We had misinterpreted the shortfall as a market issue rather than an internal issue linked to the way in which the acquired franchisees were being integrated into the City Link business.
Although the rest of the group traded in line with our expectations for the fourth quarter and continued the positive trends seen during the earlier part of the year, guidance that City Link might not trade better than breakeven in 2008 has had a further adverse impact on the share price when announced in February 2008. The share price fell by a further 23% on the day of the results, reducing the group’s market capitalisation by £445 million. In total, the fall in market capitalisation since the first warning in December and since the announcement of our full year results is £1.2 billion which exceeds the value of the City Link business as a whole. City Link’s performance has clearly damaged the market’s confidence in the group and increased its view of the risk inherent in the balance of the portfolio.
The board considered, as a matter of urgency, the steps that could be taken to create value for shareholders and this has led to the appointment of a new Chairman, Chief Executive and Corporate Development Director announced on 20 March 2008, as reported in the letter from the board. In the meantime, the guidance that we have given for 2008 is that adjusted profit before income tax is expected to be significantly lower than 2007 and will be heavily dependent on the performance of City Link. That said, we expect our divisions apart from City Link to produce modest growth in 2008.