This ASX200 reject could be a contrarian buying opportunity
Johns Lyng’s interim results and index deletion have sent investors running for the exits. Our analyst Esther Holloway thinks the sell-off is overdone.
Mentioned: Johns Lyng Group Ltd (JLG)
You’ll sometimes see a company blame weak earnings on poor weather. One drinks company that I own once blamed lower sales on a bad British summer. As a veteran of at least 25 poor British summers from my 30 years on Earth, this only made me doubt the company’s ability to turn a decent profit ever again.
Johns Lyng Group (ASX: JLG) is different. Its recent miss was mostly for the opposite reason: fewer extreme weather events in the first half of fiscal 2025, which meant less work for its subsidiaries and sub-contractors that fix buildings affected by events like these.
JLG shares fell by some 30% on results day and currently trade almost 35% below where they started February. This even pushed the company's market value low enough for JLG to be removed from the ASX200 index in its most recent rebalance - and it all started with just a 5% cut to management's full year sales forecast. What is going on?
A quick look at Johns Lyng Group
JLG's main business is the rebuilding of residential and commercial properties on behalf of insurers. This work comprises roughly 80% of the group’s revenue and is carried out through over 200 group subsidiaries in Australia, New Zealand and seventeen US states.
Most of JLG’s repair work is related to everyday insurable events, while catastrophes such as natural disasters make up roughly 20% of repairs revenue in an average year. As the magnitude and timing of catastrophes are unpredictable, however, few years actually end up being ‘average’ at all.
Instead, sales are lumpy and earnings are even lumpier because catastrophe work (referred to as ‘CAT’ revenue by the company) carries higher margins to JLG than everyday repairs. This is partly because JLG’s resources are utilised more efficiently in cases like these, as there will be a high number of jobs in the same area.
JLG does not give guidance on future catastrophe revenue, instead guiding only to sales still to flow through from events that have already happened. This makes perfect sense, yet analysts and investors obviously still need to weigh up what potential revenue and profits can be expected from this segment.
If the reaction to JLG’s recent earning miss is anything to go by, investors seem to have a hard time dealing with this uncertainty. Even if, as Esther puts it, the occurrence of these events at some time in the future is highly likely if not guaranteed.
The market has shown a tendency to simply extrapolate recent levels of CAT work into the future. Could this potentially lead to overly high expectations following stronger years of CAT revenue, and overly depressed expectations following periods of more fortunate weather?
A different and longer term approach
Esther takes a different approach in her long-term valuation of Johns Lyng: she assumes that revenues from catastrophe will, on average, comprise a similar percentage of JLG’s overall construction revenue as they have over the past several years - that level of around 20% that we spoke about earlier.
In doing so, Esther is trying to be ‘roughly right’ about the revenue derived from catastrophic events over the medium and long term, rather than taking on the impossible task of predicting an exact number every year.
Esther’s forecast also bakes in a small increase in mix towards CAT revenue, as has been the case in recent years. This is partly down to how JLG’s footprint in Australia has grown organically and through acquisitions.
The following two maps hint at the increase in JLG Group locations in Australia between the end of fiscal 2019 and the first half of fiscal 2025. The 2025 map actually underplays this growth a bit, as it doesn’t include 40 locations operated by its Steamatic cleaning and restoration business.
Figure 1: JLG locations 2019 versus 2025 (excludes Steamatic). Source: Company presentations
This bigger footprint and stronger regional presence means that when there is an extreme weather event somewhere in Australia, JLG’s subsidiaries are even more likely to be involved in the clean-up than they were before.
What about the underlying business?
Contrary to what a 25% sell-off in the shares might suggest, the other 80% of JLG’s business seems to be humming along just fine. Once you exclude revenue from catastrophe events, revenues in H1 were up 9% on last year and profits were up 4%.
This continues the strong ‘business as usual’ sales growth in JLG’s insurance and building restoration services business in recent years, defined as revenue excluding that derived from catastrophic events.
Figure 2: Business as usual sales growth (ex CAT revenue) at Johns Lyng Group. Source: Morningstar, Datawrapper.
Esther thinks that JLG’s restoration business in Australia can continue to grow because it enjoys a strong competitive advantage over smaller peers. A lot of this comes down to how this kind of work is awarded and paid for.
Contracts in the repairs business are awarded on a multi-year basis, upon which the company joins a ‘panel’ of companies that get work allocated to them by the insurer based on factors such as past performance and customer satisfaction.
This work is almost on a cost-plus basis with an agreed margin. These margins are generally set so that smaller providers can also make a viable profit if chosen for a job, thereby ensuring a bigger pool of potential suppliers for the insurer.
To complete its assigned jobs, Johns Lyng will usually tap into its network of around 16,000 sub-contractors. The price quoted by these suppliers becomes JLG’s cost, upon which the firm will earn the agreed margin from the insurer they have the contract with.
This is a highly efficient model for JLG as it only pays for labour when it is needed. It is also a model less available to smaller players that don't have as much work to offer sub-contractors. This more efficient use of resources helps JLG to make more economic profits on the same terms as smaller players.
JLG also seems advantaged when it comes to winning contracts in the first place. For one, its large geographic footprint allows it to respond more quickly to situations and opportunities nationally. Bigger operators are also better equipped to shoulder compliance burdens, while ‘one-stop-shops’ like JLG can appeal more to insurers preferring to juggle fewer suppliers.
Taken together, Esther expects profits in the core Aussie insurance repairs business to grow at an average annual rate of 8% over her forecast period due to market share gains, population growth and inflation. Inflation is more of a tailwind for JLG than most firms because of its cost-plus contract work.
What’s the strata-gy?
Esther likes JLG’s focus on continuing to grow scale on its restoration, rebuilding and catastrophe response businesses in Australia and the US. Due to the factors we discussed earlier, she thinks building greater scale will help it win more insurance contracts in what are both highly fragmented markets.
Another focus for JLG is an attempt to shift more revenue towards higher-margin strata maintenance and restoration work in Australia. JLG’s approach here has revolved around buying strata management firms that can recommend (but not guarantee) jobs for JLG’s providers.
Esther isn’t as keen on this part of the business, which she says is structurally different to insurance repairs because of the way that business is awarded. It is not contract based, meaning that project bidding could be more competitive, even if JLG’s strata management interests could give it an edge.
What’s it worth?
Esther’s updated Fair Value estimate for Johns Lyng is $4.30 per share, just 4% lower than before the JLG's recent results.
The key assumptions underpinning Esther's Fair Value estimate are her revenue growth estimate for the core Australian construction segment and her forecast that operating margins can improve to 9.5% mid-cycle from a current level of around 7.5%.
Esther thinks these margin improvements could flow through from achieving greater scale in the US, where JLG currently needs to be more aggressive on price when it bids for contracts. A bigger skew to higher-margin catastrophe and strata work would help too.
In the context of Esther’s valuation and analysis, the reaction to Johns Lyng’s recent earnings miss seems massively overdone and the company’s shares look cheap.
Potential risks to her valuation, which are baked into Esther’s Uncertainty rating of Medium for the stock, include the difficulty of predicting catastrophe linked revenue and potential changes in insurance and strata management industry regulation.
Johns Lyng Group
- Moat Rating: Narrow
- Fair Value estimate: $4.30 per share
- Uncertainty Rating: Medium
- Star Rating: Five stars (as of March 11)
Joseph’s investment in JLG
Disclosure time: I own shares in Johns Lyng Group. These were bought after the recent sell-off, and not only because Esther's analysis convinced me that the share price fall might have been overdone.
I added JLG to my portfolio because as well as a compelling entry price, it seemed to fit well with several of the criteria I seek in a long-term investment:
- It has fair to good industry growth prospects. Unfortunately, bad stuff isn’t going to stop happening to peoples’ properties and neither are bad weather events. The number of properties in Australia, JLG’s biggest market, also seems to be supported by solid population growth.
- It has a business model and competitive advantage that I think I understand. The scale advantage that Johns Lyng enjoys in Australia makes sense to me and it seems to be getting stronger over time as compliance demands increase. I also like the skew towards cost-plus contracts that turn inflation from a worry into a potential tailwind.
- It has a sound balance sheet. Johns Lyng has a small net debt position at the moment compared to its profitability and has traditionally run with a net cash position. It also has a solid and growing base of ‘everyday’ business that could support debt if needed.
It also seemed to me that sentiment towards JLG had become far more focused on short-term issues and disappointments, maybe stemming from the rather high valuation it had in the past, instead of what looks like a very solid platform to grow profits for shareholders over the long-term.
As a result, I felt this opportunity fitted well with my strategy to turn short-term uncertainty to my advantage by investing with a longer-term view. To learn more about defining an investing strategy that aligns with your goals, see this five-step walkthrough from my colleague Mark LaMonica.
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Terms used in this article
Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.
Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.
Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.
Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.
