A sustainable product and profitability

Shanks’s recently announced interim results showed a good underlying growth in revenues (+5% in constant currency [cc]) and pre-tax profits (+4% cc). Due to the heavy European exposure of both the Commercial Waste and Hazardous divisions, the weakness of the euro translated into modest declines at the headline level. While all the divisions faced various short-term pressures, the market-facing focus has allowed Shanks to withstand these pressures, produce resilient results and maintain dividends.

At the interim stage debt was slightly better than expected at £184m and is expected to peak below £200m as the major investment programmes near completion. Strong free cash flow conversion (95%) and a lower need for replacement capex after a period of heavy spend has helped. While net debt/EBITDA at 2.7x is relatively high, it is manageable and the group retains ample headroom, supported by a PFI portfolio valuation of £115m. In the longer term, Shanks has the option of realising value and giving itself additional financial flexibility by either disposing of the PFI portfolio as a whole or selling packages of debt/equity. In addition, the group has taken advantage of the current interest rate environment to launch a Green Retail Bond and refinance part of its borrowings at lower rates.

Another feature of the group’s strategy is to maintain strong capital disciplines with regard to existing activities and any new investment. With divisional return on assets now up to 12.4% and trending higher, it appears this focus is working. Investors will take particular encouragement after a period of major investment that returns on new investment are producing a higher 17.9% return, which indicates that capital is being allocated to the right areas and adding value for shareholders. Aligned to this capital discipline is the portfolio approach, which ensures all activities are constantly under review. We believe the majority of non-core disposals have now been completed. While M&A remains under review, nothing is imminent, the same hurdle rate (15% pre-tax return) will be applied and management needs to be sure that any acquisitions will produce incremental returns for shareholders.

Helped by a modest recovery in construction volumes in the Netherlands, this division showed a sharp recovery with trading profits increasing 30% (cc) to €11.3m. However, this is not the whole story as it masked very different performance from the Netherlands and Belgium. Whereas Belgium went slightly backwards due to pressures in the SRF and wood dust markets, the Netherlands’ operating profits were up an impressive 78% (cc). While the macro background was slightly more helpful as the residential market showed a modest recovery, management actions were key to the improvement. By better targeting customers the business was successful in gaining market share and achieving a better waste price and gate fee. In combination with the self-help programmes and cost reductions, most of the benefits dropped through to the bottom line with margins increasing from 3.9% to 6.5%. With margins still below historic levels, management is confident that the continuous improvement programmes will allow a further recovery in the coming years.

While the slippage in Belgium is slightly disappointing, plans are in place to introduce similar self-help programmes. It is pleasing that agreement has been reached to extend the Cetem valorisation permit for a further four years. The Commercial Waste division still represents c 50% of group revenues and with margins at 5.6% it remains a key opportunity for improvement and important to Shanks’s medium-term profit targets.

As highlighted in the recent trading statement, this division was suffering short-term issues due to the current weakness in the oil and gas industry. With c 50% of its revenues exposed to oil and gas, a 1% increase in trading profits (cc) is a reasonably robust performance in what remains a high margin and returns business. The weak oil price had an impact on both industrial sludge volumes and industrial cleaning and is estimated to have reduced H1 profits by €2m. In addition, the division suffered from a minor contamination issue, which has now been resolved. Despite the temporary setback, management has continued to invest given the high potential returns on capital and has now completed the Rotterdam jetty expansion and Total Care Centre.

Although low oil prices look set to continue and will have a smaller impact on H2, the statement suggested the situation was now stabilising and management was slightly more positive. With the majority (80%) of Shanks’s services linked to opex rather than capex, spending plans were curtailed, but can only be temporarily put on hold and activity levels are now improving. The absence of one-offs and the benefit from recent investments suggests a better H2.

The division produced a strong operational performance on existing contracts and brought the new BDR facility into service, which led to an 11% increase in revenues to £90.2m. While this division operates under long-term PFI agreements, the current pressure on local government budgets has increased discussions over targets and incentives in the contract frameworks. While there was a short-term decline in profitability (operating down 9%) as demand for off-take products and recyclate pricing remained mixed, the programme of productivity improvements and self-help initiatives is continuing to offset these pressures and should reverse the short-term decline in profits.

The other main disappointment in the period was the delay to the Wakefield facility as a result of its AD contractor being in receivership. This has resulted in a £4.6m exceptional cost, although management is confident that the facility will now be open in line with the revised schedule of December 2015. In addition, with Derby and Surrey (Canada) under construction and set for completion and commission in March 2017, the recent heavy capex programme is entering the latter stages. The nature of this business and ongoing pressures means that Municipal needs and is particularly suited to a programme of continuous improvement focused on productivity and cost reduction to maintain margins and hit return targets.

Given the ongoing self-help actions, as well as recent investments and lower interest costs after recent refinancing, we are maintaining our 2016 forecasts. While mindful of further euro and oil price weakness, at this stage of the year management predicts a slightly better second half.

While Shanks faced a number of macro and operational challenges in the period, we are encouraged by the robust performance and maintaining our forecasts. The focus on self-help initiatives and strong capital disciplines should herald a period of improving margins and returns for the group. Clearly, an improvement in the Benelux economies would be helpful, but forecasts are predicated on a benign economic background rather than strong recovery. Against this background, we are maintaining our valuation range (106-130p), which suggests good upside from current levels if Shanks continues to deliver and execute on its plans.