A sustainable product and profitability

Shanks Group 11 November 2015 Update

Shanks Group

A sustainable product and profitability

Interim results

Industrial support services

11 November 2015

Price

96.00p

Market cap

£382m

€1.35/£

Net debt (£m) at end September 2015

184

Shares in issue

397.9m

Free float

100%

Code

SKS

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

3.5

(4.5)

(1.5)

Rel (local)

5.4

1.9

1.1

52-week high/low

112.5p

88.5p

Business description

Shanks Group is a leading international waste-to-product company. Its focus is on sorting and processing waste, rather than landfill and incineration. The business now operates across three divisions: Commercial, Hazardous and Municipal.

Next event

Final results

May 2016

Analysts

Neil Basten

+44 (0)20 3077 5700

Roger Johnston

+44 (0)20 3077 5722

Shanks Group is a research client of Edison Investment Research Limited

Against a difficult economic background, it is encouraging that Shanks saw a modest growth in revenues and pre-tax profits aided by its self-help programmes. Strong long-term growth drivers driven by regulation to reduce incineration and landfill should underpin margin expansion in the next few years. This focus, complemented by tight capital disciplines, suggests increased returns should be evident in both the existing business and new investments and reward shareholders in the long term.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

03/14

636.4

30.2

5.7

3.45

16.8

3.6

03/15

601.5

21.7

5.0

3.45

19.2

3.6

03/16e

597.0

22.7

4.5

3.45

21.3

3.6

03/17e

611.6

27.0

5.3

3.45

18.1

3.6

Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments.

Netherlands the star performer

As indicated in the company’s recent trading statement, the recovery in its Netherlands Commercial business has continued and produced a sharp turnaround in performance at the interim stage. Helped by a modest recovery in construction volumes, firmer pricing and self-help programmes were the key drivers behind the 78% increase in trading profits. As a market leader, this important division has the potential to see a further improvement in margins and returns as they remain below long-term averages.

Impact from oil price weakness now stabilised

In the recent trading update, Shanks highlighted that the Hazardous Waste division was suffering from its 50% exposure to the oil and gas industry. While these pressures will continue to affect the second half, it the situation has now stabilised. Given that this business is more exposed to opex rather than capital projects, any cutback in spending can only be deferred temporarily and it is encouraging that the first signs of the impact unwinding are starting to become evident.

Valuation: Improved returns to benefit shareholders

Despite some minor one-off issues in the first half, we believe investors will be reassured that trading showed a modest improvement despite the difficult economic backdrop and in line with current market expectations. The group’s strategy is based on a programme of continuous improvements rather than a quick fix and, as such, even assuming a benign environment Shanks should show a sustainable improvement in both margin and returns over the medium term. Following recent price weakness as confidence that these improvements are achievable grows, the gap in our valuation range (106-130p a share) should narrow and in the meantime the shares should be supported by a 3.6% yield.

Interim results

Constant currency growth in revenues and pre-tax trading profit

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.

Financials

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.

Divisional commentary

Commercial Waste

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.

Hazardous Waste

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.

Municipal

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.

Forecasts

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.

Exhibit 1: Shanks interims breakdown and 2016 forecasts (£m)

Divisional snap shot

H115

H215

FY15

H116e

H216e

FY16e

Commercial

159.2

154.9

314.1

145.5

152.4

297.9

Hazardous Waste

69.2

68.8

138

64.4

70

134.4

Municipal

81

76.7

157.7

90.2

82.9

173.1

Intra segment revenue

(4.6)

(3.8)

(8.4)

(3.1)

(5.3)

(8.4)

Total revenue

304.8

296.6

601.5

297

300

597

Commercial

7.2

6

13.2

8.1

7.9

16

Hazardous Waste

8

8.4

16.4

7.3

8.2

15.5

Municipal

5.7

6.4

12.1

5.2

6.3

11.5

Intra segment revenue

(2.8)

(4.6)

(7.4)

(3.2)

(4.1)

(7.3)

Total trading profit

18.1

16.2

34.3

17.4

18.3

35.7

Interest

(7.2)

(6.2)

(13.4)

(7.1)

(6.9)

(14)

Associate

0.3

0.5

0.8

0.4

0.6

1

Profit Before Tax

11.2

10.5

21.7

10.7

12

22.7

Source: Edison Investment Research

Valuation

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.


Exhibit 2: Financial summary

£m

2014

2015

2016e

2017e

March 31

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

 

636.4

601.5

597.0

611.6

Cost of Sales

(530.6)

(506.2)

(498.7)

(507.0)

Gross Profit

105.8

95.3

98.3

104.5

EBITDA

 

 

88.7

72.6

75.7

82.7

Operating Profit (before amort. and except.)

48.7

36.8

38.5

43.2

Intangible Amortisation

(2.8)

(2.5)

(2.8)

(2.8)

Exceptionals

0.0

0.0

0.0

0.0

Other

0.0

0.0

0.0

0.0

Operating Profit

45.9

34.3

35.7

40.4

Net Interest

(16.0)

(13.4)

(14.0)

(14.5)

Associated company

0.3

0.8

1.0

1.0

Exceptionals

(52.5)

(40.9)

(10.0)

0.0

Profit before tax (reported)

 

 

30.2

21.7

22.7

27.0

Profit Before Tax (IFRS)

 

 

(22.3)

(19.2)

12.7

27.0

Tax

(5.9)

2.3

(4.9)

(5.9)

Profit After Tax (norm)

27.1

26.5

20.6

23.9

Profit After Tax (FRS 3)

(28.2)

(16.9)

7.8

21.1

Average Number of Shares Outstanding (m)

397.6

397.8

397.8

397.8

EPS - normalised (p)

 

 

6.4

5.6

5.2

6.0

EPS - normalised and fully diluted (p)

 

6.4

5.6

5.2

6.0

EPS - clean (p)

 

 

5.7

5.0

4.5

5.3

EPS - (IFRS) (p)

 

 

(7.1)

(4.3)

2.0

5.3

Dividend per share (p)

3.45

3.45

3.45

3.45

Gross Margin (%)

16.6

15.8

16.5

17.1

EBITDA Margin (%)

13.9

12.1

12.7

13.5

Operating Margin (before GW and except.) (%)

7.7

6.1

6.5

7.1

BALANCE SHEET

Fixed Assets

 

 

741.3

745.0

796.0

819.5

Intangible Assets

212.7

173.8

171.0

168.2

Tangible Assets

327.1

282.9

307.4

313.8

PFI/PPP financial assets

195.6

278.2

306.6

325.4

Investments

5.9

10.1

11.1

12.1

Current Assets

 

 

261.0

194.6

193.6

196.8

Stocks

9.4

6.9

6.8

7.0

Debtors

147.0

126.9

125.9

129.0

Cash

104.6

60.8

60.8

60.8

Other

0.0

0.0

0.0

0.0

Current Liabilities

 

 

(276.8)

(400.2)

(444.9)

(446.4)

Creditors

(271.4)

(262.9)

(263.5)

(272.5)

Short term borrowings

(3.7)

(75.0)

(119.2)

(111.6)

Short term PFI debt

(1.7)

(62.3)

(62.3)

(62.3)

Long Term Liabilities

 

 

(452.0)

(350.3)

(361.5)

(379.3)

Long term borrowings

(256.9)

(140.8)

(140.8)

(140.8)

Long term PFI debt

(149.5)

(160.3)

(171.9)

(188.5)

Other long term liabilities

(45.6)

(49.2)

(48.8)

(50.0)

Net Assets

 

 

273.5

189.1

183.2

190.6

CASH FLOW

Operating Cash Flow

 

 

73.2

69.2

64.4

86.8

Net Interest

(18.3)

(13.4)

(15.8)

(16.7)

Tax

(1.6)

(5.7)

(2.5)

(2.9)

Capex

(42.7)

(42.1)

(61.6)

(45.9)

Acquisitions/disposals

22.4

(1.5)

0.0

0.0

Financing

0.2

0.0

0.0

0.0

Dividends

(13.7)

(13.7)

(13.7)

(13.7)

Other

(49.3)

(63.2)

(26.6)

(16.6)

Net Cash Flow

(29.8)

(70.4)

(55.8)

(9.0)

Opening core net debt/(cash)

 

177.3

156.0

155.0

199.2

HP finance leases initiated

0.0

0.0

0.0

0.0

Other

51.1

71.4

11.6

16.6

Closing core net debt/(cash)

 

 

156.0

155.0

199.2

191.6

Source: Company accounts, Edison Investment Research

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