Augean — Growth fuels upside

We last published on Augean in March 2018 at a point when the company had embarked on a plan to transform the business. In 2017 Augean was a sprawling waste management company with a range of businesses that frequently failed to meet market expectations and in October 2017 management issued a profit warning due to a weaker trading performance, pointing to lower profitability in 2017 than 2016, and that it had reduced its outlook for 2018. In addition to these operational challenges, Augean had been served notice by the HMRC (August 2017) that it faced a substantial financial liability in relation to unpaid landfill taxes.

To tackle these challenges, Augean appointed Jim Meredith, the non-executive chairman, to the role of executive chairman (October 2017) and the company embarked upon a dual strategy of running the business for cash while dealing with the legal dispute with HMRC. Mr. Meredith has focused the management team (led on a day-to-day basis by Mark Fryer (FD) and John Rauch (COO)) on cash and ROI, allowing the position of divisional head to be eliminated. Since Mr Meredith’s appointment, Augean has sold underperforming businesses such as the East Kent Incinerator, Colt and AIS, raising c £10m and eliminating ongoing losses in the process. Augean has also reorganised the business around its operational sites and now operates via two divisions (from five previously) – Treatment & Disposal and North Sea Services. The position of divisional head has been eliminated and the workforce has been incentivised by the introduction of a bonus scheme. Annual cost reductions of £6m (versus 2017) have also been achieved (original company forecast – £4m).

The disposals, corporate reorganisation and cost reductions have helped to significantly improve the financial performance of the company. In broad terms, in 2017 Augean reported profits of £4.6m, to which can be added £6m of annual cost savings, £4m from price increases and £4m of volume-related benefits (including those recently announced), taking profits to around the c £18.4m that we forecast for 2019. The balance sheet has been transformed over the period (see Exhibit 2) and interestingly, Augean generated almost as much in EBITDA in H119 as it did in the whole of 2017. Returns, as calculated by Augean, have also risen significantly. We forecast further growth in H219 and beyond.

Although Augean has dealt successfully with the operational issues facing the business, the dispute with HMRC remains unresolved. At the H119 results Augean disclosed a potential outstanding liability of £37.3m (including interest) and has subsequently (31 July 2019) received an additional assessment of £3.1m and a penalty notice of £4.6m (2 August 2019), taking the current liability to c £45m. A further penalty notice and assessment cannot be ruled out; assuming they are of a similar scale to the recent announcements, the total liability would amount to c £53m. In reality, it is important to remember the dispute with HMRC covers three separate areas of tax, including hazardous mixed load (c £20m of the £53m), biomass ash (£15m of the £53m) and drill cuttings from the North Sea (£10m of the £53m), as well as penalties and interest payments (£8m of the £53m).

Augean continues to believe that it has a strong case and that its legal challenge will ultimately be successful. Of course, given the tripartite nature of the dispute, success in one area, but not another, cannot be ruled out. However, with a strengthened balance sheet (net cash of £22.8m at 30 June 2019) and generating cash at the rate of c £1.5–2.0m per month, Augean could, if successful in negotiating a credit facility of c £30m (c 1.2x EBITDA), pay off the liability to the HMRC, while awaiting the outcome of the tax tribunal expected next year.

The company believes that such a payment would be beneficial, as it would draw a line under the dispute, bringing to an end the rate of interest accrual on the unpaid potential liability, thus allowing Augean to reduce tax from the interest shield of the debt incurred to pay off the liability. It is also worth noting that HMRC interest is payable at the rate of 4% versus a figure of 2% for bank loans. Future cash flow could be used to pay down borrowings, recommence dividend payments, which have been suspended for the duration of the dispute, or to fund expansion (no policy yet enunciated). Augean has long argued that the UK waste management industry is undergoing a process of consolidation, leaving Augean as either predator or prey.

Augean argues that payment to HMRC would not constitute an admission of error (we understand the payment would be expensed as an exceptional item) but remains the only way of securing the benefits of the tax shield.

The recent (16 October 2019) trading update from Augean confirmed the current strength of the business. A strong Q3 led the company to state that it expected the result for the year to 31 December 2019 to be ‘materially ahead’ of consensus figures of adjusted PBT of £16.5m. The latest upgrade is in fact the third market upgrade of 2019 and follows three upgrades in 2018, highlighting the cautious nature of management guidance. Augean pointed to a 20% increase in landfill volumes and a further 20% increase in pricing (versus 2018), increased profit from the radioactive waste business and a good performance by treatment and the North Sea Services businesses as the principal factors behind the improved outlook. Our new forecasts for 2019 and beyond reflect this latest trading update.

The longer-term business outlook for Augean appears encouraging, particularly in three key areas.

Augean demonstrated strong growth in revenue and EBITDA in H119 and the recent trading update confirmed that Q3 has been similarly strong. We have significantly revised our forecasts compared to our last published estimates (March 2018) to reflect the cost reductions, disposals and corporate reorganisation that has taken place and the strength of current trading. We have also extended the timeframe of our projections to 2023. Our revenue forecasts include a base case and a slightly more optimistic scenario, with a higher win rate for ash bids.

Revenue: In H119, Augean reported a 40% increase in adjusted revenue versus H118. We expect strong growth in H219 boosted by continuing strong performance as detailed above. Under our base case, we expect revenue to increase at a CAGR of 14% for the period 2018–2023, while our high case forecasts a CAGR of 15%. We assume most of the growth will be generated by ash, soil and North Sea Services as outlined above. The main difference between the two forecasts is due to additional waste volumes (ash) and some small accretion in the margin.

EBITDA margin: We expect an EBITDA margin of 26% for FY19 and FY20, rising to 30% in 2023 under the base case and 31% under the high case.

Strong cash generation: We do not expect any further disposals in FY19 or FY20 so cash generation is likely to remain strong (c £1.5–2.0m per month) due to the improving profitability of the business, the absence of dividend payments and capex in the range of c £5–6m. We do, however, expect a cash tax payment of £3.0m in FY19 and £4.7m in FY20 (versus £0m in H119). Our forecasts do not include any landfill tax repayment to HMRC, although, as discussed, this remains a possibility.

Net cash position: At H119, Augean had a net cash position of £22.8m and given the strong cash flow that we are forecasting, we expect this to increase to c £30.0m by FY19 and c £52.7m by FY20. By 2023, we expect Augean to have accumulated a cash pile of £143.9m under the base case scenario, rising to c £152.5m in our high case. If Augean reaches a financial settlement of its dispute with the HMRC, the net cash figures would be reduced by up to a maximum of £53m.

Tax rate: We assume a tax rate of 19% for FY19, FY20 and beyond (H119: 19%).

EPS: In light of the revenue growth and stability in the operating margin and tax rate, we forecast EPS of 14.1p in FY19 and 17.6p in FY20. For the period 2018–2023, we forecast a CAGR in EPS of 27% in our base case and 29% in our high case.

DPS: We assume no dividend payments while the uncertainty surrounding the HMRC landfill tax dispute persists. In the event of an early financial settlement however, Augean possesses the financial firepower to recommence payments. For example, an FY20 DPS of 10p a share would represent a pay-out ratio of 53% of FY20 EPS.

To provide an indicative valuation guide for Augean we have considered peer multiples and PEG ratios for both the base case and the high case scenario. In the context of the valuation analysis it is important to remember that Augean continues to face the prospect of the payment of back taxes and penalties relating to the landfill tax liability to HMRC. Assuming full pay back of £53m, this is equivalent to c 51p/share.

Applying the peer group average EV/EBITDA multiples of 6.8x and 6.5x to FY19 and FY20 forecasts would indicate a valuation range of 208p to 250p (average 229p) before the impact of the HMRC repayment under the base case. Simply subtracting 51p from this total would reduce the average valuation to 178p. Applying the peer group average EV/EBITDA multiples to the high case profile increases the average valuation to 236p before the landfill tax repayment and 185p after repayment. If our forecasts are met, Augean also offers significant earnings growth potential; therefore, it is also worth considering PEG ratios. Placing Augean on a PEG ratio of 1.0x would yield a valuation of 223p (base case) and 242p (high case). By way of comparison, we calculate that the FTSE All-Share Index is trading on a multiple of just under 1.0x, while the Support Services sector is trading on a multiple of c 1.5x.

The table below shows illustrative valuations struck before and after the payment of the HMRC tax liability with most approaches showing a valuation in the broad 175–225p range. By way of illustration, at a price of 176p/share Augean would be trading on an FY20 EV/EBITDA multiple of 5.7x and 6.5x at 200p/share (in line with the peer group averages for FY2 as shown in Exhibit 4). In the event of a takeover a change of control premium might be expected, which could add 20–30% to the totals. To put this into context, a 20% premium would represent c 30p/share at current levels, equivalent to c £31.2m, or 7.8x Augean’s central costs of £4m.