Appreciate Group — Resilient H1 and well placed for recovery

Appreciate’s business is highly seasonal with most billings (typically more than 80%) generated in the second half of the year, which includes the Christmas trading period. This is true of both the Corporate and Consumer businesses although it is higher in Consumer, which is dominated by the Christmas savings business. With costs spread more evenly across the year, H1 is typically loss making with all profits generated in the second half of the year. We expect a similar trend in the current year, although with the significant effect of the pandemic lockdown and gradual ongoing recovery accelerating the trend in the current year.

Billings fell sharply as the lockdown was introduced but have been recovering month by month. Importantly, this positive trend continued into H221 and at the time of reporting interims the seasonally important Q3 trading period, through November, continued to reflect this trend, with no material effect from the second lockdown at that time.

It is worth noting that Exhibit 3 refers only to billings through the corporate business and highstreetvouchers.com (HSV) and specifically does not include the Christmas savings business. Christmas savings is not included to provide a better indication of underlying trading. Christmas savings billings are driven by Christmas order despatches, primarily in the second half of the year, from an order book built primarily in the first half of the year. Positively, the Christmas 2020 order book has ended up c 8% lower year on year compared with earlier indications of c 10%.

The strategic business plan aims to build a more robust and scalable business model, capable of capitalising on growth opportunities in the large and fragmented market in which the group operates, which should position the group well for post-pandemic recovery. Although ongoing, the progress made in FY20 in the strategic business plan, enhancing operating systems and process and putting a greater focus on digital products and services were a positive support in H121, mitigating the effect of the pandemic. Decisive action was taken to adapt to the new environment, with a further acceleration in digitalisation, in step with market developments, leaving the group in a better position to capitalise on market recovery and exploit growth opportunities. The group has also taken steps to increase its focus on the core offering of own branded multi-retailer product, putting in place plans to exit the hamper production and contract packaging and is in discussions for the sale of the brand engagement subsidiary FMI. The next stage of the new enterprise resource planning system is on track for implementation in summer 2021.

With the pandemic lockdown measures introduce at the start of the current financial year, performance in the six months to 30 September 2020 (H121) was relatively resilient, and ahead of management’s mid-range scenario for the effect of COVID-19 as detailed in the FY20 annual report.

The key drivers of the H121 financial results were:

Looking more closely at the trends by business division and product, we note the following:

The positive trend in billings in recent months combined with the accelerated shift away towards higher-margin own branded multi-retailer product, particularly digital and card product, and away from vouchers led us to increase our FY21 forecasts. For FY22 we had already assumed a material rebound and have increased our billings forecast slightly, although our PBT estimate is not materially changed. We have also introduced a tentative FY23 forecast for the first time.

Our forecast uplift for billings is driven by the Corporate business, while for the Consumer business we have taken a more cautious approach in respect of the headwind from the agency distribution channel.

For FY21 the billings forecast uplift feeds through into higher adjusted PBT, although for FY22 we have taken a slightly more cautious view on gross margin development despite the continuing positive shifts in product mix.

Our DPS forecast for FY21 is increased to 1.2p per share (was 1.0p) and we continue to expect further growth in FY22 and FY23, well covered by earnings.

Our analysis continues to identify significant value in Appreciate Group shares based on the return to more normal trading conditions reflected in our near-term forecasts and longer-term growth, enhanced by the strategic refocusing on card and digital products, the drivers of industry growth. We estimate a fair value of c 60p and the shares are trading at a c 50% discount to this value. We believe this discount reflects the uncertainty created by the pandemic in respect of near-term earnings and dividends as well as the distorting, negative effect of the shift from paper vouchers to digital/card product.

As discussed in detail in our outlook note, we believe this is primarily a one-off, temporary adjustment to cash flow, which masks the long-term recurring cash flow potential of the business and is any case ‘stripped out’ of our valuation analysis. The continuing strong growth in the share of card/digital products and the relative decline in own voucher products, both as a share of the total and in absolute terms, is positive for profitability and to be welcomed. However, in the near term it has the effect of reducing operational cash flow. This is not because card/digital products consume cash to any significant extent; rather it is because the lower-margin voucher products are cash generative so long as sales are rising and cash negative when sales are falling.

Given the lack of satisfactory direct valuation comparisons (see below), we continue to focus on an ‘absolute’ valuation determined by our modified discounted cashflow methodology, cross-referenced to a ‘relative value’ based on a comparison with a selected group of listed stocks that are engaged in activities providing at least some overlap with the group. There are no direct comparators for the Christmas savers business and competitor employee benefits and service providers are either private companies or relatively small parts of larger groups, complicating any attempt at a relative valuation approach. In incentive and rewards products, Sodexo and Edenred are both much larger and more international and the overlap between Appreciate and Sodexo is limited (Sodexo Benefits and Rewards Services is only a minor part of Sodexo Group). We nevertheless include these in our quoted comparator group along with a selection of prepaid card and payments service providers (Euronet Worldwide, Fleetcor Technologies, Green Dot Corp and EML Payments).

Our DCF value is unchanged at 60p with the effect of higher near-term earnings offset by an increased long-term capex assumption. This DCF valuation implies a CY20 P/E multiple of 22x adjusted EPS and a CY21 P/E multiple of 21x. Although relatively high as a result of near-term earnings pressures, we believe these multiples are reasonable in the context of the comparator stocks, despite the relatively low market capitalisation and implied lower liquidity. Based on our FY23 forecast, the CY22 implied P/E is 15.6x.

Our modified DCF valuation differs from a standard DCF in that we include the interest earned on segregated customer cash balances (but not on the group cash balances), recognising this is an integral part of the returns the company generates. The customer cash is excluded from the overall valuation and we also exclude the voucher provisions balance, as this will eventually flow out in settlement of vouchers that have been issued but not yet redeemed. Our key assumptions have been held constant for an extended period, including an assumed 10% discount rate and 10x terminal multiple. Beyond the forecast period (now extended to FY23 from FY22) we use a two-stage growth assumption to allow for the potential medium-term benefits of the strategic business plan investment. For the first two years (previously three) beyond the forecast period (years four and five) we assume 10% growth in underlying free cash flows, followed by a reversion to a long-term growth rate of 5% up until year 10. We continue to assume an eventual ‘normalisation’ in interest rates and assume a stepped increase in market deposit rates to 1.5% in FY24 (was FY23) and 3% from FY25 (was FY24) and, as noted above, we deduct upfront from the DCF valuation the amount of voucher provisions (£30.2m at end-FY20) on the basis that the matching cash is only temporarily available to the group, albeit on a revolving basis. As a result, the expected further decline in the voucher provision balance, and the negative impact on near-term operating cash flow, has no effect on our DCF valuation.