Renewi — A circular economy champion

Renewi is holding a capital markets event on 4 October. At the FY23 full year results management set out a target to grow the top line by 50% by FY28, as highlighted in Exhibit 1. Along with a target for ‘high single-digit EBIT margin’ against the FY23 margin of 7.0%, this would suggest at least a similar uplift to operating profit. We expect the event to focus on these growth plans and the underlying dynamics driving these opportunities.

Management’s last set of medium-term initiatives was announced in 2020 with a goal of generating an additional €60m of EBIT, €20m per initiative, through three discrete avenues:

This report looks at Renewi’s recent performance and delivery of these initiatives along with the underlying market dynamics for the group, which we expect to be further developed in the capital markets event.

The broader sustainability agenda has arguably been focused on climate change and carbon- related emissions, but there is increasing realisation of the wider issues of the natural world and human consumption. This is perhaps best highlighted by ‘Earth Overshoot Day’, the date when all the biological resources that the Earth (nature) can renew during an entire year has been used up. In 2022 this was 28 July, see Exhibit 2, or to put it another way, we are using up 75% more resources in a year than the natural world can sustain. Overshoot Day for Belgium was 26 March, the Netherlands 12 April and the UK 19 May.

This has led to calls to reduce the consumption of nature’s resources, a key driver to the solution being seen as a move to a more circular economy employing strategies such as:

In practical terms, many of these strategies involve the ‘hierarchy of waste’ as highlighted in Exhibit 3, moving away from disposal, primarily landfill or incineration, to various forms of repurposing or recycling.

National governments are increasingly layering legislation to drive the agenda while corporations are also increasingly taking up the challenge.

Europe and national targets

The EU adopted a circular economy action plan in 2020 as part of its Green Deal agenda set around a target of climate neutrality by 2050 and to halt biodiversity loss. In 2022 it set out an ambition to decouple economic growth from the extraction of non-renewable resources. The overall goal includes a reduction of the material footprint by 50% by 2030, to be achieved through a range of prescribed targets:

This overarching European programme framework is translated to national targets and legislation. Key for Renewi are:

It is worth noting that Belgium and the Netherlands are already leaders in waste management and recycling in Europe. This not only ensures a more positive backdrop for Renewi but enables the company to develop processes that may be transferable to other regions.

Corporate agenda

Companies are looking to improve their sustainability credentials for numerous reasons, including marketing purposes as consumers become ever more environmentally conscious. This is leading many companies to set targets for use of recycled materials, which in turn is progressing the market for recyclates. For instance:

Renewi’s position

Renewi refers to itself as a ‘waste-to-product company’ as it looks to align its strategy with the advancing circular economy. Management has set a target to achieve a recycling rate of 75% (FY23: 63.6%). Note, this target has been retained despite a redefining of the calculation which reduced the reported recycling rate by c 6%, see Exhibit 7. This commitment is given further emphasis in management’s latest long-term incentive plan, which contains targets for recycling with a 25% overall weighting.

Management has made good progress in improving the performance of the group in recent years. FY20 and FY21 demonstrated the resilience of the business through COVID-19 while the exceptional rebound in FY22 was helped by particularly strong recyclate prices, which eased in FY23. Taking these volatilities into account, Exhibits 8 and 9 demonstrate the underlying progress achieved.

A key strand to improving the group’s performance came in 2020 when management set out three strategic initiatives to increase EBIT by €60m (€20m per initiative).

Renewi 2.0 is a three-year programme to bring about simplification of the group structure, increase customer focus, improve efficiency and raise employee satisfaction. In particular, this involved:

The programme is now largely complete at a cost of €28m, significantly below the original €40m budget, with the full €20m benefits being achieved (FY23 benefits estimated at €17.8m). Given the progress made, we believe there could be further upside potential, particularly from the digitisation transformation.

Management announced a range of new investment projects in 2020 with the aim of achieving c €20m of additional EBIT from an investment of over €100m.

The key investment has been in advanced recycling in Flanders, by far the most significant project at a cost of c €60m. Belgium is a federal state split into three regions: Flanders, Wallonia and Brussels. OVAM is the Public Waste Agency of Flanders, responsible for the preparation and implement of policies on sustainable material management. Companies are required to report their waste, which is then monitored by OVAM. In January 2023 additional legislation, Vlarema 8, came into force. This requires companies to increase the level of waste sorting and recycling, with up to 24 different waste streams required to be identified. Waste that is not sorted in line with the new legislation is subject to a €50 a tonne charge.

As the largest industrial waste company in Flanders, with around a third of the market and therefore having strong links to customers, Renewi is well positioned to benefit from this legislation. The company is building three advanced lines at Ghent, Puurs and Limberg in Flanders, with the Ghent facility now fully operational. These facilities will have a capacity of c 400kt, capable of generating c 130kt of recyclates and promoting residual recycling rates from 18.8% to 56.9%.

Income will come from three sources: additional gate fees, expected to reflect the cost of the alternative charges under the new legislation; sales of recyclates generated; and reduced incineration fees from the reduced waste. The first commercial benefits of this investment should be seen in FY24.

ATM is based at the Moerdijk port and industrial complex in the Netherlands and provides contamination processing services to commercial customers. Materials treated include soil, tar asphalt granulate (TAG), wastewater and oily sludge, as well as disposal of hazardous waste including chemical waste.

Soil and TAG are treated in a thermal remediation facility to burn off and collect/filter contaminates to produce ‘neutralised’ thermally treated soil (TGG), which can then be reused. In 2018 concerns were raised over the quality of remediated soil by IL&T, an independent Dutch regulator, leading to the Dutch government halting the use of TGG. This moratorium inevitably pushed the business into loss.

In response a recovery strategy was developed based primarily on additional processing of the treated soil into secondary materials for the construction industry. These are sand (55%), gravel (30%) and filler (15%) to be used in the production of cement, concrete and asphalt. The investment was planned to increase capacity to over 1.5Mtpa. In addition, the plan included disposing of the 1.5Mt legacy stocks of TGG, requiring legal authorisation per individual use.

A combination of COVID-19 and additional legislation, both on the existing stockpile of TGG and in gaining certification for the upgraded new products, has delayed the project with full recovery now expected in FY26. According to the latest update:

There have inevitably been shifts in the three programmes, which have also been affected by COVID-19 and changing regulations. These have delayed the full benefit until FY26 although management guidance remains for an additional €60m of EBIT. Our view is that the ATM recovery is likely to prove the most challenging timeframe, but that Renewi 2.0 offers additional potential that could offset this. Exhibit 13 sets out our forecast financial impact, which would provide for 28% benefit to FY23 underlying operating profit by FY26. These numbers are incorporated in our forecasts, albeit we anticipate lower recyclate prices and softer economic conditions in key markets to weigh on progress in the current financial year.

The group is exposed to the normal economic cycle including activity levels, energy pricing and wage inflation, particularly in the key Netherlands and Belgium territories. We see two significant company-specific issues that investors should consider: recyclate pricing and the UK municipal waste contracts.

The group treats 11Mt of waste generating 7Mt of recyclates. The majority is exposed to stable pricing (eg minerals, glass and treated water), but around 1Mt is exposed to metals, paper, wood and plastics where pricing is more dynamic. The company uses pass through pricing for c 65% of these more volatile commodities to reduce the impact. However, the remainder is unhedged and therefore exposed to such variances. Assuming 350kt and an average recyclate price of €150 a tonne suggests over €50m of exposure. This may not seem overly significant for a group with revenues of more than €1.8bn but the lack of any offset means that the fluctuations flow straight through to the P&L. While there are many other moving parts, Exhibit 14 highlights at the very least the direction in movement between the recyclate (outbound) revenue and operating profit for the key Commercial Division.

Renewi has a portfolio of long-term contracts to operate waste treatment facilities for UK councils, as highlighted in Exhibit 15.

The performance of the private finance initiative (PFI) contracts has been disappointing, requiring significant increases in provisioning and continued cash spend. Note that changes to IFRS accounting for long-term contracts increased the provisions by €53.2m in April 2022.

There are reasons for optimism with two of the contracts due to expire in the medium term: Argyll & Bute in September 2026 and East London Waste Authority in December 2027. We also note that the timing of provisions from the accounts, as shown in Exhibit 17, suggest a more modest financial cost from the medium term. There also remains the potential to renegotiate individual contracts. The UK government is targeting 65% recycling of municipal waste by 2035, up from 44.6% in 2021, which, depending on legislation, may provide a catalyst.

Our valuation uses an underlying discounted cash flow (DCF), a quoted peer group comparison and a read-across from recent corporate activity.

Exhibit 18 provides a DCF valuation relative to the weighted cost of capital (WACC) and longer-term growth rates, two key variables. To provide a conservative approach, the valuation includes the provisions for the UK municipals and site restoration and aftercare as well as all finance leases. It excludes the UK PFI debt, which is non-recourse to Renewi (currently €69m or 75p a share). Our cash flow forecasts include €10m of ongoing exceptional spend a year for potential restructuring programmes, additional pension contributions (currently €3m a year), etc. Note this is a change in methodology from our previous valuation where provisions were assumed within the annual cash flows. Given the limited guidance from management as to the timing etc, we see using the balance sheet figures as a more conservative approach, albeit it has reduced our valuation from 926p.

Our current calculation for the group’s WACC is 9.5%. Assuming a conservative terminal growth rate of 2%, this suggests a valuation of 825p a share.

The following is based on European peer group valuations, reflecting both the locus of Renewi’s earnings and the lack of UK-listed comparable companies.

Our valuation includes the provisions for the UK municipals and site restoration and aftercare as well as all finance leases and excludes PFI debt, in line with our DCF calculation. The pension has been included as €30m of debt. This is higher than the €9.3m balance sheet figure but arguably more representative of the annual €3m cash payments agreed with the trustees. Renewi forecasts have been calendarised.

Note there is a clear discrepancy between the EV/EBIT and EV/EBITDA valuations averaging 661p and the P/E based valuation averaging 1,064p. This largely reflects the provisions on the balance sheet, which are excluded from underlying earnings but account for 330p a share. Adjusting for these provides an overall average valuation of 724p a share.

There has been significant corporate activity in the waste and recycling sector in recent years with particular interest from private equity.

Our implied valuation uses the same assumptions and methodology as for the above peer valuation. To provide an undisturbed share price we have assumed a take-out premium of 35%, in line with the recent deals in the UK market: Augean (50%), Filta (30%) and Biffa (28%).

Exhibit 23 provides a summary of our valuation from the three methodologies. We note the high valuation from the corporate activity, even taking into account a premium for control, highlighting the potential. However, our preferred on-market valuation is an average of the DCF and listed peer ratings, providing a figure of 726p a share.