Augean — Update 8 August 2016

Augean’s 21 July trading update stated the business was trading ‘in line’ with expectations. On 19 May Augean announced it had acquired Colt Holdings, a Hull-based specialist industrial cleaning provider. We look briefly at each of Augean’s five operating segments in this section, with a particular focus on the I&I unit, which will integrate Colt. We have updated our forecasts where necessary. Outside the updates made for the acquisition, the contract win and the legal settlement, we have made minimal changes to our assumptions for the underlying business as we do not believe Augean is significantly exposed to macroeconomic factors.

Augean sounded positive on this unit, citing growth “across a broad range of waste streams” and highlighted in particular a meaningful increase in air pollution control residues (APCR). We have significantly increased our APCR revenue forecast (FY16e +27% and FY17e +24%) to reflect the new contract wins announced on 20 April, in addition to the high level of underlying gate fee growth in that business. While we still forecast a 1.8% year-on-year revenue decline in FY16 due to declines in hazardous landfill, our new FY17 divisional EBITDA forecast is 8.6% above our previous estimate.

In the trading update, management guided to a continuation in the “sharp reduction in volumes from UK nuclear decommissioning”. We maintain our forecast of a 10% decline in revenues within Radioactive Waste Services to £1.7m.

According to the trading statement, I&I traded “ahead of management expectations” during the first six months of the year. The announcement mentioned enhanced profitability at its Avonmouth site and stated that the integration of the Colt acquisition is underway. As outlined above, we have worked cash flow from Colt through the I&I unit in our updated forecasts. In FY17e – the first full-year contribution from Colt – our segmental EBITDA forecast for the I&I business is materially increased from £1.18m to £2.62m post-acquisition. On a group basis, this converts to a 10% increase in FY17e EBITDA, previously £14.21m. Our updated I&I FY16 and FY17 EBITDA forecasts of £1.31m and £2.62m represent respective increases of 83% and 123%.

We do not include further cash flows from Colt meeting its sales targets (see page 5 for more discussion), nor do we include the cash outflow of £4.75m as these events are not strictly organic in nature. However, to give an idea of the potential impact of the triggering of the earn-out, Exhibit 2 shows the potential impact on Augean’s group EBITDA in a range of scenarios depending on the implied ‘EBITDA multiple’ of the earn-out payment. There are two parts to the earn-out, and both have different expiry dates. For ease however, we assume a full year EBITDA contribution for the full £4.75m and its impact on our FY17e and FY18e base EBITDA assumptions. For example, for FY18e the earn-out could add between 4.8% (at 6.0x EBITDA) and 14.4% (at 2.0x EBITDA) to our base case EBITDA forecasts.

At the trading update, Augean management blamed H116 weakness on “Below-plan availability at East Kent,” although it remains confident that an operational improvement plan, together with new contract wins, will contribute to a recovery in the second half. We do not make any changes in this division to our previous estimates.

The decline in the oil price has clearly been a major driver behind the weaker half-on-half performance in Augean North Sea Services (ANSS). We maintain our 19% year-on-year revenue decline in our FY16 forecast, but note that management has made excellent headway in offsetting the impact of declining oil and gas spend. In the trading update, Augean highlighted “A number of significant contract wins in the first half”, which it argued was “In line with the ANSS strategy of reducing its dependency on exploration drilling.”

On 19 May Augean announced it had acquired Colt Holdings, a Hull-based specialist industrial cleaning provider. The £9.2m paid by Augean for Colt implied a trailing (FY15) EV/EBITDA multiple of 6.6x. We believe Colt offers significant optionality via two means: the earn-out offered to management; and the potential for revenue synergies from Colt’s existing customer base.

Colt’s management is heavily incentivised to hit targets for securing new contracts over the coming years. If met, these targets would trigger a further total payment from Augean of £4.75m. It is our belief that these payments would imply a lower EV/EBITDA than Augean paid for Colt in the first place. In other words, if the earn-out targets are met, Augean will unlock even more shareholder value than in the first stage of the transaction; it will receive more EBITDA in return for each pound of initial outlay.

Of potentially more value to Augean shareholders, especially in the long term, is the number and quality of client relationships Colt brings to Augean. There is very little overlap between Augean’s and Colt’s existing customer base and each of the companies has a different geographical focus. The potential to cross-sell Augean’s existing client offering to Colt’s customers is a significant opportunity for management to drive enhanced shareholder returns. We do not include any upside to account for this for now as it is very difficult to quantify. However, we would expect management to begin to offer some insight into this potential at the interim results on 20 September.

Colt is a particularly attractive addition to Augean’s business portfolio as it not only brings a complementary skill set – namely specialist on-site cleaning services – but it also has a quality client franchise with little overlap with Augean’s existing customer base. As we explain below, while the Colt acquisition immediately enhances our earnings projections and fair value, the real benefit is the future revenue synergies for Augean from Colt’s complementary customer relationships.

The £1.45m additional FY17e EBITDA provided by Colt, together with the incremental £0.89m FY17e EBITDA from new contract wins in E&C and the other net changes, translate into a 16% increase in our FY17 EBITDA forecast to £16.5m, still well below Bloomberg consensus. The £9.2m cost for the Colt acquisition translates into a higher FY17e net debt figure. That said, our net interest charge estimates for FY16 and FY17 increase by 55% and 87%, respectively, as a function of the increased debt burden. We should stress, however, that Augean remains very conservatively geared and that given the enhanced cash flow from Colt and new contract wins, we forecast net debt/EBITDA to drop from 0.94x in FY16e to 0.25x in FY18e.

The forecast changes include:

Our forecast changes do not include the following in relation to the Colt acquisition:

Even with some headwinds on the operational side – for instance in ANSS – Augean has remained highly profitable in comparison to international peers as a function of its specialist waste management capabilities. Its high level of cash flow generation means it will continue to have the ‘high quality problem’ of a surplus of capital and will have to decide whether to deploy capital either in enhanced shareholder returns, such as increased dividends or a buy-back, or look for other bolt-on acquisitions. We remain confident in Augean’s capital discipline and ability to make the right decision for long-term shareholder value.

We have increased our fair value (FV) range for Augean from 49-77p to 60-90p to reflect the improved earnings profile. As well as updating our earnings forecasts, we have lowered the terminal growth rate to 1% from 2%. Our DCF-based fair value of 88p/share is derived using a post-tax WACC of 8.5% (2% risk-free rate, 0.8x beta, 5.5% debt risk premium, 8.5% equity risk premium, 10% debt weighting) and forms the basis of one part of our valuation methodology.

We explicitly model cash flow for three years and then take a terminal value. Below we also include our conversion of group NPV to equity value per share.

We also use an Economic Value Added (EVA) model as part of our valuation methodology. Our FY16e EVA implied FV is 60p/share. This is based on an FY16e ROCE of 9.3% and a WACC over the same period of 8.9% (the EVA WACC is different from our DCF WACC as it calculates the cost of debt directly from the income statement, so is slightly higher). We note that, even when taking into account the increased capital employed during the Colt acquisition, our FV for Augean continues to rise in the coming years, based on our profit assumptions. The fact that the ROCE/WACC multiple continues to rise in FY17e and FY18e, with the addition of Colt, confirms our views on management’s capital discipline and this is before revenue and cost synergies. Finally, we note that our EVA analysis does not produce such a high FV as our DCF. This shows the usefulness of the EVA analysis, as it takes forward-looking capital employed into account explicitly. It is our EVA analysis that provides the lower end of our valuation range. However, even the lower end of our valuation range still offers 33% upside.

In comparison to its listed peers, Augean trades at 47% and 69% discounts to one-year forward EV/EBITDA and P/E multiples, respectively due to the following factors:

While we acknowledge that there are very real limitations on the stock, both technical (eg the low free float), and fundamental, we believe that if management can continue delivering and exceeding market expectations, Augean’s profits should drive a substantially higher equity value.

Even before management delivers on its integration plan for Colt, we see significant upside on a P/E basis – the third component of our valuation range. If we exclude Clean Harbors from Augean’s peer comparison table (as an outlier), we see a global +2y P/E of 15x. If we placed Augean on 15x its FY16/17e average earnings, we would reach an FV of 90p/share. This, therefore, constitutes the high end of our FV range of 60p-90p.