Park Group — Continued growth in earnings and cash

Park Group continued to grow billings, profits and cash during the year that ended 31 March 2018. Although billings growth was modest, with the previously flagged delayed start to a significant contract within the corporate business, profit growth was supported by higher margins, primarily reflecting business mix changes, including the on-going trend towards pre-paid cards. As we discuss later in this report, Park continues to enhance its product capabilities and recently introduced initiatives continue to gain traction. We list the highlights below:

As noted above, although billings growth was held back in the corporate business by the delayed start to a significant contract, the mix of billings had a positive impact on margin. The shift towards cards within billings, including Park-issued MasterCard products, is a continuing trend that has provided structural support to margins. Less easy to predict over shorter periods is the growth in hampers and gifts (a small part of the total but higher margin) and the decline in lower margin third-party vouchers.

Looking at performance by operating segments, both the consumer and corporate businesses increased operating profits, while in the other segment (group costs, eliminations) the loss reduced.

In the consumer division, billings growth reflected an increase in customer numbers to 436k from 431k and a 2.6% increase in average customer order value to £521. Billings of Park-issued MasterCard products, rebranded as the Your Choice card (previously Anywhere) doubled to £20.7m. Customer interaction via the internet and mobile devices continued to increase and downloads of the Park savings app continue to grow, reaching more than 170,000. In what has been a difficult consumer environment in recent months, Park says that year-to-date orders are running at a similar level to last year. It has plans to focus on seeking to reduce order attrition (orders placed but not funded and fulfilled) during the year, and we have assumed modest billing growth in FY19 as a result.

The corporate business saw operating profit increase despite flat billings. Park is seeing increased traction in the value loaded onto flexecash products, and continuing customer uptake of the Evolve platform and Love2shop Worldwide. The number of corporate clients using the Evolve platform in the UK had reached 269 by end FY18, compared with 165 a year earlier and 249 at the time of the interim report in November 2017. Love2shop Worldwide, launched in May 2017, now has 48 international organisations using the platform, up from 31 in November.

After many years of stability, a period of significant transformation and development for the group, during the past year the senior management team at Park has been through a process of transition. Ian O’Doherty became CEO and joined the board on 1 February 2018, replacing Chris Houghton, who retired from the group after more than 30 years of service, and who had held the position of CEO since 2012. He has a strong background in financial services, specifically in banking, payments and card services, which appears well suited to leading the continued development of the business. He spent 28 years at MBNA, most recently as chairman and CEO of MBNA in the UK, between 2008 and 2017. During this time he oversaw the re-engineering of MBNA’s digital capabilities and reorganised the business, leading it through the financial crisis and subsequent sale (for £1.9bn) to Lloyds Banking Group in 2017.

In August, Tim Clancy will join the company and the board as CFO, replacing Martin Stewart who announced last December his intention to leave the group after 13 years in his position. Martin Stewart will remain with Park until an orderly handover can be completed. Tim Clancy joins Park from Assurant Europe, the European subsidiary of Assurant, the US-listed global insurance provider, where he has held the role of chief financial officer since 2013. That role has included overseeing a number of acquisitions in the UK and Europe and their integration into the group. He has previously been finance director of the Airtours division of MyTravel, and managing director of high street retailer, Going Places.

Gary Woods, managing director of Park Retail, who joined the group in 1980 through the acquisition of Chrisco Hampers, also stepped down from the board in March 2018. As he approaches retirement he is assisting with the orderly handover of his operational duties to Julian Coghlan who joined Park in August 2017, having previously been executive director of Adare SEC, a provider of secure communication technology.

We would expect the new management team to continue to build on the range of existing product and distribution growth initiatives that Park has put in place, but given the scale of the changes we also think it is reasonable to anticipate it will bring some new ideas and changes in emphasis. The handover to the new management team should be complete by September and we anticipate the company will provide a briefing to investors at around that time regarding its strategic objectives. We would also expect some additional guidance on the effects of IFRS 15 implementation in the coming months, as discussed in the following section.

IFRS 15 became effective from 1 January 2018 and will be the basis of which Park will report for the current FY19 financial year. Under IFRS 15 the accounting treatment for prepaid cards and vouchers, currently very different, converges and will have a noticeable impact on reported revenues, a relatively small impact on reported profit, but no impact on cash flow.

Currently, voucher revenue is recorded when the vouchers have been despatched to the customer, generating revenues that equal the amount paid by the customer for the voucher (typically the face value) and a gross profit margin that represents the service fees receivable from the retailers/redemption partners at the same time; a provision is made for the redemption liability arising. For cards, the revenue recognised is generally much lower, representing only the fees charged to cardholders and service fees receivable from retailers/redemption partners. There is also a timing difference, with card revenues and profits recognised later than similar voucher-based customer transactions. Where the cardholder has the right of redemption, revenue is recognised when amounts are deducted from values held on cards, ie when cards are redeemed at retailers/redemption partners or when charges are levied.

In short, card ‘sales’ to customers generate much lower reported revenues than vouchers, but are recorded as 100% gross profit margin, while profit recognition may be delayed. To provide greater clarity, the group reports the (non-statutory accounting) measure of billings. It represents the face value of voucher sales and the amount of value loaded onto prepaid cards, net of any discounts given to customers, and as such provides a consistent measure of customer sales activity in any period. The effect can be seen in the 2.0% growth in FY18 billings compared with a decline of 4.9% in accounting revenues.

Exhibit 4 shows how £100 of billings generates very different accounting revenues depending on whether it is a voucher or prepaid card, although assuming all card balances are spent in the same accounting period as the voucher sale, the gross profit contribution is the same. However, in reality, it is unlikely that all card balances will be spent in the same accounting period, deferring gross profit (and a similar amount of revenue). As card balances grow, so too does the deferral. Accumulated, unspent customer card balances are held on balance sheet within the segregated e-Money Trust, a regulatory requirement. The balance as at end-FY18 was £25.9m, representing around £2.5m of deferred gross profit (and revenue) that will be reported in future accounting periods.

IFRS 15 moves the accounting treatment for Park’s own prepaid vouchers (c 50% of billings) to the same basis as cards, although the treatment of third-party vouchers, hampers and gifts will remain the same. The impacts are mitigated by the fact that a high proportion of the vouchers sold/billed in any year, particularly when Christmas related, are in fact redeemed in that same year, triggering an IFRS 15 revenue recognition. We have not yet incorporated these changes into our forecasts. In broad terms, the impacts on the reported numbers are likely to be:

The published results for the year to 31 March 2018 (FY18) turned out slightly higher than our revised forecasts, published after the trading update released on 26 April 2018. The 2% beat on EPS was substantially due to a lower fully diluted share count than we had allowed for. Our revised forecasts for FY19 are little changed, with EPS similarly benefitting from a slightly lower diluted share count than previously assumed. We also introduce a FY20 forecast for the first time.

Our FY19 billings forecast is based on just over 1% growth in consumer and a little over 10% in corporate. In consumer, we assume that the current order book position, at a similar level to last year, translates into modest billings growth for the year as a result of management efforts to reduce intra-year order attrition. In corporate we look for the commencement of the delayed large order to support what we would consider to be 5-10% underlying growth. For FY20, we forecast c 6% consumer billings growth (3% from average order growth and 3% from customer growth) and a similar rate of growth in corporate.

Our forecast gross margin (as a percentage of billings) is stable in FY19 (at 7.7%) and increases to 7.8% in FY20 as a result of the continuing positive mix shift. Operating margin is forecast to be stable at 2.9% in both years. We expect net finance income to resume growth in FY19 following the growth in average cash balances that should result from our forecast increase in order books, with only a very modest c 0.1% improvement is average deposit margin in the current year.

Following the pre-results trading update, we reduced our fair value estimation by a little under 5% to 84p, in line with earnings forecast change that we made at the time. We are now increasing our fair value to 87p.

Our approach to valuation is to consider both a potential absolute value based on a modified DCF analysis as well as a relative value based on a comparison with a selected group of listed stocks. Our fair value of 87p represents the average of the two.

Our modified DCF valuation increases to 90p with no change in the fundamental assumptions other than to push back our expectation for higher interest rates. It is modified in the sense that we include the interest earned by Park on segregated customer cash balances (but not on the group cash balance), as this is an integral part of the returns generated by Park. The customer cash itself is excluded from the overall valuation and the voucher provisions balance as this will eventually flow out in settlement of vouchers that have been issued and accounted for in earnings but not yet redeemed. Our forecast period runs to 31 March 2020; beyond this we grow free cash flow at 5% per year until year 10, enhanced by an assumed normalisation of interest rates. For interest rates we assume an increase to 1.5% for FY21 and to 3% for FY22 and beyond. The terminal cash flow is valued at 10x, and we use a discount rate of 10%. The terminal value represents 46% of the total 90p value. A 1% increase in the assumed discount rate, a reduction in the terminal multiple to 9.0x, or a 1% reduction in the long-term growth rate reduces the value by c 6%, 5% or 4% respectively. We note that the current share price could be said to be assuming a long-term growth in free cash flow of just more than 3% a year.

Competitor employee benefits and service providers to Park are either private companies or relatively small parts of larger groups, complicating any attempt at a relative valuation approach. Sodexo and Edenred are both much larger and more international than Park, and the overlap with Sodexo is limited; Sodexo Benefits and Rewards Services is a minor part of Sodexo Group. Because within Park’s traditional Christmas prepayments business (c 50% of Park) there has historically had some socioeconomic overlap of customer bases, and a similar use of agency distribution, with that of the home collected credit operators, we also show valuation data for the non-standard finance providers, for which this continues to be the case to varying degrees. We would expect a premium rating for Park as it does not have similar credit risk and we believe it has less regulatory risk.

Both groups, the incentive group and the non-standard finance group, have de-rated a little over the past few months and while we continue to feel that a fair value for Park is at a premium to the non-standard finance companies and a discount to the larger incentive-related peers, our judgement is that a multiple of c 14x FY19 earnings is appropriate, whereas we previously used 15x. A 14x multiple is similar to the rating on the FTSE All Share Index as a whole, and implies a fair value of 83p per share.