WYG — Focusing on earnings recovery and cash

Having lowered expectations during FY18, actual group profitability matched revised guidance set in November. That said, Consultancy Services had a better H2 than we had anticipated, offsetting International Development weakness. While underlying free cash flow was positive, outflows relating to separately disclosed items led to increased year-end net debt, after a good H2 working capital performance. FY19 guidance has been maintained and management has a clearly stated focus on improving margins and cash generation.

This division is involved in the development, creation and management of assets (ranging from infrastructure to property) in relatively advanced European economies and across public and private sector clients.

The increase seen in the interim order book – after a disappointing H1 trading period – proved to be a good indicator of improved activity levels and profitability in H2. WYG also took steps to remedy underperforming areas, including re-building planning staff capacity and announcing the closure of North Associates in Cumbria. (The latter business contributed a £0.7m trading loss to FY18 results and reduced local business prospects have led to the decision to exit this location.) On the whole, the UK market sector environment was considered to be good. The traditional areas of residential housing, energy, infrastructure and UK government defence work all appear to have generated good workflows and remain the primary driver of divisional profitability. Outside of the UK, withdrawal from unprofitable socioeconomic business lines led to a downsizing of the Polish office but we estimate that the prior year loss more than halved in FY18 and H2 trading approached a break-even position. Poland now focuses on higher-margin business lines including transport and infrastructure. Smaller offices in Bulgaria and Romania have also now been closed (although their trading licences are retained). Elsewhere, as in the prior year, WYG’s Russian JV made a small profit contribution in FY18.

Following management restructuring, this division now reports directly to CEO Douglas McCormick in five sectors (each with an MD and FD), as follows:

Simplifying this move, it essentially splits out Environment (from Planning) and distinguishes between the development of new assets and management of existing ones compared to the previous three-sector approach. Although we have discussed country performance above, this is a service-based structure in which some of the skills are deployed with UK customers (eg UK government) on overseas projects. It should also be noted that WYG is a multi-disciplinary service provider that provides a broader entry point for project involvement and potentially greater value as a result. A new group business development appointment aims to increase the identification and generation of these opportunities.

Consultancy Services’ order book was £96.1m, up c 7% y-o-y, at the year end, sustaining the improvement seen since September 2016 and in line with the September 2017 level, despite the increased revenue run rate in H2. The c £6m y-o-y growth was all in the ‘beyond current year’ category with the current year delivery component stable y-o-y at c £48m.

This division supports long-term projects in less-developed countries or regions or fragile and conflict-affected states regarding complex governance, institutional and societal issues.

Delays in migrating from the first Instrument for Pre Accession funding mechanism (or IPA I) to IPA II caused a temporary lull in project awards during the year. After a busy end to FY17 – including some high-margin work that provided a tough comparator – work in Turkey was particularly affected. Having been a strong profit contributor in recent years, we believe that H2 trading was probably break even at best in H2 and explained most of the y-o-y EBIT reduction shown in Exhibit 1. It is difficult to verify but we feel the local political landscape may have partly influenced this outturn. A positive impact of this trading pattern was the favourable working capital swing and collection of a significant receivables amount. The results announcement listed a number of new Turkish projects – for both public and private sector clients – and we understand that four new IPA II wins with a total value of €7m have been secured, so the awarding hiatus appears to have passed. WYG’s Western Balkans workflow appeared to be relatively solid after a slower start to the year, while in Africa – especially in areas such as climate change and migration – it is building further with new programmes. New overseas aid streams from UK government are also helping to diversify the funding sources and countries served beyond these traditionally strong areas for WYG. In a noteworthy development, WYG established a Netherlands holding company for activities in this division, designed to maintain the company’s status with EU funding agencies in a post-Brexit environment. (This supersedes previous management’s stance of local operating companies being sufficient to meet this aim.)

Consistent with the slow start/stronger finish business development scenario outlined above, the divisional order book showed a c 27% increase to £70.3m at the year-end (just slightly below the c £74m cited at the interim stage). We note that the order book showed good increases in both the current year portion (FY19 delivery, +13% at £34m) and beyond (+44% to £36m).

Year-end net debt of £6.3m (or 1.25x FY18 EBITDA) was up £3.8m y-o-y, and in line with interim guidance, owing to reduced EBIT and further non-trading cash flow items (defined below). Improved second-half profitability and a favourable working capital swing meant a lower year-end net debt position than seen at the interim stage (£10.1m).

We have already discussed the divisional and group profit performances; EBITDA for the year of £5m was just under half of the FY17 level, including modest y-o-y reductions in depreciation and amortisation of internally-generated intangibles. As previously flagged (and reported on 2 January), an H1 build-up of working capital relating to projects in Turkey unwound during H2; this included a c €14m work-in-progress inflow, broadly half of which was offset by associated payments to sub-contracted partners part funded by advances received. For the year as a whole, there was a c £1.5m underlying working capital inflow, giving group operating cash flow on the same basis for FY18 of c £6.5m. Cash net interest and tax (paid on overseas profits only due to UK tax losses) were both below the prior year. In contrast, group capex rose to £2.7m and included the fit out of new offices in London and Ankara, raising the company’s presence in these two important markets. After all of these items, WYG’s underlying free cash flow (FCF) for FY18 was a c £3m inflow.

A small amount of deferred consideration and normalised cash dividends (after adjusting the payment schedule in the prior year) totalled £1.5m. We split WYG’s non-underlying cash movements into legacy and in-year items. As seen in prior years, provisions established at the end of the last downcycle relating to exited office space and project claims have been steadily used up since. In FY18, c £1m related to vacant property and c £1.5m to professional indemnity insurance (PII) payouts. We believe this virtually extinguishes those original long-standing provisions. There were a further c £2.5–3m cash costs relating to in-year separately disclosed items, including the closure of North Associates and implementation of the strategic growth plan (including management restructuring).

Cash outlook: we anticipate a gradual rebuild of profitability and underlying FCF, which is effectively absorbed by unchanged dividend payments in FY19. This is struck after c £3m capex on the business (or c 1.7x depreciation and amortisation of internally generated intangibles) to reflect ongoing efficiency improvement initiatives across the office network. Based on guidance, we have factored in c £2.5m further non-trading cash costs to cover portfolio re-shaping activity and new PII provisions disclosed at the interim stage. Overall, these features lead to our expectation that net debt will rise by c £2-3m in FY19 before starting to trend down towards £6m (or c 0.8x EBITDA) by FY21.

The business streams in WYG’s larger ongoing UK segments appear to have healthy workflows; in this context we expect the company to be able to win new work on acceptable terms and, without chasing revenues, improve profitability through improving efficiency. In Turkey, the programme timing delays that led to an uneven trading pattern should diminish now that the IPA II transition has been made. Management maintained existing FY19 guidance; we have moved the divisional mix more in favour of UK Consultancy Services and factored in lower tax rates than before. Based on these estimates, we see FY18 representing an earnings low for WYG and the beginning of an earnings recovery phase.