Eddie Stobart Logistics — Forecasts reduced, material value upside remains

The recent H1 trading update highlighted solid revenue growth but profit margins under pressure due to slower productivity improvements in Contract Logistics and Warehousing and the negative impact of exiting a problematic contract in March on the transport network’s operational efficiency. Despite this, ESL said it expects to deliver full-year results in line with the board’s expectations, not least because volumes have been historically weighted towards the second half. We have prudently cut our FY19 and FY20 EBIT forecasts by 5% and 6% respectively based on broadly stable EBIT margins y-o-y (vs a small increase before). Despite our lower forecasts, we believe the recent share price drop provides an attractive entry point as the stock is trading at a significant discount to other logistics companies, as well as UK small-caps, on several valuation metrics. We see significant upside to the current share price, although the overhang risk from the 22.89% stake of Woodford Investment Management may continue to weigh in the short term (the fund is currently suspended and is selling several holdings). Increased visibility of the outlook for FY19 at the H1 results on 29 August may act as the next catalyst for the stock.

H1 trading update: Revenue growth but pressure on margins

Revenue progression: H1 revenues increased 25% y-o-y (including a full first-half contribution from recently acquired The Pallet Network (TPN); like-for like revenues were up 8%) and the growth trend appears consistent with our FY19 forecast of +15% y-o-y revenue growth.

EBIT margin development: H1 adjusted EBIT is expected to be towards the lower end of management expectations, due to slower productivity improvements in Contract Logistics and Warehousing and the negative impact on the operational efficiency of the transport network of exiting a problematic contract in March. In addition, following the appointment of Anoop Kang as the new CFO, the company announced some adjustments to historical financial statements, including a £2m reduction in FY18 adjusted EBIT (4%) and a £1.6m negative impact on FY19 adjusted EBIT (2% of our current forecast). Despite the level of H1 margins and the adjustment to historical EBIT, ESL expects to deliver full-year results in line with the board’s expectations, not least because volumes have been historically weighted towards the second half.

The pressure on margins is disappointing as these were a key focus for investors following a significant EBIT margin reduction in FY18 (from 7.8% in FY17 to 6.6% in FY18, which the company explained reflected the integration of the acquired companies, coupled with strong organic growth and management’s decision to invest in quality service and customer loyalty). However, even on our new forecasts, we show that ESL’s EBIT margins continue to be well above the average level of international logistics companies (Exhibit 1). Further, the gradual implementation of an optimised transport solution starting from mid-2019 may be supportive of profit margins (mostly in FY20). The system will automate transport planning and improve utilisation rates by reducing empty vehicle miles, as well as provide enhanced visibility to customers.

Cash flow generation: net debt reduced to £154m in H119 from £160m at the end of FY18. We have increased our net debt forecast for FY19 to £154m (from £146m). Our forecast requires an acceleration in cash flow generation in the second half of the year, as dividends are paid in H2. We believe this is realistic considering that results are usually weighted to the second half. Net debt/EBITDA was 2.4x at the end of 2018 (based on pro forma EBITDA, which includes the full-year impact of the TPN acquisition), which was above the 2.0x targeted by the company. ESL previously said it expects a return to historical levels of cash generation in FY19 and that it will move towards 2x net debt/EBITDA in FY19. On our updated forecasts, net debt/EBITDA will reduce to 2.1x in FY19 and 1.8x in FY20.

Forecasts changes: FY19 and FY20 EBIT forecasts cut 5% & 6%

Following the trading update, we have maintained our top-line estimates but cut our FY19 and FY20 EBIT forecasts by 5% and 6% respectively based on the assumption that the EBIT margin will remain broadly in line with FY18 (6.5% and 6.6% vs 6.6% in FY18). As results are usually weighted to the second half of the year (we expect H1 EBIT to represent c 30% of FY19), analysing the development of the business over the summer will be key. We expect ESL to provide more visibility on the outlook for FY19 at the H1 results on 29 August. We maintain our dividend forecasts (implying c 5% CAGR in FY18–20e) and have marginally increased net debt.

We believe the recent share price decline provides an attractive entry point into the stock. In our view the recent trading update, concerns over shareholder structure and overhang risks (Woodford Investment Management owns a 22.89% stake as of 8 July 2019) as well as Brexit have pushed the share price down to excessively low levels. We note the following:

Looking at the discount at which ESL had been trading vs other UK logistics companies ahead of the trading update, specific concerns about overhang risks (rather than Brexit) appeared to be the main driver of the recent share price drop, hence we would expect the removal of this risk to drive significant share price appreciation.

As a result of the lower estimates, our DCF valuation is reduced to 154p (from 175p previously), still implying significant upside to the current share price. Our DCF valuation is based on an unchanged 6.9% WACC, implying an EV of £737m (10.8x FY20e EV/EBIT) and an equity value of £583m (11.2x FY20e P/E). While the upside to our DCF valuation is significant, the share price may not recover completely until the overhang risk disappears (we apply no discount to reflect this). Apart from a potential resolution to the shareholder situation, we believe the main short-term catalyst is visibility on the outlook for FY19, which the company may provide at the H1 results.

The trend for companies to outsource logistics to achieve savings continues to support ESL’s growth outlook, especially in the consumer and retail sectors, where there are revenue and cost pressures and companies are refocusing on their in-store and online operations. In our view, the outsourcing opportunity is large, with 45–80% of logistics and supply chain services in the UK and Europe still performed in house (according to EU Commission estimates). ESL’s pay-as-you-go model offers customers significant opportunities for cost savings and flexibility compared to running their own logistics networks. Clients can transform internal logistics fixed costs to variable costs and cope more easily with seasonal demand, as well as expansion projects.

The positive impact of the logistics outsourcing trend was clear for ESL in FY18 when group revenues grew organically 18% y-o-y, thanks to growth from existing contracts and £162m from new contracts (full-year impact). In retail, 2018 revenues grew by double digits in organic terms, even though UK retail conditions were difficult. The trend continued in H119, with top-line organic growth of 8% y-o-y. ESL is supporting top-line growth with investment in expanded capacity, with a company plan to open a 644,000 sq ft warehouse at Appleton, next to the operational headquarters, in Q420 (this would increase the company’s warehousing capacity by 7% vs 8.8m sq ft at the end of FY18).

The shift to e-commerce provides strong growth opportunities for ESL, as it has developed a solid track record in reorganising the logistics of traditional retailers as a result of its e-commerce capabilities. It has a full service offering across multiple customers and sectors (not final mile), which it has recently strengthened with the acquisition of iForce, which provides a full end-to-end logistics service.

Over the last few years, growth in the e-commerce market has been supported by both traditional retailers looking to further develop their online offering and new e-commerce entrants. This has led to strong growth for e-commerce historically and most recent statistics show this trend is continuing. Internet sales have risen as a proportion of UK retail sales from 3.1% in 2007 to 19.3% in May 2019 with online UK retail sales up 8.3% y-o-y in May 2019, according to data from the Office of National Statistics. These dynamics have historically driven strong growth for ESL, as we estimate that e-commerce services represent c 20% of FY18 revenues vs 7% in FY15.

While we do not believe that acquisitions will be a priority for the company in the near term (we expect ESL to focus on improving cash flow and leverage over the course of FY19), we see room for further external growth opportunities in the medium term due to high market fragmentation. We also believe that acquisitions in logistics create a high level of cost synergies as duplicate transport routes and warehousing can be eliminated. ESL has acquired four companies since its IPO and in our view has built a positive track record through its ability to buy companies at attractive multiples. It acquired iForce, Speedy Freight, Logistics People and TPN at a weighted average EBIT multiple of 5.7x vs the current FY19e EV/EBIT for ESL of 7.0x.