Appreciate Group — In line FY20 but significant COVID-19 adjustment

At the end of March 2020, APP announced that in response to the spread of COVID-1, and following government guidance, it had closed all its offices and fulfilment locations, ceasing the delivery of physical product to focus on digital opportunities. A number of new digital products have been launched, albeit in the face of a substantial near-term reduction in customer demand. APP says that in the short term, demand in the Corporate and Other Consumer (together c 50% of total FY19 billings) areas is approximately 70% below last year. In Christmas Savings (the other c 50% of FY19 billings) the order book normally begins to build in around September of the preceding year (ie September 2019 for Christmas 2020), completing around the end of March. For Christmas 2020 (FY21) the order book is currently c 10% below the prior year level. Typically, net cancellations result in some attrition in the order book, once built, over subsequent months, but positively APP says that cancellation rates are currently running at similar levels to previous years and the company is making efforts to reassure customers their savings remain safe, segregated and protected within the Park Prepayment Protection Trust. Nevertheless, the potential for customer financial stress over coming months poses the risk of increased cancellations.

While customers are continuing to redeem products online and at retail outlets that remain open, the lockdown has seen many outlets close with the result that redemption rates have slowed overall. This has deferred revenue and profit recognition into subsequent periods and was the reason for the negative £0.3m COVID-19 impact on FY20 earnings. Conversely, the delay in customer redemptions has a positive impact on cash flow, particularly in relation to APP’s own prepaid vouchers.

In addition to the COVID-19 impact on the near-term operational result, the recent reduction in interest rates (the Bank of England reduced base rate by 0.50% to 0.25% on 11 March 2020, and again to 0.10% around a week later) will have a material impact on net interest income, typically around 12% of underlying PBT. APP earns interest on corporate cash balances as well as the customer cash balances that are held in trust. Total cash balances fluctuate throughout the year but are normally at their highest level in or around October as Christmas approaches, peaking in FY19 at c £236m.

APP expects adjusted PBT to be c £11.5m before exceptional items, which are expected to amount £2.5–3.5m, predominantly non-cash. The exceptional items comprise a non-cash impairment of the Valley Road site and goodwill relating to the brand engagement agency FMI acquired in 2016 and exceptional redundancy costs of c £0.5m.

The commercial property market has taken a knock from COVID-19 as a result of a near-term slowdown in rents collected and a weakening of longer-term occupational demand expectations. With transaction volumes having substantially dried up, there is a dearth of supporting evidence for valuations and a statement of material uncertainty has become widespread industry practice. Against this background, sale of the Valley Road site, substantially vacated by the relocation of core activities in modern fit-for-purpose accommodation in central Liverpool that was nearing completion has been postponed. A currently held for sale asset, Valley Road had a 30 September 2019 value of £5.0m and in our revised forecasts we have assumed a non-cash impairment of £2.0m.

Goodwill relating to FMI was £882k at 30 September 2019 and we have assumed a full impairment.

The redundancy charge follows a management restructuring in Q420 to streamline operations.

APP started the current year with cash of c £30m and no debt. In addition to cancelling the payment of the previously declared DPS of 1.05p (representing a £2.0m cash outflow previously scheduled for early FY21), the company has taken a number of measures to conserve cash and reduce costs were possible including delaying discretionary spend or capital projects, cancelling annual pay reviews, reviewing all bonus schemes and postponing the leadership team’s incentive awards.

Looking further ahead, management remains confident of the group’s growth plan and we note that on 2 April it was announced that CEO, Ian O’Doherty, had acquired 40,000 shares at 34p each. The board has reviewed several financial scenarios of the likely impact of COVID-19 on the business and in each case projects positive free cash at end-FY21. Between balance sheet dates, free cash is sometimes lower, particularly in August/early September, as stocks are built ahead of Christmas shipments. To ensure adequate resources to facilitate an acceleration medium and long-term growth, as well as investment in the continued switch to digital, the group has commenced a bank financing exercise and will provide an update on the progress of this with the full year results.

The exact impact of the COVID-19 pandemic on near-term financial performance remains highly uncertain and APP continues to feel it inappropriate to provide forward-looking financial guidance at this stage. With this caveat we have revised our forecasts, attempting to model a steady recovery in trading activity from the end of September 2020 (ie H221) and a resumption of growth in FY22, from a lower base and amidst a less supportive overall economic backdrop. Given the potential for materially worse or even better outcomes than we have modelled, we prefer to view our forecasts as illustrative.

Our main income statement forecasting assumptions include:

FY21 billings remain difficult to predict and will be significantly determined by the duration of the lockdown and the speed of recovery of the UK economy and consumer confidence. Our modelled adjusted PBT for FY20 would increase/decrease by 36% if group billings were 5% higher/5% lower than assumed and would increase/decrease by 73% if group billings were 10% higher/lower than assumed.

Although our modelling extends to end-FY22 this does little more than capture our best guess at the immediate bounce from a challenging FY21. Looking further ahead, we still expect the implementation of the strategic plan to bring income statement benefits derived from faster than otherwise growth and increased efficiency. APP’s previous guidance of income statement benefits of £2–5m pa after FY21 (ie first benefits in FY22) has been withdrawn given the current uncertain operating environment, but nevertheless provides an indication of the scope for medium-term benefits that, depending on market conditions, may accelerate growth or provide an offset to a more challenging trading environment.

As noted above, payment of the interim DPS of 1.05p (scheduled for April 2020) has been cancelled. The board will decide on the final DPS in respect of FY20 at the time of the results. We have assumed only 1p final DPS, a low pay-out of FY20 earnings but conserving cash for the more challenging FY21. We have similarly assumed a 1p full year DPS for FY21 (a c 70% pay-out) before increasing to 2.75p in FY22 (c 1.5x covered by earnings).

Based on these DPS assumptions, our modelling suggests a decline in free cash in with a further decline in FY22 offset by the c £3.0m sales of the Valley Road site. We have not factored borrowing into our modelling but as noted above, this is a possibility to manage seasonal cash flows.

In our December 2019 update, our estimated modified DCF valuation was 87p, which equated to a 2020 calendar year P/E ratio of 16.0x.

Given the near-term reduction in earnings and cash flow that we assume above, our DCF value is also reduced and similarly uncertain depending on the duration of the pandemic lockdown and the shape of the recovery.

At 64p our revised DCF value is equivalent to 34x calendar 2020 EPS and c 19x calendar 2021 EPS with the prospect of the strategic investment plan supporting performance over the medium-term. At 64p, our assumed FY21 DPS of 2.75p would represent a yield of 4.3%.