Eddie Stobart Logistics — Life in the fast lane

ESL is among the largest UK transportation and logistics market participants, albeit with only around 1% of the fragmented £70bn market. Management estimates that between 45% and 80% of logistics and supply chain services are carried out in-house, which accounts for ESL’s relatively small market share despite being in the top five contractors by revenue. Road transportation of goods in trucks still accounts for the bulk of revenues. The group has refocused to growth areas such as e-commerce and changed its model to be a provider of consulting-led outsourced logistics management. ESL is differentiated by its above-average profitability and growth pipeline. It listed on AIM on 25 April 2017.

ESL currently trades at a discount to its closest peers. Its FY18e EV/EBIT ratio of 11.5x and price to earnings ratio of 12.9x compares to sector averages of 14.2x and 19.8x, respectively. Given ESL’s sector-leading EBIT (three-year CAGR 15.3%) and EPS growth (three-year CAGR 27%) we believe the stock should trade at least in line with its global peers.

Our fundamental analysis implies a fair value per share of 200p, which offers 26% upside to the current price of 158.5p. We arrive at our fair value per share by taking an average of three valuation methodologies. Our DCF (WACC 7.4%, terminal growth 1%) implies a value of 190p. We also use a peer comparison adjusted for superior growth, which gives a value of 200p. We also make use of an EVA analysis, which gives a fair value of 207p per share. A simple average of the three gives our fundamental fair value per share of 200p.

ESL’s management has been proactive in addressing specific operating risks. Fuel costs are passed through in all contracts and the cost structure is set up to be flexible. However, a couple of operating and technical risks should be noted:

ESL continues to evolve from its heritage as primarily a road-based haulier of retail and consumer goods towards providing integrated consulting-led logistics services in higher growth markets such as e-commerce and MIB products. It has 5,500 employees, 2,200 vehicles, 3,800 trailers and four rail-connected distribution centres, which combine into the most profitable UK-based logistics companies. It listed on the AIM market in April 2017, having been in private hands since 2014.

Several factors differentiate ESL; uppermost among them are the company’s highly competitive offerings in price and service. The Eddie Stobart brand (held by licence from Stobart Group Brands, for which ESL may start paying a royalty fee or purchase a perpetual right) is very well-known to UK consumers. Its distribution network across the UK (see Exhibit 1) brings network benefits that translate into low empty-leg journeys and therefore higher fleet utilisation and sector-leading profitability. Investment in recent years in technology means ESL has a modern IT platform, which brings the capabilities in inventory management, real-time tracking and route optimisation sought by complex customers. Management will continue to invest further in technology and in higher growth end-markets, such as e-commerce and building supplies, to enhance the growth prospects of the company in order to sustain above-average industry levels.

The recently installed management team with the benefit of the new capital raised at listing have the ambition and platform to grow the business through both organic and inorganic means. CEO Alex Laffey brings with him decades of experience and contacts in UK logistics. Management is applying margin discipline more rigorously and using its reputation and sector know-how to bid for outsourced logistics contracts as they come up.

ESL has longstanding relationships with the largest customers in UK logistics. 75% of its FY16 revenue came from 25 clients and more than half of its relationships have been in place for longer than 10 years. Several aspects of the ESL business proposition are attractive to customers, in addition to price competitiveness. For instance, ESL’s contracts are often ‘closed book’, which means that, with the exception of a fuel pass-through, ESL takes on utilisation risk from its customers in return for higher rewards.

ESL’s most important end-markets are Retail (27% of FY16 revenues), Consumer (30%), MIB (24%) and e-commerce (9%); however, the e-commerce proportion will increase to more than 20% in FY18e as the iForce acquisition contributes part and then full-year revenues. ESL’s three largest end-markets – Retail, Consumer and MIB – have historically grown in line with GDP while e-commerce is growing by double-digit percentages.

UK consumer demand has remained resilient even after the EU referendum result. The key industry trend in recent years has been the switch in consumer demand to non-store retailing at the expense of in-store retailing. Euromonitor estimates that non-store (online) still only accounts for 14.7% of the market. We forecast this trend will continue with traditional in-store Retail and Consumer sectors growing at a ‘GDP plus’ rate of 2.5% and online sales growing well above. Integrated logistics providers are set to benefit from the changing market due to their warehousing skills and assets, which are attractive to online retailers. Indeed, post iForce, ESL has the second largest e-commerce business in the UK.

MIB sectors have displayed a far more diverse set of growth patterns in recent years. Bulk (often rail) shipments of coal and steel have declined significantly, while the construction sector has grown. ESL continues to target more construction customers to exploit this continuing trend. Recognising the diverse range of industries served by ESL, we forecast a ‘GDP plus’ rate of organic growth of 2.5%. Importantly, ESL aspires to capitalise on the outdated single operator model, which prevails in MIB. Integrated logistics offerings, common in the retail and consumer segments, are yet to fully penetrate MIB clients. Increased market share at the expense of smaller independent names is a key attraction for ESL’s management.

The e-commerce business is expanding both organically and by acquisition, and is becoming an important part of ESL’s business and a significant growth engine. We forecast a 25% growth rate in ESL’s e-commerce businesses over the coming years. Taking into account the iForce acquisition and the significantly higher rate of growth in this market, we forecast e-commerce will account for at least 20% going forward.

ESL’s network model, investment in technology, high on-time delivery record and scale contribute to its highly efficient operations. The result is an FY16 EBIT margin of 7.4%, which is around 250 basis points ahead of the average of its closest peers. In a highly competitive and mature market, this is a considerable achievement. With 47,000 deliveries per week enabled by a network-based approach that ensures fewer empty leg journeys and IT systems enabling route optimisation, ESL generates vehicle utilisation well above the industry average, near-perfect scoring on on-time deliveries (see Exhibits 5 and 6) and a strengthening brand reputation. Exhibit 4 shows the benefits of having exposure to complementary sectors. For instance, when MIB deliveries stop at 17:00, the same curtain-sided trucks can be used for e-commerce customers in the evening.

Management has stated it will not actively seek to expand EBIT margins much from current levels. Rather it will invest in headcount and other costs to better service customers.

Finally, Alex Laffey’s focus on margin discipline was illustrated well with the June 2016 cessation of the Tesco Ireland contract and also its exit from the Britvic contract.

Several of ESL’s key customer segments – such as MIB (24% of FY16 revenues) – are cyclical. The company has built flexibility into its cost structure to absorb reductions in revenues from economic contractions. For example, ESL leases its vehicles from Volvo and Scania. The company can adjust its fleet size downwards by up to 300 trucks out of a total of 2,200 as part of the lease agreement. Also, with approximately one-third of its leases up for renewal annually, it can reduce its fleet size quickly to absorb the impact of softening end-markets. Taken together with ESL’s use of subcontractors on short-term contracts, agency drivers who account for up to 25% of all drivers and the company’s ability to manage headcount flexibly, there are several mechanisms in place where management can rapidly adjust the cost base to offset any future decline in revenues.

The bulk of ESL’s revenues come from long-term contracts. CEO Alex Laffey, previously in charge of in-house logistics at Tesco, is a well-established and respected name in the sector. Management stresses that relationships and reputation are very important in the sector and the fact that 25% of ESL’s relationships, many with blue chip customers, are over 10 years old illustrates the company’s perceived quality as a counterparty. With 67% of ESL’s FY16 revenue from existing contracts, such arrangements demonstrate stability and add visibility to group cash flows. Added to this, the company has a rolling pipeline of £450-500m of new business split between existing and new clients. Note: ‘evergreen’ contracts are rolling annual renewals.

We forecast ESL’s year-end FY17e net debt will be £79.1m, equivalent to 1.4x EBITDA with £130m in proceeds from the April 2017 IPO, enabling the company to pay down some debt and to complete the April 2017 £45m acquisition of iForce, an e-commerce company. We fully expect management to continue with its policy of making selective bolt-on acquisitions as long as the company remains below its self-imposed net debt to LTM EBITDA ceiling of 2x. The UK transportation and logistics market is very fragmented (ESL’s market share in 2015 was under 1% of the total market value of £70.3bn) so there is no shortage of potential small targets around. iForce was acquired for £45m. Based on £55m of revenues and 6.5% operating margins (company guides to above 6%), ESL paid a reasonable multiple of around 12.5x trailing EBIT for iForce, which is well below market multiples for similar companies such as Clipper, which trades at more than 20x forward EV/EBIT. When high revenue growth is taken into account, ESL probably paid well below 12.5x forward-looking EV/EBIT. iForce, once on ESL’s operating platform, will gain access to ESL’s customers and operating capabilities, which will immediately enhance the performance of the target and produce synergies.

ESL reports by operating activity – Road Transport, Contract Logistics (CL) and Warehousing, EU Transport and Other. We briefly discuss each operating division in the following section.

In the three months to February, ESL grew quarter-on-quarter revenue and EBIT by 18% and 20%, respectively. Management commented that the high growth was due to a mixture of contract wins in 2016 and organic growth, and that it continues to invest in existing customers and pipeline. It is worth noting that Q1 is normally the slowest month as it captures January and February, which see a drop-off in demand following Christmas.

We forecast ESL will grow revenues at a CAGR of 13.6% over the next three years from £570m in FY16 to £836m in FY19e. As Exhibit 14 shows, organic growth increases as iForce gives the company more exposure to the high growth e-commerce segment: e-commerce accounted for 9% of FY16 revenues, which increases to over 20% pro-forma with iForce. The fact that ESL is one of only a handful of logistics operators that can undertake complex, nationwide logistics outsourcing contracts, and that, in addition, the CEO used to work for Tesco, convinces us the company is well placed to win new contracts in the coming years. With large retail, consumer and industrial customers continually inviting tenders for £20-40m per year contracts (ESL, significantly, recently won a £28m per year contract in the aggregates space), it only takes one or two such new contracts per year to increase revenues by mid- to high-single-digit percentages as per our forecasts. The final revenue growth driver is M&A. We only explicitly forecast the iForce acquisition (in for part of FY17e and all of FY18e) and Stobart Ireland disposal, which are both complete.

We forecast ESL’s e-commerce end-market will grow at 25% year-on-year while the other divisions – Retail, Consumer, MIB, Other – will grow at a far lower 2.5%. We take on board management guidance where it expects that the largest reporting segment, Road Transport, will grow by a higher rate than the other divisions as it has greater e-commerce exposure.

Road Transport (68% of FY16 revenues) is where the bulk of the MIB and e-commerce growth will come through. There will be a one-off effect in FY17e from the disposal of the Irish operations, which contributed £21m of FY16 revenues. Excluding this, we expect underlying three-year EBITDA CAGR of 9.1%. We expect margins to stay flat over our forecast period in line with historical reported figures.

With 2016 revenues of c £55m and operating margins above 6%, the £45m acquisition (implied EV/EBIT multiple of 12.5x based on 6.5% EBIT margins) of e-commerce specialist iForce early in 2017 offers ESL increased exposure to this high-growth segment. Note that it is unclear whether ESL will account for iForce as a separate reporting segment or split it between Road Transport and CL and Warehousing. For transparency and until we get confirmation from management, in Exhibit 14, we split out the iForce contribution. iForce’s activities complement ESL’s existing logistics operations. It offers an end-to-end service and has sophisticated software in areas such as fulfilment management, carriage management, returns and stock clearance, which fits with ESL’s outsourcing model. The acquisition makes strategic sense for ESL as it gains a foothold in a high-growth market and new software, plus ESL will be able to extract synergies as it brings iForce onto its scale platform.

CL and Warehousing (17% of FY16 revenue) tends to be a slower growth business. We therefore forecast this division to report a three-year EBITDA CAGR of 24.1%, partly driven by 7.5% revenue CAGR and partly by our forecast of a margin recovery to 6.0% after FY16, during which ESL expanded its warehousing capacity and therefore saw lower margins as rent payments increased. Management now guides to capacity utilisation having increased enough for margins to recover. Therefore, we expect EBITDA margins to remain around 6.0% across the forecast period.

Although small, accounting for only 7% of FY16 revenue, we forecast the EU Transport business will grow at a rate in line with the broader group with 7.5% revenue CAGR. We also forecast EBIT margins of 6% for the next three years, in line with the average of the last two years. However, we note EU Transport’s strong margin performance in FY16, and do not expect this level to be sustained; hence our three-year EBITDA CAGR for this business is -5.6%.

iForce is a good example of what we believe will be an active programme of bolt-on acquisitions for ESL. At the time of listing, management indicated it was assessing three further targets. Taking into account the 2x net debt to last-12-month EBITDA (currently 1.6x) ceiling ESL has set itself in conjunction with its annual free cash generation of c £10m from FY18e, we calculate that ESL has scope to make acquisitions totalling up to c £30m over the next year or two. In a highly fragmented market, there is no shortage of potential targets.

Pulling together our divisional estimates (see Exhibit 14), we generate our three-year forecast EBIT CAGR of 15.3%, driven by top-line growth rather than operating margin expansion. Despite the fact that industry reports such as the one published by KPMG in March 2017 estimate that transport and logistics as a whole will only grow by an average of 2.5% to 2021, we believe ESL can grow organically at mid- to high-single-digit percentages. We highlight again the £450-500m rolling pipeline of new contracts disclosed by ESL at the IPO. Our underlying three-year revenue growth forecast (excluding one-off effects of the iForce acquisition and the disposal of the Irish operations) is 11.8%. ESL’s superior growth is driven by a mixture of exposure to higher growth market segments such as e-commerce and the likelihood of it winning large-scale (£20-50m per annum) outsourced logistics contracts from large retailers. As an example of the scale of opportunity, a £40m outsourced logistics contract would boost ESL’s revenues by more than 7% alone.

We bring together each of our individual reporting segment revenue forecasts into the group revenue growth forecasts below with growth split between organic, net new business and M&A.

We forecast ESL’s operating margins will remain around 7.5-7.7% across our forecast period. The company’s margins are well ahead of its nearest competitors (Exhibit 2), which is due to ESL’s scale and efficiency. ESL does take on utilisation risk through its ‘closed book’ contract but there is a fuel cost pass-through in all contracts. Management points out that ESL has weathered economic downturns well in the past and preserved margins, through a mixture of flexibility in its lease agreements, its ability to increase and reduce subcontractors and agency drivers, and the company’s capability to cut costs quickly. Likewise, management would ‘reinvest’ (ie expense more to cap margins) in the business rather than let margins continue to rise.

A lower interest charge due to ESL paying down some debt post capital raise, together with high EBIT growth, combines to drive our three-year (Edison definition – pre-amortisation and exceptionals) underlying EPS CAGR of 27.4%. Furthermore, we assume ESL will start paying a dividend this year on the basis of a 50% payout of underlying earnings. This implies an FY17e DPS of 5.5 pence per share, which implies a dividend yield of 3.4%.

From 2019, in common with all other companies, ESL will change how it accounts for its operating leases. It will bring an asset and a liability on to its balance sheet and the £72m annual lease payment, instead of being expensed, will be split between depreciation and interest. Both net assets and EBIT will remain identical, but EBITDA will increase significantly. According to its admission document, under IFRS 16 FY16 EBITDA would increase by £72m to £118.7m. In the EVA analysis section below, we discuss how this might affect ESL’s fair value, including what we believe to be an appropriately higher WACC due to the increase in net debt. Until we know specifics on the impact of future changes, we have not altered our forecasts to reflect it.

A second order effect of this change would be an increase in ESL’s clients outsourcing their logistics operations. Retail and consumer goods companies might not want to increase their net debt (and therefore creditworthiness) by bringing operating leases onto their balance sheets and so may be more likely to seek to outsource their logistics operations. ESL, among others, would benefit in this scenario.

Each of ESL’s top managers has significant experience running large organisations. Most have held senior roles, either within ESL or in logistics roles in other large organisations. They bring a wealth of both contacts and experience to the firm.

Chairman: Philip Swatman

Philip Swatman has extensive capital markets experience, having been a managing director and subsequently co-head of investment banking of NM Rothschild between 1998 and 2001, before serving as vice-chairman of investment banking until 2008. He has served as a non-executive director at nine companies.

CEO: Alex Laffey

Appointed in May 2015, Alex is an international logistics expert with over 25 years’ experience in supply chain distribution at a senior level. He headed international distribution for Tesco and managed Tesco’s UK logistics, with over 50,000 store deliveries per week and a £1.6bn annual cost base.

CFO: Damien Harte

Damien has over 30 years’ experience in senior financial positions at large organisations across a range of sectors in the UK and internationally, including logistics and distribution, manufacturing, renewable energy, media and leisure.

COO: David Pickering

David Pickering has worked for Eddie Stobart for over 25 years and as chief operating officer has leadership of operations directors, spanning manufacturing, industrial & bulk, e-commerce, retail and consumer.

As is to be expected, the nature of ESL’s business points to a number of stock-specific and general economic risks.

Boosted by the £130m raised from the IPO on 25 April, and after the £45m iForce acquisition in April 2017, ESL carries a strong balance sheet and is cash-generative, leaving scope for further bolt-on acquisitions and payment of a dividend.

Due to ESL’s asset-light model – the company leases its fleet of 2,200 trucks and 3,800 trailers from Volvo and Scania – the company’s capex requirement is low. We forecast investments of around £7m per year in PP&E, which is just over 1% of sales. The largest drag on cash flow is working capital; we forecast that FY18e receivables alone will absorb cash flow of £21m, although we note that management has extended its discounting facility to £60m from £40m to tackle its working capital drag.

With our forecast FY18 underlying EBITDA of £64.4m, net interest of £5.5m, tax of £6.7m, net working capital of £11.5m and capex of £7m, ESL will have ample cash to cover our forecast cash dividend cost of £22.1m (final FY17e dividend and interim FY18e dividend) and pay down some debt.

We expect the company to continue to actively seek small-scale, bolt-on acquisitions, which will be financed mainly through debt. We do not include acquisitions other than those already announced in our earnings forecasts.

At the end of November 2016, ESL had net debt of £165.5m. It raised £129.7m from the IPO in April and used £45m of the proceeds to buy iForce. We forecast it will generate £24.7m of operating cash flow in FY17 and net interest, tax, capex and dividends will absorb £23.4m, resulting in our forecast FY17 net debt figure of £79.1m.

Given balance sheet strength and our forecast that ESL will start paying dividends in FY17, we believe the company will finance M&A mainly through debt. Management has publicly stated it will look to make small acquisitions in the highly fragmented UK transportation sector and has put in place a debt ceiling of 2x the last 12 months (LTM) EBITDA. We estimate that end November 2017 net debt/EBITDA will be a conservative 1.4x, down from 3.4x at the end of November 2016.

We value ESL using multiple valuation methodologies: discounted-cash-flow (WACC 7.4%, terminal growth 1%), peer multiple comparison and EVA analysis. Our fair value per share of 200p is based on the average of these three methodologies and offers equity holders an attractive 26% upside to the current price of 158.5p per share.

We base our peer multiples comparison-driven fair value on global average one-year forward EV/EBIT multiples. These are typically used in the transport and logistics sector globally as this measure removes different accounting treatments of operating leases (see comment on page 11 relating to upcoming accounting changes for operating leases). Exhibit 15 shows a global average EV/EBIT of 14.2x. The UK average one-year forward EV/EBIT is 13.1x with a significant valuation differential between perceived e-commerce-focused operator Clipper, trading on 22.0x, and traditional logistics company Wincanton, which trades on 8.6x. Following its iForce acquisition, ESL will earn more than 20% of its revenues from e-commerce. Furthermore, it compares very favourably to Wincanton in terms of revenue growth (13.6% three-year revenue CAGR versus consensus revenue CAGR for Wincanton of 3.0%). We forecast ESL will continue to outperform Wincanton on EBIT margins (FY17e 7.5% versus 4.6% for Wincanton according to consensus). In addition, it offers a 3.5% dividend yield versus Wincanton’s consensus forecast dividend yield of 3.0%. We consequently apply a 14.0x EV/EBIT multiple for ESL and note that our multiple-based fair value per share of 200p implies a reasonable price-earnings-to-growth ratio of less than 1.0x.

Our DCF valuation of 190p is based on five years of explicit earnings forecasts after which point we take a terminal value with a 1% terminal growth rate. Our WACC is 7.4%.

Exhibit 17 shows our valuation with a range of WACC assumptions. A 2% increase in the WACC decreases the implied value by 26% to 140p. A 2% decrease in the WACC increases the fair value by 50% to 282p.

We believe ESL’s return on capital employed (ROCE) should be properly calculated in order to complete an EVA analysis. In our preferred ROCE measure, we take account of operating leases that are currently accounted for off balance sheet and we deduct intangible assets that relate to a previous acquisition. We add back £72m operating lease cost to NOPAT as this should be accounted for as a finance charge. We add the value of the right-of-use asset (£462m) to ESL’s capital employed and we add the liability (also £462m) to our net debt estimates. Given the fact that our FY17e net debt to EBITDA increases from 1.4x to 4.3x using this methodology, we feel it appropriate to increase ESL’s WACC, which we currently assume is 7.4%, to 9.5% to reflect the significantly higher leverage. The net result of these changes, shown in Exhibit 18, is an FY18e ROCE of 21.0% and a WACC of 9.5% giving a ROCE/WACC multiple of 2.2x. We gross up ESL’s capital employed by 2.2x and deduct net debt of £539m in arriving at our FY18e fair value per share of 207p, which offers equity holders 31% upside to current levels.

For completeness, in Exhibit 18 we also show our calculations for ESL’s ROCE based on two other definitions of capital employed: a simple ROCE calculation and a ROCE minus intangible assets calculation. This is to give investors the ability to flex the value per share depending on their own definition of ROCE.