Eddie Stobart Logistics — Outsourcing and e-commerce boosting growth

A unique feature of ESL’s model is its pay-as-you-go, shared-user network, which maximises fleet and warehouse utilisation, thus reducing costs for customers and providing them with greater flexibility. This greater efficiency is shown in ESL’s vehicle utilisation of 86.2% in FY17 compared to the industry average (according to the UK’s Department of Transport) of 69.8%. We think the greater efficiency of ESL’s model is prompting customers to outsource as they look to save money. Another structural growth area for ESL is e-commerce, where it is helping customers organise their logistics to respond to the shift to online retailing. E-commerce has risen from 5% of ESL’s revenues in FP14 (8M14) to 21% in H118.

We believe ESL’s shares look undervalued compared to its peer group, where it is the second lowest rated company based on 2019e P/E, even though it has the highest margins. In particular, ESL trades at a substantial discount to Clipper, another UK-listed logistics company. Clipper is the second largest UK e-commerce logistics company, which probably explains its high rating, but we note that ESL is the number three, with XPO, a US company, being the largest. We use a DCF model to value ESL, which we think is especially suitable for cash-generative companies like ESL. Our DCF value is 190p/share, which provides 73% potential upside to the current share price of 109.5p. We use a WACC of 6.9% and a terminal growth rate of 1%.

ESL won £158m of annualised contracts in H118, compared to £89m in the whole of last year. This level of wins led to 10% organic revenue growth. To be cautious, especially given the backdrop of Brexit, we fade growth to 7.4% and 6.8% in FY19 and FY20, which may be conservative if the current pace of contract wins continues. ESL’s growth should be supported by the structural growth of e-commerce, the outsourcing of logistics and market share gains. Acquisitions, like the recent purchase of TPN, could also boost revenue and profit as ESL acts to consolidate a fragmented UK logistics industry. Its net debt/EBITDA was at 2.0x in FY17. Management has said it would like to keep it around this level, so will look to finance deals through a mixture of cash and equity, as was the case with TPN. ESL may also expand its small presence in continental Europe, which accounts for 6% of revenues, and we think it could look to make acquisitions there.

ESL was founded in 1970, established in its current form in 2014 and listed in 2017. Based in Warrington, the company operates some 2,300 vehicles, 4,000 trailers, 26 distribution centres and has c 7m sq ft of warehousing (Exhibit 1).

A unique feature of ESL’s model is the pay-as-you-go, shared-user network, which maximises fleet and warehouse utilisation, thus reducing costs for customers and providing flexibility so that customers can cope with seasonal demand better and also grow more easily. In contrast, if customers operate their own logistics or have their logistics managed by a third-party company on a cost-plus basis (where companies charge customers a margin on the cost of operating), it could result in empty vehicle miles or spare warehouse capacity. This greater efficiency is shown in ESL’s vehicle utilisation in FY17 of 86.2% compared to the industry average (according to the UK Department of Transport) of 69.8%. ESL’s ability to achieve high utilisation rates is helped by the complementary operating times of its four sectors, which means that its vehicles and warehousing can handle a range of customer orders (Exhibit 2).

ESL provides its services to a range of national and international customers. The fact that 88% of revenue is either contracted or evergreen provides the company with a high degree of visibility (Exhibit 3).

The company’s top 25 customers comprised 67% of FY17 revenue and the majority of these contracts have more than 10 years left to run (Exhibit 4). The largest customer accounts for 15% of revenues, but none of the others for more than 5%.

In the table below, we list ESL’s main customers in each sector, which we think shows a good spread (Exhibit 5).

ESL showed strong revenue growth of 25% in H118, including 10% organic, an acceleration of the 6% organic growth reported in FY17. Organic growth was boosted by a good level of new contract wins. ESL won £158m annualised value of contracts in H118 compared to £89m (£34m from existing customers and £56m from new customers) in the whole of FY17.

ESL also renewed contracts with existing customers with an annualised value of £113m compared to £41m in the whole of FY17. In terms of losses, management said at the H118 results presentation that they totalled £13m of annualised revenues, a small amount compared to historical levels.

We think the increased wins could be a sign that outsourcing of logistics is accelerating, as customers look to create greater flexibility and also reduce costs in the face of a fairly subdued UK consumer/retail environment. We note the European Commission estimates that between 45% and 80% of logistics and supply chain services in the UK and Europe are still be performed in house, which we think shows a large opportunity as it is usually more cost-efficient to outsource.

H118 saw a number of large-sized contract wins including Britvic (c £30m), Homebase (c £20m), Cemex UK (c £10m) and Knauf (c £9m). Management pointed out that large contracts are normally in the range of £5-10m. A new contract with PepsiCo/Walkers (c £30m) was won after period-end. We think the contracts won so far this year will provide a useful backdrop for continued revenue growth.

By sector, ESL has focused on growing the proportion of revenue from e-commerce and Manufacturing, Industrial and Bulk (MIB), which rose from 5/21% to 22/25% of revenue respectively between FP14 (8M14) and H118 (Exhibit 6).

E-commerce showed the highest revenue CAGR over the last three years (Exhibit 7). The consumer sector was affected by the loss of the Britvic contract, which has since been regained.

ESL’s e-commerce sector reported 30% organic revenue growth in H118. Growth in the e-commerce market has been supported by traditional retailers looking to further develop their online offering and also new e-commerce entrants (Exhibit 8).

Internet sales have risen as a proportion of UK retail sales from 3.1% in 2007 to 17.4% in 2018 (Exhibit 9). ESL has continued to augment its e-commerce capability through the iForce acquisition, proprietary software and a multi-user offering (ie Corby Euro Hub). The e-commerce division has recently won new contracts with MedicAnimal, Made.com, Steamer Trading and The Works.

On the negative side, we think that e-commerce sales could cannibalise ESL’s trading retail sales, but note that at 22% of revenue ESL’s exposure to e-commerce is higher than the 17% of UK retail sales are made via the internet, suggesting it is more exposed than average. Indeed, in terms of e-commerce, ESL is the third largest UK logistics company, behind Clipper Logistics and XPO. Also, we think that new ‘internet-only’ companies often do not want to own logistics and therefore their growth will only be through outsourcing.

Growth in the MIB market is slower than e-commerce but ESL targets it partly as outsourcing levels are low (Exhibit 10).

In H118, MIB won new contracts with an annualised revenue of c £31m including Knauf, Cemex and Tarmac.

In Retail, we think two interesting trends for ESL are the shift to e-commerce, where it can deploy its experience to help customers develop their own presence, and generally tough retail market conditions, which are prompting customers to consider outsourcing logistics more than in the past (Exhibit 11).

In H118, Retail won new contracts with an annualised revenue of c £34m including with Homebase, Morrisons and Argos. It renewed contracts with an annualised revenue of c £16m. Management has said that the Homebase contract, which was won before the recent change of ownership, is being closely managed, with cash controls. However, we note the positive news that on 31 August Homebase reached agreement with its creditors to approve its Company Voluntary Agreement (CVA) plan.

In Consumer, companies are looking to develop an online capability, partly we think so they do not become too dependent on Amazon as their main e-commerce route to market (Exhibit 12). Also, as in Retail, financial pressure, especially as consumers increasingly shop around among brands, is leading companies to seek to reduce costs and consider logistics outsourcing.

In H118, Consumer won new contracts with an annualised revenue of c £76m, including with PepsiCo/Walkers and Britvic, and renewed contracts with an annualised revenue of c £74m including Johnson & Johnson, Unilever, Proctor & Gamble, Coca-Cola and Tate & Lyle. ESL also completed a significant warehouse realignment for Coca-Cola and Tate & Lyle.

ESL’s European operations are headquartered in Belgium, with subsidiaries in Bulgaria, the Czech Republic, Poland and Romania. The company also has joint ventures in Germany and Spain. It sold its Irish retail business in FY16. Europe comprises two divisions: car storage & distribution and general cargo.

Continental Europe only comprised 6% of ESL’s revenue in FY17, compared to 94% in the UK. However, we think it could be a large opportunity given the relative size of the two economies. We would expect ESL to expand in continental Europe through acquisitions.

ESL reports by operating activity rather than by sector. We set out our revenue forecasts in Exhibit 13 below. The company only reports organic revenue growth at the group level but we make assumptions for organic growth at a divisional level as well as for acquisitions and currency. In FY19 and FY20 we assume that Road Transport shows the highest level of organic revenue growth as it is most exposed to e-commerce.

ESL is acquisitive, buying four companies since IPO (Exhibit 14). The UK logistics market should be attractive to consolidate as it is fragmented. ESL, for example, is one of the top five (by revenue) multi-modal road transport operators in the UK, but has a market share of less than 1% according to the company. We also believe that acquisitions in logistics create a high level of cost synergies as duplicate transport routes and warehousing can be eliminated.

At the H118 presentation, management said that the acquisitions of the last year were performing well, with iForce and Speedy Freight reporting 20% and 52% organic revenue growth respectively.

TPN, acquired in June, was ESL’s largest acquisition since listing. ESL said that TPN is the UK’s second largest pallet distribution company. We believe the largest company is Palletways, which is owned by Imperial, a South Africa-listed company.

TPN operates a pallet network, comprising 106 regional hauliers. By creating a network, TPN can ensure national coverage for its customers. Customers also benefit from not having to own or maintain pallets and the majority have been with TPN for more than 10 years.

In the table below we set out ESL’s reasons for buying TPN (Exhibit 15). We think the key point is how TPN expands ESL’s product offering.

TPN’s financial performance has been strong, with a three-year CAGR of 14/36% at the sales/adjusted EBITA level (Exhibit 16). ESL paid £52.8m EV for TPN. The acquisition was part-financed by ESL through a £30m share placing. TPN reported adjusted EBITA of £6.1m for the year to March 2018, which means that ESL paid 0.5x historic EV/Sales and 8.7x historic EV/EBITA. We think this looks like an attractive price given TPN’s fast growth. Management said that the acquisition would be immediately earnings and cash accretive in FY17.

ESL has the highest EBIT margin among its main competitors, which we think reflects the greater operational efficiency of its pay-as-you-go, shared-user network (Exhibit 17).

ESL’s pay-as-you-go, shared-user network does potentially have more operational gearing than a cost-plus model, as it carries the cost if vehicles and warehouse space are not filled. However, the company’s cost base has some flexibility:

ESL saw its EBIT margin increase from 7.2% to 7.8% (FP14 8M14 to FY17) (Exhibit 18). The margin declined to 7.2% in FY16, before recovering again to 7.8% in FY17 because in FY16 ESL won a large aggregate contract that had relatively high implementation costs.

ESL reports EBITDA at a divisional level (Exhibit 19). In H118, the EBITDA margin declined from 6.9% (H117) to 6.5% due mainly to re-optimisation of the business to handle the high level of new contract wins, eg the need for extra agency staff and adding warehouse capacity, which takes time to fill.

These extra costs are temporary and this was reflected in management’s outlook statement, which stated: “As with previous years, we now move into the traditionally stronger second half with costs of new contract wins absorbed in the first half. The second half has started well and the Board remain confident of delivering full year in line with expectations.”

Alexander (Alex) Laffey (CEO) joined ESL in 2015, and has over 25 years’ experience in supply chain distribution at a senior level, most recently heading international distribution for Tesco. Since he joined, Mr Laffey has focused on adopting a consulting led approach, working with customers to understand their requirements and develop valued-added supply chain solutions.

Damien Harte (CFO) joined in 2016 and has over 30 years’ experience in senior financial positions of large organisations across a range of sectors in the UK and internationally. Prior to ESL, Mr Harte was global CFO of LM Wind Power, a leading player in the global renewable energy market.

After 10% group organic revenue growth in H118, we moderate the growth to 7.4% and 6.8% in FY19 and FY20. We fade the growth mainly because we feel that Brexit creates some economic uncertainty. We believe that ESL should be able to generate organic revenue growth ahead of nominal UK GDP growth, as in particular it will benefit from the growth of e-commerce, the outsourcing of logistics will continue and larger companies are likely to continue to take market share, mainly as they benefit from scale.

Our growth assumptions may be conservative as the strong level of contract wins seen so far in FY18 could boost growth further, the high contract win rate may continue and recent acquisitions have had strong organic growth, which will add to group organic growth as they annualise.

Given the high level of contract wins and organic growth rate we assume in FY18 and the costs associated with integrating these contracts, we reduce the EBITDA margin from 8.9% to 8.1%. We then increase the margin to 8.5% in FY19. Management has stated historically that it would not seek to increase the margin much above current levels, but rather would invest in further improving service levels.

ESL’s capex and working capital requirements are relatively low at 1.4% and 1.5% of revenues respectively in FY17. Capex benefits from the fact that the company leases its vehicles. Working capital is ESL’s main requirement and is likely to increase in absolute terms to support contract growth in the core Road Transport division. Good cash flow has allowed ESL to both make acquisitions and increase its dividend, which rose by 10% in H118.

In H118, free cash declined from £16.9m to £0.3m, which was also mainly due to the capex and working capital ‘cost’ of higher revenue (Exhibit 20).

Capex increased from £4.1m to £7.2m due to the cost of fitting out new warehouse assets (expected to be at full capacity by year end) and technology spend on scheduling systems. Management said that capex was front end-loaded for H1 so will be lower in H2. Working capital swung from an inflow of £6.1m to an outflow of £11.1m (Exhibit 21). The net investment was due mainly to significant contract wins and increased levels of revenue.

ESL’s net debt/EBITDA was at 2.0x in H118, at management’s target level and comfortably below the covenant level of <3.2x (Exhibit 22). ESL is acquisitive and, to maintain the current debt ratio, we think management will look to finance deals through a mixture of cash and equity. For example, the acquisition of TPN was part-funded through proceeds from a £30m share placing

From 1 January 2019, under IFRS 16 and in common with all other companies, ESL will change how it accounts for its operating leases. It will bring an asset and a liability onto its balance sheet, and the 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. We will update our forecasts in 2019 once the impact of this change becomes clearer.

ESL last provided an update on the impact of IFRS 16 in its listing document when it said: “Had Eddie Stobart adopted IFRS 16 at 30 November 2016, the impact under the modified retrospective approach would have been to recognise a right-of-use asset and a lease liability of approximately £462 million. Net assets would remain unchanged. The annual lease payment of £72 million in FY16 currently classified as an operating expense would be split between depreciation and interest. Profit before tax would remain unchanged but EBITDA would increase by £72 million to £118.7 million.”

A second-order effect of this change would be an increase in ESL’s clients outsourcing their logistics operations, as they might not want to increase their net debt (and therefore creditworthiness) by bringing operating leases onto their balance sheets.

ESL currently licences the Eddie Stobart brand from Stobart Group, an arrangement that ends in February 2020. ESL has three options to continue the licencing arrangements beyond 2020:

In the FY17 results statement, management said: “The team at Eddie Stobart is passionate about our name and the leading brand. However, we also recognise that following the introduction of our new strategy and the recent acquisitions, we need to review our position given the broader range of supply chain services we now offer.”

We use a DCF model to value ESL, which we think is especially suitable for cash-generative companies like ESL. Our DCF value is unchanged at 190p/share, which provides 73% potential upside to the current share price of 109.5p (Exhibit 23). We use a WACC of 6.9% and a terminal growth rate of 1%.

In our forecast we model 7% revenue CAGR in 2019-29e and maintain the EBITDA margin at 8.7%. In the table below we show the sensitivity of our DCF to different WACC values and rates of revenue CAGR (Exhibit 24). We have maintained our financial estimates.

ESL’s shares also look undervalued compared to its main peers, where it is the second lowest rated company based on a 2019e P/E (Exhibit 25). ESL also trades at a substantial discount to Clipper. Clipper is the second largest UK e-commerce logistics company, which probably explains its high rating, but we note that ESL is the number three.

We have made some minor adjustments to our forecasts, mainly to account for FX, interest and tax. As a result, our EPS forecasts are reduced by 5.9% in 2018 and 0.9% in 2019 (Exhibit 26).