Appreciate Group — Positioning for market recovery

Appreciate Group is the UK’s leading multi-retailer redemption product provider (cards, digital and vouchers) to the corporate and consumer markets. The UK market is large (the UK Gift Card & Voucher Association estimates just under £7bn per year) and growing, while fragmentation provides ample scope for market share gains.

The group’s consumer-facing brands meet a range of prepayment and gifting needs, while products delivered to business customers support engagement by helping them to reward and recognise their customers and employees. Own brand, in-house, multi-retailer redemption products (pre-paid cards, digital equivalents and vouchers), accepted by a wide range of carefully selected retail partners, account for the majority of sales (c 84% of the total in FY20), but the group also offers third-party sourced single retailer products (eg M&S gift cards). The majority of group sales are generated online, which complements and supports traditional distribution through a direct salesforce and agents. Most income is generated from the service fees paid to Appreciate by partner retailers, leisure and other service providers, based on the face value of money spent in their outlets. Interest is earned on all prepaid cash until the obligation to the redeemers has been settled.

During the past two years a new senior management team has been implementing a strategic growth plan that seeks to accelerate growth and improve efficiency over the medium term. FY20 and FY21 are years of significant implementation for the plan, which gives greater focus to the core multi-retailer redemption offering, where the scale of the market provides significant potential, and greatly accelerates the digitalisation of products and delivery, in step with market trends, enhancing the attractiveness, accessibility and reach of the offering, and tapping into new market segments. Appreciate recently announced the discontinuation of hamper production, the historic core of the business but now a very small, non-core share of sales. The strategic acceleration of the shift to digital product promises faster medium-term growth and enhanced margins although, as we explain below, cash generation is less positive than has traditionally been the case with paper vouchers. As voucher sales decline, near-term cash flow is reduced, but our discounted cash flow valuation model has always anticipated this, and the impact is neutral. Appreciate recently agreed a flexible unsecured borrowing facility on favourable terms that will fund working capital needs during seasonal peaks and support expected future growth.

Trading for the first 11 months of FY20 was in line with earlier expectations until the first impacts of COVID-19 were felt in March. In line with updated guidance, the FY20 impact of the pandemic was relatively modest, reducing billings by c £2.0m and profitability by c £0.3m due to slower customer redemptions, deferring earnings recognition. The impact on the current year will be more significant, as we discuss below, and to preserve cash while maintaining investment for medium-term growth, no dividend was declared in respect of FY20. The company plans to return to its previous dividend policy as soon as it is appropriate (we forecast a 1p per share DPS in the current year). Meanwhile, significant progress was made with the strategic business plan, which seeks to adapt the business for future growth with a greater focus on digital products and delivery. While depressing near-term sales growth, the pandemic is actually providing an additional boost to this trend and the company’s continuing investment should see it well placed to benefit from the expected market recovery, delivered off a more robust and scalable platform.

The key drivers of the FY20 financial results were as follows:

Looking more closely at the trends by business division and product, we note the following:

By product, card and digital billings showed good growth and paper product continued to decline. These mix changes reflect structural changes in the marketplace and the group’s strategy, and the higher margin earned on cards and digital product is positive for ultimate profitability. We expect the trend to continue in the current year, given an additional boost by the pandemic.

During FY20, the group made tangible progress on its strategic business plan, announced in December 2018, including relocating offices, implementing new technologies, trialling new digital products, and changing the company name and branding. All these initiatives will contribute towards the aim of building a more robust and scalable business model, capable of capitalising on growth opportunities in the large and fragmented market in which the group operates.

The move of most operations to new offices in Liverpool’s city centre has enabled the creation of a more collaborative and effective working culture, while providing access to a broader and more skilled pool of potential employees. The substantially vacated site at Valley Road has now been sold with the limited continuing requirements for space leased back.

The group invested £3.0m in upgrading IT infrastructure in FY20 as part of an ongoing programme. Implementation of a new enterprise resource planning (ERP) system is progressing well despite some COVID-19 delays and is on track for implementation in 2021. Management expects the new ERP to provide the scalability, resilience and efficiency required for more seamless and automated back office support functions across the business. Deployment of cloud-based technology is expected to save costs and further improve reliability.

Significant steps have been taken to make it easier to work with customers, particularly in the digital space, and this has accelerated during the lockdown. New e-gift cards and e-codes have been added including additional brands that are especially relevant in lockdown conditions. In a successful pilot, the new ‘Select’ contactless-enabled digital gift card generated c £1.0m of billings and is being made available to corporate clients.

The greater focus on digital product dovetails with existing trends in the marketplace that have been accelerated by the pandemic. As noted above, the group’s multi-redemption card/digital billings exceeded voucher billings for the first time in FY20 and digital redemptions more than doubled to £9.7m. In the current year, until end July, digital billings have tripled to £18m and digital redemptions have grown by 135%.

The COVID-19 pandemic had a relatively modest impact on FY20, but will materially affect the current year by reducing customer orders and slowing redemptions. Billings fell sharply in April as the lockdown took effect but have since begun to steadily improve. As at the end of July, underlying billings were down 41% year to date. The performance of total billings includes the short-term impact of the partnership with Iceland to provide access to the Department of Education free school meals national voucher scheme during the summer weeks. Management indicates that on a full-year basis the Iceland deal will add c £10m to billings but with a low single-digit margin.

Positively for margin, a larger share of billings year to date is represented by core own-brand, multi-retailer redemption products, and within this by card and digital product.

Due to the closure of shops and other redemption outlets during the lockdown, redemption rates have reduced. In the current year, up to 31 July, the overall rate of redemption was 39% lower compared with the same period in FY20, with a sharp fall in physical redemption (-54%) partly offset by strong growth (+169%) in online redemptions. Slower redemptions defer the recognition of revenues and profits for the core multi-retailer redemption products, but the delay in customer spending has a positive impact on cash flow.

There is a strong seasonality to APP’s business with more than 70% of billings and all profits generated in the second half of the year (with H1 seasonally loss-making), particularly focused on Q3. The seasonality is particularly marked in the Consumer business (more than 80% of billings in H2) given the importance of Christmas savers. The Christmas savers order book for the current year (Christmas 2020), which will be the driver of Consumer billings in the current year, was effectively built before the pandemic took hold and subsequent order cancellations continue to run in line with historical trends. The Christmas savers order book is nevertheless lower than in the previous year (-9%), reflecting pressures on traditional agency distribution.

Ahead of the peak Q3 trading, the company continues to feel it inappropriate to provide forward-looking guidance. In addition to the uncertain development of the economy, the potential for a second wave of the pandemic, continuing social distancing constraints, and the winding down of the hamper business all represent additional operational risks.

However, Appreciate has provided details on several scenarios that it has modelled in order to assess the potential impact of the pandemic on its results of the group going forward and says that it is currently trading slightly ahead of its base case scenario. The base case assumed a 60% decline in corporate and other consumer billings in Q121 (compared with the actual outcome of -48%) followed by a gradual recovery to -25% by Q4. The recovery is assumed to continue in the first two quarters of FY22, with year-on-year increases of 40%. Subject to its independent order and billings pattern, Christmas savers’ billings are assumed to be 11% lower in FY21. While each of the scenarios points to a positive cash position including the new £15m revolving credit facility (RCF) by end-FY21, the base case does not show a need for any RCF drawing, to fund resumed growth in billings, focused on card and digital product, until July 2021 and for a short period, with offsetting positive cash flow emerging by September 2021.

We have updated our own tentative forecasts, increasing our FY21 PBT forecast (with no anticipated adjustments required) despite very slightly trimming billings and revenue forecasts. The PBT increase is driven by an expectation of higher gross margin, in line with FY20 performance, resulting from the product mix shift towards more profitable card and digital product. For FY22, we have trimmed the strength of the assumed billings and revenue recovery, reflecting an anticipation that the economy will be slower to bounce back.

We forecast a reinstatement of DPS payments in respect of FY21 and continued growth in FY22, albeit at a slower rate than previously forecast.

The continuing strong growth in the share of card/digital products and the relative decline in own voucher products, both as a share of the total and in absolute terms, is positive for profitability and to be welcomed. However, in the near term it has the effect of reducing operational cash flow. This is not because card/digital products consume cash to any significant extent; rather it is because the lower-margin voucher products are cash generative, so long as sales are rising.

As a non-regulated product (unlike card/digital), although customer balances in respect of own voucher sales are segregated, at the point of despatch/billing the cash may be transferred to the corporate cash balance. The majority will eventually be paid out to retail partners once the vouchers have been redeemed, but meanwhile sits with the company and is offset by an equivalent balance sheet provision. Customer card/digital cash balances are strictly segregated within the e-money trust until such time as ‘contractual ownership’ passes to Appreciate. The change in contractual ownership most commonly occurs at redemption and in this respect is in line with revenue and profit recognition. However, revenue recognition in respect of ‘breakage’ (where there is anticipation that the card balance will never be redeemed) is determined by observed redemption patterns and this is likely to differ from cash emergence over the short term, with cash emergence typically lagging revenue recognition when billings/sales are increasing.

During FY20, own voucher billings (paper) declined from £200m (48% of the total) to £170m (42% of the total) and the voucher provision balance reduced from £36.3m to £30.2m, representing a cash outflow of £6.1m. We forecast a continued decline in voucher billings over the next two years, both in absolute terms and as a share of the total (to less than 30%), and forecast a further halving of the provision balance. This is the main driver of our forecast reduction in the group cash balance. It is worth noting that in our DCF valuation (see below), we deduct upfront the value of the voucher provision balance and so its anticipated decline is neutral to valuation.

Total cash balances, combining free cash and segregated customer cash, normally peak in September/October, ahead of Christmas. The peak in FY20 was £234.6m, only very slightly below FY19. Free cash tends to be weakest around the same time (Exhibit 11), as stocks are built, but then increases again as orders are despatched, particularly in respect of vouchers as described above. Exhibit 12 shows that with the declining share of vouchers in sales, the swings in free cash have become somewhat more muted. It also shows that without the benefit of cash temporarily released from vouchers, free cash would have been negative around October 2019.

In August, to provide additional financial flexibility to drive medium-term growth of higher-margin but less immediately cash-generative card and digital product, Appreciate agreed a £15m unsecured five-year revolving credit facility on favourable terms (1.65% above Libor on drawn balances). The agreement includes an accordion option to extend the facility by an additional £10m. Consistent with our billings growth and mix forecasts, we anticipate that this may be first used during FY22, when we expect sales volumes to be recovering quite strongly, led by card and digital product, and with the positive cash effect of vouchers further diminishing. Our expectation is that, at least initially, it will be used during peak funding periods and so does not appear on our forecast balance sheet at end-FY22.

Under IFRS accounting, there is a distinction between sales where Appreciate has control over the promised good or service, acting as ‘principal’, and those where it is simply arranging for another party to provide the good or service, acting as ‘agent’. In the case of own-branded, multi-retailer redemption product, the group acts as an agent. For third-party, single-retailer redemption products and all other goods and services, the group acts as principal. When acting as an agent, revenues are recorded on a net basis representing the service fees receivable from the retailers/redemption partners. When acting as principal, revenues are recorded on a gross basis. For third-party, single-retailer redemption products, this means that revenues are equivalent to the face value of the voucher or card less any discounts. In the case of services provided by the group, revenues represent the values invoiced.

As a result, changes in the mix of sales will significantly affect the revenues reported as well as the gross margin (on revenues), but does not change the gross profit that will ultimately be earned. For this reason, billings is our preferred measure of customer activity and our preferred measure of ‘sales’. It represents the gross value of vouchers, cards, and other goods and services provided and, unlike statutory revenues, it is unaffected by changes in business mix between multi-retailer redemption product and other goods and services, including single retailer cards, vouchers and e-codes.

Revenues are recognised when control over the good or service has been transferred to the customer. In the case of multi-retailer redemption vouchers, cards and digital products, service fees are recognised at redemption, ie when the product is ‘spent’ with one of the group’s retail partners. For single-retailer redemption products, revenues are generally recognised when they are received by the customer. A certain proportion of the vouchers and cards sold by and distributed by Appreciate will never be redeemed and for multi-retailer redemption products (but not for third-party, single-retailer redemption product) where the customer has no right of redemption (ie cannot request a refund of unspent balances), this ‘breakage’ represents an additional source of revenue and earnings, and is recognised in proportion to the rate of redemption. Rather than breakage being recognised on unredeemed balances, cards with a right of redemption are subject to account fees that are recognised as levied on or after the expiry of the card.

A satisfactory direct valuation comparison of Appreciate Group with quoted competitors is not possible. There are no direct comparators for the Christmas savers business, and competitor employee benefits and service providers are either private companies or relatively small parts of larger groups, complicating any attempt at a relative valuation approach. In incentive and rewards products, Sodexo and Edenred are both much larger and more international, and the overlap between Appreciate and Sodexo is limited (Sodexo Benefits and Rewards Services is only a minor part of Sodexo Group). With that in mind, our valuation approach continues to combine a potential absolute valuation, based on a modified DCF analysis, alongside a relative value based on a comparison with a selected group of listed stocks which are engaged in activities that provide some overlap with Appreciate.

Our DCF value is 60p, down slightly from 64p due to our FY22 forecast reduction. It continues to include a two-stage growth model to better capture (albeit imperfectly) the expected recovery from COVID-19 and medium-term benefits of the strategic business plan investment. Given that our near-term forecasts are suppressed by investment spending and the pandemic, it is difficult to attach a target multiple, but we note that the 60p DCF value implies a CY20 P/E multiple of 30.0x and a CY21 P/E multiple of 22x. Although high as a result of near-term earnings pressures, we believe these multiples are reasonable in the context of the comparator stocks, notwithstanding the relatively low market capitalisation and implied lower liquidity.

Our modified DCF valuation differs from a standard DCF in that we include the interest earned on segregated customer cash balances (but not on the group cash balances), recognising that this is an integral part of the returns the company generates. The customer cash is excluded from the overall valuation and we also exclude the voucher provisions balance, as this will eventually flow out in settlement of vouchers that have been issued but not yet redeemed. Our key assumptions have been held constant for an extended period, including an assumed 10% discount rate and 10x terminal multiple. Our two-stage growth assumption comprises three years of 10% growth beyond the two-year forecast period (to end-FY22), followed by a reversion to a long-term growth rate of 5% up until year 10. We continue to assume an eventual ‘normalisation’ in interest rates and assume a stepped increase in market deposit rates to 1.5% in FY23 and 3% from FY24 and, as noted above, we deduct upfront from the DCF valuation the amount of voucher provisions (£30.2m at end-FY20) on the basis that the matching cash is only temporarily available to the group, albeit on a revolving basis. As a result, the expected further decline in the voucher provision balance, and the negative impact on near-term operating cash flow, has no impact on our DCF valuation.

Our quoted ‘comparator’ group includes both Sodexo and Edenred, and also the prepaid card and payments service providers Euronet Worldwide, Fleetcor Technologies, Green Dot Corp, and EML Payments (we previously included Wirecard but have removed it due to its accounting issues).

As a result of the continuing COVID-19 pandemic and its uncertain effect on the economy and trading conditions, our forecast assumptions, set out in the financial section above, are best seen as tentative. In addition to pandemic-related risks, we note the following fundamental sensitivities to the performance of the business and our forecasts: