John Laing Group — Positive outlook for growth

JLG originates, invests in and manages portfolios of infrastructure projects. The business operates in selected geographical markets – Asia-Pacific, North America and Europe – and is focused on the transport, environmental and social sectors. As at 30 June 2017, the value of the investment portfolio of 42 projects and JLG’s holding in JLEN was £1,119.3m. The assets are split between projects under construction, ‘primary’ (c 59%) and operational projects, ‘secondary’ (c 41%). JLG has separately listed two funds on the London Stock Exchange: John Laing Environmental Assets (JLEN in 2014) and John Laing Infrastructure Fund (JLIF in 2010). JLG retains c 2.8% of JLEN.

Over the last year JLG has increased its NAV from 263p (30 June 2016) to 284p (30 June 2017). During the same period, the share price moved from a discount to NAV to a small premium. As a result of its strong share price performance, JLG now stands at a premium to its last reported NAV but still at a discount to other infrastructure funds, which currently trade at a 14% premium. We believe that the higher proportion of primary assets, when compared to its peers, should allow for superior NAV growth and help to compensate for the lower yield available to shareholders. The growth that we forecast for the period 2016-21 should provide for an attractive total return for shareholders.

Our forecasts for NAV and DPS growth, considered by JLG to be its key performance benchmarks, are shown in Exhibit 1. Our forecasts are constructed on the basis that in the long term annual realisations in the portfolio are equal to annual investments. For the period 2016-21 we expect a CAGR in NAV per share of 11.1%. We expect 3% growth (2016-21e) in the ordinary DPS and assume a special dividend equivalent to c 7.7% of the value of the investment realisations, resulting in a CAGR of 5.2% in DPS for the same period.

JLG’s valuation is particularly sensitive to changes in discount rates and foreign exchange rates.

JLG’s market positioning and track record of delivering growth should allow it to benefit from the strong macro trends for both primary and secondary investment in the infrastructure and renewable energy markets globally. These trends should, in part, also benefit JLEN and JLIF, whose assets are managed by JLG, and whose continued growth will have beneficial impact on JLG. As a result, we expect JLG to continue to deliver strong growth in DPS and NAV over our forecast period, providing an attractive potential total return for shareholders.

We have already noted that JLG originates, invests in and manages portfolios of infrastructure projects on a global basis. It is also important to recognise that JLG benefits from both a diverse portfolio of projects and a pipeline of potential new projects. The business encompasses infrastructure and renewable energy projects at both the greenfield and operational stage. The diversity of the business, in terms of geography, asset type and stage of development, provides JLG with a strong competitive position compared to some of its more tightly focused peers. In a market where reputation and experience as an investor/developer are important, JLG can also point to a long and successful track record of investment, particularly when compared to some more recently constituted funds. JLG made its first infrastructure project investment in 1969 (over 120 projects since) and has a track record of successful investment in renewable energy since 2011. The existence of JLIF and JLEN provides a market opportunity for JLG to sell its operational projects.

JLG’s strategy is to create value by utilising its investment origination and project management skills. JLG pursues this strategy on an international basis and across an array of infrastructure (roads/rails/hospitals) and renewable energy (solar/wind). To deliver its strategy JLG targets growth in primary investment and external AUM and ongoing active management of its portfolio. In keeping with this focused approach, JLG sold its Project Management Services (PMS) activities in the UK in 2016 to concentrate on the origination of greenfield projects and the active management of construction and operational risk.

Phil Nolan remains chairman of JLG and Olivier Brousse and Patrick O’D Bourke stay as CEO and group finance director respectively. Carolyn Cattermole remains as company secretary and Chris Waples remains as MD of asset management and sits on the Executive Committee. Derek Potts, formerly MD of primary investment, retired during the year but remains actively involved in the Investment Committee. The business retains significant experience and expertise in all of its core markets. In addition to Phil Nolan, four other non-executive directors sit on the board of the company.

The combination of embedded growth in its existing portfolio and the active management of the New Royal Adelaide Hospital (NRAH) and Manchester Waste projects enabled JLG to report continued growth in its NAV in H117 (+7p/share). With less onerous dividend payments due in H2 (c £7m versus £23.1m in H1), we expect this combination of structural growth and active value creation to deliver more significant growth in the second half of the year (+19p/share) and enable JLG to achieve an attractive 9.7% in NAV per share for FY17 as a whole. Strong market positioning and a growing demand for infrastructure investment should provide opportunities for investment and enable attractive longer-term growth.

JLG measures its success by reference to growth in the DPS and NAV. In FY16, it succeeded in increasing the DPS by 5% (vs a theoretical payment in FY15) and the NAV per share by 14.3% (277p vs 242p). Underpinning the growth in NAV and DPS, JLG has targeted three supporting objectives: growth in primary investment, growth in external assets under management (AUM) and ongoing management and enhancement of the investment portfolio. Successful implementation of its strategic plan has enabled JLG to achieve an impressive track record of growth in these operational benchmarks in the period 2011-16.

In H117 JLG increased the interim DPS by 3%, to 1.91p (Edison estimate 1.89p) and the NAV rose during the period by 2.3% to 284p. The growth in NAV was achieved despite a £25.5m (c 7p/ share) reduction in the valuation of its holding in the Manchester Waste project and the payment (in May) of last year’s final ordinary dividend and special dividend, at a total cost of £23.1m (c 6p/ share). Prior to the payment of the DPS, but not the reduction in the value of the Manchester Waste project, JLG stated that the NAV would have risen by 4.6% (to c 290p/share).

Beyond the headline growth in DPS and NAV, there were further increases (vs FY16) in the investment pipeline (+1.4% to £1,885m) and external assets under management (+7.4% to £1,582m) versus FY16 levels. Investment commitments of £111.3m (post-period end increased to £158.9m as a result of Buckthorn wind farm in the US) also compared favourably to the £76m made in H116. Actual investment in H117 totalled £56.1m, with realisations of £151.3m. The c £95m disparity between investments and realisations contributed the most significant proportion of the reduction in value of investments, from £1,258m to £1,147m, but also a reduction in short-term borrowings by c £100m. JLG has maintained its guidance for FY17 of investment commitments and realisations of c £200m.

The fair value movement on the portfolio in H117 of £53.3m (which also constitutes >95% of the net gain of investments at fair value through the profit and loss account) fell significantly on H116 (£128.2m), in large part due to a £46.0m fall (H117 vs H116) in foreign exchange movements, a decrease in value due to changes in power and gas forecasts (-£6.6m H117 vs H116) and the £25.5m reduction in the carrying value of the Manchester Waste project. Changes in operational discount rates (H117 8.6% versus 8.9% for FY17) contributed £20.2m of the FV movement (£27.5m in H116), while the annual unwinding of discount in the DCF model and the reduction of construction risk premia (“embedded value”) totalled £59.4m (£54m H116). The reduction in the FV movement in H1 contributed to the reduction in PBT from £108.3m to £36.6m and a fall diluted EPS from 28.9p to 10.1p.

We have updated our forecasts to reflect the H1 results and we now expect a FY ordinary DPS of 9.80p versus 9.75p previously (special DPS unchanged at 4.09p) and an FY17 NAV per share of 304p (310p previously). Our forecast NAV per share for FY17 represents year-on-year growth of 9.7%. The changes to the key benchmarks of DPS and NAV per share are shown below (Exhibit 4). Implicit in our forecasts is the expectation of stronger growth in H2 (helped in part by lower DPS payments in H2) and we discuss the assumptions underpinning our forecasts in more detail in a later section of this report.

JLG’s portfolio currently (H117) comprises 43 investments (18 primary investments + 24 secondary investments + £10.1m holding in JLEN), with a total value of £1,119.3m. The portfolio remains well diversified by geography, sector, operational status and revenue drivers (see Exhibits 5 to 8). The investment pipeline, which now stands at c £1.9bn, is also well diversified, split between PPP of £1,383m and Renewable Energy £502m. The total pipeline is geographically divided as follows: North America 36%, Europe 35% and Asia Pacific 29%. In addition, as at 30 June 2017, over 50% of the total portfolio had more than 25 years of concession life remaining, with the five largest investments comprising c 45% of the total portfolio valuation.

The value of the portfolio evolves as a result of the addition of new investments, less the value of realised investments and the cash paid out by the underlying investments (cash yield). In addition, the value of the portfolio is significantly influenced by the annual fair value adjustment.

A proportion of the FV adjustment is the product of enhancements made to projects by JLG (‘value enhancement’) and some are the result of exogenous forces such as exchange rate movements. However, a significant proportion of the FV relates to embedded value within the investment portfolio and is generated by the twice-yearly updating of a project’s DCF. In FY16, the unwinding of the discount rate and the reduction of construction risk as the projects neared completion, the two principal constituents of embedded growth, represented a positive increment to the value of the portfolio of c £130m, equivalent to 61% of the total fair value adjustment and 15% of the opening portfolio value. In H117 embedded growth contributed c £59m to the fair value movement. Over the period 2014-16 the value of the embedded adjustments averaged c 12% of the opening portfolio value.

JLG also creates value as a result of active project management, which is also reflected in the FV movement through the P&L. Value enhancement can arise as a result of a variety of actions, for example changes to a project’s financial positioning or bulk purchase of insurance, but can also be delivered as a result of dispute resolution with other interested parties. In H117, JLG was heavily involved in the active management of two projects, in particular the New Royal Adelaide Hospital (NRAH) and Manchester Waste.

The SA Health Partnership consortium achieved financial close on the A$1.85bn NRAH in June 2011. JLG provided private equity for the project to develop the facility, but the project was delayed from the scheduled technical completion date of April 2016. The NRAH project company was subsequently in dispute over the Government of South Australia’s non-acceptance of a cure plan devised to address delays. However, after a period of negotiation with the Government of South Australia, JLG achieved commercial acceptance for the NRAH on 13 June 2017. Contract payments of A$1m a day to the consortium have started and JLG included the investment in its secondary portfolio as at the end of June, resulting in a small, but undisclosed uplift to the valuation.

Similarly, JLG was involved in continuing discussions to resolve the dispute with the Greater Manchester Waste Disposal Authority (GMWDA). JLG’s investment in the Manchester Waste project is held via two vehicles: Manchester Waste VL Co and Manchester Waste TPS Co (waste to energy plant). The two projects are contractually linked. The GMWDA signed a 25-year private finance initiative deal with Viridor Laing in 2009, but in May this year it became known that the GMWDA was seeking to terminate the contract. Since the beginning of May JLG has been in discussions with GMWDA, which have now culminated in legally binding heads of terms between VL Co and its shareholders, the operator Viridor Waste and GMWDA. The transactions involved in the completion of the dispute resolution are expected to complete by the end of September and will result in the termination of the PFI contract and the purchase of VL Co by GMWDA. TPS Co will continue to be held by its existing shareholders. JLG estimates that the financial effect of the transactions will result in a reduction in the value of its two Manchester Waste investments by £25.5m and this has been reflected in the H117 results. While the reduction in the valuation of the investments is clearly unwelcome, JLG believes that by agreeing the deal it has avoided continuing uncertainty and a potentially costly legal dispute. Post the reduction in value, we believe the Manchester Waste investment will amount to c 6% of JLG’s total portfolio (previously 8%) of £1,119.3m (c £67m –still above the original equity investment in the projects).

The primary portfolio (£656.5m, c 59% of the total portfolio as at 30 June 2017) contains investments in projects that have yet to reach ‘financial close’ or assets that have reached financial close but are not yet operational. Each year the value of the primary portfolio is boosted by new investment (£55.3m in H117) but diminished by the transfer of investments to the secondary portfolio (£166.7m in H117). Investments are valued using a DCF template with a variety of discount rates applied depending on project type, location and/or state of completion.

Each year, in addition to the effects of new investment and disposals, the value of the primary portfolio is boosted by the impact of portfolio book value evolution (£71.6m in H117) of which embedded value forms a part. This portfolio book evolution effectively captures the progressive reduction in the risk profile between the time of initial investment and commercial operation. Renewable energy projects have a shorter gestation period than infrastructure projects..

As we have noted, once operational, projects are transferred to JLG’s secondary investment portfolio (£166.7m in H117) and valued using a market-based discount rate. Secondary assets can either be held to maturity or sold to secondary market investors (disposal of three projects in H117 raising £151.3m). JLIF and JLEN retain the right of first offer in respect of certain assets. In the period 2011-16, on average, JLG made annual disposals equivalent to c 20% of the opening value of the total portfolio (minimum 11%, maximum 29%). Management has guided to disposal for FY17 as a whole of £200m.

While projects are held, JLG receives income from the investments, known as ‘cash yield’ (£14.7m H117). The cash yield takes the form of dividend income and the repayment of subordinate debt and, along with revenue generated from the management of external funds, which we consider in the following section, constitutes the principal source of income for JLG. Management guidance is that, in a normal year, the cash yield on the portfolio should amount to between 6.5% and 8.5% of the average annual value of the secondary portfolio.

Beyond the cash yield from the investment portfolio, JLG generates additional revenue (fees) from the provision of investment management services (IMS) to external funds, JLIF and JLEN, as well as its own primary and secondary portfolio. Along with the cash yield on the secondary portfolio of assets, investment management fees comprise a significant proportion of operating cash flow for JLG. In FY16 JLG generated £17.8m from IMS. Of the £17.8m, £2m related to services provided to its own primary and secondary portfolio, with £15.8m (£8.1m H117) generated from the provision of services to JLEN and JLIF. JLG’s management fee is directly linked to the value of the assets under management (AUM) and therefore the financial health of JLIF and JLEN, beyond their ability to acquire secondary assets, is important to JLG. In H117 both funds raised additional capital from investors (£175m). In March JLIF placed 89.8m new shares with investors, raising gross proceeds of c £119.5m (bringing the total raised since launch in 2010 to £1bn). JLEN has carried out two placings so far in 2017, raising £55.5m in February (issuing 55m shares) and a further £40m in July (38.8m shares). The evolution of JLG’s external assets under management can be seen in Exhibit 11. As JLG earns a management fee approximately equivalent to 1% of the AUM, each £100m (6.3%) move in the average aggregate value of the funds is equivalent to c £1m of annual revenue.

In addition to IMS revenue, JLG generates revenue from Project Management Services (PMS) provided under management service agreements to projects in which JLG, JLIF or JLEN hold investments. In 2016 JLG sold the UK activities of the PMS business to HCP. The business sold accounted for £7.9m of the total revenue of £14.9m generated in FY16. The costs associated with this business were c £6m in FY16.

The long-term drivers of infrastructure investment; namely population growth and increased urbanisation, remain in place. Long-term forecasts from the McKinsey Global Institute Bridging Global Infrastructure Gaps (June 2016) argues that the world will need to invest $3.3tn pa in the period 2016-30 to meet its needs for transport, power, water and telecoms compared to $2.5tn today. JLG has stated that “we continue to see strong opportunities for growth” and in particular has highlighted a strong market in the US at the city and state level (not yet federal) and some tentative signs of growth in selected European markets (Spain, Germany).

The outlook for investment in renewable energy continues to appear favourable. In its 2017 Energy Outlook, BP revised up its projections for the deployment of renewable power generation over the forecast period (2015-30 and now predicts annual growth of 7.6% (previously 6.6%). The IEA in its World Energy Outlook 2016 forecasts that 60% of all new power generation capacity in 2040 will come from renewable sources. Both bodies anticipate that increased deployment will be driven by falling costs, in particular for solar and wind, which are predicted to comprise the majority of renewable capacity. According to the United Nations Environment Programme , around 94% of all new renewable investment in 2016 was represented by either solar or renewable.

Beyond the scenarios for primary investment, the market for secondary assets remains strong. The Frankfurt School - UNEP Collaborating Centre for Climate & Sustainable Energy Finance has pointed out that the fastest evolving aspect of equity provision for renewable energy projects is at the post-construction stage. Investors (North American yield cos/London-based project funds) have been attracted to the “predictable cash flows and income-producing characteristics of an operational project.”

Derek Potts, formerly MD of primary investment, retired during the year but remains involved in the Investment Committee. Aside from Mr Potts, there have been no other significant changes to the management team and the business retains significant experience in all of its core markets. Phil Nolan remains chairman and Olivier Brousse and Patrick O’D Bourke stay as CEO and group finance director respectively. Carolyn Cattermole remains as company secretary and Chris Waples remains as MD of asset management and sits on the Executive Committee. In addition to Phil Nolan, four other non-executive directors sit currently on the board of the company.

Under IFRS 10, JLG meets the criteria for classification as an investment entity and prepares its statutory accounts accordingly. As such, investment in all subsidiaries, other than those directly owned subsidiaries which provide investment-related services and are not classified as investment entities, is consolidated on a line-for-line basis. This means that subsidiaries which hold non-recourse investments, along with other assets and liabilities, are consolidated on a line-for-line basis.

However, for the purposes of the day-to-day management of the business, the directors use accounts “re-presented” on a management reporting basis. In its 2016 Annual Report and Accounts, JLG set out a re-presented set of financial statements and again reported re-presented figures in H117.

For H117 the changes to the P&L were minimal, with PBT unchanged and EBIT £0.6m higher on the re-presented basis. On the balance sheet there were more significant changes. Among the principal differences were cash balances, which were £3.9m higher (at £5.6m) on the re-presented basis with a further £20.5m of cash collateral balances. The FV of investments was £27.4m lower due to the exclusion of other costs and liabilities in the recourse investment subsidiaries. In total, assets were £8m lower once other smaller differences were accounted for, while liabilities reduced by a corresponding amount, principally as a result of changes to working capital balances. Net debt of £38.6m was calculated as cash of £5.6m, plus cash collateral of £20.5m, less borrowings of £64.7m. Net debt of £38.6m is therefore lower than the figure that would be calculated using the statutory figures (net debt £60m = cash of £1.7m less £61.7m of borrowings).

The most significant discrepancies arise in the cash flow statement. In Exhibit 12 below, we show the major area of differences. Within the operating cash flow the most significant difference is that the re-presented figure includes a cash yield of £15.1m, not included in the statutory figure. The figure for investing activities differs because the re-presented figures exclude FV movements and principally reflect only cash investments and proceeds from the realisation of projects. The financing line in the re-presented accounts also includes finance and dividend costs (£27.5m) and excludes net movement in borrowings of -£100.3m.

We continue to use NAV per share as the principal benchmark for evaluating JLG’s share price. Exhibit 13 shows that since the beginning of 2015 JLG has achieved growth, both in its NAV/share and its absolute share price. Over the last six months in particular, a strong share price performance has allowed JLG to move to a premium to its historic stated NAV (284p at 30 June 2017).

However, as Exhibit 14 shows, despite the strong share price performance, JLG still trades at a discount to its peers when judged on a P/NAV basis. JLG’s yield lags that of comparable companies and while dividend cover remains strong, the early stage nature of JLG’s portfolio, giving rise to a lower cash yield than many of its peers, acts as a short-term restraint to higher DPS payments. In the longer term, we expect an expansion of the secondary portfolio and with it the cash yield, allowing JLG to move towards cash coverage of the DPS. We expect that the lower yield will be compensated for by a higher rate of NAV growth (Edison forecast 2016-21 c 11% CAGR) than conventional infrastructure funds, which have grown at a CAGR of c 10% over the last five years and c 7% CAGR over the last three years (JLG 13% CAGR 2014-16). While JLG has posted strong share price performance in recent months and now stands at a premium to NAV, we expect the superior rate of growth in NAV and ongoing increases in the DPS to continue to deliver an attractive total return for shareholders and close the remaining valuation gap to its peers.

Below we set out some of the principal assumptions that underpin our forecasts. Our projections for the benchmarks of NAV per share and DPS have changed marginally following the H117 results and are summarised in Exhibit 15.