Appreciate Group — Return to profitability in H2 as expected

Pandemic lockdown measures throughout the year, as well as costs related to the continued business transformation programme, had a significant negative impact on the statutory results reported under IFRS. The IFRS annual result nonetheless remained positive and showed a strong rebound in H2 (H2 PBT was a positive £8.8m vs a H1 loss of £7.5m), in part reflecting the normal seasonal pattern but also the steady recovery in year-on-year billings from the initial sharp decline during the first pandemic lockdown. The impact of the pandemic was similarly apparent in the FY21 adjusted/underlying earnings although on this basis the financial performance was noticeably more robust. Exhibit 1 provides a summary of the IFRS results with PBT declining to £1.3m (FY20: £7.7m) including c £1.0m (£3.7m) of net negative exceptional and non-recurring items. Not shown separately within the IFRS exceptional and non-recurring items are the temporary, up-front negative impacts of the business transformation programme on the trading performance, particularly in relation to non-core activities that have been wound down or disposed of. We do not expect these negative impacts to be repeated, while future business growth and profitability should benefit from the measures undertaken.

In Exhibit 2 we show a reconciliation to adjusted earnings of £4.2m before tax. This adds back the exceptional and non-recurring items that are contained in the IFRS results (and shown in Exhibit 1 above), as well as management adjustments for the temporary impact on trading performance of the wind-down of hamper production, the sale of the FMI subsidiary and the group relocation to its new head office in central Liverpool. Adjusted PBT of £4.2m compared with our forecast of £4.5m on the same basis.

FY21 group billings fell by 3% to £406.5m. This is comprised of core billings of £402.5m and ‘other’ billings (fees and services) of £4.0m. This included a £23m contribution from the successful free summer school meals partnership with Iceland, one-off in nature and relatively low margin, as well as a £7.8m reduction in billings related to the strategic wind-down of the hamper and packaging operations. Excluding both these items, billings were 8% lower.

To provide a clearer picture of trading performance, APP has throughout the year published data on underlying billings. This measure of billings excludes Christmas savers (where billings are driven by the timing of order despatch, primarily in the second half of the year, ahead of Christmas), as well as the ‘other’ group billings, and the £23.0m of one-off billings related to the free school meals scheme. Hence, underlying billings comprise corporate billings (less free school meals billings) plus HSV.com. Based on redemption products only (ie excluding hampers) Christmas mas savers billings were down by c 6%. If hampers are included, the decline was c 8%. The order book for the current year is currently predicted to be down by 14% (compared with the 11% predicted in May), having been held back by lockdown restrictions impacting face-to-face agent activity.

Underlying billings fell sharply during the first lockdown, but the year-on-year comparison improved during Q2 (July-September) and was strongly positive in Q3 (September-December), seasonally the most important trading period in the year (c 70% of the annual total). December 2020 was APP’s busiest ever month, with corporate customers seeking ways to reward employees as an alternative to Christmas parties. The post-Christmas Q4 period is typically the quietest quarter of the year (although it was stronger than Q1 during FY21 due to the pandemic) and although billings were 11% lower year-on-year, in absolute terms the drop was only c £4m. For the year, underlying billings were c 8% lower, with H2 growth of c 6% year-on-year.

Q122 billings are up strongly compared with a very weak Q121 (82.7%) but are down by 8.6% compared with Q120, not affected by the pandemic. While billings performance since the start of CY21 is a little weaker than management had anticipated it is important to remember that due to seasonality these are normally the weakest quarters. We estimate that an 8.6% decline in Q122 billings versus Q120 is likely to represent less than £4m. APP believes that since the strong pre-Christmas period, corporate customers have likely been focused on operational planning for their business in the post-lockdown environment and expects that demand related to employee recognition and customer acquisition will increase during the year.

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

The share of billings represented by the group’s own higher margin multi-retailer product (cards, vouchers and digital) increased further to 86.5%. The reduced share of ‘other’ reflects the winding down of hampers and storage and the sale of FMI. In terms of revenues, an increased volume of digital code product was converted, at the option of customers, to single store product. Management believes that the increased use of this flexible option built into the digital codes reflects customer behaviour during the lockdown.

Decisive action was taken during the past year to adapt to the new environment. This included a further acceleration in digitalisation, in step with market developments, as evidenced by the strong growth in digital product billings and further reduction in paper product. The strategic actions taken by management in the past two years both mitigated the worst impacts of the pandemic and left the group in a better position to capitalise on the market recovery and exploit growth opportunities.

Having disposed of, or withdrawn from, FMI, hamper production, third-party contract packaging and the small operation in the Republic of Ireland, APP is now fully focused on growing its more profitable core business of own branded multi-retailer product. Clarity of the product offering has increased significantly with more than 400 product variations removed. The stability of core systems has been greatly improved, allowing a significant increase in online transactions to be handled with zero system outages.

The next stage of the new enterprise resource planning system, the cornerstone of APP’s plans to build a robust and scalable business platform, remains on track to be delivered in the summer of 2021, with the following phase to be delivered in the second half of the year.

A new partnership with PayPoint will see APP’s gifting products offered to customers across PayPoint’s 28,000 UK retail partner store outlets. This is APP’s first physical distribution presence for Love2Shop e-gift cards, which management sees as adding additional depth to how customers can access the group’s products. APP is also working with PayPoint to provide marketing support for its retailer partner stores to maximise their awareness of, and familiarity with, the product. At this early stage management has not provided any guidance on the potential impact of this novel distribution development. However, given the size of the PayPoint network the potential for incremental sales growth is clear.

FY21 billings had been previously reported. Our FY21 revenue forecast did not account for the £23m free school meal scheme revenues and adjusted for this were lower than we had assumed due to product mix and redemption patterns. As indicated by management in its 29 April trading update, adjusted PBT was within the range of market forecasts at that time (£4.1 to £4.8m) but at the low end, and below our £4.5m forecast. DPS of 1.0p reflected a 50% pay-out of adjusted earnings, in line with the historical pay-out ratio but below the 1.2p that we forecast, assuming higher earnings and that the 0.4p paid for H121 would be reflected in a ‘one-third/two-third’ DPS pattern for the year.

Our forecasts reflect a more cautious appraisal of the likely speed of the trading recovery, with billings and revenues both lower in FY22 but substantially offset by stronger than previously forecast growth in FY23.

The impact on adjusted PBT is somewhat larger due to operational gearing, and also reflects a more cautious assumption on gross margin, reflecting the FY21 data. Our DPS forecasts reflect a c 50% pay-out and are reduced in line with forecast earnings.

Our cash flow forecasts continue to reflect our expectation of a cash outflow as paper voucher redemptions pick up with lockdown easing and as the share of paper vouchers in the billings mix continues to decline in favour of higher margin but less immediately cash generating card and digital product. Should this occur at a faster pace than we allow, the £15m undrawn revolving credit facility is in place to provide financial flexibility during peak trading periods. As we explain in the next section, the cash outflow associated with the run-off of voucher provision balances has no impact on our valuation.

Assuming a return to more normal trading conditions, as reflected in our near-term forecasts, and considering the longer-term growth potential, we continue to see significant value in APP shares. The price discount to our unchanged fair value of 60p has widened since the FY21 results to c 50%. In our view the poor reaction of the share price to the results reflects indications at this early stage of the financial year that the sales and profitability improvement in FY22 may not be as strong as the market (and we) had previously anticipated. This is reflected in our revised estimates and the c 20% decline in the share price since the results compares with a c 4% reduction in our FY23 forecasts. Evidence of continued improvement in trading as the economy begins to fully open has the potential to act as a catalyst for a significant re-rating.

A satisfactory direct valuation comparison of APP with quoted competitors is not possible. There are no direct quoted comparators for the Christmas savings 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 APP and Sodexo is limited (Sodexo Benefits and Rewards Services is only a minor part of Sodexo Group). We nevertheless include these in our quoted comparator group along with a selection of prepaid card and payments service providers (Euronet Worldwide, FleetCor Technologies, Green Dot Corp and EML Payments).

Our DCF value is unchanged at 60p as FY21 drops out of our rolling 10-year time horizon and offsets the impact of reductions in FY22 and FY23 forecasts. The DCF valuation of 60p implies a ‘target’ P/E multiple (using adjusted earnings) of c 22.8x for CY21 and 16.4x for CY22. Although relatively high due to near-term earnings pressures, we believe these multiples are reasonable in the context of the comparator stocks, despite the comparatively 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 group cash balances), recognising this is an integral part of the returns the company generates (although the contribution is greatly reduced at current low interest rates). The customer cash itself 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. Beyond the forecast period (to end-FY23), we use a two-stage growth assumption to allow for the potential medium-term benefits of the strategic business plan investment. For the first two years beyond the forecast period (years three and four), we assume 10% growth in underlying free cash flows, 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 FY24 and 3% from FY25 and, as noted above, we deduct upfront from the DCF valuation the amount of voucher provisions (an estimated £34.8m at end-FY21) on the basis that the matching cash is only temporarily available to the group, albeit on a revolving basis. As a result of this methodology, the DCF value is not enhanced by the current voucher provision balance, nor does the expected future decline in the voucher provision balance have any impact.