Stobart Group — Update 14 June 2016

In 2014, Stobart Group partially disposed of its Transport and Distribution business, Eddie Stobart Logistics (ESL). Stobart retains 49% of ESL (Stobart accounts for the group as an associate) and therefore has good exposure to its earnings growth and any future disposal proceeds from its Private Equity majority owner, DBAY.

Stobart aims for its Support Services business – Energy, Aviation and Rail – to be its main growth engines over the coming years.

Stobart’s other two reporting segments are ‘Infrastructure’ and ‘Investments’. Infrastructure is where the physical assets are owned and Investments is composed of its two minority stakes in Eddie Stobart Logistics (ESL) and Propius – an aircraft leasing business. AT FY16, Infrastructure assets had a book value of £147m and Investments a carrying value of £105m. We expect achieved sale prices to be in excess of these valuations based on recent disposals announced (for example the Speke property disposal in June 2016 achieved a price of £37m versus a book value of £25.2m).

Our SOTP-derived fair value based on FY17 estimates is £1.35/share offering 7.1% upside to the current price of £1.27. We use different EBITDA multiples for each operating segment within the Support Services business depending on business-type and outlook. We use a book value multiple for the Infrastructure and Investments businesses. Given we are four months into FY17, we take an average of our FY17 and FY18 FVs. As EBITDA ramps up between FY17 and FY19, our FV will increase. Our provisional FY18 EBITDA-based fair value is £1.50/share.

Stobart reported a healthy group EBITDA of £30m for FY16 although the bulk of outperformance in the Infrastructure division was driven by an upwards non-cash asset revaluation (Speke). On the whole, the business performed well in FY16, with 25% EBITDA growth in the Support Services businesses, £24m of disposals, a continuation of the 6p DPS (4.7% dividend yield) and, most importantly, the company reiterated its FY19 guidance for the Energy and Aviation units.

The targeted 2m tonnes of biomass supplied at an average EBITDA of £10/ tonne in 2019, together with the 2.5 million passengers forecast at Southend Airport in the same year, with each passenger providing £8 of EBITDA will drive a marked increase in group EBITDA. Energy and Aviation together will contribute over £40m of EBITDA in FY19, in comparison with £11.4m in FY16.

Having reviewed and updated our model, we make the following changes to our earnings estimates for Stobart.

Given its disparate operating activities, Stobart Group is not overly exposed to any individual macro or operating risk. Rather, each of the group’s different business carries its own risks:

In 2014, Stobart sold a majority stake in its logistics business (ESL) and in so doing, radically altered the group’s strategic focus, reporting lines and capital structure. Beneath we outline each division, its EBITDA contribution and any associated targets.

Stobart Group is now radically different from its logistics heritage with an enhanced focus on its Energy and Aviation businesses. That said, it still uses its logistical expertise in its Energy business and, to a lesser extent, its Aviation business. This trend will continue in the coming years, with management focused primarily on building its biomass infrastructure, supply chain and customer base as well as actively looking for increased airlines at London Southend Airport.

In 2016, Stobart supplied 1m tonnes of biomass to electricity generators across the UK. The volume supplied to its customer base has nearly doubled since the business started in 2013. Stobart continues to sign up significant clients for supply contracts with index-linked pricing (see Exhibit 6 below) so the company enjoys good visibility of price and volume in the coming years.

Regulatory drivers underpin the biomass supply business. While Stobart does not have any direct exposure to power prices or achieved margins on power generation, it does have a direct earnings link to demand from generators for biomass which, in turn, is driven by regulation.

As the business scales up, profitability in Energy is growing, with underlying EBITDA per tonne rising to £9.28 in 2016 versus £7.87 and £8.16 in 2014 and 2015 respectively. This translates into an EBITDA margin of 12.4% (2015, 11.4%), which accounts for 30% of FY16 group EBITDA. We forecast this to rise in the coming years to 39% as we believe Stobart can achieve its target of supplying 2m tonnes per year by FY19.

Therefore, by FY19, we forecast Stobart will supply 2.2m tonnes of biomass: achieving an average revenue per tonne of £47.7, an underlying EBITDA per tonne of £10.3 and total EBITDA of £22.7m, which equates to 39% of group EBITDA for the year.

Downside risks are present for the Energy segment with demand being driven by UK power market dynamics and biomass regulations in particular. On the margin side, the energy business is exposed to fuel costs. Management highlights technology risk and execution risks in particular. Many of the technologies are new to the UK (in fact Stobart has already had issues with a boiler at Evermore) and contractors are unaccustomed to building them. However, volumes have scaled up to 1m tonnes per year without major outages, so we are cautiously optimistic on delivery.

Of London Southend and Carlisle Lake District airports, Southend is far more advanced operationally, with 0.9 million passengers using the airport in FY16. The company believes there is capacity for up to five million passengers at Southend annually and is sounding out the market for potential airlines to use the airport.

Currently EasyJet and Flybe are the main airlines operating out of Southend. Management is focusing on attracting other airlines and encouraging both current clients to increase their range of destinations. For airlines, Southend has a cost advantage over the main London airports. For passengers, transfer times to central London are comparable with Stansted and there is a rail link to Liverpool Street station. Stobart points out that Southend technically lies just outside London airspace, so the likelihood of delays is reduced. Additionally, the investments have already been made, so incremental revenue largely passes through to net cash flow.

If the company can bring in one or two other major airlines then there is meaningful EBITDA upside. According to Stobart’s own EBITDA sensitivities, each passenger brings £8 of EBITDA, so if it hits its FY19 target of 2.5 million passengers it will generate £20m EBITDA. Furthermore, the airport already has capacity for five million passengers per year, so that number could double before meaningful investment is required.

Stobart’s Rail business carries out specialist civil, rail and infrastructure engineering to external clients and companies within Stobart Group (internal revenues for FY16 totalling £17.4m or 37.6% of divisional sales).

Stobart Rail is targeting 20% annual top-line growth. There is an excellent array of opportunities for this business as UK rail infrastructure spend continues to hold up. Network Rail is an important client for Stobart Rail and the medium and long-term outlook for the firm is positive with HS2 on the horizon.

We model revenue growth in line with company targets based on the excellent underlying market growth and strong Stobart brand. We believe also the company can continue to expand its EBITDA margins from 7.4% in FY16 to 10% in the coming years as a function of the company selling less work proportionally to other group companies at low/ zero margin. Risks to our bullish view of the profit outlook for rail are twofold: there is a shortage of experienced project managers in rail engineering and the company does not have a strong track record EBITDA growth.

The ESL business and Propius Aircraft Leasing are accounted for in the Investments Segment. The £11.1m reported in FY16 EBITDA is actually net income from associates and this cash flow remains meaningful at a group level. Stobart Group receives some cash in the form of dividends from Propius, but surplus cash in ESL is used to pay down debt, benefiting Stobart’s equity stake in the unit. FY15 saw strong performances from both ESL and Propius with the former generating strong cash and paying down £23m of debt and the latter selling two aircraft at a profit and paying up a £4.3m dividend to the parent company. ESL’s EBITDA to November 2015 was £44.5m, an increase of 6% from the prior year.

DBAY, as private equity investors, will have an exit plan for ESL, so Stobart Group at some point will see proceeds from either a disposal or listing. ESL is on Stobart’s group balance sheet with an equity value of £51m. Given management’s track record of deal-making plus DBAY’s strong reputation, we see upside to this figure.

DBAY Advisors, an Isle of Man based fund, bought 51% of ESL in a deal headed by William Stobart. According to DBAY’s website, it has a particular interest in ‘companies overlooked or deeply misunderstood by the market and in many instances out of favour with investors, often taking a contrarian view’. According to the FT (John Guthrie, March 6, 2014) DBAY took on £160m of debt soon after buying ESL in order to pay a special dividend to the owners.

DBS has a track record in the logistics space having acquired TDG, a UK logistics company, in 2008. It was sold in 2010 to Norbert Dentressangle. In April 2015 ESL hired Alex Laffey, a former Distribution Director at Tesco, to be CEO. For several years Tesco has been a large customer for ESL so Mr Laffey will know his new employers well. Given the increase in EBITDA, decrease in debts at ESL, high quality executive hiring and the fact that DBAY has already owned ESL for two years, we would expect the company to be sold soon and potentially for a good multiple.

Similarly, given reports in the Irish press showing that Propius is seeking buyers, we would also expect to see this business sold. Given the fact that the business has returned to profitability since being bought during financial difficulties in 2010, together with the fact that in FY16 it sold two aircraft for a $6.5m profit, it seems likely there is upside to the £11m book value of the firm.

Therefore, while both ESL and Propius are markedly improving businesses, in reality the main story for Stobart Group shareholders, is the return of value from their potential disposals. We value both firms at a 25% premium to book value in our sum-of-the-parts but see further upside in a takeover scenario. Management has indicated excess cash would be returned to shareholders in this situation.

We are positive on the potential for meaningful upside to the £62m book value Stobart carries in its Investments unit. In our sum-of-the-parts valuation we ascribe a 50% premium to book value to these assets, in comparison to 30% for its Infrastructure assets. The Propius business was bought at a distressed price and ESL continues to perform strongly, increasing in equity value as it improves returns and pays down debt.

Stobart has £134m of assets in its Infrastructure business. This segment is where Stobart accounts for its physical assets. These assets span airports, renewable energy infrastructure, anaerobic digestion plants, biomass facilities and a commercial property portfolio. In recent years, Stobart has been disposing of assets steadily throughout the year – in FY15, some £27.2m of assets were disposed of across ten transactions. In FY16, a further £24.1m of assets were sold and another significant asset – Chelford – is being disposed of for a total of £7.4m. It is this cash flow that has underwritten the high dividend in recent years. The 6p/share dividend costs the firm £20m, well in excess of operating cash flows.

Early FY17 transactions for instance Speke (announced March 2016), indicate firstly that Stobart is sitting on a valuable land bank and secondly that its appetite to continue to monetise its land bank is undiminished. It should also be pointed out that, beyond selling off land, Stobart can make a profit by other means such as by leasing or developing the assets. There is ample scope for Stobart to achieve premia to book value as it disposes of these assets.

Trading assets continues to be a central plank of Stobart’s strategy and DNA. The merger of the Westbury Property Fund and Eddie Stobart in 2007 created the Stobart Group. The partial disposal of Eddie Stobart Logistics in 2014 left the group with its current reporting structure and strategy. Additionally, Stobart continues to dispose of and otherwise monetise its land bank with property sales totalling £24.1m in FY16 and 10 property disposals in FY15 totalling £27m in proceeds for the group.

At end FY16, Stobart reported a total of £134m worth of property assets on its balance sheet encapsulating energy and aviation infrastructure as well as land. We expect management to continue to release value from these assets via a mixture of disposals, leasing and other means of monetisation. For example, Stobart has developed an air and road freight distribution centre at the Carlisle airport site.

We do not explicitly forecast asset disposals but do acknowledge that there is value within the property portfolio. We do take the book value of Stobart’s property assets into account in our sum-of-the-parts valuation as explained on page 12.

The net result of the growth in Stobart’s support services businesses, plus enhanced profits at ESL provide a robust earnings story for equity holders. As is shown in the chart beneath, the most important moving parts in Stobart’s operating earnings evolution are the continued expansion of the Energy and Aviation businesses.

Since ESL was carved out of Stobart in 2014, a criticism of the company from investors has been the opacity caused by so many exceptional items in reported earnings. Impairments, amortisation, assets held for sale together with various one-off charges such as restructuring costs negatively impacted PBT, for example, by a total of £15.6m in FY14, translating into a £10.2m reported pre-tax loss. Amortisation at group and associate level is expected to continue in the coming years at £3.94m. This is related to a clause in the ESL disposal, which results in a licence revenue for Stobart from ESL in return for ESL using the ‘Eddie Stobart’ brand name to FY20. As this contract period matures, Stobart Group will amortise its intangible assets by £3.938m per year. Obviously this is a non-cash item. Exhibit 11 below itemises each non-underlying charge in the last three years, assesses its impact at various points in the group P&L and separates out the cash component for each year.

Having been chief executive of Tate and Lyle between 2003 and 2009, following a 26-year career at Unilever, Mr Ferguson brings experience of running complex operations. He became chairman in 2014, after a difficult spell for Stobart Group, which had lost two chair people in the space of months. Mr Ferguson’s experience has coincided with the emergence of a far more settled management structure and the formulations of a clear strategy.

Mr Tinkler’s association with Stobart goes back many years. He founded the predecessor business of WA Developments International, a civil engineering contractor, which acquired Eddie Stobart in 2004. He went on to lead the merger between Eddie Stobart and the Westbury Property Fund. The 2007 merger created Stobart Group in its current form and that heritage accounts for the fact that Stobart Group holds and trades property assets.

After nine years with accountant Grant Thornton, Mr Whawell joined Stobart in 2004. He had been an advisor on the 2004 WA Developments acquisition of Stobart. In 2007, he became CFO and has been a leading figure in the continuing transformation of the business away from multi-modal logistics towards a support services and infrastructure business.

Having been MD at Luton and Bournemouth Airports, Glyn Jones brings relevant experience to his responsibilities as CEO of Stobart Air. Appointed in September 2015, and supported by Jon Horne – himself with over 40 years in the aviation industry – Jones’ principal task will be to drive passenger numbers at London Southend Airport. He brings experience and contacts which should enhance the likelihood of Stobart delivering on its FY18 targets.

In 2014, Richard Butcher was made an executive director of Stobart Group after over 10 years in various positions with the group including CEO of Stobart Estates and company secretary. In his time at the helm of the Energy unit it has grown EBITDA to nearly £10m. Given his strong track record within the firm and delivery thus far on meeting the Energy segment’s targets,

Our principal valuation methodology is a sum-of-the-parts combining EBITDA-multiple-driven valuations for each of Stobart’s operating support services segments – Energy, Aviation and Rail. This is the most appropriate method for valuing such a disparate collection of businesses, as opposed to either a DCF or a peer based multiple There are no directly comparable listed companies with similar scale and regional and operational focus to compare EBITDA multiples for any of the segments. Furthermore, a DCF would be of limited value given the diverse nature of operations and the sizeable component of assets potentially for sale. For each of the Investment and Infrastructure businesses we base our valuation on reported book value and adjust upwards (by 25% in the case of the investments and 10% in the case of the infrastructure assets). We also add on a valuation for Stobart brands on the balance sheet, for which ESL pays a royalty every year. We deduct net debt and pension liabilities to arrive at an equity value per share. We carry out the same exercise based on our FY17 and FY18 estimates to demonstrate the rising EV as it is driven by Energy and Aviation. For these we apply a blended multiple based on the factors and proximate comparators as shown in the table below. Given we are four months into FY17, we take an average of our FVs for FY17 and FY18 in arriving at our FV of £1.35/share.

EBITDA sensitivities to volume in the Aviation and Energy businesses are £8 per passenger and £10 per tonne respectively. Another key driver of value is the book value of its property assets and associates investments. For each of these components, we outline our bases case, bull case and bear case scenarios beneath.

As can be seen in Exhibit 12, a 0.5m tonne change in EBITDA in the Energy business translates into £5m± of EBITDA, which, based on our 8x EBITDA valuation, translates into approximately 12p/share on our fair value. In Aviation, a one million passenger increase or decrease converts into £8m± of EBITDA, which translates to c 20p/share onto our fair value.

Energy and Aviation are the operating story. Their combined £40m in FY18 dwarf the comparable figure of £11.4m in FY16.

Disposals will continue to be a key driver of value. Over £50m has been realised in the last two financial years. With £134m of property assets still on the books and management determined to monetise them, we expect significant cash realisation and view shareholder returns as likely to increase.

The 4.7% dividend yield has been a key attraction of the stock while the operating assets ramp up. This is likely to continue for the time being and, we calculate, will be covered by underlying EPS in FY17.

Given its encouraging operating performance in FY16, especially within its support services divisions, we are now more comfortable with Stobart’s cash flow. Since the restructuring in 2014, both Energy and Aviation have been in start-up mode and therefore returning minimal underlying EBITDA. FY16 marked a watershed as these businesses now return a combined £11m of EBITDA. Since 2014, Stobart’s sector-beating dividend has been funded by a disposal programme that returned £27.2m in FY15 and £24.2m in FY16. Given £134m of assets remain on the balance sheet, together with the fact that already in FY17 we have seen further evidence on monetisation of the land bank (Speke) and the fact that the Support Services units remain the focus, we expect to see a continuation of Stobart’s disposal programme. As we do not forecast future disposals, we simply note that if Stobart continues to make disposals at a similar rate to FY14, FY15 and FY16 – which saw an average of in excess of £20m – then there is material upside to our net cash flow forecasts.

Furthermore, we note the fact that Stobart undertook the bulk of its capex programme in relation to Southend Airport and its biomass build-out in the Energy unit in previous years.

Management is currently guiding to a capex spend of £10m per year in FY17-FY19. There will be additional HP-financed and asset-financed non-cash investment on vehicles and biomass processing equipment. For FY17, 50% of capital spend will be in the Aviation division – new taxiways at Southend and commercial development at Carlisle. The other 50% will be invested in biomass processing facilities. FY16’s capex of £45m was high in comparison to recent years. The bulk of the investment was in land assets with Speke and Pollington accounting for £17m and £9m respectively. The other material component was the PP&E spend on the Carlisle distribution centre, which required £12m of investment.

Therefore, Stobart still needs to make approximately £30m of cash investments in its assets, primarily within energy, to facilitate its expansion plans. Beyond this, we expect capex to retreat substantially, with management guiding to maintenance capex being below depreciation. We believe Stobart can produce cash flows well in excess of its commitments that could be used to fund shareholder returns. We forecast cumulative EBITDA of £130m between FY17 and FY19 and once again highlight the approximately £200m book value of assets in its infrastructure and investments divisions slated for disposal. Additionally, current debt to EBITDA (FY16) of 1.93x is low so the group can well afford to enhance shareholder returns.

Based on its earnings trajectory, associated working capital drag and investment programme, Stobart is not going to produce exceptional levels of cash flow until the tail end of the decade. Once more, it will reply on disposing of assets to finance shareholder distributions and, we believe, debt will increase to FY18. We believe debt peaked at 1.93x group EBITDA in FY16. So Stobart will at no stage be stretched in its valuation, as long as it makes good progress towards its targets.

We have confidence in management’s ability to selectively acquire, invest in and dispose of assets to drive shareholder value. Uncertainty around delivery and timing is more than compensated by yield and improving operations.