Appreciate Group — Strategic progress with results in line

Appreciate Group (APP, formerly Park Group) performed well during H120, evidenced by sales growth across both the consumer and corporate-facing businesses, increased margins, and reduced seasonal losses (c 85% of revenues are typically generated in H2, and all of the profits). Group cash flow was negatively affected by the timing of transfers from customer funds held in trust, but total cash balances remained strong at £213m. Additionally, the shift in product mix away from vouchers to cards, subject to Bank of England regulation in respect of segregated customer balances, slows the release of operating cash flow and is discussed in detail on page 8.

Positively, despite a more muted economic and retail background, the group is trading in line with management’s (and our) expectations for the year. Perhaps of greater significance, however, given the seasonality of the group’s business, are the H120 operational developments and progress with the strategic business plan. The plan was presented in December 2018 following a comprehensive review of the business, which identified a number of opportunities to build on existing strengths, accelerate growth and improve efficiency. The core multi-retailer redemption offering, where the scale of the market provides significant potential, is being given even greater focus and the digitalisation of the business has been significantly accelerated to enhance the attractiveness, accessibility, reach and delivery of existing products, tap new market segments and areas of demand, and enhance efficiency.

As previously reported, the group has now successfully relocated its core operations to a new fit-for-purpose head office in Liverpool city centre and has renamed itself to better reflect its product offering and aspirations. The first phase of the new ERP system has been initiated and the new digital marketing platform has been implemented. Product developments include a new Mastercard gifting product with digital fulfilment and mobile wallet capability that is being tested through highstreetvouchers.com, while trials have commenced on the new consumer-facing digital product, Giftli, aimed at a new millennial audience. A soft launch of Giftli is planned imminently, before Christmas 2019.

Key features of the interim results were:

In its outlook statement, the group says that underlying trading prospects for H220 are unchanged, with the Corporate business continuing to grow and Christmas savings looking to capitalise on refreshed marketing plans, including a refreshment of the brand imagery and media strategy, as orders are built for Christmas 2020.

APP’s strategic business plan aims to accelerate growth by improving the customer experience, simplifying the product offering, making those products and services available to a wider customer base, and accelerating the development of digital platforms that can better capitalise on the strong customer-driven trend towards card and digital delivery (and away from paper). Progress in the period is set out below.

APP has accelerated its IT investment in both back office functions and digital capability in order to improve both efficiency and functionality. The first phase of the new ERP system has been implemented, and further design and planning for subsequent phases in 2020 is underway. The group’s data and infrastructure architecture has also been completely redesigned for progressive deployment to cloud-based and managed service provision that management expects to scale benefits, as well as increased efficiency and resilience.

Good progress has been made with the near-term goals of enhancing the capability of existing mobile apps, and providing mobile digital enablement and personalised e-delivery of e-codes. A new contactless-enabled digital gift card, delivered by email, SMS or WhatsApp for loading into the wallet app of a mobile phone is in pilot. The technology engine behind the digitally enabled card will dovetail with the new consumer gifting product that is now in the trial stage.

APP wants to broaden its customer appeal to drive faster growth, including the launch of new product targeting a broader customer base. Management’s analysis of the marketplace highlights a particular opportunity from addressing the broader consumer market for a multi-redemption product, alongside the group’s existing dominant position in the Christmas savings consumer segment and strong positions in the corporate market segments. Capturing an increased share of the ‘other consumer’ segment, where management estimates a current share of c 0.4%, represents a material opportunity for growth. A new consumer digital gifting product, Giftli, aimed at a new millennial audience, will target a part of this opportunity. In contrast to traditional gift cards and vouchers, by embedding the customer’s own digital content, Giftli creates a highly personalised message/product to share with the recipient. APP believes this will especially appeal to its target customer base, with its above average familiarity and use of social media. A trial is underway and a soft launch is expected before Christmas ahead of a full launch in the New Year. Profitability of the product will continue to be driven by retailer service fees and interest earned on customer balances, although compared with Christmas savings these balances may be of shorter duration and potentially more variable.

In H120, the implementation costs for the strategic business plan were c £1m and management has not changed its guidance that profits will be negatively affected by c £2.0m, net of savings achieved. This includes c £1m of investment in the new consumer market product, £0.8m in temporary overlapping property costs resulting from the relocation of the core operations and £1.0m in technology-related costs, offset by cost benefits of £0.8m realised during the year.

Additional IT capex to support implementation of the strategic plan is expected to be c £4.0m over the next two years, with a three-year payback period. Property capex related to the migration of the core activities to central Liverpool will be c £1.5m in the current (FY20) year, but management expects the disposal of redundant property assets to generate proceeds of c £5.0m in FY21. The Valley Road site is now carried as a ‘held for sale’ asset, indicating management’s expectation of a timely exit.

We have made no material changes to our forecasts for the current year and next, shown in Exhibit 4.

Our key forecasting assumptions include:

IFRS 15 (Revenue from contracts with customers) became effective for annual reporting periods beginning on or after 1 January 2018 and APP reported under IFRS 15 for the first time in FY19, on a full retrospective method, providing restated financial statements from the beginning of FY15. All of the financial analysis presented in this note is on a consistent IFRS 15 basis. Historically, the accounting treatment for prepaid cards and vouchers differed and adoption of IFRS 15 put revenue recognition for the group’s own-branded, multi-retailer redemption products on a similar basis. The effect was to reduce reported revenues, although ultimate profitability and cash flow was unchanged. There was also a timing impact, with IFRS 15 leading to a deferment of revenue and operating profit in respect of all the group’s multi-retailer redemption products. Given the dominance of own-branded, multi-retailer product in the sales mix, IFRS 15 has brought welcome consistency, although important differences remain in terms of the accounting treatment for third-party, single-retailer redemption product, as well as the other goods and services that the group provides.

The issue is dealt with in detail in the group’s annual report and below we provide a brief overview.

The key distinction is between sales where APP 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. This is why 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 APP will never be redeemed. 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.

IFRS 15 has no impact on the ultimate profitability and operating cash flow that emerges over time, although it does have some short-term timing effects. Of more significance is the difference between the timing of cash emergence between regulated (ie APP’s own multi-retailer redemption cards/digital products, which fall under the Bank of England e-money rules) and unregulated product (APP’s own multi-retailer redemption vouchers). The rapid growth of card/digital sales and what we believe will be a continued reduction in voucher sales, both as a share of the total and in absolute terms, is positive for profitability but has the effect of reducing operational cash flow in the near term. Much of this is already captured within our DCF analysis, which deducts an amount of cash, equal to the balance sheet voucher provision, recognising that this will eventually be transferred to retail partners in settlement of customer voucher redemptions.

Customer card/digital cash balances are strictly segregated within the e-money trust until such time as ‘contractual ownership’ passes to APP. 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’ 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. Other than through redemption, the change in contractual ownership and the transfer of cash from the e-money trust to the APP corporate cash balance will occur at the expiry of the card and (where the customer has a right to redeem unspent balances) as card fees are levied and accrue to APP. Management comments that redemption rates for card/digital products are currently lower than for vouchers, and this is likely to increase the near-term cash drag from card/digital sales growth.

Although customer voucher cash balances are similarly segregated within the Christmas prepayments protection trust they may be transferred to the APP corporate cash balance at the point of despatch/billing. Revenue recognition at the point of redemption will typically occur a short time afterwards. During this period, the corporate cash balance includes the expected future payments to retailer partners that will be due at redemption, represented on the balance sheet by a provision balance. If voucher sales reduce, this ‘cash float’ and provision balance can be expected to reduce, and if APP were to cease voucher sales the provision balance would be expected to run down altogether, matched by a similar cash outflow. For this reason, our DCF valuation excludes an amount equal to the voucher provision even though ongoing sales of vouchers continue to support APP’s corporate cash position.

At the end of FY19, balance sheet provisions amounted to £58.3m comprising a voucher provision of £36.3m and a card provision of £22.0m in respect of corporate gifted cards where the cardholder has no right of redemption. The card provision represents the expected liability to retailers and is matched by cash held within the e-money trust (not, as the case with the voucher provision, by corporate cash). By H120 the total provision balance had grown to £66.4m, including some seasonal fluctuations. No breakdown of the H120 balance is available but given the reduction in paper format billings (we believe this is all APP own-product vouchers) from £50.2m in H119 to £45.2m in H120 we believe that voucher provision balance will have declined while the card balance, driven by strong growth, will have increased. The reduction in the voucher provision balance represents cash paid out to retailer partners and had the effect of reducing operating cash flow. The increase in the card provision is similarly matched by cash, but cash held within the e-money trust, and did not contribute to operational cash flow.

As a result of the accelerated shift in sales mix, we now forecast that working capital movements will consume a little more than 100% of EBITDA (£11.7m) in FY20 driven by a c £9m run-off of voucher provisions. Allowing for the capital expenditure items noted above as well as dividend payments, our forecast cash balance at end-FY20 is now £25.0m (previously £33.7m). We expect a slower run-off of the voucher provision in FY21 (£2.4m) and our revised cash balance is £29.8m (previously £42.3m). Our forecast for net operational cash flow in FY21 represents c 85% of EBITDA, a conversion ratio that we expect to be sustainable.

Despite the progress with the strategic plan and an in line financial performance, Appreciate shares have trended down over recent months such that the current year (FY20) P/E is 9.2x and the fully covered dividend represents a yield of 6.8%. The shares appear low valued compared with our revised absolute DCF valuation of 87p (previously 90p), which we cross-reference to a relative valuation compared with a selected group of listed stocks that are engaged in activities which provide some overlap.

Our modified DCF valuation differs from a standard DCF in that we include the interest earned by APP 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 in full, as this will eventually flow out in settlement of vouchers that have been issued but not yet redeemed. For this reason, the accelerated run-off of the voucher provision has no impact on our DCF valuation. Our key assumptions have been held constant for an extended period, and we continue to include two stages of growth so as to better reflect the near-term drag and subsequent potential upside from the strategic business plan. For the first three years after the forecast period (to end-FY21), we grow the free cash flow at 10% pa and then revert to the assumed long-term growth rate, unchanged at 5%, up until year 10. We assume an eventual normalisation in interest rates with a stepped increase from our near-term forecast return on cash balances of 0.9% to 1.5% in FY22 and 3% from FY23. The terminal cash flow is valued at an unchanged 10x and we have applied a discount rate of 10%.

Our relative value comparison recognises the lack of direct comparators to APP, most of which are either private companies or relatively small parts of larger groups. Sodexo and Edenred are both much larger and more international than APP, and the overlap with Sodexo is limited; Sodexo Benefits and Rewards Services is only a minor part of Sodexo Group. We therefore extend the comparator group to include payments service providers and companies engaged in UK home collected credit (HCC) services, directed at a customer group with some demographic/ socioeconomic overlap between the traditional customer bases of the group’s Christmas prepayments business (c 50% of APP). We recognise that the read-across is somewhat limited and note the difference between the savings nature of APP’s Christmas prepayments business and the lending nature of HCC. Given APP has no credit risk and we believe it has less regulatory risk, we would expect a higher valuation.

The strategic business plan has a distorting impact on the near-term earnings comparison as well as affecting near-term cash flow, but even if we apply the 90p per share DCF value to our calendarised forecasts for APP, the 2019 (CY1) P/E would be 18.0x and that for 2020 (CY2) 16.0x. These are not materially different from the overall average shown in Exhibit 8 and well below the incentive and rewards and payments services average. The overall average is suppressed by the HCC rating.

We believe a successful implementation of management’s plans, leading to faster growth, increasing scale and a greater focus on digital payments services, has the potential to lift both earnings and valuation over time. On this basis, the multiples implied by our DCF value of 90p per share appear entirely reasonable.