Renewi — Strong H1 performance

Renewi reported a strong H118 trading performance, its first meaningful results period since the merger between the former Shanks and Van Gansewinkel (VGG) groups in February this year. Hence, the 21% pro forma EBIT growth (in constant exchange rate or CER terms) for the enlarged business was achieved at the same time as undertaking a significant integration programme. Merger synergies contributed to this result but good underlying market conditions in Commercial Waste were the key driver of underlying progress. We have increased earnings estimates for the current year, with subsequent years in line with previous levels. Guidance on expected merger benefits is unchanged. This note makes comparisons with pro forma revenue and EBIT numbers in prior year periods as shown in Exhibit 1 along with reported H118 divisional results.

Commercial (FY17 pro forma – Netherlands: Belgium, revenue 60:40, EBIT 50:50)

The leading operator in the collection and treatment of solid waste in the Netherlands and Belgium, following the merger between former Shanks and VGG operations in the region.

Commercial is the largest of Renewi’s four ongoing reporting divisions at two-thirds of pro forma FY17 group revenue. Approximately 85% of revenue is generated by service fees (ie collection and processing) with recyclate income (ie the sale of materials recovered from sorted waste) accounting for the remainder. Positive GDP progression is translating to rising levels of secondary or post-use materials from each of – in order of importance – the industrial/commercial, construction/demolition and municipal/residential sub-sectors.

The improvement in Commercial performance is substantially down to higher volumes of waste being handled at this division’s Dutch and Belgian facilities. So far this year, pricing is not understood to have been a material contributor to the revenue progress shown above. Moreover, management has stated that there were no unusual items included in reported profitability so we consider this to be a sustainable, representative outturn at the prevailing volume levels. The elimination of obvious overlap in the operations of the merged division and increased internalisation of collected waste into processing (at the same time lowering third-party processing costs and aiding plant utilisation levels) will have been early synergy gains, though these were not quantified. Recyclate income has benefitted from firmer pricing in the Netherlands supporting year-on-year gains – with a good incremental margin drop through, although Belgium’s wood activity has been more competitive. This division recycles received waste and has longer-term agreements in place (to or beyond 2020) with incinerator operators, so it has a degree of protection in this area in a market where volumes are rising.

Hazardous

Operation of specialised industrial cleaning and waste processing facilities and transport fleet, largely in Holland. Oil and gas/petrochemicals and soil remediation are important client sub-sectors.

This division is substantially comprised of two former Shanks businesses, being ATM (treatment of contaminated materials – soil, water, chemicals) and Reym (cleaning of industrial equipment/heavy industry), into which the smaller VGIS operation has been incorporated following the merger with VGG. The majority of revenues are generated through service fees with relatively low recyclate revenues in this division. Activity levels overall were reasonable, although there were variable sub-trends in both of the primary business streams. At Reym, refinery-based equipment cleaning saw improved volumes and utilisation levels were high, though under competitive pricing conditions. Thermal soil treatment and remediation is ATM’s biggest work flow and demand for these services is considered to be strong, consistent with a recovering construction sector. This said, Renewi has voluntarily reduced throughput pending the resolution of a regulatory investigation and/or finding new market outlets. Consequently, current guidance is for a throughput run rate of around half of the normal level (being c 1m tonnes pa) for the remainder of FY18 and all of FY19. We sense that this is a conservative position and a faster resolution is being sought. More positively, quayside/ ship-based volumes have been particularly strong, boosted by the start-up phase of a major long-term offshore project. Elsewhere, truck-based volumes received have remained subdued. Overall, divisional revenues were marginally ahead in euro terms and, despite the challenges outlined, its EBIT margin improved (by 20bp to 13.3% versus H117 pro forma). Selective investment is ongoing and the integration of VGIS sites into the divisional footprint is progressing well.

Monostreams

Four independent specialist recycling operations (comprising three former VGG businesses and one former Shanks business) addressing specific waste flows with inbound and outbound supply partnerships.

Coolrec (recycling of electronic and electrical goods and associated materials) is the largest of the four specialisms by revenue; while revenue was boosted by higher metals prices, variability in individual product volumes coupled with some fire disruption held profitability slightly below the prior year. Mineralz (treatment, re-use into building materials or landfill of incinerator waste) has historically been the leading profit generator and benefited from both an increase in volumes and rising metals prices. Moreover, its developing recycled intermediate materials streams used in new building products continue to gather momentum. Plans to expand a landfill site near Europort are said to be making good progress, while the planned cost of closure of two others in the next 18 months or so is expected to be within existing provisions. Maltha (leading glass recycler) has been rebuilding profitability in the last couple of years and this process continued, supported by good activity levels, operational improvements and investment across a number of sites. This business is one-third owned by Owens Illinois, which is also the leading customer for the recycled cullet and powder materials it produces. Lastly, Orgaworld (treatment of organic food and horticultural waste, producing bio-based products and green energy) is the former Shanks operation and achieved a revenue and profit performance in line with the prior year despite being partly hampered by a leak at one of its sites. Overall, the Monostreams division delivered a healthy single-digit revenue uplift and a 160bp margin improvement (to 10.5%) led by Mineralz and supported by Maltha.

Municipal

The receipt of local authority waste to which a variety of advanced treatment solutions are applied, generating energy, recovered fuels and recyclates and maximising landfill diversion. There are nine operational sites (seven in the UK, two in Canada), plus two under construction (Derby UK and Surrey, Canada). Typically operated under PPP/PFI arrangements in a range of ownership structures from 100% consolidated to 20% associate interest.

The Municipal division’s trading environment has been affected by a number of external market and internal operational factors, as reported during FY17, and this has been reflected in its financial performance. H118 saw a stabilised reported trading loss of £3.5m in line with H217. (Prior year provisioning of £3m matched other anticipated onerous contract issues.) The new management team has taken steps to redress suboptimal plant utilisation and output pricing challenges by developing new offtake arrangements and investing to improve process efficiency. That said, management expects a gradual step-by-step recovery in performance rather than a sharp return to profitability over our estimate horizon. The new Derby Mechanical Biological Treatment (MBT) facility is now scheduled to become operational in mid calendar 2018 (Renewi is the plant operator under a 25-year PPP arrangement in a 50:50 JV with EPC contractor Interserve). Canadian financial performance has been distorted by the construction and commissioning of the new Surrey facility, the associated gross revenue and costs for which are included in reported numbers. There has been a delay in the commissioning phase (now expected to complete by the end of calendar 2017) but Renewi anticipates recovering at least a partial contribution from its contractual partners. Elsewhere, Ottawa has performed well although London has experienced secondary odour issues following process challenges, which has led to restricted capacity utilisation. We believe that this is the likely cause of the larger Canadian operating loss reported in H118 compared to H217 (and compared to a healthy profit in H117). Management confidently states that it expects all three facilities to be generating profit in FY19, though they will not be sufficient to offset the losses (albeit reducing) in the UK.

Having outlined the industrial logic behind the Shanks merger with Van Gansewinkel (VGG) when the deal was first announced in Q316, more synergy financial details emerged prior to the end of FY17, following completion in February.

Management has consistently flagged €40m of expected cumulative pre-tax synergy benefits with an indicative 30% – 75% – 100% (ie €12m – €30m – €40m) realisation profile over the three years to FY20. Unsurprisingly, Commercial Waste was identified as the leading beneficiary of integration activities, though the other three divisions were also expected to gain. From a P&L impact perspective, around half of the overall €40m in synergies is to come from indirect (including group/central costs) and the other half from a combination of direct costs and scale efficiencies. We believe that the sources of the €40m of synergies have been substantially identified now and are in various stages of planning, preparation and implementation. Cash costs of integration of €50m have been flagged and there will be non-cash exceptional charges, which will depend on specific footprint changes, with further detail to emerge here.

A key message with H118 results was that the expected merger benefits previously outlined are unchanged as are the anticipated costs of achieving them. Management stated that some of the ‘quick win’ gains have perhaps come through ahead of schedule. Operationally, these will have included some pricing alignment and internalisation of waste flows. We would also expect there to have been actions taken to reduce management duplication and some central cost categories.

The larger more complex and inter-dependent work streams are understood to be on schedule and we would expect these to be more visible from mid FY19 onwards. IT is considered to be a key enabler of future group performance and a facilitator of some of the integration gains.

As things stand, Renewi is on track to achieve €12m cumulative synergies by the end of FY18, having delivered c €4m in FY17 and a further €4.6m reported for H118. Non-trading merger-related costs booked in the period totalled £7.9m (£6.8m cash, £1.1m non-cash) with £4.5m allocated to synergy delivery and £3.4m to integration costs. For the record, we currently have c £30m net exceptional costs factored into our model for FY18, followed by c £25m in FY19 and c £9m in FY20.

Group net debt on the balance sheet at the end of September stood at £521m; we distinguish between core debt and non-recourse debt related to PPP/PFI waste activities (being £436m and £85m, respectively) and discuss the associated cash flows separately.

Underlying core net debt rose by c £12m during H118 and this was almost entirely attributable to the FX translation effects of weaker sterling against the euro (c 3% movement). In other words, operating company free cash flow broadly matched the £16.8m FY17 final dividend cash payment made in the period. We have identified c £22-23m outflows relating to non-trading items – some of which may reverse in H2 (see below) – so the underlying cash inflow from operations was broadly c £40m in the period. We accept that some of the benefits from exceptional spending may not have occurred otherwise – and therefore it could be seen as inconsistent to include the former and not the latter – but as the benefits are considered to be sustainable/long-term we think it valid to identify this illustrative underlying figure.

Looking at this underlying (ie pre-non trading items) cash performance in more detail, Renewi generated a healthy c £87m EBITDA in the first six months and this was supplemented by a small (c £3m) working capital inflow, driven by the payables position struck at the period end. Interest costs were naturally higher year-on-year (at c £13m), resulting from the increased debt carried following the merger with VGG, while cash tax – for now – was in line with the prior year (at c £1m). Capex activity moved up to a higher level for the enlarged group with net expenditure of c £37m in the period, which was substantially replacement spending. We would expect this to have been heavily weighted towards Commercial Waste activities (including new vehicles), with a material amount allocated to more specialised Hazardous Waste equipment also. Returning to our illustrative c £40m underlying free cash generation, bear in mind that this was after c £7-8m outflows (ie trading losses and provision movements) relating to the Municipal division. This reinforces the impression of a strong cash performance from continental European operations.

Exceptional cash outflow: The breakdown of the major non-trading cash outflows are as follows:

The latter item is expected to be substantially refundable once commissioned and this is expected to be prior to the end of FY18. On a smaller scale, there have been costs and insurance receipts relating to facility fires and current guidance is for further receipts (unquantified) to fall into H218.

Non-core debt position stable: Net investment flows relating to Municipal project vehicles were modest in the period, being a capital receipt of £2m, largely offset by £1.6m funding arrangements. This partly contributed to a c £2m reduction in non-recourse net debt to c £85m at the end of September. There would also have been a small translation benefit (on Canadian debt) and we assume that project cash flow in aggregate will have accounted for the remaining net movement.

Cash outlook – further outflow expect in H2: In overall terms, we expect to see c £60m group cash outflow in H218, around two-thirds of which relates to non-underlying items including merger-related activities and other movements on provisions. Of the c £20m underlying cash outflow, c £8m arises from the H118 dividend payment. Hence, the underlying free cash outflow is modelled as c £12m. Trading volumes are seasonally quieter in H2 as is recyclate income where pricing typically softens. Interest costs should be broadly stable in H2 and we expect a rising cash tax profile given increasing profitability. FY18 capex guidance is now £100m, below earlier guidance but suggesting a sizeable step up in H2 and consistent with an accelerating integration programme. After these items (we assume that Municipal project funding is neutral) our FY18 core net debt projection is c £495m, at current exchange rates.

Further GDP growth is anticipated in Renewi’s core trading regions and the operating conditions seen in H1 are largely expected to continue in H2, albeit with the usual seasonal variation. Commercial Waste will continue to be a key driver in the short, medium and longer terms. In the near term, Hazardous Waste progress will be restricted by reduced soil remediation volumes but should otherwise see some further Reym/VGIS integration benefits. As outlined earlier, individual and market challenges remain in Municipal though we expect to see evidence of an improving underlying trend in both Canada and the UK by the year end. H118 benefited from favourable FX translation effects compared to the prior year, approaching £4m. We note that the prevailing £/€ rate is nearer to the average seen in H217 and will provide a smaller boost to year-on-year comparisons in the second half. Overall, we have raised our group EBIT expectations for the current year – effectively revising estimates published prior to the positive 23 October update – with a strong uplift to Commercial Waste partly offset by a weaker Municipal contribution. Factoring in lower net finance charges in FY18 (with subsequent years unchanged) and an amended underlying group tax charge of 25%, consistent with earlier guidance, yields the estimate changes shown in the table below.

At the current share price, Renewi is trading on an FY18 P/E of 21.1x and EV/EBITDA adjusted1 of 8.3x. Post-merger integration is providing the enlarged group with the opportunity to grow much faster than its underlying markets and most UK quoted companies, and our model factors in a three-year (FY17-20) EPS CAGR of around 30%. By the end of our estimate horizon, these multiples have reduced to 12.6x and 7.4x, respectively.

These headline multiples are slightly distorted by the performance of the Municipal division, which dilutes earnings by c 7% this year and is a modest net contributor in the subsequent two years. Our revised estimates include a reducing EBIT loss for this division over our forecast horizon and small pre-tax profit contributions (after taking into account finance and JV/associate income) beyond the current year. For the record, the net operating asset position of this division was recorded as c £185m at the end of FY17, with attributable non-recourse PPP/PFI net debt of £85m at the same date.

We note that Renewi’s closest UK peer Biffa’s comparable valuation multiples on the same basis are: FY18 – P/E 13.7x, EV/EBITDA 6.7x; and FY20 – P/E 12.2x, EV/EBITDA 6.3x.

Hence, the near-term P/E premium is eroded to a minimal level in the third forecast year, though Renewi retains a higher EV/EBITDA multiple. Some of the international peers listed in our initiation note in July (Cleanaway, Suez, Veolia Environment and Waste Management) appear to attract generally higher multiples (FY20 ranges: P/E 15-22x and EV/EBITDA 6-10x).

Lastly, on a maintained dividend profile, Renewi’s current dividend yield is 3%. We expect the underlying dividend payout to start to increase in FY20, as the merger integration concludes.

A two-day capital markets event in Holland at the end of September took in five operational sites encompassing three of the divisions and a mix of activities, including sorting, cleaning and recycling, with full access to senior management of the enlarged group. We now summarise some of our key observations from the event and highlight a number of commonalities across what is, in reality, a fairly diverse group operationally.

Renewi’s executive committee (Excom) has 11 members. Excluding the group CFO, this comprises three each from the former Shanks and VGG businesses together with four new hires since the merger.

Markets are characterised by environmental drivers, typically backed by regulation, and require operating licences. The development of long-term relationships and partnerships with local authorities, industry players and supply chain members reinforce strong market positions. Renewi primarily operates at the recycling stage of the waste hierarchy.

Each division appears to have strong (ie number one or two) positions in its leading divisional waste streams. Some are based on scale – especially in the integrated collection/processing capability in Commercial Waste – while others are in established and emerging niches particularly those with a developing re-use of materials.

The importance of recyclate income varies across the divisions, ranging from 5% in Hazardous Waste to 85% in some of the Monostream activities. Targeted reductions in landfill and, ultimately, incineration volumes are a driver for increasing sophistication in the recovery of materials in a reusable form and there is also market pull from producers wishing to increase recycled content. Renewi is active across a range of end markets and clearly focused on developing further presence here.

We have covered integration plans in earlier sections but the capital markets presentations gave the strong impression of a coherent and aligned strategy, tailored to divisional and group service level with a strong buy-in across the new and enlarged management team.

A number of examples of capex were given including equipment for sorting, stone crushing and new ultrasonic cleaning capability. Process efficiency (eg faster line speeds, more automation), improving recyclate quality and broadening the service offering were commonly cited drivers and the payback should be enhanced by higher volume throughput.

Although Renewi addresses a broad range of sectors there is an overall bias towards a stronger H1 trading period, most notably in the construction, petrochemical services and horticultural recycling activities. An illustrative normal bias would be in excess of 50% of group revenue, c 60% of EBIT and approaching two-thirds of group PBT.

The accompanying presentations from the capital markets event can be found on Renewi’s website.2

Given the significant merger that completed in February 2017, external attention has understandably been focused on the integration of the enlarged entity and delivering targeted synergies by FY20. As explained earlier, these are now substantially identified with initial change programmes either delivered or underway and others being incorporated into detailed operational planning. At group level, further business improvement programmes are under active consideration already and being developed in parallel with the ‘first wave’ merger integration.

Management has outlined two further waves of value creation, being margin improvement and strategic expansion. Further detail can be expected to emerge over time but they are under active consideration now in parallel with more visible corporate actions that are currently underway. We outline the company’s aspirations in these ‘three waves’ as we currently understand them:

This is the dominant driver of profit growth over our estimate time horizon to FY20, by which time the full integration of the former Shanks and VGG businesses is expected to be complete. Renewi is approximately nine months into this programme, targeting €40m annualised group synergy benefits by the end of its three-year implementation period. It is on track to achieve a €12m benefit run rate by the end of FY18 while the indicative €30m rate by the end of FY19 is believed to be intact.

After a prolonged downturn and recessionary period, northern continental European economies have gradually improved over the last two years or so and this is partly reflected in Renewi’s reported results. Classically, rising volumes should lead to improving plant utilisation and firmer pricing conditions. We acknowledge that Renewi operates in a number of markets with differing individual characteristics so such benefits may not accrue evenly across the business. That said, management points to leading market positions in many areas that should support margin improvements across all divisions. The primary basis for this approach is an advantaged cost position driven by economies of scale and market presence. In essence, the objective is to enhance commercial effectiveness and lean manufacturing to raise profitability at any given activity level in improving markets. From an external perspective, the nature of the competitive response (especially in pricing and investment) is difficult to gauge but the competitive advantages outlined above should drive relatively more benefit to the market leader.

The core principles behind this third wave are the typical portfolio management filters of strategic fit, sustainable competitive advantage and appropriate returns. In other words, the objective is profitable revenue growth through a number of possible routes. These can include the internal development of new markets (eg applied recyclate applications in conjunction with commercial partners), geographic spread into adjacent or infill territories and enhancement of the value that can be extracted from waste streams by increasing integration or expansion of internal processing capabilities.

Behind each of these waves is an intention to become a more innovative organisation to leverage market positions into faster growing and profitable niches. This extends beyond products into the service offering also and the increasing digitalisation and adoption of IT-based enhancements throughout the supply chain is a key focus. The second and third waves could play out through changes in organisational behaviour rather than via tangible, discrete events. Nevertheless, they are likely to require investment and an allocation of resources and so we expect management to quantify impacts on cash flow and returns at some point. As far as timing is concerned, a schematic diagram suggests that the margin improvement wave could develop some momentum in FY19 while strategic expansion feels more like a year later with both continuing beyond FY20 itself.