Wincanton — Update 8 March 2016

After restructuring and the disposal of its loss-making mainland European operations, Wincanton is now focused on providing a market-leading logistics solution to its customers in the UK and Ireland. While the economic environment is both tough and challenging, the group is seen as a progressive supplier that has embraced technology to provide a broad supply chain solution and leverage its strong operational capabilities. With sales of c £1.1bn, it is one of the market leaders in the UK logistics sector with its flexibility and strong relationship with customers reflected in new business wins and high contract retention. A well-managed supply chain is increasingly seen as a competitive advantage with this partnership beneficial to both Wincanton and its customers.

The interims announced in November were in line with expectations with a very strong performance in Contact Logistics, offset by short-term problems in the Specialist businesses.

A historic share price graph tells a story, with the price peaking in 2007 at 423p before collapsing after the financial crisis to 37p in 2012 before a subsequent recovery to its current price of 155p.

A lack of a clear UK comparator leads us to make a comparison with its international logistics peer group. The high level of average debt combined with pension fund liability suggests an EV/EBITDA is the most appropriate valuation metric. The company currently trades on FY16e EV/EBITDA of 6.0x and a large discount to our valuation range of 219p (peer group) to 242p (DCF) suggests 30-48% upside. For reference we also note the 2015 takeover of Norbert by XPO at 9x EV/EBITDA.

The Contract Logistics business is seen as a key partner in managing the supply chain cost effectively and providing a flexible service solution. Broadening the industry exposure to include construction and defence increased the resilience to any customer-specific issues or macro pressures. Open book contracts also reduce the risk profile with Wincanton protected by the customer against any volumes shortfalls or cost escalations (from rising oil prices, for example). Much reduced debt levels have increased the group’s financial flexibility and will allow it to further normalise its trading relationships; we view the risk with the pension fund deficit as contained.

Since its inception delivering milk, Wincanton has evolved significantly into other industry sectors and broadened its service offering, fully utilising technology to deliver a market-leading logistics solution in the UK and Ireland. The group has a reputation for delivering very high levels of operational excellence and efficiency. This helps blue chip customers to unlock the potential in their supply chain and has driven a high renewal rate of existing contacts and new business momentum.

Wincanton demerged from Uniq (formerly Unigate) and subsequently floated in May 2001 with the aim of transforming itself from a relatively small UK logistics provider into a leading European supply chain services group. This involved a series of acquisitions over the rest of the decade to expand its European operations (P&O Trans European, Premium Logistics) and move into other sectors (construction, defence) and broaden its service offering. While some of these acquisitions proved successful and remain a key part of UK logistics business today, others were more problematic, particularly the move into Europe where a relatively high fixed cost bases were exposed by the economic slowdown and never achieved adequate returns.

The timing of this expansion was also unhelpful with a weakened balance sheet, high borrowings and large pension deficit leaving Wincanton very exposed as the 2007/08 financial crisis unfolded. The board initiated a strategic review in 2010, segmenting the business into four general areas.

The priorities were to focus on the business's organic growth, target a significant reduction in the level of debt and seek an improvement in profitability through a major reduction in both operating and overhead costs. Following Eric Born's promotion to chief executive in December 2010, the decision was taken to completely dispose and exit its European operations and focus on its core UK logistics businesses. The board decided to suspend the dividend in June 2011 ahead of the forthcoming bank refinancing and pension review, saving c £17m pa. When combined with the plan to reduce debts, this allowed some flexibility to invest in higher-growth areas. The board structure also evolved with the appointments of a new chairman (Steve Marshall) and FD (Adrian Colman – now chief executive from August 2015).

Wincanton has now completed the bulk of the disposals to return it to being a pure UK logistics provider raising c £148m in gross proceeds, which, given many of the operations were making negligible returns or loss-making (£8m total profits), restored some shareholder value.

The disposals have combined with a number of other actions to restore the group to a more healthy financial position and improve shareholder confidence.

After recently disposing of Records Management and with net debt reduced from a peak of £270m to c £45m in FY16e (£62m in H116), we are approaching the end of the balance sheet phase and management can focus on the growth opportunities in UK logistics and the possibility of a dividend.

The stretched financial position has led to significant pressure on working capital over the last few years and, while a good discipline it was potentially constraining growth potential. Now back on the front foot, having normalised supplier relationships it can be slightly more aggressive with the aim of growing market share and absolute profitability, but in a controlled and risk averse manner.

While the board is committed to ongoing cost reductions and cash generation, the increased focus on Contract Logistics and excellent recent operational performance (strong KPIs and top of the league margins) leaves the business well positioned to grow and exploit its undoubted potential.

The three key strategic growth pillars are to:

With sales approaching c £1.1bn, Wincanton is a top two supply chain logistics provider in the UK in what remains a relatively fragmented market, despite some consolidation among the global players. The UK logistics market is estimated at £36bn (source: Institute of Logistics), and while it is directly linked to economic health and business activity, it has resilience and has consistently grown faster than GDP, helped by the complexity of supply chains and the evolution of multi-channel retailing. Currently it is estimated there is a 50/50 split between in-house supply of warehousing and transport compared with outsourcing. A specialist logistics company can deliver supply chain management and warehousing services to provide a flexible, cost-effective and efficient solution. The adoption of technology allows a fully integrated service to give a competitive edge, with retailers particularly suited and more advanced in their adoption of outsourcing due to the growth in multi-channel retailing and their complex needs and service requirements.

While a dynamic and changing marketplace provides many opportunities, we see outsourcing as one of the main drivers for growth due to enhanced business performance and increased competitiveness. The drivers for outsourcing include:

Overall, the market background (source: Barclays and Moore Stephens survey) is supportive for specialist logistic providers who embrace this challenging market and are happy to become an integral part of the supply chain and build a longer term ‘cost effective’ partnership. While we have seen some global consolidation of logistics providers, industry pricing seems rational and we believe Wincanton can take advantage of being a strong local player and use its renewed financial strength and entrenched customer relationships to gain market share.

This division represents the bulk of Wincanton providing a range of transport, warehousing and supply chain services to a blue chip customer base. It employs over 15,500 people and operates from 200 sites across the UK covering 13m sq. ft. of warehousing space and using 4,000 vehicles. Since disposing of its loss-making mainland European operations in 2011, the renewed focus on the UK market has allowed Wincanton to build on its strong, profitable base business and reputation in the area.

While the headline changes were being made in Europe, the UK business also underwent a fundamental change. It addressed the main elements of the cost base – people, properties and vehicles – and by improving use of transport and properties and becoming cost-effective it was well placed to share these operational efficiencies with existing and new customers. The group is undoubtedly more resilient and risk averse, and is now modifying the strategy to maintain market leadership and enhance future growth prospects. The three main elements of this strategy are to:

The effectiveness of this strategy means that despite modest revenue declines caused by the economic slowdown, Wincanton has been able to grow operating profits and margins from 3.2% to 4.8% (2011-15). The broadening of industry exposure (Exhibit 3) has built further resilience into the business to withstand general macroeconomic pressures or industry-specific issues helped by the use of open book contracts (Exhibit 4).

Despite a diversified customer base, retail remains an important part of the mix representing c 50% of revenues. A key part of its traditional retail customer base under significant ‘group’ pressures and needs a flexible and cost effective supply chain to respond to the challenging conditions. For example, both Tesco and M&S realigned their supply chains in 2014/15 and as open book clients, Wincanton reshaped accordingly without the need for major restructuring. Retail remains a challenging environment and Wincanton’s customer base expects its logistics provider to be an increasingly integral part of the supply chain. This helps contract retention but the service needs to be innovative and flexible while remaining cost-effective.

In addition, the growth in multi-channel and internet retailing is seen as an important growth opportunity and helpful to the outsourcing trend. The growing complexity of the supply chain increases the need to provide a wider ‘managed solution’ including store support, central stock holding and scheduling. Multichannel also places increased pressure on the supply chain to maintain service levels and consumer experience. As evidenced by its new contracts with Williams Sonoma and Screwfix, Wincanton looks well placed, with the proposed takeover of Home Retail by Sainsbury's (both clients) also a good example of this multichannel strategy.

Recruiting industry-facing management expertise has proved helpful to push into other sectors and is combined with best-in-class innovative solutions. Although some sectors, such as Construction, have been slower to adopt outsourcing by applying best practice from Retail, the recent contract win with Howden Joinery shows the potential for growth. While outsourcing is the dominant long-term growth trend in Logistics, certain industries from time to time go through a phase of insourcing, prevalent in the historic Tankers business in 2015, but the division was capable of more than offsetting this elsewhere with other new wins and contract extensions.

While typical contracts last three to five years, many of Wincanton’s customers have been with the group for more than 20 years (Sainsbury's, Heinz and Britvic), indicative of high service levels and contract retention. Renewals obviously involve some negotiations on price, but as the partnership develops and the service broadens, the group and its technology become embedded and integrated into the supply chain and more difficult to displace. A high-quality, stable customer base produces a reliable and steady revenue stream. Exhibit 5 shows its blue chip customer base.

The resilience of the income stream is an encouraging attribute given the economic background. A number of factors contribute to this including the diversity of customers and industries, but a key factor has been the use of open book contracts as a key part of the operating model and risk management process. Retail is a prime user of open book contracts and mix between open and closed book contracts has stabilised at 67/33%.

Whereas in closed book contracts the group retains the principal risk and hence seeks to earn higher margins, open book contracting protects Wincanton against volume shortfalls and cost fluctuations, and improves the visibility and security of the income stream. Open book contract arrangements mean Wincanton earns a management fee for a logistics service with all costs and expenses tightly managed, but agreed and invoiced to the customer. The major cost elements of property and vehicles can be owned by either parties, but as part of the risk management process the exposure is matched to the length of the contract with no residual risk if the contract is not renewed. The clarity over the cost base is beneficial to both parties and helpful to the outsourcing trend while not reducing the need for closer collaboration to seek great efficiency. In comparison, the lower risk profile of open book contracts tends to initially earn a lower margin. However, in addition to the basic management fee Wincanton can earn extra profits via selling higher-value technology services or by achieving strong operational performance, earn KPI bonuses or benefit from gain share arrangements. By achieving market-leading operating statistics Wincanton looks to have a loyal customer base, which is shown in the high renewal rates (90%+), and by consistently meeting KPI targets the division is earning top-of-the-range margins at close to 5%.Overall the business looks in very good operational shape and with the financial constraints easing, is well positioned to add extra business to a resilient base business and gain market share in a challenging and dynamic marketplace with the trend to outsourcing set to continue.

Three businesses (Containers, Pullman and Records Management) have formed a standalone Specialist division since the strategic review. This structure was formed to ensure they fully used their specialist capabilities to provide wider supply chain services but with a dedicated management team seeking to exploit the superior growth potential while supporting its customer base.

The recent disposal of its high-margin Records Management business for £60m at an attractive valuation (£55m net proceeds imply 11x EV/EBIDTA) suggests this strategy has proved successful and created value for shareholders. However, post this disposal (least synergy with Contract Logistics) and combined with the recent problems at Pullman, the benefits of remaining a standalone division look limited and in our view should be reconsidered. With customer overlap, it appears that closer integration with Contract Logistics would enable best working practices to be adopted and there seems to be potential for both revenue and cost synergies.

At the interims, issues at both Containers and Pullman left the division loss-making. Containers suffered temporary problems due to volatility in its customers' volume requirements and a lack of flexibility in its staffing cost base. This was exacerbated by the current driver shortage and Containers has put in place various operational improvement plans. The difficulties at Pullman centred on two problem contracts, where poor contract structure in terms of pricing and underestimating volumes caused further provisions (c £2m) to be taken. Pullman has now exited both contracts, recruited a new executive team and returned to its core fleet maintenance service, which has historically been a solid performer. Despite recent difficulties in the medium term, both remaining businesses should be capable of turnaround and achieving Group average margins.

Since the start of the decade there has been a major change in the board's composition, with all three top positions changed as the business evolves from the strategic review and restructuring. Steve Marshall joined as chairman in 2011 and has been overseeing the implementation of the plan, supported by Eric Born and Jon Kempster in the early-stage restructuring and financial negotiations. Adrian Colman was appointed as FD in 2013, before stepping up to chief executive in August 2015, to be supported by Tim Lawlor as FD.

We regard the changes as evolution rather than revolution and a natural progression given the different strengths and skills required, as the focus moves from restructuring to operational measures. Wincanton has been successful in the initial phase of the restructuring and debt reduction and believe the recent changes will prove to be a smooth transition and allow the next stage of strategic plan to be implemented, supported by a strong operational management team.

As shown by the volatile historic share price chart, the share price has been heavily influenced in the past by both operational and financial issues. We believe Contract Logistics is now a very resilient business with strong operational and financial performance. In addition, the group has made significant progress in reducing debt levels and pension deficit risk. Key sensitivities are:

As we near the conclusion of the current phase of the restructuring plan, we believe the share price continues to reflect past issues rather than the consistent progress made in the core Contact Logistics business (CAGR EBIT 2012-16e +9% pa and improved margins to 5.0%). Operationally the business is much stronger with a very resilient income stream and strong market position, and is well placed to benefit from further outsourcing and market share gains. The possibility of dividends resuming in 2016/17 also underpins the shares with a potential initial yield of c 4.5%.

Concern over both the financial position and the pension fund deficit appear to overshadow the share price but appears misplaced. Helped by disposal proceeds of c £148m, net debt has reduced from a peak of £270m to £62m in H116 with improvement in all financial covenants. The pension fund deficit remains high but manageable, and in terms of valuation we treat it as debt.

The lack of any direct UK comparators doesn’t help valuations; however, with Wincanton competing in the UK logistics market with global competitors it is this global peer group that makes the most logical comparison. A P/E of 6.9x 2016e looks modest, but we believe an EV/EBITDA is the most appropriate valuation metric taking into account average debt levels and the pension fund deficit.

Despite substantial reduction in net debt over the period, EV/EBITDA of 6.0x FY16e (to March 2016) using average net debt, remains at a significant discount to UK and international peers. Exhibit 6 below includes global competitors and for reference three UK comparators (although not directly comparable as services and ratings vary significantly). Assuming the multiple expands to 7.3x EV/EBITDA (c 40% discount to international peers), this suggests a base valuation of 219p and upside of c 30%. In addition, as sector consolidation continues the 2015 acquisition of Norbert Dentressangle by XPO Logistics (implied EV/EBITDA of 9x) is another potential valuation point.

The interims announced in November 2015 were robust and in line with market expectations. Net debt was lower at £62.2m (average net debt of £124m) vs £66.9m (£141m) in H115 and will be further reduced by the disposal of Records Management. Gross pension deficit stood at £125m (£144m at FY15). A 5.7% growth in Contact Logistics revenues translated into a 16.7% increase in EBIT, with 5% margins helped by project fee income and gain share payments. There was good momentum with contact wins and extensions in the period. In contrast, the Specialist businesses segment disappointed and reported a small loss, as Containers suffered from volume and cost issues while the contract problems at Pullman led to a further £2m provision ahead of termination.

Our financial forecasts are driven by the following assumptions: