Wincanton — Update 25 January 2017

As we argued in our most recent report, Wincanton has moved beyond recovery and is well positioned to continue delivering a strong operating performance, which, in tandem with its significantly improved balance sheet, will support enhanced shareholder returns in the coming years. The turnaround in Wincanton’s balance sheet, operating performance and share price over the last few years is commendable and we credit management with this achievement.

As the company continues to resolve the final legacy issues (such as the sizeable pension deficit), investors will be attracted to the growth provided by Wincanton and its end markets. The company’s scale, track record in collaborating with key clients and investment in technology equip the company well to exploit the positive growth trends in its key end R&C and I&T markets.

Based on recent operating performance and current macroeconomic trends, we are positive on the overall financial outlook for Wincanton.

Our fair value per share is based on an average of a DCF-derived fair value per share of 328.5p (WACC 9.6%, terminal growth rate 1%) and a peer multiple-based fair value of 329.5p per share. The average price of 329p is our fair value per share and offers equity holders 28.5% upside. We forecast FY17e DPS of 9.1p per share, which provides a yield of 3.5%. Wincanton’s current implied one-year forward EV/EBITDA of 7.3x and P/E ratio of 8.5x are low in comparison to its closest listed peers.

Wincanton is exposed to several risk factors:

Wincanton offers equity holders a solid amount of earnings growth with an attractive dividend policy at a reasonable price. While cyclical in nature, it provides investors with exposure to several growth markets such as construction, e-commerce and multichannel retail, and has the scale of offering, customer relationships and technology to exploit favourable trends in these end-markets.

The addressable market for UK contract logistics is £30bn. Wincanton’s primary competitors are DHL, XPO Logistics, Stobart and Kuehne & Nagel. Logistics has moved from the simple collection and delivery of goods to a fully outsourced service offering that seeks to provide customers with the infrastructure, skills, labour and labour relations to manage their operations cost efficiently. Wincanton is one of a handful of UK names with the capabilities and scale to compete in this market. The company’s model is to build long-term customer relationships by collaborating with customers, rather than simply collecting and delivering goods. Continuing mutually profitable long-term relationships with customers such as Sainsbury's and Co-op speak to the brand reputation of the group. With the recent recovery in the group’s financial position, it is well positioned to grow on its strong customer reputation.

Of the three senior staff positions, Steve Marshall (Chairman) is the longest serving. Since joining in 2011 he has overseen the implementation of the restructuring and the recovery of the business, which has been led by Adrian Colman. He has served as CEO since 2015, after joining Wincanton as CFO in 2013. Tim Lawlor is a relatively recent appointment as CFO, joining in September 2015. See below for brief introductions to key management.

With £624.4m (55.1% of group) of revenue in FY16, the R&C unit operates mainly by fixed management fee contracts plus profit share. The contracts are usually ‘open book’, which gives retail partners visibility into Wincanton’s cost management and profitability. At H117 in September, segment revenues increased by 4.8% and operating margins slightly decreased from 3.8% to 3.7% half-on-half. More significant were the renewal of the Co-op and Sainsbury’s contracts and the addition of the LDH ambient foods and Majestic Wine contracts. With the economy performing well (forecasts, margins) we forecast R&C will continue to grow in the coming years.

Wincanton’s R&C revenues are subdivided into:

Significant market trends in the R&C segment and Wincanton’s response include:

With FY16 revenues of £508m (44.9%), Industrial & Transportation (I&T) operates using more rigid ‘closed book’ contracts. The fragmented nature of the market means there is an opportunity to increase penetration. Operating margins (4.6% in FY16) are higher than in R&C (4.0% FY17e), although there was a one-off drop in revenues at H117 in September. That said, this 9.2% drop in revenues was offset by a sharp increase in margins from 3.9% to 5.9% as the Pullman fleet servicing business emerged from prior year difficulties. We forecast this unit maintains margins at approximately the 6% level, which, combined with our revenue growth forecasts, drives growth across our forecast period.

Wincanton’s R&C revenues are subdivided into:

Significant market trends in the I&T segment and Wincanton’s response include:

We forecast Wincanton’s three-year underlying operating profit CAGR will be 3.0%, which converts to a three-year underlying EPS CAGR (Edison definition) of 8.6%. We estimate underlying operating margins will increase slightly from 4.4% in FY16 to 4.8% in FY18 with lower average FY17e debt versus FY16 also benefiting EPS. Wincanton’s management aims for dividend growth “broadly matched” with growth in underlying earnings. On that basis, we forecast three-year CAGR in both underling EPS (Wincanton definition: after goodwill, tax adjusted) and DPS to be double-digit percentages. Our 9.1p DPS forecast for FY17 implies an attractive 3.5% yield.

Wincanton’s general contracting principles seek to “minimise uncontrollable risk”. For instance, there is almost always a fuel price escalator written into contracts. While such measures largely insulate Wincanton and its equity holders from adverse cyclical economic effects, it is clear that earnings are sensitive to the business cycle. Our 3.0% CAGR in operating profit is predicated on continued economic growth.

Exhibit 7 shows the impact of cyclically driven declines in revenues and FY18e adjusted operating margins. It shows that with top line growth of -2.5% (versus +2.5% assumed) and margin compression to 2.8% (versus 4.8% assumed), operating profit would decline to £29.9m, a 45% shortfall versus our FY18e base case assumption of £54.2m. At the other end of the spectrum, with 7.5% growth and 6.8% margins, the FY18e operating profit would be £80.7m, an 80.7% increase versus our base assumption.

Our updated forecasts are presented in Exhibit 8.

We are ahead of consensus at underlying operating profit in both FY17e and FY18e by 6.0% and 7.3%, respectively. This converts to underlying EPS forecasts 3.7% and 11.7% ahead of consensus for FY17e and FY18e. Our capex forecasts are well ahead of consensus following recent discussions with management, which now expects projects such as the recent acquisitions of cement mixers to increase capex nearer to £20m in FY17 and FY18. These adjustments account for the bulk of our higher net debt forecasts in FY17e and FY18e.

We have incorporated the new reporting segments – R&C and I&T – into our forecasts. We increase our underlying operating profit forecasts by 5.0% in FY17e and 5.3% in FY18e. These forecast increases are driven by a mixture of top line growth and margin expansion as the economy continues to perform well and Wincanton becomes more profitable. Our double-digit increases in EPS are a function of the superior forecasted operating performance together with a decline in interest costs. This in turn drives our DPS increases. As discussed, our capex forecasts have been guided up by management and account for the uplift to our net debt estimates.

We forecast that Wincanton will generate total cash flows from operations net of pension deficit payments of c £130m between FY17e and FY19e. This is more than enough to finance our forecast £55m capex spend and c £36m in dividend payments, as well as to cover debt servicing costs, without materially increasing net debt over the forecast period.

On a net debt to EBITDA basis, Wincanton’s level of gearing is conservative. We forecast the company’s FY17e net debt to EBITDA will be 0.5x and that, given the three-year EBITDA CAGR of 2.2%, this multiple will decline to 0.5x by FY19e. As of the half year, the company had an IAS 19 pension deficit of £169.2m versus £125.1m at 30 September 2015. The movement is primarily due to a decrease in the discount rate used in valuing the liabilities partially offset by the increase in the value of the assets. We use the higher half year number when deducting liabilities from our EV in arriving at our fair value per share. However, our financial forecasts assume no revaluations due to the volatile nature of yields on government debt. We also forecast the company will contribute £15m in cash per year towards the pension scheme across our forecast horizon.

Our fair value per share is based on an average of our DCF-derived valuation and a peer multiple-implied EV/EBITDA. The fair value per share of 335p (from 242-271p) offers 30% upside to the current price and is a 30% increase versus the mid-point of our last published fair value, with an increase in operating performance offsetting the slight increase in WACC, itself driven by rising long-term yields globally, accounting for the rise.

Our principal valuation methodology for Wincanton is a DCF model with a WACC of 9.6% and a terminal growth rate of 1%. This model implies an EV of £582.6m. After subtracting our FY17 estimates for liabilities, our fair value per share is 328.5p, which is 28.3% above the current share price.

Wincanton’s current share price of 256p implies an FY18e EV/EBITDA of 7.3x and a forward FY18e price to earnings ratio of only 8.5x. It is clear that the stock prices in the pension deficit.

Wincanton currently trades at a 5455.4% discount to its global (including UK) peers on a one-year forward P/E basis (Exhibit 12). On a one-year forward EV/EBITDA basis, which is probably a better measure as it explicitly takes the pension deficit into account, Wincanton trades at a 24.7% discount to its global peers, and a 7.6% discount to its closest listed UK peers. However, we would caution that the list of UK peers is only two names now, given the acquisition of UK Mail by Deutsche Post. If we apply an 8.7x multiple (which we see as reasonable as it discounts Wincanton versus its global peers, which trade on 9.7x one-year forward EV/EBITDA, to take account of the final pension-related balance sheet issues) to our £65m forecast FY18 EBITDA (subtract net debt of £30m, pension deficit of £83m, and £45m other provisions), we arrive at a fair value per share of 329.4p, very close to our DCF-derived fair value per share of 328.5p. The mid-point (329p) of these valuations offers 28.5% upside to the current share price.

The global macroeconomic picture continues to evolve, with increasing inflation expectations steepening the yield curve. We have increased our WACC (from 9.0%) to take account of the change to the risk free rate already witnessed. However, we do not take a macro view beyond that. For that reason we include a WACC and terminal growth rate in our DCF sensitivity table.

We also include a sensitivity in relation to our other valuation methodology: FY18e (one-year forward) EV/EBITDA.

For completeness, we also include a valuation sensitivity to the pension liability, which has fluctuated significantly in recent reporting periods due to a mixture of asset price volatility and changes in the risk free rate used to value the pension liabilities. For instance, the £44.1m change in pension liability under IAS 19 at H117 versus H116 (September 2016 versus September 2015) equates to 35.6p per share.

Our base case assumption for Wincanton’s pension deficit at FY17e is £75.9m (based on the FY16 pension deficit of £105.6m after adjusting for £30m of contributions over FY17e and FY18e). We do not adjust the pension liability based on macroeconomic forecasting. However, by fixing our base assumption for FY18e EV/EBITDA at 8.7x as per our valuation methodology, we can see that the pension liability can alter our fair value per share by 129p – from a high peak of 394p per share to 265p per share.