WYG — Update 19 December 2016

Revenue and profit growth were both achieved in H1 with PBT 18% ahead, adjusted, fully diluted EPS up 8% and DPS increased by 20% y-o-y. We expect the move into a small net debt position to have reversed by the year and the order book development is a positive indicator for trading momentum into H217 and FY18. Management has flagged a new strategic plan and we are likely to be hearing further detail on this before the end of the current financial year.

UK operations – good revenue and order book growth

The UK office network has been the bedrock of WYG’s improving financial performance over the last four years and has more than compensated for a reduced contribution from overseas operations during the transition from one EU funding cycle to the next. H117 revenues were 16% up year-on-year. Business review comments highlighted the breadth of sectors, services and clients addressed in the period, some under longer-term framework agreements. This includes the MoD; associated workflows got off to a slow start in Q1, but have resumed more normal levels subsequently. As an indication of the long-term nature of these relationships, we note that the latest Defence Estate review published in November1 contained rebasing activity out to 2032. Elsewhere, some other sectors also were relatively quiet at the beginning of the year but momentum clearly built as the first half progressed.

Order intake momentum has been sustained with further growth. Bearing in mind that the contracted UK order book – which stood at £80m at the end of September (up c 4% since the end of FY16) – is typically to be delivered in the following 12 months, management confidence is tangible here. WYG has a direct delivery model in the UK and has been upgrading office locations (five out of 17 so far) and, more significantly, making c 70 new hires (c 1,000 total UK technical staff). While the former is not understood to have affected overall location costs, the increase in employee numbers – ahead of contracted workflows translating to revenue – did provide some drag. Hence, the reported H117 margin of 8.5% was 130bp lower than H116, despite the revenue uplift. While higher staff costs will also be present in H2, orders should flow into revenues resulting in a good profit uplift, we believe. In the year to date, quarterly revenues are growing sequentially, with Q3 so far stronger than Q2, which was better than Q1. Management stated that the FY17 outturn is not dependent on significant further order wins in Q4 – though this is of course an objective – but also that the order award/deliver cycle tends to be relatively short in the UK. Consequently, this may still have a positive impact on momentum at the year end and into FY18.

Europe, Africa and Asia – subdued financial performance but growing order book

This region has experienced uneven development, being generally weaker over the preceding two years, albeit with an improved H216 performance. As EU-funded development projects have historically provided the primary workflow, a slower than anticipated transition to the latest EU Multi-annual Financial Framework (MFF 2014-2020) has affected revenue. Headline financial performance in H117 continued to reflect this, with revenue down c 11% and a maintained broadly break-even position.

H117 revenue for individual sub-regions was not split out, but we understand that Central and Eastern Europe (CEE) is the largest of the four and South East Europe (SEE) is the next biggest, followed by Africa (excluding northern countries) and then Asia. Our observations, based on their project funding profiles, are as follows:

Slower, lower-level EU project funding is not new news, but the rate at which it regained previous momentum has proved difficult to gauge. Our key observation for this region for H117 is the significant order book uplift reported; it had increased to c £44m at the end of FY15 and remained broadly stable subsequently, but has now stepped up again to £60 at the end of September. (Specific project wins in Poland and under IPF5 were both highlighted by management.) We should point out that the bulk of this (c 75%) is to be delivered beyond the current year but some uptick is discernible for H2 and we expect an improved financial performance for this division to become apparent from H217.

Middle East and North Africa – higher order book led improved financial performance

MENA provides a good example of a rising order book (which stepped up from c £8m at the end of FY15 to c £19m six months later and stood at £23m at the end of H117) translating to improving financial performance. Year-on-year revenue rose by £4.7m to £10.2m and moved from a small prior year loss to a 4% EBIT pre-central cost margin in H117. Turkey is the main hub for this region; despite some significant political unrest in the country, EU funding commitments (covering a range of pre-accession programmes and migration objectives) do not appear to have been affected and nor does project implementation to any discernible degree.

Work is underway to broaden the workflow for this region including both EU and non-EU funded projects in the Middle East and Gulf regions, including further work with UK agencies. The order position as it stands provides good trading visibility for FY17 and management expects to deliver a strong financial performance for the year in this region.

H117 cash performance: At the end of September, WYG had moved into a £4.9m net debt position having been modestly net cash positive at the beginning of the year. The free cash outflow of £4m was split broadly equally between trading cash flow and the sum of interest, tax and capex. Deferred consideration (£0.7m, relating primarily to FMW and the FY16 final dividend cash payment (£0.7m) accounted for the other cash movements.

Looking at trading cash flow, while EBITDA rose to £3.8m (up £0.7m y-o-y), there was also a c £5m net absorption into working capital and c £0.5m arising from restructuring activities at UK, EAA and group levels. The working capital movement included a £6m receivables increase; we understand that this was chiefly driven by seasonal effects and rising revenues including some project extensions. Property/PII legacy cash outflows were c £1m in H117. Otherwise, interest, tax (on overseas earnings) and capex (including group IT investment) all individually edged higher.

Historic context: In FY12, WYG successfully completed a refinancing and ended that year in a £23m net funds position. By the end of FY16, this had reduced to £0.2m net funds. In cash terms, the most significant outflows related to legacy items (c £13m in aggregate, across property and professional indemnity provisions) and M&A (c £11.5m, six acquisitions plus some disposal costs). Together, these items effectively account for the net cash movement from FY12 to FY16. During this period, UK revenue increased – partly aided by acquisitions – but was offset by lower overseas sales. At the same time, EBIT moved from a significant FY12 loss to a £7.2m profit by FY16. Implicitly, this was absorbed by operations; in decreasing size order outflows relating to advance payments in the earlier years, capex and working capital investment plus a return to the dividend list have been the most notable items.

We believe that WYG is now moving into a revenue growth phase with UK operations expanding further while the overseas ones regain traction as EU development programmes gather momentum. On our estimates the H117 move into a net debt position is temporary with an expected H2 inflow to restore a modest net funds position. This is driven by increased profitability and a substantial reversal of the H1 working capital outflow together giving a strong free cash flow performance. While further deferred consideration and cash dividend payments are anticipated in H2, the overall expectation is for a good net inflow for the period with a broadly neutral cash movement for FY17 as a whole. Beyond this, we see free cash flow rising to c £6m in FY18 and above £8m in FY19, which easily funds expected dividend growth and a small remaining amount of deferred consideration. Hence, absent any further acquisitions, WYG’s net cash position is set to build.

The H117 results contained reference to a new strategic plan whereby WYG is intending to concentrate its growth aspirations where its market positions, client relationships and market opportunities are perceived to be strongest. No further detail was given at this stage – an update is flagged for spring 2017 – but it seems reasonable to expect some change in operating structure, reporting lines and responsibilities and, possibly, financial reporting. A stated objective to focus on growth areas, served efficiently seems sensible enough and we will make a fuller evaluation when more tangible details are available.

Our headline group estimates are effectively unchanged. Reflecting H1 performance and trading momentum, we have made some regional mix adjustments to both revenue (UK up, EAA lower) and EBIT (EAA lower, MENA increased), which broadly offset each other. These changes apply to all forecast years. The only other amendments of note concern a zero tax charge (FY17 only, other years unchanged) and raised dividend expectations across all years of between 8-10%.