Connect Group plc
Market cap: £74m
Net debt: £70m
Core EBIT: £41m
Core FCF: £28m
FCF yield: 35%
Connect Group is a classic GoodCo/BadCo. The GoodCo in this case is Smiths News, the UK’s leading wholesale newspaper business. While the business is in long-term decline, it still generates a steady, capital light, £40m in annual pre-tax free cash flow. Smiths smaller, lower margin peer, was acquired by a Private Equity firm in 2018 for 5X EBIT, providing a good yardstick for which to value it.
The BadCo is Tuffnells. Tuffnells is one of the UK’s largest “odd shape” parcel delivery companies which was acquired by Connect in late 2014 for ~£100m. Today, it would be lucky to fetch £10m. While it used to be a decent company, Connect’s former management team, in all their wisdom, tried to combine the asset light operations of Smiths with the CAPEX heavy Tuffnell’s and it was a complete disaster. The only saving grace is Tuffnell’s Real Estate portfolio which the new management team is currently monetising. Through sale & leaseback transactions, it looks plausible the company could release ~£30m (£15m achieved so far). Importantly, the ParentCo only has to guarantee these leases for 1 year, after that, the lease liability sits within the Tuffnells subsidiary and is therefore, ringfenced.
Sum-of-the-parts ideas are typically a fertile hunting ground for “value traps.” However, in this case, the share register is dominated by active investors. Most notably Aberforth Partners with 15% and Munich based family office, FORUM, with a 12% stake. I believe these factors skew the range of potential outcomes towards the positive side as they are unlikely to remain supportive of a strategy that destroys shareholder value. They likely played a role in the ousting of the latest CEO and the recent initiation of a strategic review.
In my base case scenario, I assume Tuffnell’s can be sold for £1 (not a typo), and Smiths News is worth 5X EBIT, which gets a valuation of ~60p per share (100% upside) (assuming some of the funds from the recent sale & leaseback are put towards reducing the debt). In a bear case, where Tuffnell’s remains within the group (unlikely given the shareholders involved) the overall EBIT would likely be around £28m as it loses ~£1m per month. On a 5X multiple this gives a value of ~30p. Therefore, the risk/reward setup looks to be asymmetric and extremely favourable, especially when one considers further upside from sale & leaseback transactions, monetisation of the overcapitalised pension fund and a potential sale of Smiths News too. In a bull case, it doesn’t take herculean assumptions to get a valuation in excess of 80p or nearly 200% upside.
- Sale of Tuffnells
- In my base case I have assumed a sale price of £1
- The worst-case scenario would be for them to wind it down, but this seems unlikely given the depth of specialist restructuring buyout firms across UK/EU (for example, my firm would be a buyer at £1)
- The best-case scenario would be either a peer (AIM listed DX Group most likely) or an overconfident Private Equity shop
- Post the two sale & leaseback transactions, Tuffnells should still have in excess of £15m in monetizable Real Estate. Therefore, someone may pay a positive equity value for it
- Reinstatement of former dividend policy
- Assuming Tuffnells losses are gone and an 80% pay-out-ratio, at 30p the yield would be >30%
- Sale of Smiths News
- As a Public Holding Company, the management team estimates they incur £5m+ in corporate costs that could be cut
- At 5X multiple, this adds 10p per share in value
- Customer concentration
- While pricing pressure from customers is not a major concern, due to the geographic-monopolistic structure of the industry, it is a concern from the perspective of them remaining customers
- The customer base is relatively concentrated, as one would expect. The largest customer was 10% of revenues in 2019, with the second largest being 6%
- Based on the overall structure of the newspaper industry, I would guess they have another 1-2 customers at ~5% before it begins tapering off
- Therefore, if one customer was to go bankrupt, it would be a material event
- Looking at News Corp, which owns The Sun & The Times, it still remains quite profitable with EBITDA margins in the “News and Information Services” segment of 8%
- Daily Mail & General Trust’s “consumer media” segment still generates a health 10% operating margin and despite sales continuously declining over the last 10 years, margins have remained very consistent
- So, while I reckon the publishers will continue to be pressured, imminent bankruptcies for the larger firms do not seem highly likely
- Acceleration in volume declines
- Volume declines have been pretty stable (as a %) since 2010, at around 6% p.a.
- My personal view would be that declines are more likely to slow than accelerate as they hit a “base level” of audience that still prefers physical paper. This is highly influenced by my personal preference for physical newspapers, plus that of certain friends and family members. Therefore, it is highly biased and should not sway ones opinion
- Volume reductions have historically been offset by price increases, and I haven’t seen any evidence as to why this is not likely to continue in the future
- Failure to adequately remove costs
- This is the highest probability risk
- When they renegotiate their contracts and do internal budgeting, they base all profit assumptions upon cost realisations they expect each year
- Currently, to maintain profitability, they will need to reduce operating costs by £5m p.a. for the next two years
- As part of their budgeting process, they have assumed £5m in cost out p.a. for the next two years, which is required to offset sales declines
- Going back to 2014, on average they have reduced OPEX by ~£6.5m p.a. and the man running Smiths News has been doing so for over a decade. So, it seems reasonable to have confidence in their ability to deliver on the required cost-out
- Monopolistic practices coming under attack
- Smiths News holds 55% market share and the remaining 45% is held by Menzies Distribution (acquired by Endless LLP in mid-2018)
- There is extremely little cross-over between the businesses, meaning they essentially operate regional monopolies
- I have read some stories from local papers discussing how the companies leverage this power to deliver poor service quality to their customers, while consistently increasing prices
- Therefore, there is some risk that Governments decide to take action against them. Although, they are in a tough/declining industry, so would be difficult to see people being able to say they’re earning “too much money” etc.
- In 2017 the Group entered into a banking facility which matures in January 2021
- At that time, Tuffnells was still profitable, and the group was generating over £55m in operating profits (last year reported OP ~£30m)
- Therefore, if Tuffnells is still within the group and losing money, they may have difficulty in re-financing the debt at favourable rates
- This could also be viewed through a positive lens, because the management team is acutely aware of the impact Tuffnells has on the groups refinancing ability, and are therefore, more likely to sell it off
- In 2017 the Group entered into a banking facility which matures in January 2021
The key swing factors that will determine whether this investment is profitable or not are:
- Operational performance of Smiths News
- Whether Tuffnells is sold or not
Therefore, I construct the following Decision Tree to create the reasonable bounds of potential outcomes:
- Smiths News current EBIT £41m
- Smiths News worse EBIT £31m (based on achieving none of the budgeted costs out for the next 2 years
- Tuffnells EBIT (£12m)
- Net debt £65m (was £70m at year-end, but have since done 2 sale & lease back transactions totalling ~£15m)
- EBIT multiple 5X
Even assuming a very conservative 50% chance that Smiths News operations get worse (it has had extremely consistent profits for 15+ years), the probability of losing money still seems unlikely with a conditional probability of only 10% (50% x 20%).
Putting the valuations and probabilities together, I get the following expected value:
Therefore, given the range of potential outcomes, I calculate an expected value of 42p – providing for an expected return of 40% if one was able to run this bet multiple times.
The Board plan to make a decision regarding Tuffnell’s future within the next 6 months, and given the shareholder base, if they fail to come to a conclusion, I don’t think they will retain their jobs. Therefore, this investment should have a relatively short duration of 1-2 years, providing very attractive annualised expected returns.
At current prices, there is also a large cushion providing room for a deterioration in operations at Smiths News. The following matrix shows the return potential at various levels of EBIT and multiple, with the assumption that Tuffnell’s is sold for £1:
As the matrix shows, as long as the core business is worth at least 4X (in-line with the recent peer transaction) the outcome from this investment should prove very favourable. The only outcome which results in a loss is in the event the core Smiths News operating profits decline ~25% and the exit multiple is 4X.
Smiths News is the UK’s largest newspaper and magazine wholesaler, with roughly 55% market. Every morning they facilitate over 27,000 deliveries, before 9am. They pick, pack and consolidate supplies from over 3,000 printed titles, as well as process returns and recycling of unsold copies from 39 depots across the UK.
The company has two primary revenue streams:
- They receive a % of the cover price for sold newspapers & magazines
- This is why the decline in revenues has been less than the overall UK circulation decline – pricing increases
- They receive payments from the re-sellers for making the delivery
- Fixed price service/deliver fee
The business model is capital light, wherein they only operate the distribution centres and the drivers are independent contractors with their own vehicles. This has been of crucial importance given the structural decline in the industry as it allows them to more easily reduce capacity.
Smiths and Menzies operate geographical monopolies and barriers to entry are almost insurmountable. They stagger contract renewals (which average 5 years in duration) so that in any year, only a fraction of the total market is up for grabs. Therefore, a competitor would have to suffer substantial losses while they slowly acquire market share, only to end up in a declining industry! Competition is not a risk in this industry.
It would also be difficult to convince the publishers to switch, as they need to have a lot of faith in the distributors as a going concern due to the enormous debts they have with them due to the long payment terms. Therefore, a competitor, which would initially be losing money due to lack of route density, would have to convince the publishers that they will remain in business long enough to pay them back for the inventories. Doesn’t seem likely.
The current MD of Smiths News, Jon Bunting, has been with the Group since 1994 and has done a tremendous job in offsetting the declining revenues through cutting costs. It requires some assumptions to be made on gross profit margins, but since 2013 it looks like he has managed to reduce operating expenses by ~£40m or £6.5m per annum. This gives more credibility to their currently budget £5m in annual OPEX reductions to maintain current profits:
Jon was recently rewarded for his efforts through being promoted to interim Group CEO.
As expected, the overall industry (measured by circulation) is in a steady, long term decline. The following chart is based on circulation data for the 12 largest publishers over the last 19 years (including the now defunct “The Independent”)
The average rolling CAGR is around -6% but there are quite large differences between different papers. For instance, the Evening Standard and The Times are roughly flat on where they were 3 years ago.
The next chart compares Smiths News revenues, with overall circulation, rebased to 2010:
This chart essentially highlights the price increases, with circulation declining at 6% p.a. over the period, and revenues declining at 3% p.a.
Why is it mispriced?
- Dividend cut forced “income funds” to sell
- It doesn’t look great from the reported numbers, with ongoing write-downs etc. causing it to report heavy losses in the last two financial years
- It’s quite a small, illiquid stock
- Numerous “unforced errors” from prior management team likely don’t give investors much faith
- It’s in a declining industry, which public markets do not often correctly value
Smiths News is not a compounder. It has a commanding position in a dying industry. However, for this investment to work, it does not require herculean assumptions. As long as Smiths News is worth more than 3X EBIT and it can maintain relatively steady profits, this investment should generate attractive returns. Given a near exact peer was acquired in 2018 for 5X EBIT, I think it’s safe to assume this is the going rate.
At current prices, if Tuffnells is removed, and the company returns to its former high pay-out-ratio policy, the stock would likely be providing a dividend yield in excess of 30%. The guy who’s been in this business for 25 years is confident they can at least maintain current profits for the next three years. Therefore, whatever happens after that is the cherry on top, because we would have recovered our entire investment by then!
Is it really worth 5X EBIT?
Before I found out that Menzies had been acquired in 2018 for 5X EBIT, I had already come to the conclusion it would likely be worth 4-6X based on the following DCF assumptions: