Renewi — Growth catalysts in place

Upon completion of the merger between Shanks and Van Gansewinkel (VGG) on 28 February 2017, Renewi became the leading player in the Benelux waste market. Its scale, vertical integration and waste-to-products model, which aligns well with trends in the emerging ‘circular economy’, give it a platform for profitable growth that will deliver benefits as end-market recovery continues. The €40m in annual cost synergies already identified for implementation by FY20 are a key driver of our forecast underlying three-year EBITDA CAGR of 10.9%.

Renewi currently trades at a discount to the waste sector. Its global peers trade on a one-year forward EV/EBITDA of 8.7x, while its closest listed UK peers average 8.9x, so Renewi’s current 6.5x multiple implies a significant discount. While we acknowledge Renewi has been challenged by operational and end-market issues in recent years, the platform is in place for higher growth and, provided management continues to deliver, the stock should rerate. We arrive at our 102p fair value per share by averaging two valuation methodologies: our DCF (WACC 7.5%, terminal growth 1%) implies a fair value of 99p per share; and our conservative 8.0x one-year forward (FY19e) EBITDA model gives a fair value of 104p per share.

Our forecast 10.9% underlying (pro forma) EBITDA growth over the next three years is attractive in a typically GDP plus or minus sector. Between FY18e and FY20e, we expect to see underlying EPS double and net debt/EBITDA drift downwards from 3.3x in FY18e to 2.3x in FY20e. This comes despite Renewi’s high dividend payout (yield 3.9%) and capex requirement. Therefore, while management will be preoccupied with integrating the two businesses in the coming year or two, we forecast cash returns to the extent that further substantial organic or inorganic investments would be possible by FY20e. We do not explicitly include revenue synergies in our forecasts. This would provide further upside.

Although through the worst of the Dutch waste market’s troubles, investors should remain conscious of this and other risks inherent in Renewi’s business model:

We believe Renewi – as a newly merged entity of Shanks and VGG – has the requisite scale, end-market exposure and skillset to grow profitably in the coming years. Furthermore we believe the equity story can be boiled down to four specific catalysts that will drive returns: the stock’s exposure to recovering markets in the Netherlands, its capabilities in waste-to-products, planned synergies from the merger and the culture of commercial effectiveness inherited from Shanks.

The waste market in the Netherlands and Belgium is in the process of recovering after several years during which the economy remained soft, construction activity was at record lows and there was excess capacity in Dutch incineration. These factors, which depressed volumes and prices, have reversed and Renewi, as the waste operator with the largest market share in Benelux (and which accounted for 73.0% of Renewi’s pro forma FY17 revenues) is especially well-placed to benefit from the recovery. FY17 results in Benelux Commercial Waste were strong and we expect growth to continue.

Renewi is a market leader in the production of secondary recyclates. Secondary recyclates from paper to cardboard and glass and metals, when separated and processed from waste streams, can be sold to a range of industrial users as inputs. This serves the twin objectives of meeting government recycling targets and diversifying revenues. Sorting and processing technologies can be complex, with Renewi’s Monostreams division a specialist operator. Strategically therefore this capability provides Renewi incremental diversified revenue streams, technological barriers to entry and the ability to provide complex integrated waste management solutions to demanding corporate customers.

Renewi has begun the process of realising €40m in annualised cost savings by FY20e (FY18e target of €12m). The two companies share operational footprints, especially in the Netherlands and Belgium with synergies expected from VGG’s heritage as a collections company and Shanks’ background in waste processing. A three-year structured integration programme overseen by a new executive team will, we believe, deliver the €40m in synergy targets with the potential for further upside and further benefits such as revenue synergies. Based on our FY20e revenue forecasts, €40m of synergies equates to a 2.2% improvement on underlying EBITDA margins and accounts for c 17% of FY20e EBITDA. We calculate the NPV of the synergies is £376m/47p per share and increases our NPV by 36%. A significant amount of senior resource has been added to Renewi to execute synergies, including a group integration director, and we increasingly view integration and business optimisation as a core competency for the group.

A skillset developed within Shanks, commercial effectiveness applied discipline to the management of existing customers and targeting of new business. By analysing key data, Shanks was able to eliminate or upsell loss-making contracts. The same skillset enabled the company to target profitable niches for business development. The result was that Shanks was able to squeeze higher returns out of its existing contract portfolio and ensure new business enhanced profitability. While not explicitly included in Renewi’s merger plans, we believe this capability will have an increasingly important role to play as the merger evolves.

At the time of the merger, Renewi management put in place a new divisional structure that more closely resembles customer groupings and needs: Commercial, Hazardous, Municipal and Monostreams. We forecast a material increase in trading profit by FY20e primarily driven by the synergies programme, but also underpinned by revenue growth and underlying margin expansion especially from FY18e onwards as the business integration develops.

Representing 63% of pro forma FY17 revenues, with exposure to the Benelux commercial, construction, demolition and municipal collection markets, the new Commercial division is currently focused on implementing the merger and delivering synergies and margin expansion against a backdrop of recovering end markets.

The unit is a combination of VGG Collection and the former Shanks Commercial division and is a leader in waste management in Benelux. Operationally, it is active across the value chain from collection to sorting, processing and ultimate disposal via incineration or landfill. Consistent with Renewi’s ‘waste-to-products’ strategy, the Commercial division recovers and resells products such as paper, cardboard, wood and plastics. More specialist products are processed by the Monostreams division. The Commercial division is active in three main end-markets:

Both the Belgian and Dutch Commercial Waste businesses within Shanks witnessed trading profit growth in FY17 in local currency, with the 27% increase converting to 47% growth in sterling due to the weakness in the pound. Trading margins increased from 5.2% to 6.5% across the whole business. The strong results were led by end-market recoveries in C&D and I&C in the Netherlands, while the Belgian growth was more muted. Margins expanded due to top-line growth as well as ‘self-help initiatives’.

Recovery in Benelux (especially Netherlands) commercial waste is a key component of the earnings story to FY20e. There are clear economic data that support the continuation of the positive trends already witnessed in this market. Exhibit 3 shows a long-term view of the Dutch construction sector in terms of both output and business sentiment from key operators in the sector. As can be seen, the most recent trough in activity and sentiment was in late 2013 and early 2014. Since then, both sentiment and activity levels have recovered significantly. In late 2015, sentiment moved into positive territory and has continued on an upwards trajectory, with positive sentiment now in line with previous market peaks in 2000 and 2008. Construction sector activity has some way to go to reach previous highs but with sentiment continuing to improve (it has been a very reliable lead indicator until now), together with positive economic newsflow from the eurozone, we are confident Renewi can continue its current positive growth trajectory in its key Netherlands waste business.

Management guides to underlying growth in FY18 driven by end market recovery. There is a slight risk that merger integration could be a drag on performance over the year. However, after merger synergies and currency are taken into account, we forecast the Commercial division to grow underlying trading profit by 6.9% in FY18 vs FY17. Over the longer term, we forecast a three-year trading profit CAGR of 21.1% driven by a mixture of recovering end markets, benefits of scale allowing Renewi to gain share by offering competitively priced integrated services and finally the positive impact of continued efficiencies to FY20.

Accounting for 12% of pro forma FY17 revenues and with operations primarily in the Netherlands, the high-margin Hazardous division specialises in industrial cleaning. It is a combination of Shanks Hazardous Waste and VGG’s Industrial Services division (VGIS). The division has struggled in recent years with slower revenue growth as the core end-market (more than 50% of revenues) of oil and gas has contracted, but other key verticals include heavy industry and the food industry. It has treatment facilities for contaminated soil and water and can provide integrated waste solutions for companies managing hazardous waste streams that require permitting and environmental control. Long-term drivers include contaminated soil arising from brownfield land development in the Netherlands.

Shanks’ Hazardous division reported a strong increase in trading profit – 9% in euros and 24% in sterling – with soil treatment strength and cost reductions more than offsetting continued softness in oil and gas. New technologies such as ultrasonic cleaning also contributed. Trading margins increased from 11.4% to 12.1% year-on-year.

Management expects growth in FY18. A strong pipeline of soil and water intake, plus currency tailwinds help to drive our assumed FY18e trading profit growth of 12.2%. The oil and gas sector is forecast to remain soft for the foreseeable future. However, as environmental legislation becomes more stringent, so hazardous waste treatment capabilities should lead to further growth. This plus a more general economic recovery in Renewi’s key end markets drive our three-year trading profit CAGR of 7.2%.

The former Shanks Municipal Division contributed 14% of pro forma FY17 revenues and provides local authorities in the UK and Canada with integrated waste management solutions. In recent years, a series of issues around the construction of waste treatment facilities and problems with local authorities have led to loss-making years. Management is taking actions to tackle the issues facing the Municipal division. A recovery programme and new management team have been put in place. The recovery plan seeks to increase capacity utilisation at waste processing facilities, which will help to cover high fixed costs and generate more power. In addition, the new team aims to enhance the quality and therefore achievable price of the recovered fuel as well as renegotiating offtake agreements for refuse derived fuel (RDF) and solid recovered fuel (SRF).

The UK Municipal business swung from a £7.8m profit in FY16 to a £4.2m loss in FY17. Over the year, the Canadian business also saw a 15% decline in trading profit to £1.7m. Trading margins declined to -1.8% from 5.1% in FY16. Several of Renewi’s UK treatment facilities, including Wakefield, BDR (Barnsley, Doncaster, Rotherham) and Westcott Park experienced a range of issues over the course of the year. The plant under construction in Derby (where Renewi is not the EPC contractor, which therefore limits the negative impact although it delays the cash flows) is facing ongoing delays due to the exit of a technology supplier.

We forecast the Municipal division will return to profitability in FY19 as the recovery plan takes effect. However, we remain cautious about profitability and growth prospects thereafter for several reasons. Firstly, Municipal customers continue to experience pressure from central government on costs. Also, an increasing number of listed waste companies (Viridor/Pennon, Augean) are experiencing similar profitability issues with waste-to-energy plants. Namely, capacity utilisation has to be very high for such assets to break even. On the whole, we believe in management’s ability to arrest the deterioration in operations witnessed in FY17, but we do not expect a meaningful return to operating profit contribution within our forecast period. However, with the right management team in place, we can see Renewi recovering some value from this business in the medium to long term.

With international operations spanning Benelux, France, Germany, Hungary and Portugal, the new Monostreams division is a combination of three former VGG divisions – Coolrec, Maltha and Minerals – and a former Shanks unit – Orgaworld. The combined division contributed 11% of Renewi’s pro forma FY17 revenues. Monostreams’ core activity is the production and sale of recycled materials such as glass cullet, plastic chips/ granulates and fertilisers. It is the number 1 in Europe in recycling and trading of glass ‘cullet’, the number 1 handler of mineral waste in the Netherlands and number 2 in organic waste processing in the Netherlands.

Management guides to growth in FY18 in all four of Monostream’s businesses. We forecast 10.3% growth in FY18 trading profit and, based on the strong outlook for these services, factor in a three-year trading profit CAGR of 8.4%. Given the fact that the unit was merged from various entities from within Shanks and VGG, there is little historical data.

Pulling together each of our segmental forecasts gives us the earnings forecasts contained in Exhibit 11. Three-year EBITDA CAGR of 10.9% and trading profit CAGR of 24.4% are exceptionally attractive in a sector context. However, we would add a note of caution that, of the near £50m in additional trading profit implied by our FY20 forecast in comparison to that reported in FY17, £34m is from planned synergies rather than underlying business performance. Of course, the objective of the merger was to extract synergies; however, this indicates how difficult Renewi’s end markets and competitive landscape are.

In 2012, the current management team were installed at Shanks during a period of turbulence for the waste industry and the European economy as a whole. They have brought experience and leadership from a number of industries and helped the group weather macroeconomic headwinds. The merger marks a new phase during which significant management time will be spent ensuring a successful business combination and, crucially, €40m of synergies are extracted over the next three years.

Chairman: Colin Matthews

Previously CEO of Heathrow Airport, Hays and Severn Trent, Colin Matthews currently chairs Highways England Company Ltd. His earlier career spanned the aviation, infrastructure and motor industries.

Chief Executive Officer: Peter Dilnot

CEO of Shanks since 2012, Peter Dilnot has previously held roles at the Danaher Corporation and the Boston Consulting Group. He has also been an officer in the British Army.

Chief Financial Officer: Toby Woolrych

CFO since joining Shanks in 2012, Toby Woolrych previously held roles at Arthur Andersen, Johnson Matthey and Consort Medical.

Integration Director: Geert Glimmerveen

Previously head of the Netherlands division for VGG, Geert Glimmerveen, has previous experience in integration, strategy, operational excellence and continuous improvement. He has also worked for McKinsey and Company.

We highlight the following risks as the main drivers of Renewi’s earnings and valuation.

Our 102p per share fair value estimate is an average of a DCF-based analysis (99p) and a multiple-driven model (104p). It implies 27.5% upside to the current price of 80p.

We believe it is prudent to include provisions and the pension deficit in our EV calculations shown in the Valuation section. Liabilities totalling £188.2m in relation to provisions for site restoration (including landfill capping) are carried on the balance sheet. Also, pension liabilities relating to pension schemes from both Shanks and VGG, which total £26.9m, are carried on the balance sheet. We include liabilities from both provisions and pension liabilities in our enterprise value calculations.

We explicitly forecast five years of cash flow in our DCF, which we discount using a post-tax WACC of 7.5%. We assume a terminal growth rate of 1%. We believe our WACC is prudent. We use a cost of debt of 5.0% despite Renewi issuing a 2019 bond at 4.23% and a 2022 bond at 3.65%.

We also include a DCF sensitivity table to show the sensitivity of our valuation to changes in the discount rate and the terminal growth rate.

We also conducted a sensitivity analysis based on Renewi’s execution on its synergy plans. We find that if Renewi delivered €0 in synergies (unlikely as they had already delivered €4m by year end) then our fair value would drop to 52p per share. Conversely, if management delivered €80m in synergies by FY20e, then our fair value would increase to 146p per share. Exhibit 14 shows the results of the analysis.

We take account of several listed international and UK waste management peers in arriving at a fair EV/EBITDA multiple on which to base our multiple-derived model. We pay closer attention to the UK-listed names such as Augean and Biffa (especially given Augean’s focus on hazardous waste).

We apply a conservative one-year forward EV/EBITDA of 8.0x in arriving at our multiple-derived fair value per share of 104p. The calculation is shown in Exhibit 16.

We expect significant EBITDA and operating cash flow growth from Renewi in the coming years as its earnings catalysts – end-markets, waste-to-products, synergies and commercial effectiveness – combine to enhance returns. Furthermore, at 3.3x FY18e net debt to EBITDA (its covenants are triggered at 3.75x), it has the room to maintain current assets and invest in future growth.

Renewi’s AGM trading update, released on 13 July 2017 reaffirms our investment thesis. Recovery in the Dutch construction sector together with a broader-based economic recovery in Benelux as a whole, and stronger recyclate prices, are driving a strong performance in the Commercial division. Hazardous waste has started the year well while Monostreams is trading in-line with management expectations. The Municipal business is recovering in-line with expectations. Encouragingly also, synergies are being implemented ahead of schedule with €7m already achieved in the year. On the whole management guided to Renewi trading ahead of expectations for the year.

We forecast Renewi will grow underlying earnings substantially over the coming years with three-year underlying EBITDA CAGR of 10.9% and trading profit CAGR of 24.4%. We assume the company delivers on its targets of €40m in synergies by FY20. This accounts for the bulk of the EBITDA and trading profit uplift over our forecast period with the rest driven primarily by continued end-market recovery in the Commercial division.

We forecast net interest will stay steadily around the c £25m level across our forecast period (management guides to £25m in net interest charges in FY18) and our underlying tax rate assumption is 25% owing to the bulk of taxable profit being generated in the Netherlands and Belgium where corporation tax levels are higher than in the UK. Based on this set of assumptions, we forecast underlying (Edison definition: pre-amortisation) earnings per share will climb from 3.90p in FY18 to 8.29p in FY20. In other words, EPS will double between FY18 and FY20.

The company’s stated dividend policy is to maintain the dividend at current levels until it is back within the range of 2.0-2.5x covered. We forecast dividends will remain steady at 3.05p per share in FY18 and FY19.

In Exhibit 16 we outline our divisional synergy breakdown forecasts, which are based on management’s headline guidance, which we allocate to each division based on group revenue share. The €40m in synergies can be further divided into:

Exhibit 18 outlines all of the historical non-trading and exceptional items that have obscured underlying results. Our forecasts include management guidance on acquisition costs and synergy delivery costs. This results in non-trading and exceptional items that total £31.5m, £27.2m and £11.1m at the operating profit line over FY18e, FY19e and FY20e, respectively.

We estimate that there will be a net cash outflow for FY18e of £75m. We forecast underlying EBITDA for the year of £151m. Thereafter a net working capital outflow of £6m, a net interest charge of £25m, tax of £8m, capital expenditure of £110m, a cash dividend cost of £24m, plus £50m in other non-trading and exceptional items in relation to merger integration in aggregate account for the cash outflow. This increases net debt from £424m on 31 March 2017 to £499m at FY18e, according to our forecasts.

The Commercial and Hazardous divisions account for the bulk of capex. In FY17 (pre-VGG), the two divisions comprised 77% of reported capex. In Commercial, around half of capex is invested in trucks and containers with the other half invested in processing plants. This is further split between maintenance and larger individual investments. Big ticket items highlighted by management for FY18 include €4m on a chemical waste shed and €6m on the costs of rebranding. We forecast £110m will be invested in capex in FY18, in line with management guidance. Thereafter, we expect capex to trend at 90% of depreciation.

Renewi’s pro forma net debt to EBITDA was 2.8x at FY17. Our forecast FY18 net debt to EBITDA ratio of 3.3x is in line with management guidance for the year of well below Renewi’s peak debt covenant of 3.75x EBITDA. After FY18 as the synergies benefit Renewi’s cash flow and the one-time exceptional integration costs roll off, we forecast net debt to EBITDA will decline to 2.3x by FY20, in line with management guidance of 2.0-2.5x in FY20.