Swindon-based Connect Group today announced a fresh profit warning, in a trading update which delivered almost no good news. The market reaction could have said to have been rather benign compared to other profit warnings, with the price only contracting 15% (recouping half of these losses within an hour), but it could be said that the damage was done on their original profit warning. Their share price was close to 120p at the start of the year, meaning the business is roughly worth a quarter of that today:
One thing that might get the value hunters attention is the exceptionally low P/E. But, this could be said to be merely an illusion now, as the price is based on the current price but the earnings are historic and almost certain to be cut in the light of these warnings. How far is anyone’s guess.
Connect comprises of a group of businesses in the distribution sector: perhaps the best known to the public is the Pass My Parcel service. The group also is a major news distributor to shops and the travel industry via Smiths News/DMD and also runs a freight delivery service through Tufnells. It should be noted that the Pass My Parcel service was discontinued (announced in a previous update), the obvious reason being that it was not making cash.
As you can expect in this sector, margins are slim. Connect are currently worth £83m but have a relatively large turnover of £1.5bn. However, margins have trended in a tight range of roughly 1.5-2.5%. On the positive side, the business has been consistently profitable over the years.
The warning seems to go across most of the businesses. The parcels delivery service was hit:
Conditions in the parcel freight market have continued to be challenging, with actions to improve service and efficiency having had limited time to influence financial performance in the period. As a consequence, Tuffnells’ second half performance is expected to be worse than H1 2018.
As well as further losses from the closure of the parcel business:
The swifter than anticipated exit from onerous contracts has led to additional operating losses in the period but is expected to have a positive impact on the level of provision required for closure costs in FY2019. Operating losses from the date of the Board’s decision to close Pass My Parcel will be excluded from the Group’s full year Continuing Adjusted Operating Profit.
Smiths is not mentioned but can be intimated in the summary:
In summary, trading in the period has seen a continuation of the challenging trends experienced throughout the year; as a result, the Group expects its full year trading performance to be below expectations.
A previous update had booked a decrease of 2.9% – in the absence of any more specifics the scene seems to be set for a performance worse than this.
One of the first problems here is that debt is relatively high (although the level of debt has declined rapidly in the past two years). The annual report reads as such:
As at 31 August 2017, the Group had £230m committed bank facilities in place (2016: £250m). Bank facilities comprised:
- – a £80m syndicated term loan with £10m repayable in February 2018 and August 2018 with the balance repayable in November 2018; and
- – a £150m syndicated revolving credit facility which expires in November 2018;
The facility described above is subject to the following covenants:
- – Leverage cover – the net debt: adjusted EBITDA ratio which must remain below 2.75x. At 31 August 2017 the ratio was 1.2x;
These facilities are due for renewal in November this year, but a post balance sheet item shows they have a new agreement which runs until 2021, on ‘similar covenant terms.
The balance sheet also does not make for much better reading. There are over £100m of intangibles booked onto it, which is a large figure. Accounts receivables have shrunk, and accounts payable have increased – both in substantial numbers. The number of shares in issue has also increased over the past 6 years (from 203.3m to 247.7m), representing further dilution for shareholders.
Having said that, the business is profitable, and has paid out a good chunk of their profits as dividends to shareholders. The last payout was at 9.8p/share, costing the company £24m, which was a hugely generous payout. It seems that shareholders are also on for a dividend this year, with the following caveat from the June trading update:
The Full Year Dividend for FY2018 will be substantially reduced from that paid in FY2017
There is no figures attached to this. Dividend cover was negative last year, and a big fall in profits might see the business hold onto more cash to steady itself. So whilst even a 2p dividend would be a great yield, there is also the chance of a total wipeout, as that money could be used to strengthen its balance sheet. Another possibility could be an equity raise while the business is still worth something.
Businesses in this sector are about the cheapest you can pick up on a earnings valuation basis. The reason seems clear to me, that the physical printed media industry is in decline. Things like e-readers have decreased the demand for books and papers, and so hence less demand for services to distribute them. The number of people going out to pick up a daily newspaper would have declined greatly in the last 20 years, and probably will decrease again in the next 20.
That said, the industry will not die out totally – I suppose it is a matter of judgement how far it will decline, or if indeed there could be some kind of recovery that allows new products that Connect could benefit from. But that seems a long way into the future. Current trends say to me that publications are more likely to increase efforts in their online sites rather than try to growth the market of their print titles.
Connect therefore offers an interesting opportunity for investors. Although its parcel division has suffered, its core business is newspaper distribution and it has a dominant position in that market, and is profitable. The balance sheet is not pretty, but would take a surprising collapse in earnings for the covenant to be breached, as the debt seemingly will only be coming down with the cut in dividend. It is a difficult and unattractive business to enter, which means competition is not intense.
Going against this seems to be just where organic growth might come from. With the debts the way they are, acquisitions of other companies may be dangerous and lack many synergies, as many publications are country-specific. Additionally, they would also face the same structural challenges. Growing the business in the UK seems difficult as well – Smiths are a major player already. There appears to be little pricing power in the business, and it trades off slim margins.
A Motley Fool article questioned whether this could be the next Carillion, but I disagree with that. The previous performance of the Group has shown that they are not over-extending themselves, and on the contrary are selling off their non-core parts in order to protect themselves. I do believe that they can recover from the warnings, but it may be that they will not be a massive hit for shareholders, as even on stable trading it would only be valued at modest multiples. A solid 2/5 for me.