Description

Augean is a market leader in a structurally growing niche in the UKs hazardous waste market. It promises 45% earnings growth to 2023, and trades on a prospective FCF yield of 10% increasing to 20% in 2023. COVID had a negligible impact on earnings (-c10%). It has high, protected margins and excellent returns and incremental returns on capital. We think that there are compelling short-term catalysts to drive a re-rating of the shares.

Our investment thesis centres around various quality attributes which we think suggest that – in combination with the final point (60% earnings growth) – Augean is mis-priced, namely:

o    Quality management team who have navigated a complex turnaround;

o    Niche market position which has a built-in moat;

o    Structural drivers behind ash, radioactive, and decommissioning growth;

o    High margins, strong free cash flow generation, and high returns and incremental returns on capital;

o    60% expected earnings growth rate to 2023

Combined with these attributes, there are two near-term catalysts which we think will drive a significant re-rating of the shares, and a further longer-term option which can create additional value:

o    Settlement of the HMRC landfill tax assessments

o    Return to the dividend list, signalling management’s confidence in sustained cash profitability

o    Strategic options/ disposals or acquired

Background

In 2017 the business was served with several HMRC assessments which related to potentially underpaid landfill tax (covered below), this drove a change in the management team and the strategy to focus on cash collection. Subsequently, what is obvious is that there was significant fat in the business and mis-allocated capital. The new management team have done very well rationalising the cost base and increasing incremental returns on capital through far more disciplined allocation. The net result of smarter spending is that revenues, EBITDA, and free cash flow have grown significantly and has the prospect of greater growth, while opex and capex have reduced.

Why it’s cheap

We think that there are two reasons. Firstly, the business has £40 million of outstanding HMRC assessments against it. These have been appealed and the case is expected to be heard in the Lower Tier Tax Tribunal imminently. The assessments relate to whether the correct tax band was applied to waste spanning back to 2013, either the standard rate or the low rate. Management believe that they applied the correct rates and passed the correct taxes through to HMRC and are contesting the case. We think that this is now a largely immaterial argument against the thesis since:

1.        Regardless of management’s and HMRC’s position, the company does now charge the tax as implied by HMRC’s case. This has stopped any further accrual of liability while the case is heard. Moreover, the company has successfully passed these higher taxes through, it has not impacted their competitive position

2.        The business has paid the entire outstanding amount out to HMRC through a combination of organically generated cash and some debt. This stops the accrual of interest while the case is to be heard. We also think this is a positive as it has removed any balance sheet risk and valuation risk around the enterprise value on the basis that the case is found in HMRC’s favour. The case has no downside, and considerable potential upside if found in favour of Augean.

Secondly, Augean seems to get lumped in with other waste businesses despite a very different business model. Augean’s niche carries significantly higher margins, regulatory barriers to entry, and is less capital intensive than peers, yet it trades on a similar multiple. We think that its multiple should be more reflective of its quality and growth attributes rather than grouped with its lower quality peers.

Investment thesis

1.        Management track record: the current management team took over on the back of the HMRC issues in 2017. It is a lean exec team with an exec chairman, Jim Meredith, and CFO, Mark Fryer. Jim has significant waste sector experience with Waste Recycling Group and Shanks. Notably, Harwood are also on the board (Chris Mills) and own a very significant stake in the business. Chris has a strong track record in activist value creation in UK companies. We think that his involvement is a strong positive for any new holders. The current management team have presided over significant value creation at Augean which has resulted in the share price increasing almost 250%, and almost 600% from lows.

2.       Niche market position with a moat: Augean is the only UK company to hold a hazardous and non-hazardous low level radioactive waste permit and second low level radioactive waste licence which is in planning for its Port Clarence site. Augean holds around 40% of the remaining hazardous landfill void in the UK with a life through to 2050, significantly longer than peers. To treat hazardous waste in the UK an operator must own an incinerator and a landfill, in the UK no new permits are granted and are therefore only available to existing facilities such as those run by Augean, protecting their market. There is history of non-incumbents trying to enter the market and subsequently failing – Healthcare Environmental tried to consolidate the healthcare waste market in the UK, but without experience, which subsequently lead to a significant scandal regarding waste stockpiling. This has driven a significantly more cautious approach from the Environmental Agency with regards permitting.

https://www.bbc.co.uk/news/uk-scotland-glasgow-west-50884842

3.       Structural growth drivers: Augean are a leader in EfW ash/ residue treatment and there are strong drivers for growth in this market with 8mt of capacity expected to be added in the UK over the next 5-6 years. Management have a 90% win rate in this area. This is our primary growth driver. Construction and industrial wastes should also provide a strong growth catalyst particularly with site expansion and Port Clarence capacity. This is expected to be driven significantly by redevelopment in and around London and the waste that this will create. Finally, North Sea Services, which is currently running around break-even, provides an option for long term growth and exceptional profits. We don’t make any specific assumptions for this division, but it has historically generated large one-off profits and that market is expected to attract £15-20bn of spending over the next 10 years, of which Augean could address around £1bn.

4.       High margins, returns and incremental returns: as our model outlines below – the business has historically generated good growth, with attractive and improving operating margins growing from around 10% to over 20% and expected to improve further towards 25%. Returns on capital employed are also very strong at over 30% and should grow to over 40%. The business is relatively capital light and management give a good split on maintenance versus growth capex in the accounts, as we have detailed in the model.

5.       45% expected earnings growth: all the above factors lead us to have confidence in the current forecast earnings growth from £19.9 million in 2019, to £28.7 million in 2023. As detailed above, the predominant driver of the forecasts is the EfW market. Crudely, management have outlined 30 incinerators coming online in the UK which typically represent around £1m of revenue per site for of which Augean expect to take a 40% market share at 70% margins. This is the main diver of our near-term earnings growth and therefore there is additional upside potential from the other growth drivers discussed above.

MODEL

One needs to decide on the growth prospects for Augean, particularly the long-term growth in areas like North Sea and nuclear. However, we think this is optionality, and there is enough value just in the EfW growth to warrant an investment and re-rating. Our numbers below are predominately built around EfW growth wherein 2023 the business should be rated on 4.7x EV/ operating profit, excluding any potential windfall from HMRC.

We think that the earnings growth alone can provide a 45% upside to 2023. Multiple expansion could provide another 50-60% of upside, potentially more depending on the ability to provide further growth outside of EfW

Catalyst

CATALYSTS

1.        We see the passing of the HMRC litigation as a strong catalyst for the shares as it will lift uncertianty either way

2.        Return to the dividend list has been strongly hinted at by management and we think this would send a strong signal to the market re long term cash generation and sustainability.

3.        Strategic options either for the business to be acquired by a larger player looking for strategic UK assets which are highly cash generative