Connect Group plc ("CNCT") is a classic cigarette butt with potential to be a 2x whilst paying dividends of 10%+ while you wait for management to find ancillary businesses to create a growth story that could accelerate a re-rating - or even better sell the business in its entirety. CNCT's core business is being a newspaper wholesaler or newspaper distributor, and the Damocles' sword hanging over the traditional newspaper business is presumably why today's opportunity arose after CNCT management admitted that their fledgling business of handling returns for Amazon under its Pass-my-Parcel ("PmP") banner is probably not going to be a profitable undertaking in the near term - or possibly ever. However, at current prices I think CNCT shares have more than fully priced in this fact. In its core, CNCT has a leading logistics business, reliably producing high levels of free cash flow every year underpinned by 4-5 year contracts with publishing houses, and I think most people have been overlooking the resilience in CNCT's cash flows amidst the undeniable secular decline the broader physical newspaper industry has been facing. In the interest of brevity, I will focus on the key newspaper wholesaling operations and I will be happy to provide more detail if you have any specific questions.

 

CNCT's principal business is newspaper wholesaling, i.e. they pick up printed newspaper at the newsprinters in the very late evening and distribute them overnight to the various retail points across England and Wales. CNCT gets paid a fixed margin per newspaper sold under multi-year contracts with the publishers, and in exchange performs distribution and wholesaling on behalf of them. This really means CNCT is operating a brutally efficient logistics system that can make overnight deliveries to a network of cornershops and retail stores from a limited number of depots across its coverage area.

 

In principle, CNCT is a highly interesting business proposition because of (i) very high barriers to entry due to its large (albeit shrinking) legacy distribution footprint, (ii) significant economies of scale due to route density advantages which most businesses in the logistics industry benefit from, and (iii) very strong market position vis-a-vis publishers given lack of alternatives for physical distribution as well as a fragmented base of physical retail sales points. Undeniably, general industry trends are unfavorable for on the physical news distribution side, but in the scheme of things, I think the market is overlooking the resilience and attractiveness of cash flows at current valuation levels.

 

Whilst the physical newspaper industry is in secular decline, it's worth putting the numbers into perspective with the financial performance CNCT has exhibited in the past, which has not been all that terrible so far. Based on OFCOM data, newspaper circulation in the UK declined at 6-7% CAGR decline between 2010 and 2016, however, small price increases (~+3-4%) as well as picking up smaller regional contracts from smaller local distributors (~+1%) have resulted in revenue declines of 2-3% for CNCT over the same period. Total operating profit for the newspaper wholesaling division has been pretty flat (£36mn in FY2017 and £33mn in FY2010, with a £36mn average over the entire period), which I think is the best gauge for operating performance given the sustained need / ability to restructure depots in face of sustained volume declines.

 

Despite the grim secular trends, I think it's worth highlighting that these very trends are supportive of dominant players in the newspaper supply chain like CNCT. Because there is virtually no interest by anyone else in the logstics sector to come in and compete, this has allowed CNCT to push through margin increases for itself with every contract re-negotiation with the publishers, who have little choice but to work with CNCT around the declining volumes. Historically, this was an industry handling a multiple of today's volumes so there is very little need for ongoing capex, and CNCT already got itself a state-of-the-art SAP IT system 5-6 years ago, so apart from capex for pet projects like PmP, there is little need to re-invest in the business. This is why management has historically kept paying out a lot of cash in the form of dividends.

 

As management teams of declining cash cows tend to do, CNCT management has had their fair share of pet projects, most of which have not done particularly well - for now, but maybe something will stick eventually. CNCT has a mixed track record buying ancillary distribution businesses, which is a generally pretty competitive industry even for players of scale like the national postal players and their respective parcel transport arms, but including dividends, CNCT probably didn't lose a lot of money on the Consortium and Books investments overall.

 

What has been a conceptual, but not commercial success so far has been CNCT's efforts to leverage its distribution network to handle returns for the likes of Amazon or ASOS. This is in line of many other logstics companies' thinking that on the way out, you have a full truck but on the way back it's virtually empty, so CNCT started to handle returns under the PmP banner. Little commercial details are available but it's probably fair to say that CNCT priced its services very competitively in the beginning, which does make sense given the low marginal cost. However, as volumes soared 4x over the past year, PmP has started to put a strain on its news distribution network in terms of not allowing CNCT to reduce its logistics footprint to accommodate for the declining newspaper volumes, thereby suffering a slight decline in profitability in recent periods. Amazon is quite a formidable negotiator with a lot of pricing power and with so many distribution businesses keen on getting a slice of the online growth pie, some people are probably more happily cross-subsidizing returns services than CNCT has been. In any case, management has announced a review of its offerings, which probably means scaling back their efforts to make returns another leg they want to stand on, which is probably a bit naive anyways given it's complementary to its newspaper distribution business but not really viable standalone given its pricing of  <£2 per parcel handled. Overall, I don't think they will shut PmP down completely but probably adjust pricing to turn a modest profit and to match reach with its core operational footprint.

 

With shares at 60p, CNCT"s enterprise value is £230mn consisting of ~£145mn of market cap and ~£85mn of net debt. If one were to think about earnings multiples, this implies ~6x £40mn of EBIT for FY2018E, of which ~£35mn will be from News Distribution. On an EBITDA basis, this would be ~4.5x, which is much lower than most logistics business, although of course, this business faces unique structural headwinds. Interestingly, John Menzies is currently trying to sell its newspaper distribution business right now, which is CNCT's counterpart in Scotland, and it is to be seen what value they'll get for it.

 

If one cared about cash flow, I think they'll probably end the year around ~£28mn of net income, which includes restructuring expenses and various losses. but excluding amortization of intangible assets stemming from the Tuffnells acquisition, to give a 20% equity yield. This is a robust number because it already takes into account ongoing restructuring costs, which are needed to keep the existing businesses stable without giving any credit to any diversification efforts and ancillary business that may compensate for the declining core business some day. Note that with the 2018H1 earnings announcement, management launched a review of the dividend policy to also keep an eye on the company's leverage levels. In a way, whether equity free cash flow is applied towards shareholder returns via dividends or share buybacks or applied towards reducing debt shouldn't make a huge difference to the enterprise value barring the interest tax shield, however, expect some dividend reduction from current levels, which is prudent in my view. In fact, I'd almost prefer them scrapping the dividend altogether and started a share buy back program.  

 

Key risk is of course (i) the decline rate of newspaper circulation, (ii) operational cost pressures, and (iii) more value destructive M&A. In my mind, volume risk is not just the exact rate at which circulation volumes decline but at which point publishers decide to axe physical distribution entirely. UK publishers appear to have been quite slow in adapting to the online world, particularly on the local newspaper front, although these guys also tend to not cater to the urban centers, and based on anecdotal evidence, the rural areas with a disproportionate elderly population is seeing slower volume decline rates than in the younger urban areas. It's unclear to what extent Brexit contributed to general wage pressures as the UK economic cycle has been going strong, but over the past two years', even CNCT's core distribution business has started to suffer a bit from driver shortages and labor cost inflation. Whilst this can be somewhat mitigated at contract re-negotiation rounds with publishers (note that for the better or for the worse, 90% of news distribution revenues are locked in until 2019 and 70% until 2021), you could see lower earnings in the short run. Last but not least, management has a checkered track record in its efforts to diversify and find niches to grow, so value destructive M&A is a real risk. I have to admit though, I like their management team for its keen eye on cost, straight talking, and no fear to cut losses, but I think they've often underestimated the competitive pressures as well as more seasonally volatile operations of regular logistics businesses, which is something that's been lost on them in their core newspaper distribution business.