Creston plc (CRE.L)  

Summary

Our fund generally focuses on smaller companies with Ft. Knox balance sheets and large & sustainable free cash flow yields.  We are often seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.

We think Creston plc (ticker is CRE.L in GBP) is an attractive advertising agency and market research business based in London with a stable, cash-generative business model and an unleveraged FCF yield of about 14%.  CRE.L also has a “Ft. Knox” balance sheet with a net cash position of about 7m GBP at 3/31/14. CRE.L is a diverse group of advertising agencies and market research firms built through several acquisitions over the past ten years.  CRE.L has a strong focus on digital advertising, which represents over 50% of total revenues and has consistently increased its share over the past several years.  CRE.L operates in three divisions: Communications (about 50% of operating profits), Insight (20%), and Health (30%).  About 70% of revenues are generated in the U.K., where CRE.L is one of the top five digital advertising agencies, with 15% generated in the U.S and 15% in rest of world.

CRE.L has a very strong focus on FCF and a highly cash-generative business model.  In the past five years, CRE.L has close to a 100% conversion ratio of adjusted EBITDA into cash from operations.  Capital expenditures are modest (below 2m GBP per year).  CRE.L has consistently generated strong FCF over the past six years, despite the difficult U.K. economy.  From fiscal 2009 to 2014, cumulative cash from operations was about 65m GBP, or close to 100% of today’s EV (includes some operations disposed in fiscal 2010).  Even in the global recession of 2008-9, cash generation was solid, which speaks to the strong business model and “stickiness” of customer relationships.

CRE.L has an asset-light business model. CRE.L has limited fixed assets and its net working capital investment is small, as receivables are largely offset by accounts payable and inventories are almost zero.  Consequently, CRE.L has a business model with ROIC over 100%.  CRE.L’s primary asset is its employees and the Company had  about 810 employees at fiscal year-end 2014.

We believe that as the U.K economy continues to rebound from the recession, CRE.L’s advertising and marker research business should benefit.  We believe that during fiscal 2015 (ended 3/31) and fiscal 2016, cumulative FCF could result in a net cash position of 22m+ GBP at fiscal year-end 2016.  We also believe CRE.L could increase adjusted EBITDA to 15m GBP for fiscal 2016 and trade for 8x adjusted EBITDA or 120m GBP plus net cash of 22m+ GBP at fiscal year-end 2016 or a market value of about 142m GBP or 2.30 GBP per share, 100% higher than today’s price.

CRE.L provides marketing insights and communications services primarily in the United Kingdom, Europe, and internationally, with a strong overall focus on digital advertising.  The Insight division offers various services, including brand tracking and development, business and competitor analysis, category definition and segmentation, category management system, churn and retention, among many other services.  The Communications division provides a range of services, such as advertising, brand and communications planning, crisis and issues management, customer publishing, data planning and management, eCRM, online advertising, portal development, website design and build, industry analyst relations, media planning, and various other services.  The Health division provides integrated communications solutions to the healthcare and pharmaceutical sector, including advertising and branding, corporate reputation and crisis management, direct and customer relationship marketing, executive support, campaigns, graphic design, health advocacy, internal communications and sales, market research and consultancy, and various other services.

Management Strategy

CRE.L is a diverse group of ad agencies and market research firms built up over many years.  In recent years, CRE.L has sought to diversify revenues into new segments, with acquisitions in the Health segment, and geographically, with expansion into the U.S. market.  Importantly, there has been a major focus on digital advertising industry, which is one of the fastest growing segments of the overall advertising industry.  CRE.L’s total revenues from digital advertising have consistently increased as a percentage of total revenues over the past several years and represented over 50% of total revenues in fiscal 2014.  We believe management has positioned the Company well to benefit from the continued growth of digital advertising over time and its customers’ desire to follow and connect with end user customers as they spend more time in the digital area.  We believe this strategic position in the digital advertising industry could also eventually make CRE.L attractive to strategic acquirers, including some of the large, global ad agencies which dominate the industry.

Management has been aggressive about right-sizing its cost structure to match revenues over time.  Agencies that are under-performing have been sold or restructured to maintain strong profitability and cash generation, even when top line has struggled.  CRE.L has consistently maintained high operating margins (near mid-teens levels) similar to the large global ad agencies highlighted in Comparables table below.  CRE.L has aggressively and successfully sought new business through pitching activities when it has needed to replace lost business, such as the loss of Sanofi in fiscal 2013, where a large portion of the lost business has already been replaced.  We believe management strategies to grow revenues over the next few years, combined with disciplined cost and margin management, and selected strategic niche acquisitions, can drive significant shareholder value over the next few years.

Further, CRE.L’s acquisitions have all had a large deferred compensation component, where a large portion of purchase price is based on future performance.  This conservative approach protects downside, as shown by the Cooley Waters acquisition, where the final price was dramatically reduced due to the loss of the Sanofi business.

Customer Base

CRE.L’s client base is diversified among mostly long-term, high-quality clients.  In fiscal 2014, the Company’s top 20 clients were about 57% of total revenue and the top 50 clients represented about 76% of total revenue.  The average revenue of the top 20 clients in fiscal 2014 was 2.1m GBP.  The average tenure of the top 20 clients in fiscal 2014 was about 11 years.  The Company has sought to strategically increase share of wallet with clients through cross-marketing its agencies.  Management believes this increases the “stickiness” of its revenues with the client.  Of the top 50 clients in fiscal 2014, 18 clients were served by at least two agencies and 6 were served by 3 or more agencies.  In fiscal 2014, the Company’s top 20 clients by size of account (and start of relationship) were as follows: Danone Baby (1999); Unilever (1990); Gilead (2003); Infiniti (2007); Diageo (2002); Sainsbury’s (2007); Tesco (1992); Reckitt Benckiser (2012); Canon (2001); CDC (1999); Nissan GB (1996); Toyota (2009); Jaguar (2008); Lexus (2006); GSK (2005); Amgen GSK (2011); Aviva (1996); Astellas (2007); HTC (2006); and Sony Mobile (2011).

CRE.L lost a major account early in fiscal 2013 (Sanofi Pasteur) which impacted results for that year.  This will continue to be an ongoing investment risk, but the Company was able to replace these lost revenues with new client wins fairly quickly, and this may be a mitigating factor.  Overall, the steadiness of the Company’s revenue base through a very difficult economic climate, from 2008 to 2013, has been pretty impressive, in our view.

Acquisitions and Disposals

CRE.L has several brands across many specialties.  Management has bought and sold several advertising and market research brands over time, although much less in recent years.  In July 2010, CRE.L sold advertising agency DLKW Group for cash of 28m GBP which deleveraged the Company and enabled it to focus on higher growth areas.  In October 2010, CRE.L acquired Cooney/Waters to expand its healthcare segment and international presence for 6m GBP in cash and 13m of deferred comp (most of which was not paid due to under-performance).  In November 2011, CRE.L acquired The Corkery Group, a New York based health and medical public relations company for 3.2m GBP in cash and 3.3m GBP in deferred comp.   In November 2012, CRE.L acquired 75% of DJM Digital Solutions Ltd, a U.K. based digital healthcare agency, for 1.2m GBP in cash and 1.4m GBP in deferred comp.

Communications Division

Communications division is about 50% of earnings and includes 11 agencies focused primarily on traditional media.  The Communications division offers clients an integrated approach to their marketing and communication strategy, offering a range of services, which include advertising, brand strategy, channel marketing, customer relationship management (CRM), digital marketing, direct marketing, local marketing, social media marketing, and public relations.  The Communications division includes several operating companies, including Colombus Communications (Direct Marketing), Creston Communications (Marketing Communications), Emery McLaven Orr Ltd (Marketing Commuications), Nelson Bostock Group (Public Relations), Real Adventure Marketing (Marketing Communications), and Tullo Warren Ltd (Direct Marketing).

Health Division

Health division is about 30% of earnings with a focus on healthcare companies.  Approximately 50% of this segment’s revenues come from the U.S. market.  The health division provides an integrated communications solution to the healthcare and pharmaceutical sector and offers services which include advertising, advocacy, digital and direct marketing, public relations, issues and reputation management and medical education.  The Health division includes several operating companies such as Almebic Health (P.R.), Cooney/Waters (P.R.), DJM Digital Solutions (Digital-Health), PAN Advertising Ltd (Advertising Health),  Red Door Communications (P.R. Health), ROCK Medical (Medical Education), and The Corkery Group (P.R. Health).

Insight Division

Insight segment is about 20% of earnings.  This segment includes two agencies and is primarily market-research oriented.  The Insight division performs a complete range of market research services on behalf of its clients, through both qualitative and quantitative means, using face to face, telephone, and online data collection techniques.  The Insight division includes several operating companies, including FieldworkUK.com Ltd (Market Research), ICM Direct Ltd (Market Research), ICM Research Ltd (Market Research), and Marketing Sciences (Market Research).

Operating costs

Below are the major components of the Company cost structure.  Employee benefits are by far the largest component of operating costs, which has enabled management to adjust its cost structure to match revenues.

Attractive Valuation For A Strong Franchise

CRE.L is trading at about 1.15 GBP per share and has about 61m shares outstanding for a market value of about 70m GBP.  Net cash is about 7m GBP for an EV of about 63m GBP.  We believe this EV is attractive considering CRE.L’s LTM revenues of 75m GBP, adjusted EBITDA of 12m, and FCF of about 7m.  (We note that CRE.L’s FCF was burdened by a normalization of working capital of about 3m GBP in FY14 and, adjusting for this, FCF is closer to 9m+, which we expect in FY15.)  CRE.L is trading at about 0.8x revenues, 5.3x adjusted EBITDA, and a 14% unleveraged FCF yield.  We expect solid generation of adjusted EBITDA, cash from operations, and FCF in fiscal 2015 and fiscal 2016.  As CRE.L’s net cash position builds, the high quality and cash-generative features of its business should become increasingly clear to shareholders.

From fiscal 2009 to fiscal 2014, CRE.L generated cumulative cash from operations of about 65m GBP or about 100% of the current EV, including some contribution from disc ops.  This was achieved over a very difficult economic period, especially considering almost 70% of total revenues are generated in the U.K.  We believe CRE.L can generate free cash flow of 8m-10m+ GBP per year in fiscal 2015 and fiscal 2016.

We believe cumulative FCF could result in a net cash position of 22m+ by fiscal year-end 2016 (ended 3/31).  We believe CRE.L could increase adjusted EBITDA to 15m GBP for fiscal 2016 and trade for 8x adjusted EBITDA or 120m GBP plus net cash of 22m+ GBP at fiscal year-end 2016, or a market value of about 142m GBP or 2.30 GBP per share, 100% above current prices.

Steadily Improving Balance Sheet

CRE.L’s net debt was 25m GBP at fiscal year-end 2010.  Since the recession in 2008-9, CRE.L has steadily reduced net debt and de-risked the balance sheet.  CRE.L sold traditional advertising agency DLKW Group for 28m GBP in July 2010 and has used free cash flow to pay down debt and pay dividends.  We believe its net cash position of about 7m GBP at fiscal year-end 2014 greatly reduces risk and gives management strong options to enhance shareholder value, including dividends and share repurchases.  We believe management is focused on maintaining a strong balance sheet and is primarily looking at smaller acquisitions with solid paybacks. 

We expect CRE.L’s net cash to build through fiscal 2016.  We also expect continued discipline in capital expenditures, working capital management, and acquisitions going forward.

Strong Cash Flow Generation and Solid Business Model

The Company’s advertising agency and market research business has generated significant free cash flow over the past six years, despite a tough economy.  This reflects CRE.L’s non-capital intensive business model.  Capital expenditures are modest and have averaged less than 2m GBP per year.  Similarly, working capital requirements are not large, as there are almost no inventories and accounts receivables have been pretty consistently balanced by accounts payable.  Capital requirements in terms of capital expenditures or working capital investments are small.  Net working capital was about 4m GBP and net PPE was about 6m GBP on CRE.L’s 3/31/14 balance sheet, for a combined investment in net tangible assets of about 10m GBP.  This compares to an average operating income of about 10m GBP per year over the past five years.  Calculating return on invested capital as operating income divided by the sum of net working capital plus net PPE, results in $10m/$10m or 100%,  a very high return business model.  CRE.L generates substantial operating income with modest capital requirements.  This is exactly the type of high ROIC, cash-generative business model we like to invest in.  We believe the competitive position of CRE.L is based on well-established advertising brands and long-term relationships with major customers.  The asset-light business model of CRE.L means the company has an excellent chance to continue generating strong FCF over the next several years.  

High Operating Margin Business Model

CRE.L’s operating margins have consistently averaged mid-teens levels over the past six years, consistent with the high operating margins of the major global ad agencies (see Comparables chart below).  These high margins reflect the attractive pricing and margin structure of the advertising industry where revenues are earned based on end customer billings which are structured to allow attractive margins to be achieved on a fairly consistent basis.

Potential Beneficiary of U.K. Economic Rebound

The U.K., which represented close to 70% of total revenues in fiscal 2014, has been mired in several years of recession since 2008-9 and is only beginning to emerge from these doldrums.  It appears that the U.K. government’s austerity program may begin to start paying dividends, as the U.K. has shown among the strongest growth rates in GDP among European countries.  The U.K. is the fifth largest advertising market in the world and we believe CRE.L has a strong position in the U.K. market (one of the top five U.K. digital advertising agencies).  We would expect CRE.L’s advertising agency business to benefit meaningfully from any sustained economic rebound by the U.K.  Total U.K. ad spend was expected to reach 14b GBP in 2013, with about 50% from digital advertising.

Well-Positioned in Fast-Growing Digital Advertising Market

Management has focused on digital and online advertising revenues over the past several years, recognizing that digital advertising is one of the fastest growing segments of the advertising industry.  CRE.L has built a reputation as a specialist in these fast growing areas.  In fiscal 2014, digital and online advertising revenues represented over 50% of total revenues and this share is expected to continue to climb.  We believe that CRE.L is well-positioned to benefit from the continued growth in digital advertising and that the Company’s clients will increasingly want to pursue customers where they are consuming media, including both online and mobile advertising.  As discussed, digital represented almost 50% of the 14b U.K. advertising market in 2013 and is one of the fastest growing segments of the market.  U.K. digital advertising was about 2.7b GBP in 2007 compared to almost 7b GBP in 2013.

Overall, we expect a continued shift of advertising and marketing dollars toward more targeted digital ad dollars and away from mass marketing spending.

We believe digital advertising enables agencies like CRE.L to add more value to customers compared to traditional media advertising.  We also think digital advertising makes international growth easier for agencies like CRE.L.  The Company should benefit from these two positive factors over time.

Industry Consolidation Prospects

The major advertising agencies are large and well-capitalized (see Comparables below) and highly acquisitive in terms of adding smaller ad agencies to increase their client and service portfolios.  We believe one or more of these agencies could be attracted to CRE.L as a result of its diverse and high-quality customer base, its geographic position in the U.K. and Europe, and its well-established niche in the rapidly growing digital advertising market.  It is noteworthy that Havas (HAV.PF) took a 6% stake in CRE.L in mid-2013, which could be a prelude to an acquisition proposal.

Fiscal 2014 Results Provide Solid Momentum for Fiscal 2015

The Company’s fiscal 2014 results were solid.  Fiscal revenue was 75m GBP, about flat with prior year, and net cash (excluding deferred compensation) was 7.5m GBP at 3/31/14 versus 2m GBP at 9/30/13.  The company noted they were pleased with the second half performance in which they achieved growth over both the first half of fiscal 2014 and the same period prior year.  The Company noted that following a busy period of pitching business in the first half of fiscal 2014, new business wins had a positive impact on the second half, as expected.

We believe the positive momentum in second half of fiscal 2014 is likely to carry over into the first half of fiscal 2015 and, hopefully, beyond.   We believe this positive momentum, driven by new business wins and reduced expenses from consolidated offices, could continue over the next few fiscal years.

Management has recently consolidated offices of various ad agencies to reduce expenses and also to drive more interaction between the agencies.  Management believes there is strong potential for cross-selling different products to its major clients and thereby strengthening the client relationship and increasing share of wallet.

Solid Earnings Growth Strategy Over Next Few Years

We think CRE.L has a solid earnings growth strategy over the next couple of years with multiple potential earnings drivers.  These include: 1) organic revenue growth from existing companies supported by improving market, high levels of new business activity, and investments in service offerings; 2) organic revenue growth from cross selling and integrated group pitches under Creston Unlimited brand; 3) selected acquisitions and start-ups to complement existing client offerings; and 4) a share repurchase program in FY15 to take advantage of net cash position and current share valuation.

Excellent Potential for Share Repurchase or Dividends

CRE.L has not repurchased significant shares to date.  However, as CRE.L’s balance sheet continues to build its net cash position, we believe a major share repurchase program will be more seriously considered.  Management has announced a 2m GBP share repurchase program for FY15.  CRE.L’s strong cash generation and unleveraged balance sheet give management several levers to drive shareholder value if the stock price remains depressed.

Pension Costs

CRE.L retirement benefits to employees are provided by defined contribution programs that are funded by CRE.L and employees.  Payments are made to pension trusts that are financially separate from CRE.L.  These costs are charged against profits as incurred.

Conclusion and Target Price

Based on 8x our adjusted EBITDA estimate of 15m GBP for fiscal 2016 (ended 3/31) and a projected 22m+ GBP net cash position at fiscal year-end 2016, we believe CRE.L could trade for a market value of close to 142m GBP or about 2.30 GBP per share versus 1.15 GBP per share today (+100%).  If CRE.L’s advertising and market research business perform as we expect, we think our target prices or better can be achieved.  Further, CRE.L’s advertising-related businesses are well-established with attractive position in digital marketing and long-term relationships with well-established global clients, and these features could be attractive to a strategic acquirer.