Smith News, freed from the shackle of Tuffnells, has a lot going for it. But there is a risk that it runs out of money before shareholders benefit from the simplified and focused company.
The Group has £175m committed bank facility available until 31 January 2021, of which £68m is current unused, implying that around £107m is being borrowed.
The directors reckon they will still need to borrow £83m in the new year. They have already been in discussions with current bankers for a renewal of lending.
“However, following preliminary negotiations the company has not been able to secure refinancing terms it considers commercially acceptable…and has decided to defer the refinancing process given the current uncertainty and tightening of the debt markets, including as a result of the onset of the COVID-19 pandemic. The Company expects to re-commence the refinancing process following Completion of the Proposed Transaction (which has been consented to by the requisite majority of the Company’s existing lenders) and when the debt markets and general market conditions each settle following their current period of heightened volatility.”
In other words, Connect directors reckon they’ll get a much better deal from bankers once they have dumped Tuffnells and can point at the long history of profits and cash flow at Smiths News. They say,
“Taking into account the underlying profitability and cash generative nature of…Smiths News, which generated adjusted EBITDA of £48.6m and free cash flow of £36.8m in the year ended 31 August 2019, the Board is confident that, following Completion of the Proposed Transaction, the Continuing Group will be in a stronger position from which to negotiate the Proposed Refinancing than would be the case either prior to the Proposed Transaction.”
They are looking to conclude discussions on refinancing in the next nine months. But that is a tight timetable given the cliff edge of 31 January – if there is no new debt facility there might not be a business.
The directors are confident: “Longer term, the Board believes that as and when restrictions ease, the operational and market resilience of Smiths News mean it will be well placed to swiftly return to previous levels of service and profitability.”
And if they don’t get a good banking deal?
Then they’ll go for a combination of measures:
Will shareholders save the day if bankers will not?
In normal times Smiths News should be able to borrow the £83m it needs because it has a very stable, if declining, cash flow founded on five-year contracts with publishers most of which now stretch to 2024/5.
But we are not in normal times and bankers may be in such cautious frames of mind that they will not advance the company £83m on good terms.
Connect Group’s history of cash flow (including the deduction of Tuffnells losses in 2018 of £5m and in 2019 of £14m)
£m Interest paid Free cash flow (after paying for capex, WC changes, finance lease payments, taxation – but not interest or dividends) Dividends
2019 5.1 13.4 0
2018 5.8 26.0 7.6
2017 4.4 33.1 24.0
2016 4.9 41.1 23.2
2015 7.3 45.6 21.4
2014 5.5 43.3 17.7
2013 6.5 39.1 16.0
2012 3.7 30.9 14.9An idea: If the bankers are still reluctant to supply the full £83m then Smiths News could perhaps borrow £60m. This would mean the ratio of company debt to cash flow will be in the region of one and a half - surely an acceptable level to the bankers?
The other £23m could come from shareholders. For this to work out we need to understand the character of the main shareholders and whether they would blanch at putting money into a risky company.
Aberforth holds 17.13% of the shares. They are committed value investors and therefore used to dealing with small companies going through a time of troubles. Their website states:
“We are value investors who seek to purchase shares in companies that are selling below their intrinsic value. The chosen investment universe [small companies] yields a disproportionate numb………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Last week Connect Group (LSE:CNCT) announced the sale of its Tuffnells division. At first, investors greeted the news with enthusiasm, pushing Connect’s shares up 50%. But the following day they were back down where they started because the details of the deal revealed that Connect wasn’t getting much out of it other than removing Tuffnells’ future losses from the Group’s P&L accounts.
The sale of Tuffnells has been long awaited. When it was bought in 2015 it made a decent amount of profit, but in the last two years it has it lost money month after month and the management team seem to be bereft of ideas and skill to sort it out. (Losses were over £1m per month in the year to August. Rumours are that this lose rate have doubled during the Covid-19 crisis).
And it seems that Tuffnells’ managers can’t even stir themselves to take advantage of the current shortage of parcel delivery services in the country.
A quick sale to a rival or private equity group would be a neat solution, even if the price achieved was zero, because this would take away the financial drag of Tuffnells, releasing Connect to concentrate on collecting the fairly predictable profits from it local monopoly newspaper and magazine distribution business, Smiths News.
(Previous newsletters on Connect: 29th Sept – 4th October 2017, 24th -29th January 2018, 19th May 2018, 14th June 2018 14th – 27th June 2018, 11th – 15th Dec 2018, 5th Feb 2019, 13th – 18th November 2019, 3rd February 2020, 23rd – 27th March 2020)
But the sale is far from neat
The buyer is a special purpose vehicle set up by Broad Oak Support Services called Palm Bidco. It has agreed to buy Tuffnells for £15m.
Well that sounds good, you might think. But the £15m will not arrive for quite some time - in three tranches: £6.5m in 18 months, £4.25m in 27 months and £4.25m in 36 months.
And there are real risks that the new team will not be able to make a go of the standalone Tuffnells, and so the £15m might not arrive at all.
Then there is the problem that Palm Bidco doesn’t have much cash. It is so badly off that Connect’s directors have agreed to lend £10.5m of Connect’s shareholders money to it.
From the point of view of the shareholders of Palm Bidco the deal has tremendous upside: if they return Tuffnells to profits of £15m per year then their shareholding will be worth over £150m.
If it goes wrong, then they receive large salaries until it goes under.
They’ve ensured that the organisation that has committed the most to Palm Bidco is Connect. It faces the possibility of being in the unfortunate position of a creditor in a liquidation and then very unlikely to get back its £10.5m.
There is another problem: Tuffnells rents most of its depots. Naturally, the landlords will not be happy if the only guarantor that the rents will be paid is this poorly-capitalised loss-making Palm Bidco. Thus, landlords will refuse to allow transfer of the leases from Connect and the deal will collapse.
To get around this problem Connect agreed to guarantee that the rents will be paid, thereby putting itself on the hook for millions of pounds of rent each year should Palm Bidco falter.
And another thing: the guy who has been paid a great deal of money by Connect since November to turn Tuffnells around, Michael Holt, has jumped from the Connect ship to the Palm Bidco ship. Michael Holt will receive 5% of the equity in the new company for managing it (other Tuffnells’ executives might obtain equity totalling 25%).
He was ostensibly putting his heart and soul into getting Tuffnells on the right road for the benefit of Connect shareholders.
As a future 5% shareholder in Palm Bidco would he be most interested in the special purpose vehicle paying a high or low price for Tuffnells? and therefore would he be most interested in getting Tuffnells numbers turning up or turning down?
I make no accusation, merely raise the questions.
One comfort might be that the other Connect directors excluded him from discussion regarding the sale.
Another downside: Connect will settle Tuffnell’s £16.1m overdraft and pay about £2.6m in Palm Bidco’s transaction costs.
Despite all these negatives I stil……………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Connect Group (LSE:CNCT) has not had an attractive-looking balance sheet for many years. It had/has very high levels of intangible assets, especially goodwill, due to paying excessive prices for acquisitions. Even after including those doubtful “assets” in its balance sheet it could barely report a positive net current asset value. On top of that, it used to carry over £100m of bank debt – now down to between £50m and £90m depending on which day in the month you look at it.
Now that it has written-off large chunks of goodwill and other intangibles it shows a negative net asset value, NAV, of £74m. Excluding intangibles the net liability is £84m.
Balance sheet data.
£m August 2019 August 2018 August 2017 August 2016
Non-current intangible assets 10 51 107 165
Other non-current assets 22 44 51 62
Trade and other receivables 124 130 98 139
Other current assets 57 32 84 52
TOTAL ASSETS 213 257 340 418
Trade and other payables -174 -176 -136 -199
Other current liabilities -56 -64 -91 -83
Non-current liabilities -57 -63 -88 -123
NET ASSETS -74 -46 25 13How it survives its poor balance sheet
The BS is heavily dependent on very large amounts of credit granted by its suppliers, mostly publishers - trade and other payables are £174m. Connect does not pay for newspapers and magazines until sometime after its customers have paid them. Newsagents pay via weekly direct debits but across the Group the average credit period taken by customers is 22 days but the average credit period taken by Connect from its suppliers is 31 days.
A concern would arise if this positive cash cycle is interrupted, meaning that Connect would need to borrow more from banks.
However, there is reassurance in the contract terms with publishers - they contain clauses granting long credit periods, and the contracts last for five years.
Net bank debt
While the company has brought down its debt levels by selling businesses and by applying some of its positive free cash flow to debt repayment, the indebtedness numbers are still very high.
£m August 2019 August 2018 August 2017
Opening net debt -83.4 -82.1 -141.7
Free cash flow to equity +8.3 +20.2 +28.7
Pension deficit recovery -1.6 -4.7 -4.8
Dividend paid 0 -24.1 -23.6
Disposal proceeds 0 +12.9 +58.2
Cash flow from discontinued business 0 -8.8 -1.1
Finance lease creditor and other +2.8 +3.2 +2.2
Closing net debt -73.9 -83.4 -82.1
Net debt/EBITDA 1.9x 1.8x 1.2xSince yearend £15m has been raised via sale and leasebacks. Also another six months of stable trading to the end of February has probably reduced debt levels by around £6m.
Covenants on bank loans:
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n 2014 the big idea at Connect Group (LSE:CNCT) was to diversify into parcel delivery and at the same time gain synergy with the early morning News Distribution business by buying Tuffnells for £121m. Here are the performance numbers for Tuffnells under Connect’s ownership – not pretty reading for shareholders who forked out £121m.
£m 2019 2018 2017 2016 Less than year to August 2015
Revenue 165 175 183 174 114
Adjusted operating profit -14.1 -5.0 12.0 15.0 9.7
Exceptional items – write-offs -53.5 -52.7 -7.7 -8.9 -4.6
Statutory operating profit -67.6 -57.7 4.3 6.1 5.1
Assets n/a 109 167 176 177
Liabilities n/a -35 -36 -49 -41
Depreciation and amortisation -10.9 -57.7 -11.2 -10.4 -6.5
Additions to non-current assets 4.8 4.4 6.7 11.1 Perhaps we should be grateful turnover did not decline much, indicating that there are thousands of customers still coming to Tuffnells despite hiccups in customer service.
Having said that, Gary Kennedy mentioned, at a November analyst’s briefing that Tuffnells’ “volumes continue to be soft” and “unfortunately in that business we are not at the point we expected to be. But I have no doubt we have the resolve to get there….We’ve fallen short – competitors are picking up customers. It’s a highly competitive market. Brexit doesn’t help.” Not exactly brimming with confidence, is he?
There wasn’t any good news to report at January’s AGM other than Gary Kennedy, Chairman, saying that Michael Holt, who had recently been put in charge of Tuffnells, was doing “a sterling job”.
The Tuffnells turnaround plan
The directors have pointed to the following actions,
I’m hopeful that the increased national demand for parcel delivery has greatly increased the chances of Tuffnells being profitable this year and next.
If Tuffnells just breaks-even Connect Group makes about £23.7m pa after tax from Smiths News (perhaps declining by 4% pa in future).
Company intrinsic value is then over five times its current market price.2.
2. Sell it
An industry buyer is found to
………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Connect Group’s (LSE:CNCT) Smiths News produces profits and lots of cash flow year after year because it is a duopolist (alongside Menzies) delivering newspapers and magazines to shops. The duopolists tend to stick to their own territories when allocating their vans – it is pointless having two rivals vans passing each other in rural Norfolk for example, so either SN or M will take that contract.
A barrier deterring entry to the newspaper distribution business: A potential entrant would have to win five-year contracts from the major publishers on operating margins of around 3% and then organise a fleet of vans, with drivers and sorting depots. All the while, SN and M, with their efficiencies and experience, will be breathing down their necks and constantly undercutting on price.
Connect’s Dawson Media Direct, DMD, which supplies printed and digital media to airlines and travel points in the UK and worldwide, has recently suffered after losing contracts because some airlines switched to electronic newspapers.
In the year to the end of August DMD’s revenue and income, for the first time, are subsumed within Smiths News numbers. This is to be expected given that DMD is now quite small and engaged in media distribution.
Smiths News has a declining turnover because the volume of newspapers and magazines bought in the UK has fallen and is expected to continue to fall. Offsetting this are cover price rises, but nonetheless SN’s revenue has dropped by 3% - 5% per year – see table. This pattern has severely disturbed Mr Market – why buy into a business with falling sales?
The pattern of sales also bothered Connect’s leadership team over the past decade. It bothered them so much they thought it a good idea to go out and spend ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Connect Group (LSE:CNCT) has one business generating an operating profit north of £34m. For a £37m market capitalisation company that is a substantial amount. And this operating profit, from the Smith News newspaper and magazine distribution business, has been consistently high (2014: £40.8m, 2015: £23.2m, 2016: £34.1m, 2017: £36.1m, 2018: £25m, 2019: £36.3m, expectation for year to August 2020: £34m).
Smiths News has a 55% market share, and local monopolies all over the country. Its only opposition is Menzies News, which tends to stick to its own newsagent territories. Entry into this line of business is very hard given the strengths of the two incumbents. Over 80% of publishers have already signed up to contracts with Smiths News for another five years.
If this business was the only one owned by Connect Group then, obviously, it’s a good share to buy. Mr Market, on the other hand, thinks, because fewer physical newspapers and magazines are being bought year by year, that SN will suffer greatly, and this has helped push down the share price.
I do not see good reasons for such pessimism in the numbers coming out of the company. Even though volumes of papers/magazines sold have gone down by 5-10% per year for a long time now, the managers have largely offset this by finding efficiencies, and cover prices have risen.
The main reasons, however, for Connect’s shares to be trading on a cyclically adjusted price earnings ratio of only 2.1 is not to do with Smiths News but derive from two large risk factors.
The first is that the Tuffnells parcel delivery business, bought for £121m in 2014, might continue to lose money hand over fist for years to come.
The second is that the Group’s high debt levels will become unsustainable should the cash flow of the Group decline substantially. Bankers – in normal times - may not be understanding if the EBITDA-based ratios used for loan covenants are breached. The nightmare scenario becomes possible if directors do not get a grip of the………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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