WYG — Update 23 May 2016

WYG’s year-end update (on 31 March) was robust from both closing year and outlook perspectives. Management anticipates an FY16 financial performance in line with market expectations and also noted an order book on hand in excess of £140m, which is a group record high. Moreover, all three reporting regions experienced increased order intake. So, WYG appears to be well positioned with a strongly performing UK operation and signs of increasing momentum from overseas operations.

Our expected FY16 PBT of £6.9m is in line with market consensus and we now have a zero tax charge for the year (previously c 9%), which raises the associated EPS to 9.7p (from 8.8p). The high proportion of UK profits, which are sheltered by historic tax losses, is the key driver behind this.

At the interim stage (see our December update note), WYG reported strong progress in the UK while both overseas regions reported lower revenues and EBIT at or slightly below break-even. At group level, the combined result was flat revenue and a 30bp margin uplift (to 3.6%). Our current (and unchanged) FY16 estimates assume group revenue growth just above 3% and a 130bp increase in EBIT margin (to 5.4%) compared to the prior year. This clearly indicates a pick-up in momentum in H2. In our model this includes sustained top-line progress in the UK (aided by part year contributions from three acquisitions: FMW, North Associates and Signet), higher margins versus H1 and some recovery in both overseas regions, moving both into profit for the year. Overall, our FY16 expectation is for a c 34% y-o-y EBIT increase (PBT +c 21%, EPS +c 2% after a c 9% tax charge versus a small credit in the prior year).

We understand that Q4 was particularly active for revenue generation including the commencement of a number of new business programmes. Associated with this, WYG saw a timing-related increase in working capital investment, especially work-in-progress, reflecting the early stage in the cycle of these particular contracts. Consequently, we now expect the FY16 balance sheet to show a broadly neutral net cash position.

The combination of higher activity levels at the year-end together with a rising order book (+33% from the beginning of FY16) is very encouraging. We understand that some c £80m (or c 60%) of the c £140m of the orders on hand at the end of FY16 are expected to be delivered during FY17. Moreover, the CMD indicated that high levels of order intake had continued into H117 thus far.

A stated above, our FY16 earnings estimates are unchanged. Looking ahead, the rising order book position is a trigger for us to nudge up our profit expectations for FY17 and, to a lesser extent, FY18. This is largely driven by slightly higher group revenue expectations and a greater UK contribution, with above-average group margins. We expect to revisit these estimates pending more detail with the FY16 results announcement in June.

In FY16, we estimate that c 70% of WYG’s revenue was generated in the UK and the remainder in its two overseas regions. As the UK revenue includes overseas work undertaken for the UK government (HMG), the company clearly has significant international exposure with a bias to aid-funded development work currently. In the following sections, we consider the impact of a possible EU Brexit for WYG and go on to review the company’s current international position in the context of growing opportunities.

In FY16, an indicated c €80m of revenue was generated from project work outside the UK, though only c 70% of this had a link to EU funding. (The remainder related to international development projects funded by non-EU organisations including UK government departments and, to a lesser extent, the World Bank, Asian Development Bank and others.) Segmenting various workflow streams, WYG management would expect to see little impact on revenues in the event of Britain exiting EU membership, as follows:

The establishment of local office hubs and networks clearly already provides some protection against loss of access to EU-funded projects. Localisation could be extended further to address the EU international development segment if necessary and the process of diversifying to non-EU donor and local government project funding is already well-established.

The delayed and slower transition to project awards under the EU MFF 2014-20 budget affected international progress in FY16. We expect both of WYG’s overseas divisions to report an improved trading performance in H216 compared to the first half (though not sufficiently to attain prior year revenue and EBIT in either region). This reflects some pick-up in new business wins as the year has progressed and this momentum looks set to continue. Middle East, North Africa (MENA) had orders on hand of almost €30m at the end of FY16, around three times the prior year level. This follows a total order intake of c €27m in the year and an improving tender success rate. In Europe, Africa and Asia (EAA) the year end order book position is understood to be similar or slightly better than the end FY15 level with, we believe, a higher current proportion (ie to be executed in FY17). This evidence appears to bear out expectations of an acceleration in EU-funded work as the latest funding programme (MFF 2014-20) crystallises in annual budget allocations after some initial inertia. A sustained flow of tendering activity at higher end FY16 levels and an alignment of group capabilities with growing EU-wide migration challenges – affecting both of these regions – puts WYG in position to take advantage of significant opportunities in FY17 and beyond.

We addressed the scale, sources and visibility of international aid to fund development projects in a previous note as the EU was preparing to move into its 2014-20 budget cycle. We now provide an update showing how momentum is increasing.

At annual budget level, spending got off to a slow start in 2014 and new programme payments only began to be implemented late in the year. According to the EU Budget 2014 Financial Report, most of the payments made to member states in that year related to programmes under previous frameworks. The reprogramming of unused 2014 commitments (€16.5bn) but also reallocations in response to migration issues (€400m+) led to a number of amendments to the 2015 budget during the year itself. We understand that actual budget payments were up c 2% versus 2014. The 2016 annual budget of €43.9bn represents a c 3.4% increase in payment appropriations over 2015 (both including amendments). Within this we note that the allocations for Security and Citizenship within the EU is up c 57% (to €3bn) and Global Europe (ie Europeaid, for non-EU members) is c 36% higher (to €10.2bn), both influenced by addressing migration issues. In Exhibit 2, we show the 2016 position for selective funding instruments most relevant to WYG’s focus areas in the context of the preceding two years under MFF 2014-20.

The slow start to the latest MFF and the impact of previous programmes have caused some distortion and variability in new commitments, though 2016 is mostly above 2014 across the instruments shown. With the exception of the ERDF and Cohesion Funds, payments are increasing from a lower base, substantially so in some cases. Notwithstanding project timing differences, we would expect commitments and payments to be more aligned going forward.

At this point, we should restate WYG’s credentials in this space – and why it is well positioned – before going on to highlight some of the larger opportunities potentially available.

A significant increase in the flow of mixed migrants from a number of different non-member countries has been the headline issue facing EU members in the last two to three years. For example it is estimated that there were over 1.8m illegal external border crossings in 2015. A historical focus on humanitarian aid (eg rapid response temporary accommodation and supplies) is increasingly being integrated with longer-term solutions. These include restricting the flow of border crossings and providing support in the countries of origin.

In some respects the challenges are similar to those addressed under the EU accession process with extended planning and implementation cycles to enhance socio-political and economic development. WYG has extensive experience in projects such as these and also in so-called fragile and conflict-affected states (FCAS) and is focused on opportunities in these areas.

EU: Responding to a dramatic increase in migration

Within the EU: Under MFF 2014-20, the newly created Asylum Migration & Integration Fund budget is €3.1bn (effectively replacing three separate funds covering Refugees, Integration and Return, which totalled c €2.1bn under the last MFF). As shown in Exhibit 2 (see Migration & Home Affairs/Asylum & Migration) the allocation of EU funds to address migration issues has gathered momentum, with payments almost doubling in 2015 and set to more than double again in 2016.

Outside the EU: There is a clear twin-track approach with longer-term development funding now being supplemented by special measures to address migration flows in the shorter term. This is evident in both of the primary migration paths into EU member states. Eastern route (from Middle Eastern states via Turkey): Turkey is already the leading beneficiary of Instrument for Pre-accession Assistance (IPA) funding and in March 2016, the EU agreed a deal to constrain irregular migrant flows. This included up to €6bn of further aid for Turkey up to 2018 to support refugees located in the country. Central route (from African countries via North Africa): a number of funds (including the European Development Fund and European Neighbourhood and Partnership Instruments), adding to an estimated €20bn, are already earmarked to support longer-term development programmes in Africa over the course of the latest MFF. In addition, an Emergency Trust Fund for Africa was established in November 2015 (and is standing at c €1.9bn currently) directed at fragile states in three blocs (North Africa, the Horn of Africa and the Sahel region/Lake Chad area). This is to address some of the causes and effects of migration at source and is intended to be a relatively short-term instrument with more rapid project approval.

WYG is positioned to facilitate increased migration-related workflows

WYG is an incumbent local operator in Turkey, Egypt and both West and East Africa. Consequently, in combination with its highly relevant track record as a consultancy provider to the EU budget implementations, we believe that the company is very well positioned to secure additional workflows in the areas outlined above.

Opportunities in Africa appear to be a key focus for WYG and it formed the Migration Partners, a pan-European JV, with three other development consultancy service providers in December 2015 (GOPA of Germany, VNG/Netherlands, Altai/France) to address them. The combined proposition is to offer an evidence-based approach rooted in analysis of the causes and effects of migration as a platform for the provision of country and region-based development solutions. Potential programme targets have already been identified covering EU programmes and some with the UK government’s DfID. Around €38m of proposals have been submitted – the first award is anticipated before the end of June – with additional pipeline possibilities. In context, we believe that less than 10% of WYG’s c £46m of revenue in FY15 from overseas divisions came from work in Africa. The financial aspects of the JV have not been disclosed but the clear aim is to increase the addressable market for all four participants by being part of this vehicle (from a number of EU member states with a broader and combined consultancy offering).

The UK government (HMG) is committed to spend 0.7% of GNI on official development assistance (ODA) promoting economic development and welfare in developing countries. Historically this budget has been substantially implemented by DfID. Under a new strategic approach (announced November 2015: ‘Tackling global challenges in the national interest’) DfiD’s allocation is to reduce to c 75% of the total budget, with an increased focus on fragile states and regions. A number of other departments – including the Foreign & Commonwealth Office and MoD – and cross-government joint funds are to implement the remainder. HMG aims to have a more coherent approach to individual strategies affecting more than one department and, in particular, align conflict reduction activities (summarised as defence, diplomacy and development) with national security interests. For example, this includes addressing the causes and effects of migration.

For WYG, there are some important implications. In the first instance, an ODA funding commitment forms the critical platform and provides good forward visibility for potential activity levels. Secondly, the way in which work is being packaged fits WYG’s existing capabilities: it is a multi-department consultancy services provider to HMG and has local experience in developing and fragile states across its network of offices and supply chain partners. This is not to say that WYG can or will tender all targeted work packages alone; partnering is an established method of programme management. (To this end, WYG has entered into an infrastructure collaboration agreement with consultants Mace and Control Risks to address specific and larger opportunities in this segment.) In the context of £46m group overseas revenue in FY15 including development work for HMG, WYG is aspiring to more than double its revenues from HMG internationally to c £17.5m by 2018. This is in addition to the EU opportunities outlined earlier. HMG is also expected to continue to be a material contributor to UK revenues (eg FY15: c 10%).

Our expected FY16 group PBT is unchanged since early September (EPS is higher, due to a lower assumed tax charge) while estimates have risen by c 15% for the two years beyond. WYG’s share price has performed in line with this, so its P/E ratings for FY17 and FY18 are little changed at 10.5x and 9.4x respectively. With a three-year EPS CAGR (FY15 to FY18) of 16.5%, the company’s PEG ratio is 0.9x. (Note that the FY15 base year included a small tax credit, while our FY18 tax rate is 8.4%.) Moreover, the company has a stated FY18 PBT target of £15m, c 40% above our current estimate. The comparable EV/EBITDA multiples for FY17 and FY18 are 7.1x and 6.4x and the dividend yield for FY16 is expected to be 1.2% (including two-thirds, or 1p, as the final DPS).

There are other quoted consultancy companies such as WS Atkins, RPS Group and Waterman Group, though we do not consider them to be direct peers; although there are overlaps there is significant diversity across functional disciplines and the sectors and geographies served. For the record, we show the current ratings of these companies in Exhibit 4.

As noted earlier, we have increased our estimates for FY17 and FY18, leaving FY16 (save for a lower tax charge) following a year end trading update in March. WYG has been investing in the business to accelerate revenue and profit growth while also retaining the capability to take advantage of international growth opportunities and possible further acquisitions.

Our FY16 forecast shows a c 3% group revenue increase and we estimate that most of this will have come from acquisitions (ie three made in the year plus the full year effect of Alliance in the prior year) all of which have been UK-oriented. In underlying terms, good forward momentum from UK operations is likely to have been largely offset by a quieter year overseas. WYG has increased EBIT margins in each of the last two years (from 1.2% in FY13 to 4.1% in FY15) and we expect further progress to have been made in FY16 (to 5.4%). We see a c 60:40 split of the incremental £1.8m EBIT improvement between organic and acquired sources. Implicitly then, existing operations will have seen some underlying margin pick-up. In part, we believe that this is likely to reflect a higher proportion of UK earnings (which also benefits the group tax charge).

For our three-year forecast horizon overall, our EPS CAGR (FY15-18) is c 16%. Our expected underlying group tax charge at the end of this period is in the 8-9% range and note that FY15 EPS benefited from a tax credit. WYG returned to the dividend list in FY14 and increased its H116 DPS by around two-thirds compared to H115. Assuming a one-third to two-thirds split, this translates to 1.5p for the year, a 50% uplift year-on-year. We expect further growth beyond this but the rate is likely to be influenced by future acquisition opportunities also.

We now expect WYG’s FY16 year-end balance sheet to be broadly cash neutral, following a c £12m outflow in the year. While EBITDA will have increased (from £7.2m to an expected £9.0m) business investment has been a key theme in the year. We touched upon year-end timing effects on working capital earlier and see a full year outflow in the order of c £10m. This includes c £3m legacy payments (on vacant property and professional indemnity insurance); excluding this the end March debtor and, to a lesser extent, wip positions will be the primary drivers of our expected £7m outflow for the year. The other notable investment line is c £8.5m acquisition spend, relating to the initial purchase consideration for FMW Consultancy (June 2015), North Associates (October 2015) and Signet Planning (January 2016) as well as a deferred element on Alliance Planning (September 2014). In underlying terms (ie excluding these acquisitions and year-end working capital effects) we estimate that WYG saw a modest cash outflow over the year with those legacy cash items and rising interest, tax and dividends also contributing to this.

We expect some similarities in the next couple of years beyond FY16, with some deferred consideration on already announced acquisitions and ongoing legacy cash payments at the same or a slightly lower level. Additionally, WYG has flagged higher IT infrastructure spend, spread over FY17 and FY18. With EBITDA estimates showing a rising trend, we currently expect WYG to be modestly net cash positive overall in these two outer years. Faster revenue growth (and/or year-end working capital timing effects and, potentially, further acquisitions) could vary the profile shown in the Financial summary.

With regard to banking facilities, WYG had a £25m RCF in place at the end of FY16 including capacity for bonding arrangements (typically for projects where an advance payment is made). With increasing opportunities in the international operations in particular, this provides headroom to deliver both organic and inorganic growth.