Disclosure: I have an interest in Hogg Robinson shares
I classify investments into ‘themes’ in my head. The theme explains why or how the market is mispricing a security. It might be that the asset is in a sector or geography which is particularly unattractive for whatever reason, but the company involved is more insulated than a casual glance would betray. It might be that the company has a number of very valuable assets which are obscured by fluff, by investment in the future (opex as capex), or by loss making divisions which drag down the group picture while allowing management a clear remedy, should they choose to take it. Either way, it helps me if I can see why smarter people than me might be unable to see the attractiveness of an asset.
Hogg Robinson, thematically, fits in with Quarto in my mind. Every investment is different, but the premise is similar:
The business is being attributed a very high cost of equity – similarly a very low P/E – because the market thinks that the business has a combination of declining cashflows from a dying business and substantial cash obligations. One of these factors alone is a cause for concern. Both, together, raise fundamental questions about the value of the equity.
In Quarto’s case, their supposed millstone is the debt pile. In Hogg Robinson’s case there is also a touch of debt, but a much more sizeable pension deficit. In both cases, the black mark – QRT’s debt and HRG’s pension deficit – in combination with one’s inner reaction to the business they’re in – is prominent enough to turn the vast majority of investors off before getting to know the company.
The market view
To set up the mental model before we knock it down, then, here is what the market sees when it looks at Hogg Robinson:
Revenues flat since 2008, and declining every year since 2012. Assuming you’re dyed-in-the-wool value enough to even consider companies which aren’t growing revenues every year – and lots of investors just turn off right there – you might dig a foot deeper and take a look at what Hogg Robinson actually does. If you went to Bloomberg, you’d find that they “…provide international business support services within the corporate travel market. “. A corporate travel agent, you would assume, and you would put your mental image of corporate travel agents (old grey buildings filled with people on phones) together with the declining top-line, and move on. Your assumption has been confirmed; this is a dying business. Welcome to the digital age!
But maybe there’s cigar-butt value here? You open up the balance sheet to figure out the assets inside the company – some assets would be nice to complement the declining stream of cashflows, after all – and you’re confronted with this:
At this point, you’re done. There are plenty more fish in the sea, and there are fish in sexier industries without liabilities greater than the current market cap to pension trustees. It’s difficult being the broker pitching Hogg Robinson to clients. Where’s the hook? Where’s the one-line thesis, the explosive growth?
A variant view
I think Hogg Robinson is in a fantastic business with potential long-term growth avenues. How do I reconcile this with the declining top-line, and counter the evidence quite clearly in front of me?
Here is a graph of client spend through Hogg Robinson’s platform; the value of travel booking that is being transacted through them:
How can this – growing in a recovering travel environment, and flat in a squeezed market – fit in with financials which show a consistent top-line decline? The answer is quite simple; more and more of the travel booking Hogg Robinson is helping clients with is self-booked, not booked in a traditional way by calling up an operative. The proportion is at 47%, up from 21% only 5 years ago. One’s initial instinct – that corporate travel through call centres sounds like a troubled business – is not wrong. But, crucially, the value-add Hogg Robinson provides in the relationship is still intact, regardless of whether a client self-books through HRG’s online system or calls up an operative. Hogg Robinson still manages the relationships with the disparate travel companies, provides emergency back-up if things go wrong, helps with itineraries and so on.
So yes, revenue is declining. But all that is really being lost is low value-add revenue – the revenue you get when you have someone take a phone call to book a flight from Paris to New York. That migrates online. Instead, you’re left with a business where that sort of work is automated, and the call centres handle the trickier stuff.
The shift in progress looks like this:
Continually increasing productivity, improving margins, and a consistent upward trend in EBIT – barring last year’s blip, which gives us our entry point. The fall in metrics last year is predominantly due to a contract kerfuffle and negative exchange rate effects.
A clearer appraisal
Assuming you can see the logic in my opinion above, valuing Hogg Robinson becomes much more of an interesting exercise. Suddenly you are not valuing a declining stream of cashflows, but a business with potential to grow earnings. Not stratospheric potential, sure, but potential nonetheless.
With a clearer set of glasses on, you might see some of what makes the business so interesting:
How many businesses sail through the recession with such ease? The business exhibits incredible stability through the cycle, in a period which includes a large downturn in corporate travel spending. I can think of a few other businesses which have the same resilience of cashflows that Hogg Robinson does. I can’t think of any which trade on the same multiple.
It’s a lovely business to scale, too:
The capital employed in this business is predominantly working capital, but Hogg wiggle their payment terms in a way which makes growth very attractive. There is, of course, some PP&E and a non-trivial amount of lease obligations. But the best bit? This ongoing shift toward online-booking means the business becomes even more attractive when scaling, as there is less of this offline investment in places and space.
This feature, of course, is again only attractive if you believe the business is not shrinking. A shrinking business with excellent returns on capital is not interesting, because it cannot deploy that capital, and it does not have a pool of capital that will become available as the top-line declines. Hence, the mental shift from viewing HRG as a declining entity is paramount here, too.
Aside from the numbers, the company is intuitively attractive. They have a large roster of blue chip clients including Unilever, Deutsche Bank and Bayer. They regularly win new contracts with the big boys, though obviously lose a few to their big competitors – Carlson Wagonlit, BDC and Amex. Broadly speaking, their market share appears to be growing – probably because of their more consensual and open-book model to negotiating relationships with leisure/travel companies, as opposed to the industry generally which is still fairly reliant on the politely named ‘commissions’ (payments from, say, the Hilton, in exchange for a travel company diverting lots of company executives there).
There are growth prospects. The shift toward online booking seems to have catalyzed an increasing realization that the area where Hogg really add value is in travel booking which is non-commoditised. Booking a ticket to London is simple, though Hogg can still make your life easier as a corporate with an integrated platform and the fact that they’ll negotiate contracts with carriers. But they really provide a service if you need to fly 40 of your workers out to Yemen to fix a rig that’s going wrong, via Egypt on the way back, on a tight schedule (subject to change, of course) and with the requisite security.
There is also a focus on meetings & events booking. Previously, corporates have tended to book ‘travel’ centrally, but the onus for organizing an event – let’s say a conference for all your west-coast employees – would be on the west-coast office. They would organize the hotel, schedule the travel and so on. Clearly, as corporates turn their beady eyes on squeezing out costs, this is a category which would fit well under a more general travel umbrella. Hogg have some scary statistics about the sheer amount of money that gets spent on events and meetings (outside of their ecosystem, by definition), which makes it an attractive market.
It ain’t all sunshine
To start with the elephant in the room – the pension deficit is an issue. I’ll reproduce the graph here:
Pension deficits are irritating beasts to value, because they are highly sensitive to the valuer’s assumptions of discount rates, lifespans and inflation, among other things. Safe to say – the current low interest rate environment makes the pension deficit look much larger, because you are discounting a future stream of cash flows back to today at a rate which creates an enormous present liability. Your asset pool (which you are actually primarily investing in equities) no longer gets the hocus-pocus uptick it used to (you used to see companies assuming 11% return on equities, and then ‘model that in’).
But this is a discussion we can have, and a discussion one can have internally. How should one think about this liability? How debt-like is it? How much uplift do I want to give interest rates, if any?
A less obvious, but equally relevant consideration is the operational risk involved in a business like Hogg Robinson. They have over 5,000 employees, numerous large contracts, and are undergoing a period of significant change that requires continuous right-sizing of the business. You’d be naïve to assume that things will go perfectly, though they’ve handled the downsizing process excellently so far.
That said, there still is an air of annoyance around the Government of Canada contract that the business signed last year – and it’s one that highlights exactly the sort of idiosyncratic risk you get in a company like this. They signed a large contract to much internal enthusiasm – a great client, clearly, and a significant amount of business – only to find that activity levels were much lower than they had anticipated and staffed for. My sense would be that it’s wrong to characterize events like this as anything other than par for the course – they will happen. It is the management of the fall-out that is the key.
On that front, the long-standing CEO and his team have done what I consider a pretty admirable job.
I’ve split the conclusion of this post into two sections; pricing and valuation. My perception of what Hogg Robinson is likely to be worth in a few years’ time and the perception of the market are quite different, so it helps to see a middle ground – a stepping stone for the market to bridge then and now.
On that front, I note two things. Firstly, last year should represent a nadir for the business, as it carried within it a string of negative events. Secondly, the business is now at its stated net debt target – 1x EBITDA (which is very conservative in my opinion, but my opinion is irrelevant) – and hence the business is generating substantial free cash flow.
I estimate that next year the business can generate free cash flow of something like £25m from ~£48m of EBIT. If the European situation affects travel (and currency) significantly, which I suppose it might do, you can probably chop a couple of million off those numbers.
They then have £25m of cash burning a hole in their pocket. They have four options:
– Invest in the business organically
– Invest inorganically
– Distribute to shareholders
– Decrease net debt further
The first option is an irrelevance, because as we’ve already discussed the business has a negative working capital cycle and decreasing requirements for physical assets. The second option is also very unlikely for the business. It is an oligopolistic industry with few relevant players of scale, and given cultural and operating differences, it seems unlikely much will happen. I trust management not to do anything stupid in ‘tangential’ fields.
This leaves us with:
– Distribute to shareholders
– Decrease net debt further
Both of these should result in a commensurate uplift in valuation, and the most likely outcome is a combination of both. Shifting to something like a 60% payout ratio would still allow them to pay down a substantial amount of their debt – which isn’t, in my view, necessary – and significantly ramp up the distribution.
The then 4.5p dividend would equate to a 7% yield on the current price, which is clearly an unsustainable rating. It is both an enormous current yield and a strong signal of management confidence in the future of the business.
That said, the step change seems a bit steep (and perhaps politically difficult). We might expect a substantial increase this year, but not quite to that level. Again, that leaves one to wonder what they’d do with the rest of the cash – pay down debt, I guess, which is a shame. Clearly, given that I think the stock is substantially undervalued, I’d love them to buy back huge swathes of their outstanding stock, but liquidity and a number of large holders likely make this difficult.
In short – in a 12-18 month timeframe, I expect increasing dividends to drive the share price.
Let’s leave aside the murky world of pricing the company and try to figure out what value investors really care about; what is a business like this worth, standalone? The current market cap is around £200m.
Now we’re entirely in the realm of comparative speculation. I would argue that Hogg Robinson displays very defensive characteristics – like many of the blue chips which is serves – in having superb returns on capital and a high stability of cash flows to the enterprise, albeit a bit noisier because of its size and the resulting increased volatility in working capital.
But it’s not a stupid question. As the rate-of-change to online self-booking slows, the headwinds in terms of revenue slow with them – and so the business stops looking like it’s declining. The ugly duckling turns into a swan!
3 years out, most of this shift will have been completed. Normalised EBIT in the corporate travel business at the moment is around £45m. Given growth from meetings & events, continuing market share gains in general travel, cost savings (which will show more prominently when the rate of growth in self booking has slowed) and a recovery in corporate travel – which still sits at a depressed level, particularly in Europe – I’m comfortable giving them £50m of EBIT.
Assuming you think 12x is a fair EBIT multiple for the business and you want to attribute the whole of that pension deficit to their enterprise value, your valuation might look like this:
And that’s before Spendvision. I thought I’d rip a page out of the book of friends across the pond and pull a QVC-esque: ‘but wait – there’s more!’
Spendvision is the group’s expense management software. It’s an incredibly attractive asset – embedded in customers, SaaS model, hugely cash flow generative. Last year it made £3.2m of operating profit on £22.4m of revenue. If you were mad you would at least give it a 12x EBIT multiple, which would equate to ~£40m extra value to the business, or 12p per share. If you weren’t mad, you’d note that the margins are substantially depressed due to investment in sales & marketing, and would be significantly higher in run-rate. The business is very low marginal cost, after all. Consider that it made 30% margins in 2009, vs. 15% margins now. Margins are likely to remain depressed as management is accelerating investment into sales and marketing to grow the business, but it should be noted that transactions in this space tend to go at multiples of sales (and I’m not talking 1 or 2x) due to the attractiveness of the business model.
Management say that Spendvision is an important part of their value proposition to clients, which is probably fair. It was included in the Government of Canada contract, for instance. But three years down the line, I hope the business is twice as big as it is now (~£40m revenue), and I imagine the implication of the underlying operating margins of these business – already having made 30% at a much smaller scale – becomes clear to interested parties.
In a real blue sky scenario, the combined business is probably making something like £60m underlying EBIT (~50 from travel, ~10 from Spendvision – and I mean underlying in the sense of pre-growth-opex, so this won’t show in the accounting figures) in three years time. If we assume a 1.5% tug up in interest rates – a complete straw from a hat – the pension deficit looks more like £100m than £250m, and a 12x underlying EBIT valuation gets you to something like three times the current price. That’s ‘leverage’, for you, only pension leverage is less likely to bite you in the rear.
Fiddling with the levers
The most obvious pushback one could give on my napkin valuation above is that I’ve pulled a multiple out of thin air – 12x EBIT.
Mark, in the comments of my last post on Judges Scientific, raised some good points about the use of multiples, and I paraphrased his (much more rich and interesting) arguments by saying that multiples are just shortcuts to DCFs. They’re heuristics. They’re a simplification in our minds – we know that if we discount x stream of cashflows at y discount rate and give it z terminal value, it should be worth a certain P/E or EV/EBIT. These tidbits are passed around and repeated so often they become detached from the economic reality that they represent – which is that one is buying a real asset, with real cashflows and real variables that can’t be approximated and applied to every company on the stock exchange with a brusque ‘a company in this sector is worth this multiple’.
So a much more intuitive and intellectually satisfying way I think about Hogg Robinson is this: can I find a discount rate for the stock which captures the resilience of the cash flows while making the stock looking expensive? Because there’s an important consideration here, too; while we’re in a low-interest rate environment, stocks command much higher multiples than in a high-interest rate one. Conversely, were interest rates to rise tomorrow – and you might argue that my 12x EBIT multiple is a frothy one, based on the unusual market conditions we’re in – but you’re then substantially reducing the pension liability, which decreases by £11m for every 0.1% rise in discount rate. That’s 5% of the current market cap.
If you’re left thinking this all sounds a bit theoretical and detached from reality, I take the point. Then the outcome should be simple – follow the cash. Hogg Robinson will be throwing off cash in the next three years, and I think the market is fundamentally misunderstanding it. You’re buying it at 8x free cash flow at the moment, and I don’t think that’s a stressed figure. Cash flow will grow, the travel business is worth a higher multiple than that, and Spendvision has the potential to prove itself worth substantially more. I expect a three digit share price within a couple of years.