Adapteo – cheap spin off with highly predictable structural growth

Fast facts

Exchange: Nasdaq OMX Mid Cap
Market cap: ~488 MEUR (stock price: 117 SEK)
EBITDA 2019 (my estimate excl. listing related costs): 92 MEUR
Net debt: 402 MEUR
Estimated 5y EBITDA CAGR: +10%

Some situational background

Adapteo was recently spun off from the Helsinki listed equipment rental provider Cramo Oyj and listed on the Stockholm stock exchange. They are a builder and provider of modular buildings mostly for public use, such as daycare centers, retirement homes and schools. Social infrastructure represents 74% of revenue. The main business model is based on recurring revenues contracted primarily through public tender procedures. Adapteo’s largest and most important market is Sweden (60% of revenue), hence the choice of listing in Sweden. The stock trades in SEK but the company reports in EUR and is domiciled in Finland.

Due to regulatory complications many smaller shareholders in Cramo faced prohibitive costs in order to keep the spinoff stock. As a result, Cramo stock experienced great selling pressure in the weeks leading up to the split, making the situation ripe for misvaluation. Even after the completed spinoff – with lots of Finnish institutional owners yet left in Adapteo – I would expect more big blocks of stock to keep moving hands in the near future. Another circumstance worthy of mention is that the new listing took place smack in the middle of the all-consuming Scandinavian summer vacation.

Business, macro and peer valuation

Adapteo is the clear market leader in Northern Europe with a 13% market share. However, as you can see from the varying market shares by country, this is quite misleading. Adapteo is only a marginal regional player in the German market. In reality, they are – after the recent acquisition of Nordic Modular Group – the outstanding largest player in the Nordics.

Note that Adapteo’s target of double-digit EBITDA growth is conservative just by nature of the company’s geographical profile. The Northern European rental market was in 2017 estimated to grow 9% a year until 2023. My suspicion is that the growth of Sweden in those projections was severely underestimated. Sweden’s population is currently expected to grow about 1% a year from only immigration over the next three years, topping its historic growth rate in all but the very last few years. This new demographic is also in disproportionate need of social infrastructure because – among other reasons – they skew considerably younger than the overall population. This pushes up the demand for temporary infrastructural solutions.

My expectation is that there is little downside possibility in these numbers. The asylum proportion has already been lowered and chain migration represents the bulk. In addition, the family reunification policy was recently further loosened by parliament, with an unclear but positive pull effect. Asylum seeker flows into Sweden are on the other hand currently largely contingent on EU wide policies, relative pull among EU countries and relations with Turkey and Libya, making policy abroad a potential source of upward revision. Swedish asylum processing procedures and policies are unlikely to change significantly in the medium term.

Consequently, I expect more upside than downside in the population growth figures for the coming years. Any population growth, but particularly unplanned immigrated growth, results in cumulatively skewed demand versus supply for social infrastructure. Any extra immigration pressure has the chance to make the need for modular buildings go parabolic, as municipalities are legally bound to provide social services under all circumstances. The result would have to be either huge market growth in modular (with a return of the asylum housing boom of 2015-2017) and/or major margin potential for the providers, as municipalities in some circumstances could be forced to outbid each other against a scarce stock of modular buildings.

Exactly what happens past 2022 is subject to political decisions after the next parliamentary elections, but I currently see no practical pathways for Sweden’s intake pro rata to converge with the rest of Scandinavia (it might lower considerably for exogenous reasons, but will likely stay extremely outsized comparatively). All in all, this means that if Adapteo can keep up with the competition across all their markets, they will outpace their peers in growth – perhaps substantially so. This is further hinted at by the company’s stated goal of operative ROCE above 10%, which is conservative considering that they achieved 12% already in 2018. The expectation therefore seems to be that growth could be possibly even higher going forward, thus temporarily depressing ROCE with inflated growth capex.

The average rent level did not change much in the last three years. However, this might be skewed by a couple of factors. The rent figure is quoted in EUR and as previously noted 60% of revenue is in SEK. The euro went from 9.20 in January 2016 to 10.27 at the end of 2018 in krona terms. The krona has further weakened this year to 10.72 per euro as of this writing.

I also suspect – but have not confirmed – that there is another comparability skewing effect in the average rent in that there may have been some unusally highly priced short-term contract from the asylum crisis in 2015, masking the overall rate development in the more reliable long-term businesses from schools and daycare.

Another thing pushing down the average rent is the significant growth in newbuilds. This presumably drags down the average by quoting year-end square meter numbers with a significant proportion of the new capacity not having had the chance to make money for the whole year.

In an interview with Finnish daily Hufvudstadsbladet, company CEO Philip Isell Lind af Hageby reasoned that in addition to Sweden being their most important market, the Stockholm exchange also has lots of suitable peers for Adapteo. Specifically the many real estate companies. Now, the comparison is not 100% perfect; Adapteo will have higher real depreciation. The company uses 20 year on average, but finds that a 30 year lifetime expectation is reasonable across its fleet. Additionally, Adapteo doesn’t have any land values.


image credit to @Fritz844 on Twitter

On the upside, my contention would be that Adapteo is better positioned for reliable growth than all the real estate “peers”. Regular real estate companies as a group should not grow much faster than the overall demographic growth or the overall economy, depending on their niche. Adapteo, on the other hand, is well situated for high growth in the area of social infrastructure.

Management estimates the maintenance capex at 12% of EBITDA. For the sake of argument, I’m willing to grant both that Adapteo needs all of this spending to make their owner earnings comparable to proper real estate companies and that rising land values make up for all depreciation in the real estate companies. Adapteo has shorter term contracts but way better growth prospects and a customer base which should be very resistant to the business cycle, despite Swedish municipalities experiencing rapidly worsening finances. However, it is still almost impossible to imagine a situation where they are not ultimately backstopped by government funds. If the state can no longer help provide schooling or even financing for the voucher system, then we are in shit so deep that no domestic investments will work out.

Anyhow, even when using this EV/EBITA figure against the EV/EBITDA of the peer group, Adapteo comes in at a multiple of 10.5 vs the cheapest of the peer group at 17.3. Note that NP3 is a bit of a valuation outlier amongst the peer group. Presumably because it has a geographically rural profile which translate to lower growth expecations and higher vacancy risks.

In comparison to the real estate companies, Adapteo is actually not aggressively geared. Their interest level is very attractive, but I doubt that they could currently raise much more debt if they were aiming to. It is likely that the debt is both easily serviceable and refinancable under most conceivable circumstances. When viewed through that lense, you could also look at it more aggressively and see what kind of multiple you get on the stub stock. Owner earnings before taxes under my estimation (with constant debt, but shrinking from growth) is 73 MEUR for a pretax p/e of 6.7. There is clearly a lot of leverage built into this situation, both financial and operational.

In addition to the projected demographic growth, the Swedish municipalities have a huge infrastructural hangover to deal with. Most daycare centres, schools and retirement homes were built 30-60 years ago. This stock will have to be continually replenished as the buildings get air quality problems and other age-related issues. In some cases municipalities might be able to kick the can down the road for a while, but in others the liability problems they would face make this a no-go method.

Certain issues can be solved by renovation but many times entirely new structures are both more cost-effective and frankly necessary due to the need for simultaneous capacity increases. No matter the specific solution, modular buildings have a huge role to play either merely for the interim or as quick-fixes later turned semi-permanent. Where there is constant growth of the pupil body, doling out the children across other schools during construction gets less and less tenable even if there might be some room for class size increases (a perennial hot potato for middle-class parents across the Western world).

Additionally, budgetary concerns might compel municipalities to favor modular solutions over regular newbuilds as this spreads out the costs more smoothly over many years and there is less need to loan more money. Of course, the ultimate cost borne is likely to be higher. Budgetary planning in politics can often be a pretty clean case of the principal-agent problem in action.

Finally, building proper new infrastructure is time-consuming and could be politically contentious with geographical placement, zoning and building permits. Some of these problems could be at least temporarily sidelined by opting for modular solutions.

Insider and owner alignment

The main shareholder is the public value arm of legendary Swedish private equity firm EQT. They are the engineers behind the split of Cramo and Adapteo. Until further notice they call the shots in Adapteo, which I’m perfectly comfortable with.

The CEO is relatively young but has worked in the firm for a couple of years. He seems in steady command of facts and figures, as far as you could judge such things from a webcast. The CFO has a background as CFO of the Finnish success story Kotipizza, which was bought out by food giant Orkla last year after a very good ride for the public shareholders. Adapteo in comparison is a rather unsexy business – but there could be some major growth and value creation on the horizon here too. Management seems properly incentivized by a long-term option program which is tied to share performance. I must however admit that I wouldn’t mind also seeing insider purchases after the Q2 report to further confirm my thesis.

Barriers to entry

Management discussed a number of barriers to entry in the capital markets day. Some of these include: a network of subcontractors who might prefer the safe revenue of established players over newcomers, public tendering expertise and experience, the needs for country-specific compliance due to differing climate and regulations and “future-proofing” with high environmental standards beyond the current regulatory burden that might be hard for new entrants to match.

Something else of importance is that municipalities have experienced failure to deliver from some actors with sometimes large repercussions for operations and very costly delays. Consequently, it might not always be wisest to go only for a cheap price. Civil servants might instead opt to structure tender procedures so that established and more reliable players win out more easily. In a bind for time, public procurement officers might also sometimes elect to avoid tenders and do direct negotiations, which also should be positive for market leaders.


Risks

If you think Sweden is at imminent risk of becoming a failed state, then this investment is probably not for you. Many municipalities in the country are in bad financial shape and getting worse, although the state operates at a budget surplus and the national debt is low. There are company specific risks with exchange rates, most notably the Swedish krona vs the euro. In addition to 60% of revenue coming from Sweden, the company is also heavy on euro denominated debt.

There is inevitably refinancing risk when the company’s debt is as big as it is, although it is hard to quantify how big that risk is. Adapteo is largely financed by a term loan of 400 MEUR (at 1.8% interest) and an additional credit facility of up to 100 MEUR, both of which mature in 3 years. I would also like to see the company take up some additional financing in SEK, which should be possible to do at decent rates. At least after some amortization has been done on the current loan and/or earnings have increased to establish some room to maneuver in relation to the covenants. Another option would be to buy some currency swaps.

The not insignificant operational leverage at play can cut both ways. In the event of more intense competition profits could fall a lot.

Finally, there are of course also a myriad possible execution risks, which I won’t renumerate here. Read the risk factors in the listing prospectus for a better overview of those issues.

Possible catalysts

– Private equity buyout, conceivably after they have worked down their debt somewhat and if the equity valuation does not move up a lot

– Further roll-ups of competitors as debt levels allow

– Rerating of stock as quarterly reporting starts coming out resulting in wider analyst and investment community coverage

– Investor interest spilling over from the insanely hot Swedish real estate sector. This is pretty much a real estate company in disguise! Main difference is accounting.

– Deleveraging rapidly increases the portion of earnings attributable to the equity

– Organic growth and/or margin growth

Wrap-up

In combination with the low valuation, the case can most easily be summarized by this piece of text from the prospectus:

Disclaimer: I own shares in Adapteo and could buy or sell shares at any time without informing readers of this blog.


3 thoughts on “Adapteo – cheap spin off with highly predictable structural growth

  1. Excellent analysis. Good and nuanced reasoning and a pleasure to read.

    Thank you!

  2. Interesting case and set-up.

    Is your estimate of OE before or after growth capex? I would want to calculate both to get the full picture 🙂

  3. Emil: Thanks!

    Love: Before. It was a 2019 steady state estimate with some growth extrapolations from 2018 and Q1 -19. The topline was lower than I expected in Q2 but the year will probably be roughly in line in operating profit anyway.

    This takes the management estimate of 12% maintenance capex for granted. No amortization as I view the debt as sustainable on an ongoing basis. Of course, this is highly contingent on growth assumptions. In reality they will pay down some debt, at least in the short to medium term.

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