Irish Continental Group (IR5A.I) – Plain Sailing
(This is the ninth installment in my series of case studies on the shares that make up my portfolio. To see the other eight articles, on Independent News & Media, Total Produce, Abbey, Glanbia, Irish Life & Permanent, Datalex, Trinity Mirror and Datong, click on the company names)
I find myself having to begin this entry with a confession – I absolutely adore Irish Continental Group. It ticks all the boxes for me – very impressive cash generation, a bulletproof balance sheet, aligned manager and shareholder interests and an almost unassailable market position. More on all of these anon. It’s also delivered thumping returns for me since I bought into it at precisely €10/share in April 2009 – a gross dividend yield of 10% per annum since then and share price appreciation of over 50%. So, what better thing to write about on Valentine’s Day than a stock you love?!!
Irish Continental Group has two operating divisions. The larger of the two, contributing circa 60% of revenue and 80% of underlying profits, is its Ferries business. Within this it operates three modern ferries, Ulysses, Isle of Inishmore and Jonathan Swift, on the central corridor of The Irish Sea between Ireland and Wales. A fourth ferry, Oscar Wilde, operates on the mainly seasonal Ireland – France route. ICG’s fifth ferry, the Kaitaki, is sub-chartered to a New Zealand firm and sails between the North and South Islands there. The fleet is quite modern, with all five having entered service between 1987 and 2001. The ferries have a service life of up to 40 years in this part of the world, meaning that ICG has limited capex requirements for many years to come. ICG has, however, made some changes to its fleet in recent years, selling off the Pride of Bilbao ferry (which it had chartered to P&O for many years and which was surplus to ICG’s requirements) in 2010 and disposing of the Normandy (which was replaced by the more modern Oscar Wilde) in 2008.
The core Ferries unit has a very strong market position. In terms of Ro-Ro (roll on-roll off freight i.e. trucks) it has 50% share of the short-sea route between Ireland and Britain (Stena has the other 50%, so a duopoly). On the tourism side, it has 45% of the short-sea market (again, Stena has the balance). ICG has a very strong moat around its business, for two reasons. Firstly, there is a ban on trucks using Dublin city centre between 7am and 7pm, 7 days a week. For companies looking to make supplies to this area, they need a ferry operator that can help them get around it. So ICG’s strategically located port facilities and convenient sailing times serves hauliers very well indeed. In addition, Stena and ICG’s control of critical port slots (much like airport slots) means that they can get better use of their ferry assets through additional daily sailings on the shorter routes than their competitors, who have to sail to further away ports. Stena and ICG’s control of the shorter routes is also a key attraction for hauliers looking to minimise costs.
In terms of the customer base, as Ireland is an island, virtually all of its international trade moves by boat. I’ve already touched on its large Ro-Ro market share. On the passenger side, with Ireland being home to LCC gorilla Ryanair, one might expect that this business has been decimated, but ICG has held its own in recent years, carrying 1% more passengers in 2010 than it did in 2005. Clearly, the 2010 performance was helped by the Icelandic volcano, but there appears to be a robust market for people travelling by car to avoid getting stiffed with excess baggage charges by the airlines and so on.
ICG’s other division is Container & Terminal. This incorporates intermodal freight services Eucon and Feederlink, along with stevedoring facilities at Dublin and Belfast ports. The latter mainly involves Lo-Lo (load-on load-off freight, i.e. cranes and containers) and caters to third-party firms, including DFDS, MSC Line,Hamburg Sud and Hapag Lloyd, in addition to Eucon and Feederlink. This unit generates decent (low teen %) ROCE, despite the much reduced trade volumes compared to a few years ago.
As a play (to a certain extent) on the Irish economy, it is unsurprising to see ICG’s performance has deteriorated since the start of the recession. At the peak of the Celtic Tiger period (2007) it generated EBITDA of €80.2m on turnover of €355.8m. By 2010 this had fallen to €53.6m and €262.2m respectively. While revenues have been on the increase again, helped by a strong performance by multinationals located in Ireland, profits in 2011 will be adversely affected by rising oil prices. Looking to this year and beyond, the prospects look more encouraging for three critical reasons. Firstly, two of ICG’s competitors exited the market altogether since the start of 2011, namely Fastnet Line and DFDS. Secondly, capacity by remaining operators such as Stena has been reduced, which is positive for freight and passenger rates. Thirdly, ICG has incredible operating leverage – estimated at 75% – which leaves it well placed to capitalise on a more benign competitive environment.
Despite the challenging economic conditions, ICG is throwing off a lot of cash. I estimate that it will generate free cashflow (operating cashflow less capex) of €41.4m in 2012. That’s a free cash flow yield of 11.0%. Conservatively assuming modest (~3%) annual revenue growth out to 2014 (which gives revenues that year of €297m, some 16.5% below 2007 levels) and similarly muted cost growth over the period produces a 2014 free cash flow yield of just under 14%. So what will happen with this cash?
The group pays a generous dividend of €1/share (a yield of 6.6%), which costs €25m/year or about 60% of the free cash flow the group throws off. Given its strong balance sheet (net debt was only €13m at the end of September, while the pension deficit was only €17.5m at the end of 2010) the group could easily afford to increase the dividend, or perhaps retain an element of flexibility by periodically paying special dividends and/or buying back shares.
In terms of the valuation, I apply a DCF utilising a 10% discount rate and 2.5% terminal growth rate. In my DCF I have also reduced free cash flow by a notional €10m / year to reflect the long-term costs of replacing the fleet (the gross book value of which was €287m at end-2010). After taking into account the net debt and the pension deficit this produces an equity value of €455.0m, or €18.30 a share (21% upside from last night’s close). Using my 2012 forecasts, this valuation implies a forward (i.e. 2012) PE of 15.3x, P/B of 2.6x, EV/EBITDA of 9.5x and 5.5% dividend yield. This may look pricey, but you’re hardly going to pay peanuts for highly cash generative assets operating in a duopoly market with strong barriers to entry.
At the start of this piece I mentioned that management’s interests are aligned with shareholders. That only scratches the surface. ICG was the subject of what ultimately turned out to be a three-way takeover battle between 2007 and 2009. The three parties were management, Liam Carroll (an Irish property developer) and Moonduster (a consortium comprising One51 and Doyle Shipping). The process ended in stalemate, but since then we have seen the sale of Carroll’s stake while Doyle exited the register last year. One51 has said that it will be selling ‘non-core’ assets, which I suspect includes its interest in ICG. This leaves us with management, which has a circa 16% stake in ICG. I don’t propose to second-guess their future intentions, but it is interesting to note that during the takeover battle for ICG they were willing to pay up to €24/share for the group, which is well above the valuation I estimated above. Of course, the world has changed since August 2007, but ICG’s balance sheet has too – net debt has been reduced from €84.5m (the equivalent of €3.40/share) at end-2007 to close to zero now.
So, in summary, to me ICG is a compelling story. It offers a chunky and well-covered dividend yield, is inexpensively rated, possesses a strong balance sheet, has a robust business model and strong market positioning and is throwing off cash. My only regret is that I didn’t buy more of it when it was trading at €10/share!