July 04, 2018 - 5:35am EST by
2018 2019
Price: 15.50 EPS 1.2 1.3
Shares Out. (in M): 89 P/E 13 12
Market Cap (in $M): 1,400 P/FCF nm nm
Net Debt (in $M): 930 EBIT 150 180
TEV (in $M): 2,330 TEV/EBIT 15.5 12.9
Borrow Cost: General Collateral

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Arcadis (ARCAD NA) - Short (CP: €15.71 / TP: €9.93)
Investment Thesis – Summary
- Post a nearly two-third decline in the company’s stock price over the period April 2015-November 2016, the significant recovery (i.e. > 80% at peak) in the company’s share price in subsequent months would suggest that the company had overcome its past troubles and was well on its way to a sustained recovery with a new CEO at its helm. While the stock price has since dropped somewhat on liquidity and Middle East concerns, it still remains at an elevated level suggesting that investors are largely discounting these issues in their evaluation of the company.

- However, a more critical examination of the company’s financials suggests that a higher level of investor scepticism and scrutiny would be indeed warranted as the company appears to face issues across the board. In summary, the company needs a complete reset of its growth and profitability expectations and a significant de-risking of its balance sheet through a capital raise. Further, adverse developments in the company’s troubled Brazilian associate, ALEN could have a significant financial impact on the company in the near term.

- In terms of its growth prospects, while the company recently lowered its medium-term growth targets to >GDP in its markets, even this lowered growth target appears somewhat unrealistic given organic growth history, recent working capital developments and continuing stresses in the company’s several end markets. Given that the company operates globally, the revised target would suggest organic growth of around 3-4% in line with world GDP growth estimates. As such, this would be much higher than the company’s organic growth CAGR of ~1% over the last several years. Growth targets therefore will likely need a further reset to a number closer to their long-term trajectory. It is also worth noting in this regard that despite having spent close to €700 million on acquisitions over the last few years, underlying organic growth has failed to show any improvement at all.

- Further, profitability appears to have been significantly window dressed over the last several years through lower provisioning, classification of costs as non-recurring etc. As such, the underlying profitability of the company appears to be much lower than understood. The recently restated profitability target (operating margin trending to 8.5% -9.5%) thus appears to be overly ambitious given that the core underlying EBITA margin potential of the company appears to be around 5% or so.

- Next, and potentially of greatest concern, is that the company’s underlying liquidity appears to be far weaker than apparent with the company having been resorting to managing its debt levels at balance sheet dates (partly through squeezing its suppliers) to avoid a covenant breach. The liquidity issue appears in part to have been exacerbated by a rising amount of the company’s cash balance classified as restricted as well. The company thus is likely to need to raise significant equity capital in the near term to position its balance sheet on a more surer footing.

- Finally, the company’s material financial exposure to its troubled Brazilian associate, ALEN is worth noting as it could significantly exacerbate its liquidity situation in the near term. While the company is planning to invest more capital in the associate with a view to making it divestment worthy by 2H18, should the effort fail, the company could be on the hook for significant guarantee related pay-outs as well as potentially have to deal with a breach of its debt covenant.

- A reset of the company’s growth and profitability targets to more realistic levels should in turn lead to a significant reset of the company’s earnings potential with consequent adverse impact on the multiple and stock price. Further, an equity raise in line with the discussion above is likely to lead to significant dilution for existing shareholders with consequent negative implications for the stock.
- Modelling the company with a growth and margin trajectory at levels slightly higher than their FY17 levels leads to a downside of approx. 34% (incl. dividends) from its current level of €15.71 and an IRR of 46% over the investment period till year 1Q19.

- A capital raise in line with the discussion above would further add meaningfully to the downside potential as it is likely to be significantly dilutive to existing shareholders. As estimated, the additional financing raise could turn out to be in the range of 41%-54% of the company’s current market capitalisation given the company’s desired Net Debt / EBITDA range of 1x-2x.
[Exchange: AMS / Price: €15.50 / Market Cap: €1.4 billion / Avg. Vol: €3.2 million / Short Int.: NA / P/E: 18x / P/E (FY18): 12x

Introduction – Background, Business Overview and Competitive Landscape
Background and History
- Arcadis is a full-service design and consultancy firm focusing on natural (e.g. water) and built (e.g. infrastructure) assets. In essence, the company works with its clients to design, engineer and project manage the entire lifecycle of their assets in the areas of infrastructure, water, environment and buildings.

- The company was founded in 1888 in Netherlands as the Association for Wasteland Redevelopment. It started expanding in Europe from 1990 onwards and moved in to the US market in 1993. The Arcadis brand name and logo were introduced in 1997. Since 2007, the company has attempted to transform itself through a number of acquisitions of which Hyder Consulting and Callison in 2014 were the most prominent.

- Per the company, the key factors that define the company’s operating environment and drive demand for its design and consultancy services are the following mega trends:
Urbanization and mobility: Population growth and migration leading to rapid urbanization and clogging of existing transportation infrastructure.
Sustainability and climate change: Solutions that help preserve and protect natural resources (e.g. water).
Globalization: being able to support clients across the world.
Digitalization: Using new technologies to innovative solutions and business models.

- The company operates globally across 70+ countries with 27k employees. In FY17, it completed 35k+ projects generating gross revenue of €3.2 billion.

Industry and Competitive Landscape
- The company operates in a market with an estimated global TAM (per the company) of $500 billion and growth in line with GDP. As the graphic below shows, the key markets are North America, Europe and Asia Pacific with Asia offering the largest long-term market potential.

- The market is characterised by the presence of both global and local players with the global ones largely competing with each other based on brand, knowledge and cost efficiency. The market is further characterised by the presence of integrated E&C firms (e.g. AECOM, Jacobs Engineering) as well as by more pure play design and consultancy firms (e.g. Arcadis, Tetra Tech, WSP).

- Per the company, it is a global top ten player in the industry with a top three position in design and consultancy. Further, per ENR (an industry publication), the company was ranked 13th in 2018 in the ranking of Top 500 Design firms in the world.

- The market thus appears to be fairly fragmented with no single dominant player with long term growth approximately in line with GDP given the nature of the end markets. Growth in the near to medium term is likely to be a function of government spending plans and public/private infrastructure initiatives.

Business Lines and Segments Overview
- Following a simplification process in 2017, the company is now organized along fourteen Global Solutions spread within four broad business lines as follows:
Infrastructure (26% of net revenue) – focusing on efficient transportation and energy supply systems.
Water (13% of net revenue) – focusing on the entire water cycle from source to tap and then back to nature.
Environment (21% of net revenue) – focusing on engineering, consulting and construction services to improve the sustainability of natural and built assets.
Building (40% of net revenue) – master planning, architectural and engineering design, project and cost management for all types of buildings and cities.

- The four broad business lines seem to be the same as the four business lines as the company report earlier with the exception of defining fourteen solution lines split between these four business lines.

- In terms of segment reporting, the company now reports segmental information essentially in terms of how it is organized geographically except for its CallisonRTKL division which is reported as its own separate segment. As such, the company now reports segment information as follows:

The Americas segment comprises of two sub segments: North America and Latin America (i.e. Brazil, Chile and Peru) and accounted for 31% of the company’s net revenue in FY17. North America is by far the dominant segment accounting for 89% of net revenue from the region.
While the overall region declined organically by 2% in FY17, North America grew by 2% while Latin America declined by 26% in the year.
The improvement in North America follows on the heels of approx. three years of underperformance driven by the weakness in oil & gas spending (which in turn was driven by oil price decline) while the decline in Latin America is a function of the continuing recession in Brazil.
Growth in this segment in upcoming periods is expected to be driven by rising infrastructure spending in North America and by an improvement in the GDP growth rate for Brazil. However, given expectations of zero / near zero growth in government spending in Brazil over the next few years, a significant improvement in Latin American growth rate may not materialise as anticipated.

Europe & Middle East
This segment is comprised of the following sub-segments: Continental Europe, United Kingdom and Middle East and accounted for 46% of revenue in FY17. Within the segment, Continental Europe accounted for 49% of revenue while UK and Middle East accounted for 35% and 16% of revenue respectively in FY17.
Organic growth in the segment amounted to 4% in FY17 on the back of MSD organic growth for both UK and Continental Europe offset by a decline of 10% in growth in Middle East.
Growth in the Middle East in the future is likely to continue to be an issue given budget deficits related to the oil price which have caused projects to be reprioritized as well as by the company focusing only on deals where margins and profitability make economic sense. Further, while the UK market is likely to continue to grow organically, Brexit is reducing client confidence and thus may keep a lid on overall growth.

Asia Pacific
This segment is comprised of the following sub-segments: Asia and Australia Pacific and accounted for 14% of revenue in FY17. Further, Asia accounted for 63% of the segment’s revenue while Australia Pacific accounted for 37% of revenue in FY17.
Organic growth in the region amounted to 2% for FY17 with Asia registering negative growth of 2% and Australia Pacific recording organic growth of 12% in the year. The negative growth rate in Asia was driven was weakness in building market in Singapore and China offset by very strong growth in Australia driven by the ramp up of large metro projects in Sydney and Melbourne.
Future growth in this region is therefore likely to a function of the continued strong Australian growth in the near term offset by a more subdued but steady trend in Asia growth.

CallisonRTKL is the architectural design and consultancy arm of the company with architecture and interior design as its key offerings across the following four market sectors: Commercial, Retail, Healthcare and Workplace.
The segment recorded organic growth rate of -3% in FY17 and a further -7% in 1Q18.
The company is currently considering strategic options for this division and the business could likely be sold over the coming quarters.
In FY17, the division recorded €320 million in gross revenue and EBITA of €20.8 million.

- While private sector clients form the majority of the company’s client base, given the nature of the company’s business, government and regulated entities also comprise a fairly significant portion of the company’s client base in almost all segments except CallisonRTKL. In FY17, private sector clients accounted for 56% of the company’s client base while public and regulated entities accounted for approx. 27% and 17% respectively of the client base.

Short Thesis – Key Issues
Arcadis faces issues across the board and needs a complete reset of its growth and profitability expectations and a significant de-risking of its balance sheet through a capital raise. Further, its material financial exposure to its troubled Brazilian associate poses a significant near term financial and liquidity risk.
In terms of its growth and profitability expectations, while the growth target for the company was lowered recently at the company’s last CMD in November 2017, even the lowered target appears somewhat unrealistic given organic growth history, recent working capital developments and continuing stresses in the company’s several end markets. Further, profitability appears to have been window dressed over the last several years through lower provisioning, classification of costs as non-recurring etc. As such, the underlying profitability of the company appears to be much lower than understood and even the recently restated profitability targets thus may prove to be a stretch. As such, both growth and profitability targets will likely need to be reset to more realistic levels.
Further, and potentially more importantly, underlying liquidity appears much weaker than apparent with the company appearing to manage its debt levels at balance sheet dates to avoid a covenant breach. The liquidity issue in part appears to have been exacerbated by a rising amount of the company’s cash balance classified as restricted.  The company thus needs to raise significant equity capital to de-stress its balance sheet for both the short term and the long term (i.e. to avoid a covenant breach or to deal with guarantees getting called in the short term and to avoid having to continue managing the debt levels at balance sheet dates in the long term).
The liquidity issue could be further exacerbated by the company’s significant financial exposure to its troubled Brazilian associate, ALEN. While the company is planning to invest more capital in the associate with a view to making it divestment worthy by 2H18, should the effort fail, the company could be on the hook for significant guarantee related pay-outs as well as potentially have to deal with a breach of its debt covenant.
A reset of the company’s growth and profitability targets to more realistic levels is likely to lead to a significant reset of the company’s earnings potential with consequent adverse impact on stock price. Moreover, an equity raise in line with the discussion above is likely to lead to significant dilution for existing shareholders again with negative implications for the stock.
A more detailed discussion of the various issues relevant to the short thesis is given below.

Underlying Growth Profile Very Poor; Recently Restated Growth Target Appears Ambitious
- Over the last several years, the company’s delivery of organic growth has consistently fallen short of its promise. In particular, the company guided for organic growth for the period 2014-16 as >5% as part of its outlook statement in December 2013. However, organic growth for the years 2014-16 actually amounted to 1%, 0% and -4% respectively in sharp contrast to the targeted organic growth. Organic growth for FY17 turned out to be 1% and while an improvement YOY, hardly anywhere close to the targeted level of growth.

- The picture does not change dramatically when looking at growth trends over a longer-term period. Thus, organic revenue growth since 2010 has averaged a CAGR of 0.67% on a gross basis and 0.97% on a net basis.

- Organic growth CAGR of less than 1% since 2010 is particularly noteworthy as the company made several acquisitions over that period including Hyder Consulting and Callison for a total consideration of approx. €700 million. However, none of the acquisitions appear to have made any difference in jump starting the poor organic growth profile of the company.

- As such, this suggests that the underlying growth profile of the company is much lower than the company’s historic ambition and likely closer to its long term CAGR of ~1%.

- This does not appear particularly surprising given the company’s widespread geographic exposure as well as significant reliance on government and infrastructure spending for its revenue growth. Thus, from a geographical perspective, strong growth in one region could get offset by weaker growth in another region facing a very different dynamic. Further, macroeconomic factors impacting one business line could help offset strong growth in another business line. Growth, on a net basis and over a longer term, is therefore likely to closely approximate worldwide GDP growth assuming the company executes perfectly.

- In a somewhat tacit admission of its lower growth trajectory, the company lowered its organic growth target for the period 2018-20 to >GDP growth in its markets.

- However, even this lower growth target appears somewhat optimistic for a couple of reasons:

First, world GDP growth is estimated to be approx. 3.8%, 3.7% and 3.2% over the period 2018-20. As such, the company’s organic growth target would imply organic growth of approx. 3-4% over that period.
As such, this would be a significant improvement on the company’s organic growth trajectory of 0%, -4% and 1% over the last three years. However, world GDP growth during these years amounted to 3.5%, 3.2% and 3.8% The company’s growth rate therefore significantly trailed world GDP growth during those periods.
While it could be argued that specific issues (business line / geography) led to underperformance in those periods, many of those issues that dogged performance in those periods have continued to remain. Thus, oil price continues to remain erratic and could continue to have an impact on North American growth over the next few years. Further, the company’s far more cautious stance on projects in the Middle East and the continued weakness in the Brazilian economy is likely to keep a lid on the organic growth profile of those geographies.
As such, barring a synchronous improvement in the company’s growth profile across geographies and business lines and/or significant outperformance of one or more business lines / geographies, the company’s target of >GDP growth appears fairly unrealistic.
Second, even the poor organic growth profile of the last few years appears to have been driven at least in part by aggressive accounting given trends in working capital.
In particular, receivables jumped sharply in FY16 YOY suggesting the company may have pulled forward revenue from future periods into current periods. This appears particularly so as the increase was driven more by unbilled receivables where the company typically has more discretion in terms of revenue recognition.
The YOY increase in DSO levels in FY16 is particularly noteworthy as the company recorded its lowest organic growth level (since at least 2011) of -4% in the period suggesting that even with the aggressive pull forward, revenue growth remained negative.
While DSO levels declined somewhat in FY17 YOY, the overall DSO level remained elevated suggesting that the company remained aggressive in terms of its revenue recognition.
Further, receivables overdue > 120 days jumped from 18% in FY14 to 20% in FY16 and further to 23% in FY17. This also suggests that revenue growth in the periods FY14-16 may have benefited from a combination aggressive revenue recognition as well as from much more riskier contracts and/or less credit worthy customers.
As such, the underlying growth profile of the company appears to be even lower than its very poor reported growth profile in recent periods. The target of > GDP growth therefore once again appears fairly unrealistic in light of the above discussion.

Reported Profitability Has Been Steadily Deteriorating; Profitability Much Worse on an Underlying Basis
- Profitability in the business appears to have steadily eroded away over the last several years even when considering it on an adjusted basis (i.e. as per the company’s preferred metric). In particular, the company’s preferred metric of operating EBITA (EBITA adjusted for non-recurring costs) has been on a steady downtrend since FY14 falling from a level of approx. 10% then to 7.7% in FY17.

- In a similar vein, reported EBITA margin also declined from a level of 9-10% prior to FY15 to 6.6% in FY17 and net income margin declined from a level of approx. 5% to 2.9% over the same period.

- The key catalyst for this appears to be the acquisition of Hyder Consulting (and potentially of Callison) in FY14 as the margin profile appears to shift soon after in FY15 with a much deeper dive in FY16. In turn, this appears to have been driven by a sharp uptick in employee costs from approx. 74.5% of revenue in FY14 to 75.5% in FY15 and further to 76.6% in FY17.

- As such, profitability appears to have permanently shifted downward given the significant shift up in the company’s main expense line item.

- However, underlying profitability of the company appears even lower given the benefit to margins from primarily lower provisioning as well as provision release as discussed below:

Lower Bad Debt Provision.
While the level of receivables >120 days has increased sharply over the period FY14-17, provisioning has failed to keep up. In particular, receivables past due >120 days increased from €104 million in FY14 to €147 million in FY17. However, over the same period, provision for this line item increased only from €48 million to €52 million. As a result, provision relative to gross receivables declined from 46% in FY14 to 35% in FY17.

The decline in provision appears particularly problematic as the company has encountered significant receivables issues in recent periods especially in the Middle East and in the US. The receivable issue in the Middle East appears particularly acute as DSO for the region has now reached 250 days. Further, on the 4Q17 call, the company noted that €40 million of the total €147 million of receivables past due > 120 days were related to the US and Middle East and the rest of the past due amount was spread around all regions but skewed towards emerging markets.

While the company claims that the payments are just delayed, and they will get paid in full over the next few quarters, the significant amount of time the receivables have been outstanding for suggests that a significant impairment is fairly likely.

As such, the lower level of provisioning over the last few years appears to have benefited margins significantly over the period. The decline in provisioning also appears fairly puzzling given that the risk of receivables impairment rose significantly in more recent periods.

Adjusting the FY17 provision level to its FY14 level would require an additional provision of approx. €16 million and impact margins by 0.7% in the period. Margins would be further impacted if the company had to write-off receivables in excess of the current level of provision.

Lower Provisioning for Restructuring, Litigation etc.
Margins and earnings have also benefited in the last few years from a steady decline in the level of provisions for restructuring, litigation etc. In particular, the ratio of provisions / sales declined from 2.1% in FY15 to 1.1% in FY17 largely due to the fact that the usage of such provisions matched or exceeded the company’s addition of provisions during the period and secondarily due to a significant release of provisions (as discussed later) in FY16.

The lower provision additions are in sharp contrast to the earlier years (FY11-12) when usage / addition was far more conservative at around 50%. As such, if provision usage / addition was maintained at that level, margins would have been impacted by (and therefore benefited by) 0.6% in FY17.

Significant Provision Release in FY16
Earnings and margins for FY16 benefited from a significant release of litigation and other provisions established at the time of the acquisition of Hyder Consulting in FY14. In particular, the company released €35.7 million of provisions (of which litigation provision amounted to €32.3 million) in FY16. The amount released was so significant that net provision additions actually turned negative (i.e. a net benefit to earnings) for the period.
The release of such a significant amount of provision (i.e. 1.4% of revenue) appears particularly interesting and appears to have been designed to help avoid the company breach its key debt covenant of net debt / EBITDA <3. As the covenant reached its highest level of 2.5 at the end of FY16 even with the help of the provision release, it appears possible that the covenant may have been in breach (or close to breach) absent the provision release.
As such, if we assume net additions had remained at previous year levels (i.e. 0.4%), then margins and earnings benefited by approx. €15 million / 0.6% of revenue in FY16 from the company’s excessive release of provision in the period in addition to the 0.3% of benefit from the lower level of net provision addition as discussed in the point above.
Thus, the underlying profitability of the company appears to have been overstated significantly in the last few years with the true underlying profitability much lower than reported. Per the above discussion, underlying margin for the company would have been approx. 1.3% (i.e. 0.7% + 0.6%) lower in FY17 if the company had maintained provisions for bad debt and litigation etc. in line with past periods.

- The picture of the company’s underlying profitability appears to be further clouded by the company’s presentation of various adjusted metrics. In particular, the company presents two adjusted metrics – Operating EBITA and Operating Net Income – both of which adjust for various items considered one-off by the company.

Operating EBITA is the key profitability metric used by the company and adjusts reported EBITA for restructuring and integration costs, acquisitions and divestments and provision releases. While the adjustment for acquisitions and divestments as well as for provision releases makes sense, the exclusion for restructuring and integration costs does not seem justified given that the company has incurred such costs every year since 2012. It is also noteworthy in this regard that total restructuring and integration costs amounted to not so insignificant nearly 11% of total operating EBITA over the period FY11-17.

Adjusting for this would reduce operating EBITA margin by approx. 0.8% - 1.6% over the last few years.

The second adjusted metric ‘operating net income’ presented by the company adjusts reported net income for inter alia intangible assets amortisation, impairment charges, M&A costs and provision movements. While the exclusion of other line items could be to a large extent justified, the exclusion of the cost of amortization of intangible assets (e.g. customer relationships, trade names etc.) appears to be less so given that these costs are a legitimate expense of doing business.

As the cost of amortisation of intangible assets amounted to approx. 1-1.4% of revenue over the last three years, the exclusion of such costs from adjusted net income benefited adjusted net income and margin by the corresponding amount.

- In summary, overall profitability and margin potential of the company appears to have been reset to a level of approx. 6.6% from around 9-10% over the last several years. Further, even this lower level of profitability appears to have been overstated by approx. 1.3% (using FY17 numbers) given lower level of provisioning for various line items. As such, the core underlying EBITA margin potential of the company appears to be a little over 5% or so.

This is in sharp contrast to the company’s presentation of an operating EBITA margin of over 7% and thus appears to overstate underlying profitability and margin potential by approx. 2%. As the business overall is characterised by single digit margins, the delta between underlying and presented margin represents a significant overstatement.



Significantly Constrained Underlying Liquidity Suggests Additional Funding Raise A Near Necessity
While on the face of it, the company appears well capitalised with a cash balance of €268 million (at FY17) and net debt / EBITDA at 2.3 comfortably within the covenant limit of 3x. However, a more critical examination of the company’s underlying liquidity suggests that liquidity is far severely constrained than apparent with the company resorting to significant management of reported debt levels at balance sheet date to avoid a covenant breach. As such, a funding raise in the near term seems almost a necessity as balance sheet management at reporting dates may not continue to be as effective as it has in the past.
The various aspects of the liquidity issue are discussed in detail below:
- Underlying Average Debt Levels Much Higher than Reported
Underlying intra period gross debt levels are much higher than those reported at balance sheet dates. In particular, using cash interest cost and the effective interest rate on debt disclosed by the company leads to a gross debt level that is much higher than disclosed gross debt at balance sheet date. Thus, the calculated gross debt amount at FY17 turns out to be €1.06 billion compared to reported average gross debt of €745 million, a difference of €310 million. The difference between underlying and reported average gross debt level is similar for FY16 as well. Moreover, as the calculated gross debt figure represents the average level of gross debt over the period, the absolute level of gross debt at any particular point over the period could be even higher.
Further, using the calculated gross debt figure and EBITDA as disclosed for covenant purposes leads to a calculated net debt / EBITDA figure that is much higher than reported. In particular, the calculated covenant value turns out to be 3.6x, 4x and 3.8x for the years FY15, FY16 and FY17 respectively (i.e. much higher than the covenant limit of 3x and the disclosed covenant values of 2.2x, 2.5x and 2.3x for those years). As such, the company appears to have been in effective breach of the covenant level on an underlying basis since FY15.
- Company appears to be squeezing payables to ease its liquidity strain
The much higher average intra period gross debt level and the lower gross debt level at reporting dates implies that the company is resorting to managing the level of gross debt on reporting dates. One way the company appears to be doing that is by managing the level of payables on its balance sheet.
In particular, the company appears to be squeezing its suppliers quite significantly and thus having them finance an increasing level of its working capital. An examination of the company’s payables appears to clearly bear this out with total DSP (i.e. accounts payable and PoC billings in excess of costs) levels increasing from 99 days in FY12 and FY13 to 120 days in FY15 and further to 143 days in FY17.
The company has explained the rising level of payables as due to its implementation of the ‘pay-when-paid’ policy whereby it only pays its suppliers when it is has been paid by its customer. While this could explain part of the increase, the increase in the company’s receivables level has been far more muted relative to the rise in payables. As such, the company may be using this policy more as an excuse to hold back payments from its suppliers rather than on a more genuine basis.
The increase appears to have been fairly steady over the period suggesting that the company has become increasingly reliant on its suppliers to help ease out its liquidity issues at balance sheet dates. However, given that the DSP levels are now almost at five months from a level of just over three months a few years back suggests that further benefits from suppliers may be much harder to come by. More concerningly, any push back from suppliers could lead to a very sharp reversal in working capital and could force the company to raise financing on a very short notice.
Thus, for example, a normalisation of the payables levels to their FY15 level would require additional working capital of approx. €74 million while a normalisation to their FY13 level would require additional working capital of approx. €128 million. The working capital requirement would increase further if receivables as discussed earlier also normalise from their currently elevated level.
- Rising Level of Restricted Cash Potentially Part of the Explanation for the Strained Liquidity
The company’s restricted cash balance has gone up steadily over the last few years from €52 million in FY12 to €109 million in FY17. The balance has also gone up in relative terms with restricted cash as a % of total cash having increased from 34% in FY12 to 40% in FY17.
In discussing the issue, the company explains that restricted cash is mainly composed of cash balances held in China and some Asian countries as well as Mozambique, Chile and some JV accounts where there are restrictions on cross border cash movements or cash repatriation is more difficult and causes tax complications.
As such, given that the restricted cash amount would be largely unavailable for regular purposes, the rising level of restricted cash over the years has likely played some part in constraining the company’s liquidity position. Further, as the level of such cash also appears unlikely to change in the near term absent a significant discount (in terms of a tax charge etc.), the company will likely have to resort to other means to ease its liquidity situation.
- Significant Level of Funding Required to Reset Liquidity Concerns for the Short Term and the Long Term
While the company has thus far managed to navigate its significantly stressed liquidity situation (on an underlying basis), any stress elsewhere could quickly unravel it and lead to a covenant breach which in turn could lead to a distressed capital raise situation. As such, the company’s best option appears to be to raise sufficient capital prior to such an event occurring and forcing its hand.
As such, in order to calculate the required level of financing, the following assumptions have been made:
Net Debt / EBITDA: desired range of 1x-2x per latest CMD presentation.
Additional working capital infusion: €100 million. This is approximately mid-way between the additional working capital required (as calculated earlier) to normalise payables to their FY13/FY15 levels.
Guarantee related outflows: €50 million. While this is somewhat speculative for now, given the €84 million of guarantees outstanding on behalf of the company’s troubled ALEN associate, it appears more likely than not that the company will get called on the guarantees in this regard.
EBITDA margin: Adjusted down by 1%. While the gap between reported and underlying profitability is approx. 2% as discussed earlier, we have assumed only a 1% adjustment to be conservative.

Based on the following assumptions, the additional financing required to reach the desired net debt/EBITDA range turns to be €573 – 751 million. This in turn translates to approx. 41% - 54% of the company’s current market cap of approx. €1.4 billion. As such, a significant dilution appears to be in the offing for the company’s shareholders if the company decides to proceed with a capital raise to ease its liquidity situation.

As the company is currently considering the sale of its CallisonRTKL division, any future capital raise could be offset by the amount raised by the sale of this division. Given the significant negative trend in the division’s growth and margin development, the sale if it does occur may be a significant discount. Using reported EBITA of €21 million for FY17 and a discounted multiple of say 5x, the sale could potentially fetch approx. €105 million.

Thus, while the sale could potentially lower the level of financing required, it is unlikely to make any meaningful dent in the overall level of financing and more importantly, in the level of dilution faced by current shareholders.

Sharp Rise in Guarantees Suggests Contracts Getting Riskier; ALEN Related Guarantees Could Get Called In
- The level of guarantees provided by the company in the course of its business have increased sharply over the last few years and especially in FY15 and FY16. In particular, guarantees jumped from levels around €100 million or so prior to FY15 to €207 million in FY15 and further to €371 million in FY16. In relative terms, guarantees jumped from a little over 4% of gross revenue prior to FY15 to 6% in FY15 and further to 12% in FY17.

- A key part of this increase appears to be driven by a significant rise in the level of guarantees provided to associated companies (i.e. primarily ALEN). Guarantees in relation to associates jumped from less than €10 million prior to FY15 to €48 million in FY15 and further to €84 million in FY17.

- As the €84 million of guarantees related to associates at FY17 pertained entirely to ALEN, they constitute a significant financial and liquidity risk for the company given the precarious financial situation of ALEN (as discussed later). As such, should the guarantees get called in either in part or in whole, the company could face a serious liquidity crunch given its already constrained liquidity situation as discussed earlier.

- Further, the level of guarantees ex-associates has also increased significantly over the last few years suggesting a potentially sharp increase in the level of risk inherent in its recent contracts. As guarantees are typically provided to ensure performance on contracts secured by the company as well as for securing financing etc., the sharp and sustained increase in the level of guarantees in recent years suggests that the company has been taking on higher risk contracts and/or facing a much higher competitive bidding environment than in past periods.

- While the company has sought to downplay the rise in the level of guarantees by saying that they have never had a guarantee called in (see excerpt from 4Q17 conference call below), the precarious financial situation of ALEN as well as the much higher level of guarantees currently compared to prior years suggests a much higher risk from guarantees than in past periods. The risk is further exacerbated by the fact that the company’s ability to sustain a significant guarantee call is fairly low given its overall constrained liquidity situation.

ALEN Represents a Significant Near Term Financial / Liquidity Risk
- The crumbling financial situation of the company’s Brazilian energy associate Arcadis Logo Energia S.A. (ALEN) poses a serious near term financial and liquidity risk for the company.

- In particular, the company holds a 49.99% stake in the business emanating from its acquisition of a Brazilian entity ‘Logos’ back in 1999.  The business has equity stakes in six biogas plants with the stated intent of converting landfill gas into bio-methane and power.

- However, the business has generated negligible revenue over the last several years (i.e. total revenue of €2.8 million over six years) and has incurred losses every year since at least 2012 except in 2013. Moreover, the business incurred a significant loss of €29.6 million (Arcadis share was half of this) in FY17 primarily due to the need to shift one biogas plant from one landfill to another landfill as the previous landfill did not have enough gas to run the plant.

- As a result of this significant loss, the NAV of the business (on a stand-alone basis) declined to negative €27.7 million in FY17. The company however still recorded the value of the business as a positive €15.4 million in its financials given the value of loans advanced to the entity and other fair value adjustments to its stake.

- While the company has been attempting to sell this business for a few years, in late FY17, the company suddenly changed tack and said that it will invest an additional €20 million in the business to get it ready for divestment before initiating the divestment process in 2H18.

- As such, the company appears to have significant financial exposure to a business that appears to have very little future prospects going by past history and effectively on the brink of financial collapse. The company’s total exposure to the entity and the associated risk can be summarised as follows:

Carrying value on the books of €15.4 million. This will have to be written off if the ALEN entity fails
Outstanding shareholder loan of approx. €29.2 million. This will become non-recoverable if the entity fails although no further write-off will be necessary as the value of this loan would be already written-off as part of the carrying value write-off.
Outstanding guarantees of €84 million provided to ALEN’s lenders. This is the most significant risk as if the guarantees get called in, the company will face a significant strain on its liquidity and asset base given its highly constrained liquidity situation as discussed earlier. While the company states that it has received cross guarantees from other shareholders of ALEN, the company is likely to be on the hook for a significant cash outflow regardless.
Planned investment of €20 million this year. If the entity fails, the entire additional investment would be wasted and would have to be written off further stressing the company’s liquidity position. The planned investment also appears to be a somewhat of a desperate measure to somehow dress up the entity for divestment as based on past history, the entity’s future prospects appear fairly limited.

- In summary, the company’s planned additional investment in the ALEN business appear to be a last-ditch attempt to get it ready for divestment. However, the prospects for such divestment appear meagre and could either result in a very low sale value or fail entirely, either of which could result in significant write-downs for the company and trigger significant cash outflows.
If the write-downs further impact EBITDA for covenant purposes, the company could find itself facing a covenant breach situation even if it is able to manage its net debt number as it has in the past. This in turn could trigger further significant liquidity issues.

- Post an approx. two-third sell-off in the stock over the period April 2015 – November 2016, the stock has since rebounded sharply by approx. 80% at peak and is still up almost 50% from its earlier nadir. While the earlier decline appears to have been driven to a large extent by the significant down-trend in the company’s organic growth profile, the subsequent bounce back in turn appears to have been a function of a positive inflection in the same metric. However, subsequent concerns around liquidity and Middle East collection issues have dampened sentiment a bit causing the stock to trend lower.

- As such, the stock is now trading approximately in line with its long-term averages in terms of both forward P/E and forward EV/EBITDA. Further, in terms of its peers, the stock also appears to be trading only at a slight discount relative to the historical average of the discount to its peers that it has typically traded at.

- However, a critical analysis of the company’s underlying fundamentals as discussed earlier suggest a company that is significantly weaker than that assumed by the market. As such, the recent rebound in the company’s stock and thus its valuation both in terms of its own history as well as in terms of its peers does not appear justified.

- As such, modelling the company in line with a growth trajectory of a very low but positive organic growth and gross margin (net revenue / gross revenue) in line with recent trends leads to forecast GAAP EPS of €0.93 for FY18 (consensus €1.04) and €0.99 and €1.07 for FY19 and FY20 respectively (compared to consensus of €1.31 and €1.51 respectively).

- While forecast revenue is in line (in fact, slightly ahead) with consensus, the key difference with consensus appears to be in terms of operating costs as the market appears to be assuming a significant improvement in the cost base over the coming periods. However, in line with our earlier analysis regarding the company’s profitability, we are assuming operating costs to remain roughly in line with recent periods.
- Using modelled EPS of €0.93 for FY18 and forward P/E of 10x (from 12.6x currently) leads to a stock price of €9.27, a downside of 41% from its current level of €15.71. In a similar vein, using modelled EBITDA of €202 million for FY18 and forward EV/EBITDA multiple of 6x (from 8.5x currently) leads to a stock price of €9.44, a downside of 40% from its current level. The blended average stock price turns out to be €9.35 giving a downside of 40% from its current level.
- The discount to the current multiples in terms of both forward P/E and forward EV/EBITDA appears justified given that the current levels for both the multiples are in line with the company’s long-term averages and thus do not appear to take into account the significant underlying weakness in the company’s fundamentals.
- Similarly, applying an exit forward P/E multiple of 10x to FY19 EPS of €0.99 leads to a stock price of €9.93 (€10.45 including dividends) and an IRR of 46% over the holding period till end 1Q19.

- Further, given the earlier discussed concerns regarding the company’s liquidity, it is quite likely that the company will need to raise equity capital in order to ease its intra-period liquidity strain and avoid a covenant breach. Per our analysis, the additional financing could range anywhere from 41-54% of the current market capitalization of the company. As such, any equity raise would be significantly dilutive and thus could lead to further significant downside in the stock.

- Thus, given the significant absolute downside and IRR potential from current levels and the potential for any equity raise to lead to further significant downside in the company’s stock, risk/reward appears firmly skewed in favour of a short position.

Risks to the Short Thesis / Position
- A key risk to the short thesis is that the new management chooses not to kitchen sink but attempts to muddle their way through the company’s profitability and liquidity issues over the next several quarters. As such, this could delay the crystallization of the short thesis as the market is likely to interpret this as an endorsement of the underlying health of the company by a new set of hands. However, given the severity of the underlying issues, i) it appears unlikely that the new CFO will assume responsibility for them, and ii) even if she does, this is only going to serve to push the short thesis out by a few quarters and the eventual reset could be even harder.

- Another risk to the short thesis is that organic growth in the company’s key geographic markets improves significantly across the board over the next few quarters. While the possibility of this appears somewhat remote given the state of affairs in the company’s markets, any such improvement would likely give the management enough leeway to postpone any immediate financial reset.

- The company is currently in the process of evaluating its options or its CallisonRTKL division and is more likely than not, to attempt a sale of the division. Should the sale go through, it could potentially help alleviate any liquidity issues in the near term and thus push the short case out further.

- The company’s collection issues in the Middle East have been a key overhang on the stock in recent periods. Significant positive news flow in this regard could be taken as positive and cause the stock to inflect positively in the near term.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


* Equity raise at Q2 or Q3 results

* Kitchen sink by new CFO

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