Description

Groupe Eurotunnel SE (GET.FP) – Long, E15/share 12-18 month target

Market Cap: E5.9b (Last Sale: E10.80; Shares Outstanding: 550mm)

TEV: E9.6b (E3.7b Net Debt)

3-month Avg Daily Volume: 1.2mm shares/day (E12mm)

Investment Type:  Value w/ soft catalysts

Investment Horizon: 12-24 months

Summary

Groupe Eurotunnel (GET.FP) is a quality infrastructure asset that is trading cheap on both an absolute and relative basis for several reasons that I believe do not impair the businesses intrinsic value much.  With a 12-18 month time horizon in mind, I believe the stock is worth ~E15/share, my base case NPV for the equity.

Why This Opportunity Exists

I believe GET.FP is trading well below its intrinsic value for a few reasons:

• Brexit fears – these fears remain, though I believe are reasonably baked into the current share price.  Moreover, in the long term, it’s debatable as to the extent a Brexit would have on GET.FP’s business.

• Migrant disruption and recent high profile terrorist events in Europe – unfortunately, many of these problems are here to stay.  That being said, many components of GET.FP’s business have proven fairly resilient in the months/quarters surrounding the Paris terror attack in November 2015.

• European macro fears – The European macro environment remains tenuous, however, recent lead indicators point to stability if not modest improvement in key end markets such as manufacturing and construction.

Valuation

Base Case: E15/share (+40%) – my base NPV, which assumes a ~7.5% WACC (~11% cost of equity, ~5% pretax cost of debt).  My base case assumes ~1% per annum GDP growth for both France and Britain going forward.

Down Case: E9/share (-17%) – ~15x 2016 EV/EBITDA under a down case scenario (i.e. slightly negative GDP growth in both France and Britain in 2016)

Bull Case: E19/share (+76%) – an up case scenario NPV, which assumes ~1.5% per annum GDP growth for both France and Britain in the forecast period.

Thesis

My long case for GET.FP is based on:

• GET.FP is a quality infrastructure asset that should be able to grow levered free cash flow at a >10% CAGR for the next decade.  GET.FP has a very high degree of operating leverage (estimated incremental operating margins ~65% on average for the next several years).  Additionally, capex runs ~50% of depreciation so free cash conversion is high.  Overall, assuming just modest growth in volumes I believe GET.FP should be able to compound free cash at a decent clip for many years to come.

• The competitive environment for GET.FP is improving and becoming more rational.  In particular, the Short Straits ferry market is consolidating with DFDS taking over MyFerryLink (which was formerly controlled by GET.FP) in the latter part of 2015.  This takeover resulted in a ~5% capacity removal from the market.  Today, the Short Straits market is controlled by 3 players - ferry operators P&O and DDFS, along with GET.FP.  During their Q1 report GET.FP confirmed that they had gained ~300bps of market share over the last year.  Given a more concentrated market, I believe a more constructive pricing environment is in the offing.  Indeed, during their February conf call, DDFS confirmed that in addition to pushing through H2'15 price increases the company was increasing prices in Q1'16.  This is a very good sign for GET.FP.  

• Several initiatives, including high-speed rail and ElecLink, offer longer term upside that is not captured by consensus estimates.  In high-speed rail, growth in volumes will be driven by the opening of new routes; for instance, a London to New Amsterdam route will open in 2017. And, ElecLink, slated to be operational by 2019, is a merchant power interconnector through the Channel Tunnel that will provide a transmission link between the UK and France with a capacity of a 1,000MW in either direction of flow.        

• GET.FP’s balance sheet will continue to de-lever and improve, and given strong growth in free cash flow GET. FP will pay an increasing dividend (per their last conf call GET.FP will pay ~70% of free cash flow as a dividend). Additionally, given the zero percent interest rate environment in Europe, GET.FP will in all likelihood have the opportunity to refinance debt at lower rates in the years to come.

Catalysts / Event Path

The key events for the stock over the next 12-18 months are:

• Brexit vote on June 23.  While plenty can change in the next two months, the odds makers are pinning a Yes Brexit vote as an unlikely event.  For example, Predictwise pins a No Brexit vote at 65%, and Paddy Power has a No vote at 1:3 odds (or 75%).

• Earnings results (next earnings in mid-July).  In short I’d hope for commentary and data that indicate resiliency in volumes following the Brussels terror attacks.  Additionally, Euro 2016 should provide a tailwind to Q2 / Q3 volumes.

• Refinancing potential in H2’16

• Continued modest deleveraging of GET.FP’s balance sheet in quarters to come.

• Eurostar (GET.FP’s largest customer) launches new service to Amsterdam next year

Business Description

GET.FP holds the concession (expiring in 2086) to operate the two rail tunnels beneath the English Channel, and the corresponding terminals in Folkestone (UK) and Coquelles (France).  The Channel Tunnel is the longest undersea tunnel in the world.  The three tunnels, each 50km long (the section under the sea is 38km long), were bored at an average 40m below the sea bed.

Eurotunnel shuttles, Eurostar and national freight trains run in the two single track and single direction tunnels.  These are connected to a central service tunnel by cross-passages situated every 375m.  The service tunnel allows access to maintenance and emergency rescue teams and serves as a safe haven if passengers need to be evacuated in an incident.

The two rail tunnels are 7.6m in diameter and 30m apart.  Each rail tunnel has a single track, overhead line equipment (catenary) and two walkways (one for maintenance purposes and the other for use in the event of an emergency evacuation and on the side nearest the service tunnel).  The walkways are also designed to maintain a shuttle upright and in a straight line of travel in the unlikely event of a derailment.

The service tunnel is 4.8m in diameter and lies between the two rail tunnels 15m away from each of them.  In normal operations shuttles use the south tunnel in the France – UK direction, and the north tunnel when travelling from the UK to France.

Covering an area of 650-hectare and 23-km long perimeter, the Coquelles terminal, near Calais, is one of the largest land-travel complexes in Europe (the equivalent in size to an international airport).  The Folkestone terminal, located at 8 km from the undersea tunnels at Shakespeare Cliff, covers a 150-hectare area, i.e. about one third of the area of the French terminal.

Both terminals are easily reached through their direct access to the motorway network in the UK (M20) and in France (A16).  They both represent the loading and unloading points for vehicles travelling on Eurotunnel Shuttles.  Access to the terminals is made through tolls, for passenger vehicles and for trucks.  Once check-in operations done, in just a few seconds especially via the self check-in system, customers must go through border controls carried out by British and French police and customs.  All controls are carried out before departure in order to enable customers to continue their journey directly on the motorway network on the other side of the Channel.  Passengers then have the opportunity to take a break at the Victor Hugo terminal in Folkestone or at the Charles Dickens terminal in Coquelles (shops, restaurants, play area, etc.) or to drive towards the allocation areas before reaching the 12 platforms area, each 1-km long. There vehicles can drive on Le Shuttle for passengers (cars, coaches, camper-vans, caravans, motorcycles, etc.) or on the Truck Shuttle (heavy goods vehicles).

The Channel Fixed Link generates revenues from:

• Fees from third-party railway operators using the infrastructure (regrouped under the Railways division): primarily Eurostar, but also some freight train operators. Fees are mainly composed of tolls (according to traffic), fixed usage charges and contribution to operating costs. As a monopoly, this is a regulated business and fees can increase annually by a maximum of inflation – 110bps.

• The operation of Shuttles carrying cars, coaches and trucks. This business is directly operated by GET (which therefore takes the operational risk in full) and in direct competition with the ferries operating between Dover and Calais. Therefore, the pricing is unregulated.

The Fixed Link concession accounts for two-thirds of revenues and more than 95% profits.

GET.FP also runs Europorte, a rail freight business comprised 6 subsidiaries: Europorte France, Socorail, Europorte Proximité, Europorte Channel, GB Railfreight and Bourgogne Fret Services.  Less than 5% of GET.FP’s operating profits are derived from Europorte.

GET.FP is run by Jacques Gounon.  Mr. Gounon was a board member and Chairman of TNU (the name of the company pre-2007 restructuring) since 2004, and moved in to the position of Chairman and CEO in June 2005.  

Risks

The main risks to GET.FP are:

• Decline in UK / France GDP as traffic is largely a function of economic growth over time.

• Great Britain exits the Eurozone.

• F/x movements.  Specifically, that the GBP depreciates vs the EUR.

• Damage to the Tunnel.  Notably, the Tunnel has been damaged by fires several times since opening.

• Further disruption from migrant activity and terrorism events.

• Pricing competition emanating from the English Channel ferry market.

• Multiple compression – in a risk-off environment GET.FP could suffer disproportionately given its highly levered balance sheet.

Financial Overview

Catalyst

• Brexit vote on June 23.  While plenty can change in the next two months, the odds makers are pinning a Yes Brexit vote as an unlikely event.  For example, Predictwise pins a No Brexit vote at 65%, and Paddy Power has a No vote at 1:3 odds (or 75%).

• Earnings results (next earnings in mid-July).  In short I’d hope for commentary and data that indicate resiliency in volumes following the Brussels terror attacks.  Additionally, Euro 2016 should provide a tailwind to Q2 / Q3 volumes.

• Refinancing potential in H2’16

• Continued modest deleveraging of GET.FP’s balance sheet in quarters to come.

• Eurostar (GET.FP’s largest customer) launches new service to Amsterdam next year