Connect Group – Potentially high-reward, potentially high-risk

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Connect Group (LSE:CNCT) has one business generating an operating profit north of £36m.  For a £71m market capitalisation company that is a substantial amount. And this operating profit, from the Smith News newspaper and magazine distribution business, has been consistently high (2014: £40.8m, 2015: £23.2m, 2016: £34.1m, 2017: £36.1m, 2018: £25m, 2019: £36.3m).

Smiths News has a 55% market share, and local monopolies all over the country.  Its only opposition is Menzies News, which tends to stick to its own newsagent territories. Entry into this line of business is very hard given the strengths of the two incumbents. Over 80% of publishers have already signed up to contracts with Smiths News for another five years.

If this business was the only one owned by Connect Group then, obviously, it’s a good share to buy.  Mr Market thinks because fewer physical newspapers and magazines are being bought year by year that SN will suffer greatly, and this has helped push down the share price.

I do not see good reasons for such pessimism in the numbers coming out of the company. Even though volumes of papers sold have gone down by 3-5% per year for a long time now, the managers have offset this by finding efficiencies, and cover prices have risen.

The main reasons, however, for Connect’s shares to be trading on a cyclically adjusted price earnings ratio of only 3.8 is not to do with Smiths News but derive from two large risk factors.

The first is that the Tuffnells parcel delivery business, bought for £139m in 2014, will continue to lose money hand over fist for years to come.

The second is that the Group’s high debt levels will become unsustainable should the cash flow of the Group decline substantially.  Bankers may not be understanding if the EBITDA-based ratios used for loan covenants are breached.  The nightmare scenario becomes possible if directors do not get a grip of the Tuffnells business and pay down a substantial proportion of Group debt.

My investment in Connect Group is a potential three-bagger or more if Tuffnells is turned around and Smith News continues to pump out large amounts of cash.  It is a high-reward investment, but it is also a high-risk investment because it is difficult to judge how successful the turnaround strategy is going to be.

In a diversified portfolio I’m prepared to take high-reward-high-risk investments on a win some, lose some basis. Overall, I’ll do fine. Other investors may find the risk too much.

In the next few Newsletters you’ll find some data and analysis on Connect. Please feel free to add your observations – we are all just feeling our way with this company (and that includes the managers in charge of Tuffnells).

(Previous newsletters: 29th Sept – 4th October 2017, 24th -29th January 2018, 19th May 2018, 14th June 2018 14th – 27th June 2018, 11th – 15th Dec 2018, 5th Feb 2019)

Brief descriptions of the businesses

The Smiths News business has a turnover of £1.3bn.  It negotiates 5-year £50m+ contracts with major publishers such as Reach and News UK.   Its vans make early morning deliveries with a highly predictable loads to 27,000 shops on fixed routes out of 39 depots.

Tuffnells has day-to-day dealings with 5,000 SME’s needing to shift 70,000 parcels per day. It has been so badly managed under Connect’s ownership that there is a great loss of customer goodwill.  Many able managers left the business, and attention to customer service, procedures and pricing drifted.

I’ve long assumed that the Tuffnells’ business has no value and so has not contributed to my estimate of intrinsic value of the Group.  But Tuffnells’ shock loss of £14m to the yearend on August 2019 makes me think that even a zero valuation is optimistic.  It might have to be closed down at some cost to the Group.  We’ll look at this business in more detail later in the week.

The attempted integration of the two businesses under the fo

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