Stockwatch: Can this stunning AIM share avoid hazards?

It's already had an incredible week, and overcoming headwinds could unlock significant gains. 

Is £150 million AIM-listed hazardous waste group Augean (LSE:AUG) shaping up as an outperformer – pretty much irrespective where the Brexit economy goes?  Or might it be chiefly a reflection of not paying sufficient landfill tax, where it is exposed to a tribunal next year?

Despite a 12-month survey showing a near 5% increase in British firms in significant financial distress, and generally subdued corporate reporting at best "in line", Augean has twice distinguished itself by guiding expectations higher.

"One of the UK's leading specialist waste management businesses," it reported in July that interim revenue before landfill tax was up 40% to £44.2 million and adjusted earnings per share (EPS) rose 114% to 7.6p – forecasts for 2019 expect 12.1p, up from 8.5p last year.

Then, on 16 October, the company asserted strong third-quarter trading, hence profit is now due "materially ahead" of the consensus for £16.5 million adjusted pre-tax profit – implying EPS of at least 13p or better.  While I've been writing, the stock has kept re-rating, rallying quickly from 118p on Tuesday to 150p today! However, potentially the base-case forward price/earnings (PE) is still just a modest 11.5x.  

Source: TradingView Past performance is not a guide to future performance

History shows variability and a lingering tax issue

The table shows quite variable performance and I’m aware of a bumpy past. I initially drew attention at 23p in April 2011, then again at 26p that December, following concerted buying by the directors following a sharp decline from 145p in 2007.

The lesson back then was sensitivity both to recession and bad weather, and revisiting my April 2011 piece I noted:

"some remaining uncertainty regarding provisions for landfill tax liabilities".

The price slump to 25p in September 2017 followed mixed interim results, including a 24% fall in volumes from energy/construction waste as the general election caused construction uncertainty. There was also underperformance by an infrastructure related "Colt" contract.

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But the damage was done by an HMRC assessment for £1.9 million landfill tax plus interest for the three months to end-August 2013. Augean stood its ground, saying:

"We believe this has been issued to protect HMRC against that period falling out of time, versus a four-year look-back."

However, the matter has persisted, with regular HMRC updates that have extended the time period to end-May 2018.

"This year's results are benefiting from a 20% increase in landfill volumes across all waste types, improved landfill pricing by a further 20%, increased radioactive waste profit and a good performance by both the treatment and North Sea businesses," Augean says.

The cumulative amount due approaches £8 million, and penalties may also be appropriate; the inference being that Augean is not charging landfill tax as it should, hence may be boosting its revenues versus competitors which are.  It's hard to interpret, partly because items involved aren't disclosed, nor the advice Augean has received. However, HMRC will have had its own advice too – and continues to see tax evasion.

It's ironic how management repeatedly insists it has the high ground on this taxation liability, but, since it's arisen, and despite operations recently beating expectations – with free cashflow ramping up – there's been no dividend.

Private industry recognises opportunities for investment

Coping with waste is a high-priority social service with growing technical demands and opportunities.  Well-executed, it has potential to contribute to a better environment despite some controversy over landfill operations.

Having followed smaller listed waste companies since the early 1990s, I am aware of takeovers: Waste Recycling Group emerged back then and, in late 2000, it acquired Hanson Waste Management for £185 million. It was then itself acquired by private equity for £315 million in June 2003.  

Interestingly, just three years later, it was acquired for £1.4 billion by Spanish construction and utilities firm FCC (and remains part of it). So, and with sterling pressured in the Brexit years, Augean may similarly be in the sights of acquirers were it not for this tax issue. Might a resolution flush out a bidder?

Landfill is a chief contributor to profits

Segmental results within the interims show incinerator ash constituting 17% of revenue, "other landfill" 24%, waste treatment 23%, radioactive waste management 5% (appears to involve part-landfill) and North Sea industry services 37%.  The latter have a much lower operating margin of 6.6% versus 31.5% for waste treatment/disposal – which quite begs a question, what special advantages are involved?

On the basis it is because Augean is astute at identifying and managing its owned landfill sites, then good: Private equity might consider buying the company and hive off its North Sea side to an oilfield services group. But if it reflects a smouldering taxation liability, then both historic and future profits need de-rating.  In fairness, the results show £8.2 million landfill tax paid, so the dispute appears to be what items are involved than not paying at all – but despite already representing 26% of treatment & disposal revenue, be aware such tax is rising.

Management cites its strong advances in profits as due to its "business optimisation programme delivered with cost savings considerably exceeding target."  The income statement shows a normalised operating margin of 14.5%, rising to 19%, helping operational cashflow jump from £4.9 million to £13.8 million – and the June-to-June cash balance has soared from £5.2 million to £25.8 million.

Any stock-picker worth their salt should be all over this, although wondering whether if that is the true bottom line, then why no dividend?  What sticks in my throat is landfill providing the jam, albeit with the sourness of a tax tribunal hanging over – that won't be resolved until a tribunal sometime next year. 

An interesting small-scale speculation

With the stock at around 130p when I started writing this piece, my 'buy' instincts were aroused by the 16 October update.  This Friday - 18 October - the price initially edged higher to 152p after news of an option to buy 90 acres of land adjacent to Augean's facility near Peterborough.

It is Augean's preferred choice to extend the facility's life to the mid-2040's, currently generating over £15 million revenue and £8 million operating profit a year, "aligning with the national need for hazardous landfill and soil treatment in the South of England."

This underlines how, if Augean wins its taxation case, it's developing a high-quality earnings stream at a time of national need for such assets. On that basis, its stock should re-rate and, if anyone wants to buy the business, a decent premium for control will be required.

If Boris Johnson next humiliates Jeremy Corbyn at a general election, the risk of Labour kyboshing such margins with further taxation should recede.  But, if HMRC wins the tribunal, then the higher this stock trades currently, the further it will fall.

Despite the rise – today's further mark-up settling back to 150p – the stock is an interesting speculation on the tax case; HMRC is by no means invincible and a compromise might be declared.  Once the tax issue is resolved, and so long as not too onerously, the stock gains attraction.

This business isn't immune to recession, but waste disposal has long-term attractions. Mind Augean shares are currently a step in the dark given you can't quantify what might be the ongoing tax liability; whether the company will have to stump up for the past or continues to fight in the courts.

I think there's a case for risk-tolerant speculators tucking a few away; maybe with patience when the price comes back a bit after the jump.  Disciplined investors should steer clear. The lack of dividend shows the board ultimately wary as to risks.  For those who appreciate the gamble: Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.