Executive summary RPC (RPC LN) Manufacturing weaker returns. Sell. Northern Trust Capital Markets NTAC:2SE-18.

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1 Executive summary We believe RPC is a business that is stuck in a structurally weak position, caught between a weakening relative price position with customers and its labour cost inflation. These trends will worsen we think. It is our view that management is using a dramatic step-up in acquisitions in the last 12 months (10 deals and a doubling of revenues) and some of the most aggressive accounting we have seen, to help mask these risks. Given a history of weak free cash flow generation (FCF) and a levered balance sheet, RPC s acquisitions require rights issues and therefore, a compelling equity story. This is an equity story the sell-side has been very bullish on for many years, perhaps because of underwriting deal fees on offer. Multi-year restructuring programmes and acquired synergies have delivered surprisingly little real gains in true net income or FCF in our view. Innovative management incentives and definitions of returns on capital or return on assets, are encouraging value destructive deals we think. This can be clearly recognised in the erosion of returns on capital, which on our analysis, are now well below the cost of capital. After the FY16 accounts, where the raw material tailwind effect failed to materialise, management sold a significant amount of stock. In H1, this tailwind effect was even weaker on our analysis. We think consensus assumes the drag from one-off costs disappears and adjusted profit matches the true underlying profit figure. We disagree and believe that a strategy to buy industry peers in other segments or geographies, with modest synergies, doesn t alleviate structural threats of pricing power and cost inflation, it just reinforces them. We accept that a rights-issue funded, value destroying roll-up story can continue to report adjusted EPS growth for as long as shareholders are willing to fund it. But should the hitherto supportive appetite for rights issues fade, we think shareholders will find a structurally challenged, low margin, highly levered, sub cost of capital business trading on c.23x Mar-18 P/E on our estimates, an undeserved 50% premium to the market. The unusually poor reaction from the market to a recent large acquisition suggests to us that cracks in the story are beginning to appear. We think it is best to get out now. Sell. Northern Trust Capital Markets

2 Problem #1: Raw materials what happened to the tailwind effect? RPC is a manufacturer of rigid plastic packaging through various moulding processes (e.g. blow, injection) for a range of industries mostly in the UK and Europe (23% and 64% of sales respectively as at Mar 2016, as per the FY16 annual report). Food, beverages and personal care comprise 56% of sales, but the group has been very acquisitive and is expanding into new territories and segments. In simple terms, RPC turns polymer-based raw materials like polypropylene (PP) and high-density polyethylene (HDPE) into plastic containers for various customers. Raw materials comprise RPC s largest input cost, at c.48% of sales (FY16 annual report). The vast majority (c.30-40% of sales, depending on the year) comes from PP and HDPE. The theory goes that in a period of falling raw materials prices, RPC gains from the lag in the pass-through of the price movement to customers, while it loses when prices rise. The company explained to us that c.70% of sales is on a contractual three-month lag, the rest is on spot (no lag). This schematic from the 2013 Capital Markets Day (CMD) below explains the lag thesis. Figure 1: Impact of polymer price pass-through Source: RPC Capital Markets Day 2013 presentation Based on the Bloomberg (Nexant) prices for the two main polymer ingredients, assuming a two-month lag (70% on 3m, 30% on spot), we ought to have seen a tailwind in the polymer price pass-through during the whole of RPC s Mar 16 financial year. We believe the predominant material is PP and to a lesser extent HDPE. Northern Trust Capital Markets

3 Figure 2: YoY change in key input costs Source: RPC, Bloomberg, NTCM Research When the PP price is falling, the EBIT effect should be positive, as seen above in FY15. But in H1 of FY16, this relationship broke down, i.e. there was an EBIT headwind when PP prices fell. This may be explained by more HDPE in the mix. What is more notable we think is the strong price falls (on our analysis) in PP did not lead to strong EBIT gains in H1 of the current financial year (H1 in yellow). Graphically, based on the Bloomberg data, the YoY changes for the half-years, converted into EUR, look as follows. Figure 3: YoY price changes in EUR Source: Bloomberg (Nexant) prices, Western Europe (converted from USD to EUR at month-end spot rate); NTCM Research It is worth noting here the currency effect. Above, we have calculated the prices in EUR, but c.25% of the business is in the UK and owing to a lack of UK polymer production, polymers have to be purchased in Europe (EUR) for customers that Northern Trust Capital Markets

4 buy raw materials in GBP. In our conversation with the CFO (call 21 March 2017), he put this lack of pass-through tailwind down to a weak GBP. But using the Bloomberg data, prices in GBP for PP and HDPE are still down YoY, -16% and -2% YoY respectively there still should have been a strong tailwind in H1, when only a weak one was evident ( 3M on EBIT). Figure 4: YoY price changes in GBP Source: Bloomberg (Nexant) prices, Western Europe; NTCM Research A comparison of our price charts with the price charts supplied by the company show different headline prices, but a similar trend YoY. Note the company s comment re stable pricing in H1 (as below) is true through the period, but fails to acknowledge the YoY changes which are important to EBIT headwinds or tailwinds (i.e. in Sep-16, there ought to be a very significant tailwind for EBIT). We would regard this statement as somewhat disingenuous. Northern Trust Capital Markets

5 Figure 5: Pricing not stable YoY Source: RPC September 2016 presentation Figure 6: Polymer prices calculated in EUR from Bloomberg data Source: Bloomberg, NTCM Research We acknowledge trying to replicate the company s true polymer cost base from Bloomberg data could be inaccurate. However, the disclosure from the company in the annual report provides strong evidence for a significant tailwind from polymer pricing per se. As a percentage of sales, polymer resin costs fell from c.40% of sales in FY15 to c.30% in FY16 (see below). Northern Trust Capital Markets

6 Figure 7: Commentary on polymer costs as a percentage of sales Source: RPC FY15 annual report (our highlights in yellow) Source: RPC FY16 annual report (our highlights in yellow) By historical standards, a fall from c.40% to c.30% is a big tailwind for RPC YoY, when viewed against RPC s history of polymer costs as a percentage of sales (Figure 8). Figure 8: Polymer costs as a % of sales Source: RPC Sep-12 interim presentation (breakdown no longer given) In the past, polymer resin price moves have been reflected in materials costs. As we can see from the detailed disclosure from the annual reports, the raw materials and consumables costs as a percentage of sales also rose 600bps, just as polymer costs did as per the above graphic. Northern Trust Capital Markets

7 Figure 9: Analysis of costs as a % of sales Source: RPC, NTCM Research [As an aside, note how in FY11, a steep rise in raw material costs of 600bps was offset by a significant cut in staff costs of c.300bps, a reduction in other external charges of c.200bps and a change in the depreciation schedule equal to 130bps assumed assets lives were extended, as part of the harmonisation of the accounting policies and estimates for the enlarged Group, the depreciation period for production machinery has been aligned from 7.5 years to 10 years. Without these changes, the impact on net margins, after all costs, would be been much worse. Note the assumed lives were extended further in FY14 to 12 years, see later.] Below, we set out the theory of how a significant reduction in raw material costs, when passed through LFL to the customer, should lead to strong margin gains. We have used 100 as the theoretical base sales, assuming a 20% fall in polymer pricing YoY, i.e. from 38% of sales to 33%, in-line with the approximate numbers from the annual reports. Note the rise in gross margin by 500bps (from 62% to 67%). Northern Trust Capital Markets

8 Figure 10: Theoretical COGS impact on gross margin Source: NTCM Research Since RPC reported effectively no change in gross margin, one explanation is that non-polymer COGS rose if we assume a perfect raw material pass-though. Figure 11: Theoretical impact on non-polymer COGS Source: NTCM Research Management declined to disclose to us what the precise figures for polymer costs as a percentage of sales were in FY15 and FY16, nor what the YoY polymer price fall was explicitly. The CFO s explanation for the lack of margin gain was down to the raw material mix from the acquisition of Promens, with a higher percentage of raw material costs in the mix. In other words, Promens is a much lower gross margin business (to make the maths work, it would need to be about 800bps lower in gross margin on our analysis). This would explain why raw materials and consumables as a percentage of sales remained basically constant in FY16 at 48%, but it doesn t quite square with the commentary in the FY16 annual report about polymer costs falling to approximately 30% from 40%. In any case, a weaker margin/mix effect of Promens will drop out of the base in H1 17 (given the acquisition closed in Feb 2015) and therefore does not explain the weak tailwind effect in H1 17 in our view. We believe this reflects a weakening pricing power position. We would expect pricing power with customers to become more problematic in future. RPC has 6% market share in Europe, its largest market (far less in the UK, EU and US combined given its low share in the US). Its top 10 customers represent 20% of sales. Note in the recent acquisition of Letica the top ten was 46% of sales (source: RPC presentation Northern Trust Capital Markets

9 on the Letica transaction) i.e. much greater risk going forward in theory we think. These large brands are increasingly following the best practice lead of the likes of Heinz and ABI we think, implementing zero-based budgeting disciplines, putting increasing pressure on suppliers of commodity products. RPC is developing higher value-added products in its portfolio which are not commoditised we think, but these still represent the minority of sales (32% when last reported in FY13 presentation). RPC and its competitors are suppliers of critical products into the supply chain of customers, which are a very small percentage of the cost of the end product. However, customers, especially high volume ones, have a more powerful pricing position than RPC we think, owing to how fragmented RPC s competitive landscape is. Whatever the real cause of the weakening pass-through tailwind, be it mix, pricing power, or other cost inflation. This heralds problems ahead we believe when operating margins are c.7% (the company s adjusted EBIT margin at H1 17 was 11%, but after all costs, this figure is 7.5%). Northern Trust Capital Markets

10 Problem #2: Labour costs they are rising again RPC (RPC LN) While raw material costs requires a lot of analysis to understand, labour costs are more straight-forward to observe. This is RPC s second biggest cost, and like raw materials, it is large compared with the operating margin of the business. As we highlighted in the previous section, RPC took action on staff costs when raw materials rose substantially in FY11, but since FY12, costs are beginning to rise as a percentage of sales. Figure 12: Key costs vs sales Source: RPC, NTCM Research Owing to the high proportion of production labour (85% of total) at RPC i.e. largely low-skilled, we think the only way for RPC to reduce this problematic inflation is to announce more job cuts and plant closures. This has been done in the past, but in our view has been very expensive, and with only temporary benefits. After the financial crisis cuts, costs as a percentage of sales are rising again. Northern Trust Capital Markets

11 Figure 13: Analysis of staff costs Source: RPC, NTCM Research We view this as a greater risk in future. We have observed other companies, especially in the UK and US, talk about problems not just in the like for like increase in wages (owing to minimum wage changes in various US states, national living wage changes in the UK, hikes in Germany) but increasing hiring costs and low-skilled labour churn on account of labour shortages. Ashtead has talked about 5% blue-collar wage inflation in the US and UK in their Mar-17 Q3 conference call, while Aryzta (in their 26 Jan 17 profit warning conference call) referenced actual changes for their business towards double-digit increases YoY. We also believe that headline wage inflation statistics from statisticians also do not account for mix changes resulting from an increase in self-employment amongst higher earners, which has the effect of depressing the YoY change. When we asked the CFO how rising wage costs would be dealt with, the response was to: Raise prices at the end of the completion of pass-through contract terms, usually 1-5 years (70% sales); and Hold onto more of the tailwind from spot price falls in polymer prices. In other words, RPC will pass these onto customers. We doubt that high volume food, beverage and personal care companies will accept that we don t believe RPC s industry has pricing power. In any case, it is not happening, staff Northern Trust Capital Markets

12 costs as a percentage of sales are rising. To expect price falls in polymers as a strategy for managing wage costs seems extremely optimistic to us. Besides, as we discussed in the previous section, the pass-through tailwind has shown clear weakness on our analysis. When total staff costs are 25% of sales and grow at 5% per annum, it only takes six years to wipe out a 7% operating margin all else being equal. This is a key reason we believe more restructuring costs loom. And it is for this reason we believe adjusted EBIT and adjusted EPS headline figures are inappropriate metrics to use. Northern Trust Capital Markets

13 Problem #3: Synergies gains not sticking RPC (RPC LN) RPC has had a restructuring or synergy programme in place every year since These do actually lead to headline gains, albeit with relatively high one-off costs in our view. We have analysed the reported YoY Business Improvement gains disclosed in the profit bridge since the Sep-14 interim report. After significant net gains above the synergy savings, at the most recent Sep-16 report the business improvements reported were less than what the synergy programme reportedly delivered (Figure 15). As per the interim reports, savings from the Promens/GCS/BPI programmes were 9.4M at Sep-15 (so 19M annualised) and 56M as at Sep-16 ( 47M), so a gain of 28M cf. 21M in the profit bridge (below). This is a significant deterioration in the trend. We think this miss in savings on a net basis represents a new challenge. Where are savings going to come from in future? Figure 15: Business improvements below synergy gains Source: RPC Sep-16 interim presentation In our discussion with the CFO, the explanation for this was extra costs associated with extracting synergies from acquisitions, specifically GCS in this case. In order to get the polymer procurement gains through increasing flexibility, RPC has to invest in the form of new trials, which lowers the productivity of the production equipment, holding back margin. Northern Trust Capital Markets

14 Aggressive accounting: painting a rosy picture over FY11 to FY16 We think RPC s reporting of key metrics is notable for its size, breadth and consistency of overstatement versus what we calculate under GAAP metrics. The phrase adjusted appears consistently. There have also been multiple definition changes over the years. Revenue growth: this used to include the polymer price effect (Hexpol also does this), but the definition was changed in FY15 to adjust for the polymer price effect (we think it is because it stopped boosting revenue growth, i.e. polymer prices stopped going up). This is not an audited figure and there is no way to check organic revenue growth and, besides, the company is a serial acquirer. Operating profit: adjusted EBIT, excludes the costs of restructuring, impairments, exceptionals (provisions), nonunderlying costs and amortisation of acquired intangibles. Adjusted EPS: as per EBIT, while the bonus element of multiple rights issues requires a rebasing of the previous year s EPS. Free cash flow: adjusted for restructuring costs and cash provision charges. Leverage: based on adjusted EBITDA (excluding many costs). ROCE: like many low EBIT margin businesses we have analysed, the company s definition is pre-tax and based on adjusted EBIT (before many exceptionals). RONOA: this is a metric we think is pointless for a company that since 2013 has added 70% more goodwill/intangible assets than tangible assets. It is defined as adjusted EBIT divided by PP&E and working capital. Note if an acquisition has written off PP&E, then its RONOA will look very attractive indeed. Below is a reconciliation between the reported (adjusted) net income and our view of the true net income. Northern Trust Capital Markets

15 Figure 16: Reconciliation between reported net income and net income after all costs Source: RPC, NTCM Research Perhaps the best way to show this is to chart the company s adjusted headline figures versus the actual reported. We think the gap between adjusted and underlying shows a consistent trend. Northern Trust Capital Markets

16 Figure 17: Reported vs underlying EBIT Figure 18: Reported vs underlying EPS Figure 19: Reported vs underlying FCF Source: RPC, NTCM Research Northern Trust Capital Markets

17 Return on capital: this requires extra work, therefore we are showing annual figures only. Owing to the late acquisitions (February or March close) in FY15 and FY16 (and FY17 as well), the denominator includes the full contribution of the capital but only a small contribution to returns in the year. Therefore, we have decided to calculate returns based on the starting invested capital for the year rather than the average i.e. full contribution to the period of the profit acquired and grown organically in the period for no increase in the capital base. Even on this basis, RPC does not meet what we would view as a minimum cost of capital (8%). RPC has a very different calculation method for ROCE (before a high amount of exceptional costs as well tax), one we strongly question. It is clear though, on the company s and our definition, returns are falling it is buying in weaker returns businesses in order to grow. That is poor allocation of capital in our view. In our discussion with the company, the CFO said if RPC maintained its previous 20% ROCE target (RPC s definition) it would shrink itself out of existence, we are not about tweaking and refining margins, we are about growth. That seems to be a good summary of how senior management thinks about the trade-off of growth and quality we think, i.e. it s okay to destroy value if you grow. We discuss this further in the management incentives section, incentives which encourage this behaviour we think. Figure 20: Reported vs underlying and cash returns on capital Source: RPC, NTCM Research [In our definition of ROIC and cash ROIC, we use after-tax measures, i.e. NOPAT and unlevered FCF respectively in the numerator; the invested capital (denominator) we define as total assets, plus capitalised lease costs, plus accumulated goodwill impaired, less non-interest-bearing current liabilities.] The core assumption an investor has to grapple with is whether these one-offs from cost savings programmes, synergies, provision releases and other programmes will cease. We are inclined to think not, based on history alone let alone risks from lack of net synergy savings and raw material and wage inflation discussed earlier. Northern Trust Capital Markets

18 Free cash flow reporting this deserves a special mention Not only does the company exclude many so-called one-off costs, it has changed its definition of free cash flow (FCF) twice in the last two reports, boosting it from our view of the underlying position. We can actually say this because the company recently started giving a reconciliation of FCF to net debt. However, the basis for these improvements actually defy accounting logic. We think this takes things beyond aggressive, into the highly questionable. We have not encountered such innovative reporting in our research before. The company is adding back non-cash provision movements and other non-cash items to Cash from Operations, boosting FCF then taking these same amounts off again below FCF, in order to reconcile with the cash balance. The fact that these items appear between FCF and change in debt resulting from cash flow proves there are cash expenses. The labelling of non-cash is simply wrong we think. Northern Trust Capital Markets

19 Figure 21: Misleading labels in cash flow statement in our view Source: RPC September 2016 interim report (our highlights in yellow) Northern Trust Capital Markets

20 By comparing the Sep-16 interim report with the 2016 annual report, we can see that: the FCF figure for FY16 includes a non-cash item also wrong we think, as well as the label Less: (it should be add ); and the 109M in FCF below was revised higher to 122.6M as at the Sep-16 interim report (above). Figure 22: Previous FCF reconciliation Source: RPC September 2016 annual report (our highlights in yellow) We believe this definition of FCF has something to do with making sure management hit the Board s FCF targets so management bonuses are not reduced (more on incentives later). We are surprised to see this definition in the audited accounts. Northern Trust Capital Markets

21 Acquisitions: 10 deals and a doubling of sales in less than 12 months Even by RPC s acquisitive standards, the deal activity over the last 12 months is simply remarkable. By our calculations, if we include the acquisition of GCS which closed on the second-to-last day of FY16, RPC has made 10 acquisitions, three in H1 17 (c.60% of FY16 s sales base) and seven in H2 17 (c.45% of FY16 s sales base). Figure 23: Flurry of deal activity Source: RPC, NTCM Research In our conversation with the CEO (call on 2 March 2017), he mentioned that private equity was keen to recycle deals post the crisis and so there was a tsunami of opportunities. Also, the CEO was keen to make sure RPC was the largest consolidator in Europe (with 6% market share) and that there was no listed rival in Europe in plastic packaging. This does not strike us a strong rationale and we can t help think this has something to do with trying to acquire to offset structural issues, as well as improve adjusted EPS growth, a key incentive target. It is worth mentioning at this point, a large acquisition closing near the end of the financial year in each of the last three years (Promens closed 20 Feb 2015, GCS 30 March 2016 and now Letica 13 Mar 2017) makes it very difficult to highlight the important working capital trends, since we have the full allotment of receivables, payables and inventory on the balance and very little sales in the period. Northern Trust Capital Markets

22 Weak historic cash flow means extensive funding from shareholders What is odd to us is that from FY11 to FY16, for a business that claimed organic growth of 3-5% (5% in FY12, not disclosed in FY13, 4% in FY14, 4% in FY15, 3% in FY16) achieved cumulative cost savings of 55M acquired the equivalent of at least 124M of EBITDA (using just the EBITDA disclosed for Superfos, M&H, Helioplast, Ace, Promens acquisitions, i.e. before the end of Mar 2015) FCF (our definition) increased from 26M in FY11 to just 50M in FY16. The accounts show very little progress in real cash terms on our analysis. Note the amount of cumulative equity and debt raised cf. cumulative FCF. Figure 24: Limited cash flow generation on our analysis Source: RPC, NTCM Research As we can see above, there has been a sharp increase in the amount of equity and debt raised. On a cumulative FY12-16 basis, the dividend has not been covered by FCF. Actually we find the idea that RPC is a dividend payer at all highly ironic. The charts of EPS and DPS growth look attractive (see below), but they are not truly representative of the growth in free cash flow of the business or the flow of cash between the company and investors. From FY12 to FY16 inclusive, RPC has raised 3.6x the equity it has paid in dividends. A company that demands such equity injections from Northern Trust Capital Markets

23 shareholders should not be paying a dividend we think. And since then, there has been a subsequent 552M rights issue. Figure 25: RPC s representation of EPS/DPS growth Source: RPC Capital Markets Day 2015 presentation Northern Trust Capital Markets

24 The role of the sellside: supportive, but conflicted we think It is rare to find a company where the sellside is so consistently bullish for so long. In the last five years, there have been 100% buy ratings according to Bloomberg for all but four months. These analysts have been right, the stock has done very well. But there are few sceptics on the sellside it seems. Figure 26: Analyst recommendation history Source: Bloomberg Now that RPC is close to a 4B market cap business, deal fees are getting to be significant for the investment banking departments of the sellside if we assume an average 4% underwriting fee. Below is a history of rights issue underwriters. Figure 27: Rights issues to fund deals Source: RPC, NTCM Research Northern Trust Capital Markets

25 Sellside enthusiasm for a rights issue driven rollup story can be self-fulfilling of course a bullish rating on a stock, leading to a premium valuation relative to targets, leading to accretive deals on paper when targets are acquired, leading to higher adjusted EPS growth, leading to a bullish rating, and so on. Northern Trust Capital Markets

26 Management incentives: innovative, lots of adjustments and hurdles lowered It is not just the sellside in our view that is helping conditions for acquisitions. Management incentives reward acquisitions. To simplify an otherwise complicated bonus and share-plan scheme, two basic things may be happening we think: costs of acquisitions, synergies and provisions are not included in the PBIT/EPS hurdle rates and sometimes the PBIT/EPS is not adjusted for the acquired profit (i.e. acquired growth counts); and when acquisitions result in the failure of group ROCE hurdle rates to be achieved for that year (normally causing annual bonus deductions), the effect of these acquisitions is excluded, in order not to penalise the participants and discourage the directors from making acquisitions that were beneficial to the Group in the future. Therefore, not only is management reporting adjusted ROCE that is substantially above what we would consider reasonable, the metric used to compare against the threshold in the annual bonus plan awards has upward adjustments to the reported ROCE. This disclosure is given as a footnote in the notes of the accounts (in small font, highlighted in yellow below). Figure 28: Redefining ROCE in the small print Source: RPC FY16 annual report Northern Trust Capital Markets

27 What strikes us as puzzling for an acquisitive company is not only does the returns metric fail to take into account the price paid (RONOA is adjusted EBIT divided by PP&E and working capital it excludes goodwill and other intangible assets), but also that when reported targets are not met, acquisitions get excluded or included to help meet the targets. And these ROCE hurdle rates have shown a consistent downward trend (see Figures 20 and 30). Goodwill should be included in acquisition criteria we think. Since the CEO took over in May 2013, the business has acquired 1.7x more intangible assets than tangible assets. RPC now has a larger value of intangible assets in its balance sheet than tangible fixed assets. Figure 29: Growth in intangible assets vs tangible assets Source: RPC, NTCM Research As a consequence, while the company s RONOA trend looks positive, the ROCE trend does not. Northern Trust Capital Markets

28 Figure 30: Company RONOA vs ROCE Source: RPC FY16 annual report The company s ROCE targets have been revised steadily lower (Figure 30). The Board used to have a 20% ROCE (company definition) target as recently as FY12. However, this has been steadily revised lower as follows. FY12: on track to achieve 20% for FY14 FY13: aim to achieve 20% in a non-recessionary environment (the company blamed the recession for missing the target as at H1 results) FY14: maintain 20% through the cycle for the 2013 pre-acquisition business portfolio FY15: ROCE impacted by increased goodwill (target dropped) note the bonus plan would see an 8% reduction if ROCE is below 18.7% FY16: no target, but in the bonus plan, a 12.5% reduction would apply if ROCE below 14.3% The rationale from management for taking out return-destroying acquisitions from the ROCE hurdles has been consistent over the last three years. As quoted above, the company does not want to discourage the directors from making acquisitions. The reported (company definition), revised and threshold ROCE for the last three years are as follows. The threshold ROCE is the level required to meet in order to escape deductions to the annual bonus plan. Northern Trust Capital Markets

29 Figure 31: ROCE reported cf. threshold ROCE and ROCE other adjustments Year Threshold Reported Applied Pre acquisitions Notes FY % 18.7% 18.7% 20.2% Below threshold if depreciation change * not made, amortisation and pension admin charges not excluded FY % 14.8% 19.5% 19.5% Used the pre-acquistion ROCE FY % 15.7% 15.7% 13.3% Chose to be consistent w ith adj EBIT, i.e. include Strata and Innocan, but exclude GCS * Useful life of production machinery extended from 10y to 12y in FY14, was extended from 7.5y to 10y in FY11 Source: RPC, NTCM Research In our view, when the reported ROCE is below the threshold, it appears that the Remuneration Committee seems to apply a different ROCE in order for the threshold to be exceeded. In FY15 this involved excluding acquisitions. In FY16, this involvement excluding one acquisition but including two others (excluding all acquisitions would have resulted in the threshold not being met). Overall, we would say it appears that a relatively large component of bonuses/incentives in compensation for senior management in FY16, 4x base salary for the CEO and 3.5x base salary for the CFO (as per the annual report). Northern Trust Capital Markets

30 Senior management share sales On 13 July 2016, the CEO and CFO sold 1.4M and c. 700k worth of RPC shares (168,953 and 86,754 shares respectively) that had been awarded under previous years option schemes (Source: Bloomberg, RNS). Both managers still hold shares in the company, in the CEO s case, approximately 390,000 shares (c. 3.6M in value at the time of writing). However, the share sale last year, on the day of the AGM, still represents a significant absolute amount in value and relative to the share awards. The CEO is the longest serving member of the Board and management, joining as CFO on 1 Nov 2007 and promoted to CEO on 1 May Northern Trust Capital Markets

31 Extensive provisions There is also a relatively large balance of provisions on the balance sheet. We have consistently seen utilisation of these provisions through the cash flow statement (treated as exceptionals by management). These are largely acquired provisions, which may be helping create a cushion for management we think (they are excluded from the EPS calculation). However, a bit like working capital trends, acquisitions made towards the end of the year do skew this ratio, i.e. a full balance sheet contribution of the provisions vs a part contribution to earnings before tax, so it is difficult to be categorical about the ratios but we think it is worth pointing out the trends. Figure 32: Growth in provisions Source: RPC, NTCM Research Northern Trust Capital Markets

32 Our view on sustainable margins, 4.5% net margin RPC (RPC LN) In our view, there are weak safeguards to prevent overpaying for acquisitions. By using a definition of ROIC that makes returns look higher than we think they are, it is easier to make acquisition meet the cost of capital hurdle (8% pre-tax is the hurdle according to the CEO) than using a more conservative metric. So when we see a dramatic step-up in acquisitions (a doubling of the business through 10 acquisitions in the last 12 months), a buildup of provisions, aggressive accounting and management selling stock, we are inclined to think the underlying margin of the business is actually in decline. The most critical assumption we think on the valuation of RPC shares, is the repeatability of one-off costs and therefore where the true underlying net margin turns out to be. We have laid out in this report the gap between reported and underlying earnings and FCF. But the proforma sales for Mar-18, with the full run-rate of acquisitions, will be more than double FY16 in our estimates. So will the post-all-costs margins we have consistently seen in FY11 to FY16 be maintained, or will the leakage from restructurings, provision releases and other one-off costs disappear? We believe the corporate behaviour we have seen over the last five years will persist and any respite from restructurings will be short-lived. This is owing to: The raw material pass-through weakness we think we have observed; The rising wage inflation risk; The recent lack of progress on cost savings on a net basis; and The acquisition of fundamentally similar businesses with, in our view, few synergies. Fundamentally, RPC is growing very fast through largely a plug and play approach as management likes to say. In other words, there is little actual integration, existing management teams stay, minimising execution risk but, synergies are modest, just polymer procurement and some head office admin savings we think. The CEO is like a fund manager picking stocks, RPC is picking market segments and teams (as mentioned in a promotional video on the company s website) rather than being intimately involved in extracting large synergy gains in our view. So unless these acquisitions are very cheap and/or higher quality than RPC, we think the business is looking at a similar margin profile as in the past, perhaps slightly higher margin, but also possibly lower given the headwinds we are pointing to. In our discussions with the CFO, he did not expect margins to grow much from current levels in future. With respect to the Letica acquisition, it shows high customer concentration (46% sales from top 10 customers, vs c.20% of sales for the existing business, as per RPC Letica deal presentation) and synergies that will come from slashing benefits over next two years (risking employee churn). That ought to be worrying for investors we think. RPC has been a 1% to 4.5% net margin business over the last five years, after all costs. At the Sep-16 interim report, net margins were 4.2% (an improvement from the 3.5% in Sep-15). If we take into account the pro forma acquisitions and assume a 4.5% margin in FY17 and FY18, RPC would be trading on 30x Mar-17 P/E and 23x Mar-18 P/E on our estimates. Like any low margin business, the valuation is very sensitive to small changes in margins, up or down. But Northern Trust Capital Markets

33 such a valuation is a significant premium to the market, undeservedly in our view, given the challenges we see, the leverage (2.1x clean net debt/ebitda in Mar-18 on our forecasts), and low returns on capital. We have not gone into detail forecasting FCF, our preferred metric, simply because the size of the company is about to double and it isn t possible to have a view on working capital trends with any confidence. Before these acquisitions, i.e. at FY16, we have noted some weak working capital and the step-up in the level of provisions relative to tangible assets. It will however be interesting to see how the balance sheet looks at the year end. Northern Trust Capital Markets

34 Why sell now? We acknowledge that our margin assumptions for FY17 might be too low, perhaps boosted by a lack of restructuring costs (but something we think is inevitable eventually). There is room for further acquisitions, as banking covenants are 3.5x adjusted net debt/ebitda, very generous indeed. But on balance we think the step-up in acquisitions is about masking threats from pricing power and cost inflation. The reporting is getting more aggressive, not less. Management has also been selling stock. The market reaction to the recent acquisition was negative, the stock in the week following was -15%, cf. an average of +5% and previous worst of -6% way back in November And now that RPC has become a 4B market cap company in a short space of time, more scrutiny from investors aided by regular earnings conference calls will lead to more questioning on the quality of reporting we think. Northern Trust Capital Markets

35 Risks Still some balance sheet room to do deals, without equity raises. We believe the balance is already too levered for a business of this quality, but covenants are very generous and management is incentivised by their bonus plan to buy EPS growth. Acquisitions without raising equity, would add to the valuation multiple. The sector is one where returns on capital are barely close to WACC in our view. There is always a risk that RPC is seen as a target for a larger peer (such as Amcor, Bemis or Berry Plastics). Northern Trust Capital Markets

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