Ricardo's green evolution continues

At a capital markets day in May, the management of Ricardo (RCDO) included “corporate decarbonisation”, “zero emission propulsion”, “global policy and funding for climate change”, and “energy transition” as key trends underpinning its growth strategy. The firm’s website is also littered with references to sustainability. Strange, one might think, for a company that takes a material chunk of its revenues from services related to the burning of fossil fuels.  

But the engineering and consultancy firm can justifiably be considered an environmental, social and governance (ESG) investment play. Management expects that “energy and environmental transition” revenues will make up 75 per cent of cash profits by 2027 and that “sustainability and ESG advisory services” will drive growth in the coming years.

Just over a year ago, we wrote that “Ricardo, the reformed petrolhead, seems to have miles in the tank”. We stand by that statement. Over the last 12 months, the company has shown strategic progress in its path towards both a greener and more profitable future. With investor sentiment still dented by several years of margin dilution and bruising shareholder returns, the opportunity is barely reflected in the company’s shares.

A balancing act

Currently, Ricardo balances growing revenues from green consulting services with sales from traditional carbon-adjacent offerings. Its five divisions are automotive and industrial (helping vehicle manufacturers with product efficiency and performance), rail (certification services), performance products (engines and transmissions work), energy and environment (green consulting from air quality to waste and water), and defence, where its role as a supplier to the US Army recently resulted in a chunky new order for antilock brake system retrofit kits.

Automotive and industrial – from which it gets its petrolhead reputation – is the company’s biggest revenue contributor. Combined with performance products (where key clients include car giants McLaren, Porsche, and Aston Martin) these divisions took just over half of total revenue in the latest financial year to June. But green consulting revenues are growing. ‘Energy and environment’ work comprised 18 per cent of the revenue pie against 17 per cent in 2021, and there is evidence of growing demand for green-related services elsewhere. For example, management reports automotive and industrial is benefitting from a “rapid shift to decarbonised and sustainable transport solutions”.

To Stifel analyst Mark Davies Jones, Ricardo “is embarking on an overhaul aimed at moving the group to being a more focused and a more profitable business”. In a recent note, he suggested that “no quick fixes are offered, but momentum appears to be building”.

This feels like a fair assessment. In recent years, revenue growth has been less than inspiring. Sales edged up just 14 per cent in the six years to 2022, as big hits to the automotive and industrial segments during the pandemic dented momentum in 2020 and 2021. That means expectations for explosive top line growth should be tempered, and arguably, they are: FactSet-compiled consensus forecasts are for sales to hit £464mn in 2025, up from £380mn this year. Slow and steady.

An overdue bump in profitability would also be welcome. Before Covid-19, the company was used to posting double-digit returns on equity – a measure which shows how efficiently a business converts equity into profits – but this fell from 20 per cent in 2016 to just 4 per cent this year and goes a long to explaining why the shares trade at less than half their 2018 high. The latest accounts showed a 30 per cent increase in annual research and development spending to £13.3mn and a 9 per cent jump in capital expenditure. Both should be helpful in improving both the group’s offering and capacity to create value.

Differentiated, diversified

The good news is that Ricardo has differentiated itself from consulting peers in terms of both its sources of revenues and the breadth of its customer base. As of May, the group had over 500 “large and strategic customers across our sectors”, ranging from public sector clients to BP, Siemens, and Rio Tinto. Ricardo’s services are clearly well recognised.

Full-year results provided good evidence that these diversified services are also very much in demand. Order intake was up by a quarter at £425mn, with the year-end order book coming in at £340mn. Order growth in automotive and industrial was a highlight, up 38 per cent, as the company enjoyed rising demand for consulting services around electrification.

Automotive & industrial and defence were the best top-line performers, with both divisions posting growth of 19 per cent, while the energy and environment arm was not far behind, with sales up 18 per cent. Elsewhere, growth has lacked momentum. Performance products sales edged up 5 per cent, while the rail division saw a 4 per cent contraction in revenues.

In terms of profitability, the energy and environment division came out on top and has been in that position for several years on the trot. Going green is paying off. The segment posted an underlying operating profit margin of 13.5 per cent, ahead of second-place defence on 13.1 per cent, though it was down by 140 basis points for 2022 due to product mix and higher costs.

The balance sheet is in a strong place, with a robust £50mn cash generated from operations and a positive working capital movement of £10.4mn. This helped push net debt down by 8 per cent to £35mn, before lease liabilities. Cash conversion, always a feature to watch for a services company booking revenues and profits from multi-year contracts, came in at a solid 119 per cent. 

Target practice

As any engineer will tell you, projects cannot function without a brief. Fortunately, Ricardo is shooting for some ambitious but realistic financial targets in its bid to improve shareholder fortunes. These include doubling underlying operating profit by 2027, in large part by pushing the operating margin to the mid-teens range by the same year, from 7.4 per cent in 2022. A five-year average cash conversion target rate of above 90 per cent has also been set. How will the company hit the mark?

Brokers agree that both M&A and self-originating growth will have roles to play in improving performance. Liberum analysts view acquisitions as “part of the strategy but the vast bulk of growth will be organic”, while Investec views M&A as “a key element of delivering the targeted growth”.

Recent moves suggest the firm can buy (and sell) smartly. In March, Ricardo acquired Inside Infrastructure, an Australian water and sustainable resource management specialist, for a cash consideration of £6mn. It contributed £0.9mn to sales and £0.1mn pre-tax profit in just 10 weeks of trading in the latest financial year, which represents a small but positive start. The post-year-end sale of the company's software business for a price which could reach £17mn suggests that the business is clear on where it is headed and what it needs for success. Future deal-making is backed up by a new £150mn revolving credit facility, after banking facilities were refinanced in August, and will also be aided by the balance sheet progress with cash generation and working capital. 

Attractive valuation

Given its strategic progress and the long-term growth drivers that the company is well-placed to take advantage of, Ricardo’s market valuation looks undemanding. Investec has the shares trading at 13 times its 2023 forward earnings forecast, and the broker recently increased its target price from 555p to 660p. Liberum values the company at 12 times its 2023 forward earnings forecast and at less than one times’ the enterprise value to sales multiple. Both look conservative, if reasonable.

According to FactSet, the consensus analyst positions on both a forward earnings and price to book value basis are that the shares trade below their five-year averages. This, we think, makes Ricardo a value as well as an ESG play.

“It may take time to realise the group’s potential, but the core proposition – end to end technical capability to support the sustainability agenda – is a compelling and differentiated one,” argues Stifel’s Davies Jones. Of course, Ricardo isn’t the only consultancy moving in a green direction in these changing times. But what the group offers is unique, and the sheer breadth of its services stands the group in good stead as they enjoy increasing demand in a greener world.