Sparta Capital Sends Letter to Board of Directors of Wood Group

John Wood Group PLC
15 Justice Mill Lane
Aberdeen AB11 6EQ

Attn: Roy A Franklin, Chair; the Board of Directors
Cc: Ken Gilmartin, Chief Executive Officer
Cc: David Kemp, Chief Financial Officer

8^th December 2022

Dear Roy, dear Directors,

As you are aware, Sparta Capital is a significant shareholder in Wood Group ("Wood" or "the Company"). We invested in Wood because of our strong conviction in the intrinsic value of the company, which we believe is not reflected in the current share price.

Sparta Capital is a multi-strategy investment fund launched in 2021 investing globally in a broad range of public and private securities, across both equity and credit markets. Our investment process relies on intensively researching the fundamentals of our targeted companies and identifying investment opportunities where, for a variety of clearly identifiable reasons, we believe a disconnect exists between the price of the securities in question and their underlying value – in short, we look for mispriced, catalyst-driven, investment opportunities.

Core to our investment process is the belief that constructive engagement with the companies in which we invest is not only our duty as responsible investors, but a highly effective way to drive value creation for the mutual benefit of shareholders and companies alike. We believe that the evolution of stock market dynamics of the past several years, has created increasingly stark disconnects between share price performance and investment fundamentals and our philosophy is to work with the companies that we invest in to address this.

Wood Group: An exceptional company with outstanding long-term prospects

As discussed with you on multiple occasions, we believe that Wood enjoys a leading position in structurally growing markets globally. Thanks to the disposal of the Built Environment ("BE") division which completed in September 2022, Wood's balance sheet is robust and fit for purpose and, most importantly, Wood generates reliable and predictable operating cash to invest in its future and reward its shareholders.

Out of respect for your wish to focus on the much-anticipated capital markets day ("CMD") on the 29^th of November, we have refrained from making our views public to date. However, we believe it is now important to share our thoughts and concerns with our fellow shareholders and all stakeholders who, like us, have an interest in seeing Wood recognised for the great business it is and the strong prospects it enjoys.

The imperative to do so is now all the greater in the context of the very significantly negative share price reaction to your CMD, which we believe is evidence of disappointment at the lack of shareholder returns offered, and a misinterpretation of your messaging around free cashflow generation. The former a missed opportunity, the latter the consequence of poor communication.

Background

Sparta made its first investment in Wood in early 2022. Our thesis was the recognition that the (then putative) sale of the BE division would be transformative and mark an inflection in the Company's investment case. We believed that the sale of the BE division at c.16x EBITDA^[1] at a time when the group was trading at a multiple less than half this figure, was a materially positive development in the company's history. We believed that this decision would finally and comprehensively resolve a series of strategic and operational missteps, and we determined that Wood was at a pivotal point in its journey. As former CEO Robin Watson put it on announcing the completion of the deal:

"This transaction will deliver significant value for our shareholders and marks a new chapter for Wood"^[2]

Despite the successful completion of the transaction in September 2022, we felt that the transformative power had yet to be recognised in Wood's share price, and so we undertook to engage with you to address this. We have had many positive discussions and exchanges with you and members of the executive team – we are very thankful for your engagement. Since the closing of the BE disposal in September, we have shared views with you over a long-form letter and multiple detailed follow-up emails as well as commentary on market developments (including on analyst research publication), financial analysis and presentation materials to help shape the CMD messaging. We also covered these topics during our 6 meetings: three with the CEO and CFO on the 1^st of September, 28^th of October and the 3^rd of November, and one with you, shortly before the CMD on the 22^nd of November, and additional sessions with the IR team, including discussions on the 14^th of September and the 10^th of November.

The focus of our engagement with you has been on how to turn the strategic success of the BE sale into the value for shareholders it was expected to deliver. Three overarching themes have underpinned our advice to you:

1)  As well as highlighting the strength and stability of your business model, you should focus shareholder attention on the underlying ability of the Company to generate cashflow.

2)  You should underpin the confidence and visibility you have in your future prospects with decisive action on shareholder returns; given Wood's material undervaluation, it is our view that by far the most value-accretive choice is a share buyback.

3)  You should send the strongest possible signal to your shareholders that after years of under-delivery and underperformance, the board is committed to dramatically improving shareholder returns.

As we said to you many times, after such a multi-year period of under-delivery, words will set the scene, but only action will drive a change in perception; a change long overdue and which all your stakeholders deserve.

Finally, as we also shared with you in our discussions, we are concerned that the current significant undervaluation makes the Company vulnerable to takeover, in particular given the large central cost line ($77m in 2021 – guided to flat) which seems to us a big opportunity for cost savings going forward and an easy synergy for a potential acquiror. As things stand, an opportunistic approach with a credible premium to your current share price, could force your hand and your shareholders will not realise fair value.

In the paragraphs that follow we outline our more detailed views on the Company, our concerns and our recommended actions.

Wood Group is substantially undervalued

Wood Group is substantially undervalued both intrinsically and versus its global peers. Whether analysed in relative or absolute terms, it is our view that the shares offer well over 100% upside in the near term

Undervalued vs peers

Based on consensus numbers, Wood currently trades at a forward EV/EBITDA multiple less than half of its closest peer Worley and at the low end of the broader oil and gas services peer group, which includes businesses who – unlike Wood – focus only on the oil & gas sector and are tied predominantly to capital expenditure projects (meaning lower visibility, higher cyclicality of earnings, more exposure to turnkey lump-sum projects). Importantly, such peers also do not benefit from the same focus on enabling the transition to Net Zero carbon emissions which underpins so much of Wood's revenue opportunity.

Infographic - https://mma.prnewswire.com/media/1963938/Sparta_1_Infographic.jpg

Undervalued in absolute terms

Taking your CMD assumptions about market growth, revenue growth and margins, and resetting your cost of capital on metrics appropriate to Wood with its much-reduced operational risk and its conservative balance sheet, delivers a DCF value of c.330p per share, some c.160% above the current price.

Undervalued according to research analysts

The average analyst price target (221.6p) represents some 71% upside,^[3] with the highest target set at 285p (+124%).

Wood Group is global leader in stable markets enjoying structural growth

Wood has transformed its business and is recognised as a leading global consultant, serving loyal clients in the energy and materials sectors as they continue to drive the twin imperatives of digitalisation and decarbonisation

As you so comprehensively demonstrated at your CMD, Wood is a leading engineering consultant and a net zero enabler over diversified end markets with a $230bn opportunity^[4] by 2025. These markets are characterised by elevated growth over the medium term, as your clients' need to deliver lower carbon emissions and security of energy supply will translate into investments required over decades, not years.

Wood is held with a high degree of trust by some of the largest and most sophisticated organisations in the world and with good visibility backed by strong order books ($6.4bn as at Jun-22),^[5] can look forward to elevated secular revenue growth over the medium term.

Wood helps clients deliver value for both operational investment projects as well as capital investment projects. Wood's Consulting and Projects divisions (54% EBITDA)^[6] have small average contract sizes ($0.1-$10m) and an average contract length of 5-12 months, with Operations at $90m average size and engaged in multi-year Opex-based projects (3 years average).^[7] As such, Wood has largely distanced itself from the fickle world of large-scale capital project investment decisions often associated with its characterisation as an oil services company, serving instead a core part of the day-to-day delivery of efficient, low-carbon, energy and materials.

In our view, with continued, relentless focus on execution, Wood will enjoy sustainable profit margin improvement across all its divisions, something you guided to at the CMD. Furthermore, the group as a whole will benefit from the positive mix effect of its fastest growing Consulting business, enjoying above group average margins. Together we would expect EBITDA margins to be driven higher than peer group averages.

Overall, as an asset light business, we believe that the group will deliver ROICs in the high teens and crucially, having taken the logical decision to transition away from lump-sum work, Wood has materially lower operational risk and a higher degree of predictability over its cashflow generation than many other players in its comp set.

Wood Group is cash generative

Wood is a cash generative business. In the course of normal operations, Wood can expect to convert c.90% of its pre-tax profits into cash^[8] (pre-capex) and 60% after all investment and central costs are made^[9]

By way of illustration, if we take the latest^[10] Bloomberg consensus 2023 adjusted EBITDA of $419m (which we estimate implies $329m EBITDA after leases), we believe that, net of typical payments to JV partners and c.$110m capital expenditure, Wood should would generate $179m of unlevered FCF before tax in FY23E, which we expect will grow at least in line with the business.

We would further point out that 2023 is a year when, as per your guidance, you are investing $10-20m of opex in growth initiatives and you called out elevated capital expenditure on software improvements which will taper in subsequent years. The impact of these falling away, as per your guidance, adds $20m-$40m to your annual free cash generation, mechanically.

 Infographic - https://mma.prnewswire.com/media/1963939/Sparta_2_Infographic.jpg

Such a profile of cashflow generation is a central tenet to the investment case at Wood. Any business which can generate such a high degree of dependable cash, with relatively low operational risks, should command an elevated fair value. It was our strong advice to you that the CMD should focus on this important characteristic of the business, which we felt has been lost in the historic need to focus on elevated financial leverage and legacy exceptional costs.

In our view, whilst it was clear that your communication at the CMD moved in the right direction by trying to highlight the strong underlying cashflow generation of the business, your continued focus on known, finite and short dated legacy cash exceptionals, was misleading.

Specifically, the key message in your CMD release, copied below, left commentators confused as to the implications for near term cash generation of the business.

"Our businesses generate strong underlying cash flows and we expect these to continue to grow over the medium term. This, combined with the reducing legacy liabilities, will result in a return to positive free cash flow from FY24 onwards"^[11]

"Shares in Wood Group plunged sharply this morning as the engineering and consultancy group warned investors it would not return to positive free cashflow next year"^[12]

In our view, nothing could be further from the truth. As we show above, based on your guidance, you generate substantial positive operating cash, which you use to drive organic investment via capital expenditure and net working capital investments, and you will do so for many years after legacy issues have been addressed.

Wood's balance sheet is fit for purpose with significant excess capital

Your operational and financial risks are radically changed for the better. You can afford to run the business at the top end of your stated 0.5x – 1.5x EBITDA^[13] target leverage range without undue risk to the investment case.

As we illustrate below, on your own guidance,^[14] running at 1.5x ND/EBITDA generates c.$70m of headroom by the end of this year, c.$115m in 2023 and over $270m in 2024. Cumulatively you could therefore buyback a quarter of your current market capitalisation by the end of 2024 and still sit within the conservative leverage targets that have been set for the business.

Given your recent history of excessive leverage and the rising market cost of debt, we entirely share your caution in keeping a balance sheet within very tight limits. However, we note that the top end of your stated range sits below the leverage of your closest competitors.

We also agree with the CFO's description of the leverage target during the CMD as follows:

"This is the broad zone that we're targeting, rather than a yearly red line, and this sits comfortably below our debt covenants or 3.5x"

More importantly, we would further argue that placing the business under too strict a leverage target, as a knee-jerk reaction to your recent past, places insufficient emphasis on 3 critical improvements in the company's operating and financial profile, which will permit you greater flexibility in the use of your balance sheet going forward, without adding undue risk to the investment case.

Firstly, as you so amply demonstrated at the CMD, your business is now radically different from where it was and, from an operational risk perspective, substantially de-risked.

1)  You have substantially reduced operational risk versus your recent past, given the now de minimis presence of LSTK work within your mix, meaning working capital trends are stable through the year and will not drive big variations in your net financial position.

2)  As articulated above, your 3 divisions are "90%+" cash conversion businesses, with small contract sizes and each boasting over "90% repeat business" from blue chip clients with whom you have enjoyed partnerships over decades.

3)  You have combined order books of $6.4bn and book to bill ratios of over 1x.

Secondly, you have already invested a substantial portion of the BE proceeds in further de-risking the business financially.

1)  The working capital has seen a substantial investment this year, leaving it very conservatively set for the future. It is for this reason, that we have assumed no further outflows in FY23E and FY24E despite the revenue growth.

2)  The Enterprise settlement of $115m has removed a potentially substantial financial overhang to the business.

Thirdly, you have finally set a clear path and timetable for the resolution of your remaining legacy cash outflows you face. These are now known, finite and exist only in the very short term.

We set out our illustrative calculations below, based on guidance you helpfully provided at your CMD and using consensus operating assumptions as a starting point.

We strongly urge you to consider upcoming payments to the SFO, Onerous lease and LSTK payments as part of your overall liabilities – an effective addition to your debt at no interest cost. We show this presentation below, which reinforces the strength of your underlying free cash generation and re-iterates the quantum of your excess capital. Our operating assumptions align with your CMD guidance, replicated below.

Infographic - https://mma.prnewswire.com/media/1963940/Sparta_3_Infographic.jpg

The message from these calculations is clear. The business generates excess capital which should be returned to shareholders in short order.

Wood has failed to deliver shareholder value

Over the last 5 years, Wood has underperformed, delivering total shareholder returns of -79% vs +9% for the FTSE250 over the same time horizon.

Even the most basic review of shareholder returns over the recent past, paints a grim picture of a business which has serially let its shareholders down. In September 2019, when you assumed the role of Chairman, Wood was trading at £3.60 per share. Today, the shares trade at less than half that value. Over the same time frame the FTSE250 has delivered returns of 6%.

Infographic - https://mma.prnewswire.com/media/1963941/Sparta_4_Infographic.jpg

The Capital Markets Day was a pivotal moment for the company. The size of the opportunity; the energy of the operating management team and the skillset embedded within the company were clear and very positive. Yet the share price reaction on the day was a startling negative 16% (and the shares having slipped further and currently at -22% vs pre-CMD).^[15] As can be seen from analyst commentary in reports written at the time (pasted below), by choosing not to address the case for shareholder returns at the CMD, the board manifestly misjudged the mood of the market and showed itself to be out of touch with shareholder opinion.

"If management announces a clear, credible strategy for sustainable FCF generation, a meaningful re-rating of Wood's shares is possible. However, with limited visibility on the further use of Built Environment sale proceeds at this point, reinvestment risk is an overhang and we remain cautious for this reason"^[16]

"Another focus has been on potential for shareholder returns, part of our rationale for adding to Catalyst Watch, though none is announced today"^[17]

In its note of 7th December, Citi downgrades Wood Group to Neutral, citing the following:

"Despite the shares trading at all-time lows, we do not see any near-term catalyst for the shares to perform."

This was a missed opportunity, and your shareholders paid the price for the decision taken. In our many conversations with you, we made clear that this outcome was a possibility. Quoting from one of our letters sent to the executive team, we concluded with the following remarks:

"…a buyback is front of mind for many if not all. A token effort will not deliver the benefits we outline above and would be a wasted opportunity. No cash return at all will be a material disappointment and leave many questioning any belief you have internally in the solid underpinnings of New Wood. Either of these, is an outcome to be avoided…"

This most recent misjudgement, following in a long line of disappointments, would suggest to us, that there is a persistent lack of understanding at the board, of what constitutes the delivery of shareholder value. As a result, we believe that shareholders would be well served, if the board had a representative who was more directly in touch with market sentiment.

The scene is set for Wood to show that it cares about its long-suffering shareholders

At the CMD you have set out a compelling case for the business. With this wealth of information now public, you have provided the perfect backdrop to reset your capital allocation priorities and deploy a buyback

As we advised in our discussions, we strongly believe that nothing will affirm your belief in "New Wood" and its ability to generate steady operating cash, more than putting some of that cash to work in buying back your own shares. We have shown that in our view, you generate over $270m of surplus capital by Dec-24; putting even a portion of this to work in short order via a buyback is highly accretive and makes good business sense. Furthermore, the signalling impact of any such action cannot be underestimated:

1)  It robustly underscores your belief, evident at the CMD, that Wood is now operationally and financially on a strong footing;

2)  You enjoy structural tailwinds in your business which along with your order book, de-risks your outlook;

3)  With your shares trading at a c.50% discount to peers,^[18] with your organic investment needs already prioritised, it is manifestly a highly accretive capital allocation course to pursue; and

4)  It would return some stability to your share price reducing Wood's beta from its currently unwarranted 1.7.^[19] Using a beta of 1.7x delivers a DCF fair value of c.235p, vs a fair value of c.330p using a beta of 1.3, an improvement of over 40%.^[20]

We would like to continue our discussions with you, the CEO and the CFO at the earliest possible opportunity.

Above all, we strongly encourage you to expedite your capital allocation policy, signal the confidence you have in the cashflow generating qualities of your business and take advantage of the cheapness of your shares, creating value for all holders and closing the door to perhaps unwanted, opportunistic interest the share price under-performance will have undoubtedly garnered.

For our part, now that our views are in the public domain, we will use the next few weeks to canvass opinion from our fellow shareholders. To that end, we encourage shareholders and other stakeholders to reach out to us directly at contact@spartacapital.co.uk.

Best wishes,

Franck Tuil, CIO

Sparta Capital Management Ltd

For media enquiries:

Greenbrook 
Rob White / Michael Russell 
spartacapital@greenbrookadvisory.com
+44 207 952 2000

[1] Wood Group RNS, 21 September 2022

[2] Wood Group RNS, 1 June 2022

[3] Source: Bloomberg, as at 7 December 2022

[4] Wood 29 November 2022, CMD presentation, p.21

[5] Wood 22 August 2022, Half year results for the six months ended 30 June 2022

[6] Wood 29 November 2022, CMD presentation, p.11

[7] Wood 29 November 2022, CMD presentation, p.88

[8] Wood 29 November 2022, CMD presentation, p.88

[9] Sparta estimate: average EBITDA after leases to Unlevered FCF before tax conversion over FY23E-FY26E = 61%

[10] As at 7 December 2022

[11] CMD RNS, 29 November 2022

[12] City AM, 29 November 2022

[13] After leases

[14] Mid-point of guidance assumed for FY22E EBITDA, FY22E net debt, FY23E provisions. Cash outflow for Aegis Poland excluded from FY23E expected cash outflows as we note the expectation (expressed by the CFO during the 29 November 2022 CMD) that commercial settlements will lead to cash inflows, which we are not accounting for in our calculations

[15] Bloomberg closing prices for 28 November, 29 November, 7 December 2022

[16] Morgan Stanley, 24 November 2022

[17] JP Morgan, 29 November 2022

[18] Based on analysis set out on p.3

[19] Last 5 years daily average beta vs the FTSE 250 (Bloomberg as at 6 December 2022)

[20] Average of last 5 years daily average beta vs relevant benchmarks for Jacobs, KBR, Worley, Fluor (Bloomberg as at 6 December 2022)

This document is not an offer to, or solicitation of, any potential clients or investors for the provision by Sparta of investment management, advisory or any other comparable or related services. No statement in this overview is or should be construed as investment, legal, or tax advice, nor is any statement an offer to sell, or a solicitation of an offer to buy, any security or other instrument, or an offer to arrange any transaction, or to enter into legal relations.

No representation is made as to the accuracy or completeness of any information contained herein, and the recipient accepts all risk in relying on this information for any purpose whatsoever. Without prejudice to the foregoing, any views expressed herein are the opinions of Sparta as of the date on which this document has been prepared and are subject to change at any time without notice. Sparta does not undertake to update this information. Any forward-looking statements herein are inherently subject to material business, economic and competitive risks and uncertainties, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change.