© Tomra Systems

By the close of play on Wednesday evening the shares of Tomra Systems, a €5.7bn Norwegian recycling and optical sorting company, hovered just below its all-time-high at 403 krone.

It crowned a remarkable 5-year bull run for the Nordic business, during which Tomra’s shares have appreciated 460 per cent versus the steady eddy 43 per cent returns of its local benchmark index, the Oslo Børs:

Whichever way you cut it, the valuation is mind boggling for a company in the mundane world of plastic recycling and improving food yields. Plug in 2019’s numbers, and Tomra’s price-to-earnings ratio stands at 72, its EV/ ebitda 44 and its EV/ sales 6.5. These are the sorts of figures you might associate with a high-flying software stock like Adobe, not an industrial company with operating margins in the low teens.

Indeed Tomra’s valuation, on an EV/sales basis at least, puts it right up there with the fabled FANG stocks:

It’s not just investors who are bullish on the business either — 8 out of 10 of the sellside analysts covering the stock have a buy or hold rating on the business.

So has the market got it right?

It would be easier to believe the valuation if Tomra was growing at a clip, but the company has averaged just 11 per cent organic revenue growth over the past decade. Or if it, like its similarly valued Silicon Valley counterparts, was spitting out cash. Yet Tomra’s free cash flow margin has halved since 2016 due to both a weakening working capital position, and a jump in capital expenditure:

In both 2018 and 2019 Tomra’s cash flow was so low that, for the first time in over a decade, it didn’t cover its dividend.

Its return-on-capital-employed (ROCE) — a popular measure of assessing whether management is deploying an investor’s cash wisely — has not fared much better. Despite management targeting a 20 per cent ROCE on new projects, Tomra only achieved this figure once since 2007 and, in the past few years, the metric has been in reverse:

Similar trends in its business are evident wherever you look, from a weakening conversion of of its optical-sorting order book to revenues or an operating margin that’s now more than 4 percentage points below their 2011 highs of 16.3 per cent.

In normal circumstances, such numbers might make investors pause for a moment, and perhaps ask some pertinent questions of management. But what you have to understand about Tomra is that, like so many stocks of this era, what matters isn’t so much what the company is now, but what it might become.

Here, we’re going to have to take a step back to talk about Tomra’s total addressable market or, as its known to its friends, TAM.

A reverse vending goldmine?

On a revenues basis, exactly half of Tomra’s business is what it refers to as “Collection Solutions”, within which is the product its most famous for, its reverse vending machine (RVM).

You might not know what a reverse vending machine is, but if you’ve spent anytime in continental Europe, you will likely have come across one. As a means of upping plastic bottle recycling rates, governments over the past two decades have implemented so-called “deposit return schemes” (DRS). The scheme is simple: authorities slap a fixed levy on plastic bottles — say 20p — which the consumer can then reclaim when the bottle is returned to a store or set location, like a car park. RVMs act as a conduit for these returns; allowing the consumer to easily deposit a bottle in a machine, which then optically sorts the waste depending on plastic type, size and contamination levels, so it is easier to recycle further down the value chain.

A Tomra RVM in all its glory. © Tomra Systems

The schemes have worked pretty darn well so far. Two years after Lithuania implemented the scheme using Tomra RVMs in 2016, its plastic bottle recycling rate jumped from 33 per cent to 92 per cent. Germany, which put in place the scheme back in 2003, now has a return rate of 96 per cent.

Now, here’s the juicy TAM part. In 2019 the European Parliament passed the Single Use Plastics Directive. The legislation mandates a 90 per cent plastic bottle collection target for all member states by 2029, furthermore, all plastic bottles by 2025 must contain at least 25 per cent recycled plastic (rPET).

Here’s a neat graphic from a 2019 Barclay’s report which breaks it down:

It’s not just governments with ambitious plastic recycling and re-use targets, however. Consumer goods giants such as Coca-Cola, PepsiCo, Unilever, Danone, Walmart private label and Nestle have all committed to using between 20-50 per cent rPET by 2025 in their packaging.

While some European countries such as Germany, have already reached these targets thanks to a DRS, many — including Spain, the UK, Portugal and France — haven’t. But they must do by 2029.

Tomra, with a 70 per cent market share in RVMs, therefore, seems to have an open goal. All it has to do is tap it in.

Of course, this has analysts salivating, with each note falling over each other to estimate what this might mean for Tomra’s top and bottom line. For instance, here’s how ABG Sundal Collier calculated it last year:

So even with Tomra’s market share falling 10 percentage points, the European market alone could be worth an extra 814m krone of operating profit to the business, 69 per cent higher than the same number in 2019, by 2025. Yet, even with profits doubling — if you include management’s forecast high single digits per cent growth from its Sorting business — that’d only bring Tomra’s price-to-earnings down to a 36 times. Assuming, of course, these markets come online by then. The UK’s deposit return scheme has suffered multiple delays with the Grocer reporting in July that a push past 2023 doesn’t seem unlikely in the wake of the pandemic.

Investors might deal with delays if the cash flow was guaranteed, but there’s also question of how Tomra sells its RVMs into these markets. Since its 2018 capital markets day, management has been emphasising its “throughput” model for its RVMs. Instead of flogging the machines outright to customers, and then clipping off annual service fees, Tomra is instead regularly starting to retain ownership of the machine, and the surrounding infrastructure, and then collect fees relative to the volumes of plastic recycled. You can see why this might be appealing to governments or local partners: the model requires less upfront expenditure, and only begins to cost real money if the scheme is a success. Politically, it’s a win, win.

The inverse, however, is also true for Tomra. It requires the business to wear the capital costs upfront, and then hope the forecasted plastic recycling rates materialise.

Here’s how the two models cash profiles compare, according to the company:

A higher net present value sounds good on paper, but with this model only rolled out across a few markets of late — two in Australia and one in Lithuania — it’s hard to know whether it reflects reality. Perhaps of note, is that despite the project entering its fourth year, management has yet to update investors on how the Lithuania scheme has matured. There’s been no word of IRRs, cash flows or returns on capital employed. Yet.

Cash collection might also be a problem as governments, as any follower of outsourcing businesses will know, tend to take a while to pay. This may be materialising already in Tomra’s financials — the share of receivables older than 90 days has risen from 5 per cent to in 2010 to 9.5 per cent in 2019, along with it a slight uptick in its provisions for bad debt:

While investors are confident about Tomra’s future, it’s hard to glean the same enthusiasm from its management judging by their shareholdings. Chief executive Stefan Randstrand owns just €5.3m worth of stock and chief operating officer Espen Gundersen half of that, despite cumulatively more than 30 years of time between them at the business.

The board of directors is even more reticent to hold Tomra’s expensive scrip, with its third-largest shareholder one its employee elected representatives, David Williamson, with just 1,570 shares.

It isn’t just management either. In late May AB Latour, the investment vehicle of Swedish billionaire Gustaf Douglas and Tomra’s largest shareholder, sold 5.3 percentage points of its stake to take its holding down to 21.1 per cent of the shares outstanding. It was a rare move from an investor who, like Warren Buffett, is known for his patient approach to his investments.

Yet one increasingly popular segment of Tomra’s investor base doesn’t seem concerned: the ESG crowd.

Tomra, quite rightly, is an archetype ESG stock. Alongside the obvious environmental benefits to its products — whether it be helping to increase plastic recycling levels or reduce waste from food production — in each annual report it dedicates a page to it's a “climate account”, including a detailed breakdown of its carbon emissions, energy and water consumption (right click and open in a new tab to enlarge):

As you might be aware, flows into ESG funds have been tsunami-like in 2020. ESG and SRI (socially responsible investing) equity funds have taken in $83bn globally this year according to EPFR. Of that, Western European-domiciled equity funds account for $10.3bn of flows.

Tomra, of course, is one beneficiary given that the company has found itself in the portfolios of various ESG funds at investment houses like Impax Investment Management, BlackRock, Schroders and Hermes over the past few years.

Whether these investors, whether passive or active, are as price sensitive as traditional fund managers is hard to say, but given that Tomra — with its declining economic returns and meagre top line growth — is priced like Amazon suggests not. If that changes, then there’s only direction Tomra’s stock is heading: down.

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