Norcros — Adapting to changing markets

Reported FY20 EBIT was lower year-on-year but ahead of year-end guidance (of c £31m) and both the UK and South African operations did slightly better than we had expected. In the year, the adoption of IFRS 16 benefited EBIT by £0.5m with a £1.4m negative PBT impact.1 Year-end net debt of £36.4m came in lower than guidance (of £40m) also with neutral overall net cash flow performance after the c £9m acquisition of House of Plumbing in South Africa.

Reported revenues declined slightly, being the net result of modest UK progress and weaker export sales. The UK outturn was commendable in a generally challenging market that weakened over the course of the year, as did this division’s like-for-like performance. In summary, the retail channels (incorporating independents, specialists and big box retailers) performed better than the trade segment in the UK for most operating companies – partly due to share gains at the expense of failed competitors – while export sales were generally weaker. Management estimated the year-end coronavirus impact to be £9.4m in revenue terms and £3.0m to EBIT and adverse mix development contributed to an 80bp EBIT margin drop to 10.8% for the division as a whole. The broad base of seven operating companies served to provide some resilience against individual revenue hits taken. We understand that UK manufacturing operations – save for Johnson Tiles – are all operational again now as are distribution facilities, albeit with reduced staffing levels currently.

Norcros has four substantial UK-based businesses that each generated in excess of £40m annual revenues in FY20; three of these grew, while one (Triton) declined.

Triton was most affected by COVID disruption (ie £4.3m of management’s estimated £9.4m UK revenue hit), which we believe was a UK lockdown demand effect rather than a pre-lockdown China supply chain issue, exacerbated by trade sector de-stocking seen in H1. UK retail and export sales were also down, though slightly less so at the full year versus interim stage indicating some stability in H2. As one of the higher margin generators, we assume then that Triton also accounted for at least half of the UK EBIT gap of £3.0m attributed to coronavirus effects. That said operating margins were still said to be strong by management. Triton’s flexible cell assembly production lends itself to a gradual re-building of output and, with reduced inventory levels being carried by customers any end market demand pick-up should register reasonably quickly.

Johnson Tiles secured additional listings and new product volume in the retail sub sector, making good year-on-year progress in both half-year periods. Trade channel revenues were ahead (by 2.8%) at the interim stage but flat for the full year; while H2 was implicitly lower, the number of specification wins cited by management suggests that a return to work by the construction sector (including new housebuilders) will soon translate to shipped revenues. Exports (now less than 10% of sales) were very weak throughout the year at least partly attributed to withdrawal from low-margin project work. Tile kilns require continuous operation to run efficiently and at the date of reporting they had not resumed production. Demand is being met from a combination of inventory and imported products. The indicative restart is in July, but a £9m impairment charge taken against tangible fixed assets suggests that management is planning for lower volume throughput.

Vado put in a pretty stable revenue performance across FY20 with comparable H1/FY gains (perhaps slightly better in H2 in fact) in its UK sectors with retail being particularly strong. Middle East exports have trended lower in the last couple of years – though can be influenced by individual project activity – though sales through sister company Tile Africa are increasing. As elsewhere, Vado’s China-centric supply chain does not appear to have experienced any discernible disruption.

Similar comments apply to Merlyn, which also has a significant China supply chain. It also achieved double-digit revenue progress in the retail channel driven by an enhanced product range, while trade sales contracted modestly with merchant de-stocking again a feature. Exports were more robust for Merlyn than any of the other operating companies; 2% sales growth in the year was due to stronger H2 volume shipments.

As far as we can see, the smaller companies in the Norcros UK portfolio also experienced impressive progress through retail sales channels, while trade demand appeared to be firmer than for the larger ones. Exports were also very weak.

Croydex had a very good year with UK revenues ahead by 10.9% overall with trade channel progress slightly ahead of that in retail but both performances were commendable in flat at best markets. We note that the year-on-year run rates actually picked up in H2 – notwithstanding coronavirus effects – consistent with momentum gained from securing new listings/category extensions, we feel. This company probably has the most diverse retail channel customer list enabling it to reach into more consumer market segments and it appears that efforts to expand the commercial offer are gaining traction though this was not specifically mentioned by management.

In contrast, we are slightly puzzled by the FY20 trading performance by Abode. UK sales grew by double-digits (actually 13.9%) in H1 but ended FY20 with a near 9% decline, indicating sharply reduced activity levels in H2. We accept that the prior year benefited from a very strong comparable H219 and some pre Brexit de-stocking is flagged, but even allowing for this and management’s estimated COVID-19 sales impact the underlying run rate seems much softer. No loss of customer listings/market share loss was referenced but we will continue to monitor trading closely in FY21.

Repeating a now familiar pattern, Norcros Adhesives grew UK revenues with a strong retail sub sector performance that strengthened in H2 after a good H1. The trade segment also grew in the year albeit at a reduced rate (possibly flat year-on-year) in H2. Responding to soft H1 trading in the Middle East, management change and restructuring the local office occurred in H2.

The maiden revenue contribution from House of Plumbing (acquired 1 April 2019) more than compensated for year-on-year declines in all three existing portfolio companies. The like-for-like figures shown in Exhibit 4 indicate a more austere H2 trading environment with sales down in the 5–10% range year-on-year, though this included COVID-19 effects at the year-end (estimated by management to have been £3.8m as well as £1.6m on EBIT). Reported profitability was flat in sterling terms including the offsetting effects of a 5.7% £/ZAR translation headwind and an EBIT boost to reported results from adopting IFRS 16 in FY20 (both £0.4m effects), while EBIT margins overall declined by c 100bp to 6.7%, noting a significant COVID-19 operational gearing impact here also. All of the company commentary below is on a local currency basis.

Tile Africa (TAF) was said to have outperformed its market segment in H1, with revenue declining only modestly versus a more marked overall reduction. This was perhaps supported by contract wins to supply the smaller end commercial construction specification market. We assume then that such activity was much reduced in H2 giving rise to a full year revenue fall for TAF overall. Management attributes this to market rather than share loss. With a soft retail environment also, some self-help store improvement actions (both format and ranges) have taken place though it is unclear to what extent this was beneficial in FY20. Similarly, inventory management and import issues were both flagged previously but it is not stated whether they are now resolved.

TAL Adhesives is more commercial project oriented than TAF and probably experienced similar market conditions including deteriorating H2 conditions despite end market breadth covering offices, newbuild residential and retail malls. At the same time, domestic competition is said to have intensified so there may well have been some H2 impact from keener pricing and/or lower tendering for more marginal projects. With raw material costs rising also, it becomes particularly important to pursue contract profits rather than simply volumes. Export sales to Zimbabwe were constrained throughout the year.

Johnson Tiles South Africa’s (JTSA) revenues were comparable to the prior year and again were implicitly weaker in H2 after progress in H1. Bearing in mind that JTSA also supplies sister company TAF as well as third parties, it is unsurprising that broadly similar trading conditions prevailed. As well as contending with competitive markets, regional load shedding power supply issues around the company’s manufacturing facility in Olifantsfontein (north-east of Johannesburg) have been an ongoing challenge addressed through the use of in-house stand-by generators.

New addition House of Plumbing exhibited trading stability versus its pre-acquisition comparators with like-for-like revenues up 1% at both the half and full year stages. It represents an entry point into commercial/specification plumbing and is likely to be the platform for expansion in this segment. This business made a good profit contribution in the year at above divisional average margins (and also non-dilutive compared to the prior year).

Net debt at the end of March stood at £36.4m; an adverse translation effect on South African cash balances (£1.6m) effectively explained the year-on-year increase.

Excluding IFRS 16 effects, operating cash flow of c £30m was c £5m lower than the prior year, substantially reflecting the relative EBIT reduction over the same periods, leaving underlying EBITDA for the year of c £38m. Working capital outflows rose in FY20 and totalled c £5m, compared to c £2m a year earlier. To us, this looks like a reversal effect of an advantageous payables position at the beginning of FY20/end of FY19. Otherwise, inventory absorption (c £2m) was exceeded by receivables collection and the latter would have been a key focus in the final month of the year as COVID-19 related business disruption increased. Pension deficit recovery cash payments nudged up in FY20 (to £3.3m) although non-trading cash outflows (also including M&A costs) were slightly down versus FY19.

In aggregate, cash interest and tax payments were broadly in line with FY19 and totalled £6m, while capex was reined back to c £5m. This represented 0.7x depreciation and although spending was only slightly lower than the preceding year, we had previously expected a figure of around £10m. The difference is likely to be down to a combination of challenging trading conditions in H2 exacerbated by the coronavirus pandemic during the final quarter of the financial year. That said, we do not believe that investment in new product development – which is typically captured together as capex and opex items – was affected to any material extent. Lower FY20 free cash flow then of c £18m mirrored the year-on-year EBIT reduction referenced above.

Just over £16m was applied to the acquisition of House of Plumbing at the beginning of the financial year (c £9m) and the payment of cash dividends (being the FY19 final and H120 interims, totalling £7m). After the purchase of treasury shares there was a modest net cash inflow for the year.

For comparability purposes, the above commentary has stripped out the effects of lease liability cash flows following the adoption of IFRS 16. This standard does not alter group cash flows but requires lease cash flows to be presented differently. For the record, net cash outflows of c £0.6m were associated with leased assets, narrowing the overall group FY20 cash movement to a marginal inflow.

Cash flow outlook: The company’s c £36m core net debt position at the end of March – including c £84m gross debt drawn down – represented just c 0.9x EBITDA generated in FY20. No cash receipts from staff furlough schemes would have been received at this point and while there may have been some permitted deferral of tax payments, this should be reflected as payables within current liabilities. Management stated that the net debt position as at 7 June had risen slightly to £38.6m. Actions taken – including passing the FY20 final dividend – together with some recovery of trading activity in June (see below) means that the implied cash outflow run rate is somewhat less than the £5m scenario modelled by management for banking purposes. Existing facilities (ie a £120m RCF and £30m accordion, both to November 2022 and local unsecured overdraft facilities in South Africa) remain in place. To accommodate a potentially protracted recovery phase, covenant limits for the next two reporting periods have been waived and a maximum £95m net debt limit (measured quarterly) is in place until June 2021.

FY21 to date: The first two months of the new financial year together saw revenue generation c 60% lower than the prior year. In the first three weeks of June, the year-on-year run rate deficit had reduced to c 25% as lockdown conditions in primary markets started to ease. In the UK, certain customers – especially with click and collect business models (such as Screwfix, Toolstation and B&Q) – were relatively advantaged and were able to continue to trade, albeit with some business disruption particularly in the initial lockdown phases. That said, social distancing measures would clearly have affected the ability of tradespeople to install many Norcros portfolio products in domestic settings. Commercial building activity was less constrained and while new housebuilding sites were also closed down initially, they began to resume activity levels during May. South Africa went into lockdown in March at around the same time as the UK and began to ease restrictions from 1 May going further on 1 June including a re-starting of live construction sites.

Business challenges: Each of these main markets for Norcros was experiencing tougher H2 trading conditions before the coronavirus impact. It appeared that a decisive UK general election result in early December would increase business confidence, though more deep-seated concerns with South African government finances remained at the start of calendar 2020. As countries re-emerge from lockdown, recessionary environments and rising unemployment seem to be a given. Consequently, tight management of costs and cash flows, matching them against prevailing/developing demand levels, will be a key near-term business focus. In Norcros’s favour, it has a strong and experienced management team that has taken appropriate financial steps to retain good competitive positions with both suppliers and customers. In the past this approach has enabled portfolio operating companies to gain market share over time. In the FY20 results presentation, management explicitly commented that targeting financially weak competitors is a strategic aim in the current trading environment. Clearly, if successful, this will serve to soften weak underlying market effects. The objective of course is to do so by adding good-quality customers and sustainable market share without impinging on generally very respectable operating margins.

We hope to resume the publication of estimates at some point; as true underlying current monthly revenue run rates are not yet clearly established, the scope for gaining market share is indeterminate at this point and the rate of general economic recovery is unclear so the suspension of our estimates is ongoing.