Norcros — Key strengths undervalued, legacy issues fixed

Over many years, Norcros’s management has nurtured a simple, but successful growth strategy. Lead by a highly experienced management team that has championed the development of a multi-channel sales model, it has leveraged the growth of the acquisitions brought into the group. Ahead of the GW deal this year, the acquired businesses averaged revenue growth of 6.5% pa since purchase and contributed to a group margin expansion trend as well as an improving profitability trend. Norcros continues to operate in highly fragmented markets that offer revenue growth and market share opportunities, and has scope to move into as yet unaddressed adjacent markets that offer additional long-term growth potential.

Norcros’s growth strategy has remained largely unchanged for several years, other than the timing, which was deferred due to the impact of the pandemic. The key targets are:

With the exception of the COVID-19 affected FY21, Norcros can point towards a long history of revenue growth, as shown in the chart below. Revenue almost doubled between 2013 and 2022 and is expected to increase further in future years as it continues to grow both organically and by acquisition. The material increase in revenue in 2023 and to a lesser extent in 2024 is driven by the acquisition of GW, which completed at the end of May. It will contribute 10 months of revenue this year (c £37m), and a full 12 months in FY24. Excluding the acquisition, we estimate that group revenue will grow c 3% on a constant currency basis.

The GW acquisition fits well with Norcros’s strategy to move into adjacent markets. GW is the UK’s leader in the fast-growing bathroom panel market where it enjoys a c 40% share of a market growing in excess of 10% pa. Bathroom panels are taking share from traditional tiles due to the higher speed and lower cost of installation. It is expected that Norcros will use its existing network to expand GW’s sales in the UK and Europe, and utilise its existing manufacturing capacity. The deal offers Norcros the opportunity to cross-sell on a ‘one-stop-shop’ basis across the group and to leverage group products into the new housing and modular markets.

We are forecasting that Norcros generates almost £500m of revenue in 2024. However, it seems entirely possible that it could achieve its £600m revenue target if organic growth is supplemented with further acquisitions that are not included in our forecasts.

Norcros does have capacity in its balance sheet to finance overseas acquisitions. We estimate that by the end of FY23, it could have headroom of between £28.9m and £42.2m to invest in M&A assuming 1.5x/1.75x net debt/EBITDA, and by the end of FY24 that headroom could rise to £53.6m to £68.3m on the same basis. These calculations ignore the implied headroom of any acquired target. Taking the FY24e headroom average of c £61m, it implies the purchase of revenue of c £51m assuming a consideration/revenue multiple of 1.2x (being the arithmetic average of the six deals), which would add c £5.6m or over 10% to FY24e operating profit at the group margin.

This suggests that the FY25e revenue target of £600m might be a stretch, but our calculation not only ignores acquired profit of the target, but also ignores the potential to buy at more attractive multiples. The three acquisitions made between 2013 and 2016 were achieved at between 0.5x revenue and 1.1x revenue. It also ignores equity funded M&A. Finally, Norcros has a stated strategic target return on capital employed of more than 15%. The chart below highlights the returns generated over the last 10 years and clearly shows returns at or in excess of 15% in all but one year. Arguably the trend is also rising despite the dips in 2020 and 2021.

Norcros has a carefully cultured ‘DNA’ that has led to successful long-term growth of revenue and profit in both of its chosen markets, the UK and South Africa. The DNA includes an experienced management team where the main board directors average nearly 20 years with Norcros, and the managing directors of the divisions can point to a collective duration with the company of more than 100 years, and materially longer than this in industry experience.

Another element of the Norcros DNA is a clear and focused strategy, which we discuss in more detail later in the note, and its leading market positions and brands as well as a diversified portfolio of channels to market that includes a wide customer base, both of which can be seen in Exhibit 1 below. Norcros’s biggest customers include many of the UK’s largest housebuilders, which collectively account for c 10–12% of revenue, with no single customer accounting for more than 10% of group revenue.

Within the UK housebuilder sector, Norcros has customer relationships with each of the top 10 companies via at least one of its eight UK brands and in many cases, it has multiple relationships across its brand portfolio. However, as can be seen in Exhibit 2 below, there are many ‘holes’ in the matrix, which represent growth opportunities.

For example, Abode, which is a designer and distributor of high-quality kitchen and bathroom taps and kitchen sinks, sells into just two of the top 10 housebuilders, while GW, the recently acquired bathroom panel manufacturer, sells into only one, Barratt Homes. This clearly highlights both the growth opportunity that the housebuilder sector offers the group, but also some of the justification for acquiring GW.

Another element of Norcros’s DNA is its willingness to innovate and develop new products, which is likely to help it generate sales, especially with the UK housebuilders, which will be expected by their customers to offer modern styling and features on their new homes. The evidence of success here is seen in Norcros’s vitality rate (the Product Vitality Index is a measure of revenue derived from products launched in the last three years as a percentage of the total revenue), which stands at a market-leading rate of 29%, according to the company.

The market opportunity in the UK is sizable. Despite being a market leader in each of the six markets addressed by Norcros ahead of the GW acquisition, there is much scope for growth. With the exception of showers, the top three players accounted for less than c 35% of the total, implying a long tail of opportunity to either take market share organically, or to engage in M&A. Collectively, the six markets had total revenue of £2.1bn (source: AMA, BSRIA and Norcros estimates), with the top three players accounting for c 35%.

Furthermore, there are numerous other bathroom markets that Norcros does not currently address including bathroom furniture, decorative radiators, ventilation and sanitaryware, which over time could be areas of opportunity for M&A activity. Collectively, these markets total over £750m of revenue, which could potentially add roughly a third to the revenue of Norcros if it gained a similar market share to that which it currently enjoys. The acquisition of GW in May was a clear example of Norcros using its balance sheet strength to move into new business areas within the bathroom market. The acquisition of Merlyn in 2017 was another example of Norcros gaining exposure to previously unaddressed markets.

Norcros has a long and successful acquisition record stretching back nearly 10 years to the April 2013 purchase of Vado, a manufacturer and supplier of taps and mixer showers. All the completed deals fitted well with group strategy, and all satisfied Norcros’s acquisition criteria, which include a requirement for the target to operate in a complementary market, to offer a preferred channel mix and to have export and growth potential.

The chart below highlights the annual average revenue growth achieved by the five acquisitions executed between 2013 and 2019. On average, the group revenue CAGR amounts to 6.5%, which we believe demonstrates a superior growth rate to the underlying markets as the acquired businesses have been able to plug in to the varied sales channels developed by Norcros, as well as developing new products that have pushed up vitality sales.

The bathroom plumbing market is very fragmented, but Norcros is one of the market leaders. This implies that it is better placed to monitor the supply chain than many of its peers. This includes being able to focus on the sourcing of products that are manufactured to the highest standards and ensuring that the supply chain is as robust as possible.

Norcros sources a significant percentage of its products from more than 120 manufacturers across China and it has more than 30 employees on the ground based at four representative offices that work closely with the suppliers, thus ensuring quality of product and certainty of supply. This local presence offers Norcros fundamental strength in terms of product supply, which is a clear point of differential versus peers and therefore a competitive advantage.

It also means that it is better able to control the supply chain and drive sourcing synergies, which will be an added focus in 2023.

Norcros’s recent FY22 results highlighted good growth in both revenue and profits as well as a solid net cash position, which was subsequently utilised for the GW acquisition. Although revenues in the early months of the new financial year were up only modestly year-on-year, they were up 25% versus 2019. Despite the good trading, the share price is languishing, which seems to suggest that the market is giving Norcros little credit for the growth and size of its South African operations, the resolution of the pension deficit issue and its industry-leading supply chain, which gives it an edge over competitors.

A reminder of the FY22 results: Norcros’s revenue increased by 22.2% (up 20.6% on a constant currency, like-for-like basis) in FY22 to £396.3m. Revenue increased 20.9% versus the largely pre-COVID-19 FY20 period on a constant currency, like-for-like basis. Underlying operating profit rose 23.7% to £41.8m and underlying PBT increased 28.4% to £39.3m, comfortably ahead of the consensus PBT expectation of £37.7m. Diluted underlying EPS was up 22.8% to 38.2p, from which the company has declared a 10.0p/share dividend (FY21: 8.2p). Norcros ended the period with net cash of £8.6m, down slightly from £10.5m at the end of the previous period.

In the UK (65% of group revenue), revenue increased 16.6% to £256.7m, driven by repair, maintenance and improvement (RMI) and new housebuilding demand. The commercial and local authority markets have been slower to recover, but are now improving, which bodes well for the current year. Underlying operating profit in the UK increased by £4.0m to £30.9m, but margins edged down by 20bp to 12%, being the net effect of higher costs, efficiencies and price rises. In South Africa (35% of group revenue), revenue increased 28.8% to £139.6m on a constant currency basis as the business benefited from a post COVID-19 recovery. Retail renovation was a major driver of revenue of several brands, while House of Plumbing benefited from new branch openings. Operating profit also rose £4.0m to £10.9m, implying that the margin rose from 6.6% to 7.8%.

Management recognises that there are some uncertainties in its markets and believes it is well placed to deal with these issues. In the first two months of the current financial year, revenue was up 1% versus FY21, which was itself a very strong period. To put current trading into context, revenue in the period was up 25% versus the same period in 2019.

The acquisition of GW, a manufacturer of waterproof bathroom panels, was completed on 31 May. Despite ending FY22 with net cash, post the acquisition, Norcros has leverage of c 1x EBITDA. The uplift in estimates in this note largely relates to the earlier completion of the GW acquisition than we had previously assumed.

Norcros’s South African operations appear to be somewhat overlooked by the market. However, we believe it is worth revisiting the growing contribution it makes. Back in 2014, South Africa accounted for 25% of revenue and just c 12% of operating profit. By 2022, and including the contribution of House of Plumbing acquired for £12.5m in April 2019, it accounts for 35% of revenue and 26% of operating profit. The proportion may decline in the current year due to the UK-based GW acquisition, but there is no reason to assume that in the long term it cannot continue to take market share in a fragmented market.

South Africa is an attractive market for Norcros because it is a large economy with a business-friendly environment and a population of c 60 million, similar to that of England and Wales combined. Furthermore, the socio-economic dynamics of South Africa favour Norcros as the country improves existing housing and sanitary provision and expands the total housing market to cater for a growing population.

Norcros operates four businesses in South Africa, covering different market segments. It is the market leader in adhesives and construction chemicals, and it is the number two player in floor tiles, bathroom retail and plumbing. These four markets account for sales of c £1.2bn (source: RAND, Frost and Sullivan and management estimates) with the top three players accounting for c 60% of the total. The remaining 40% is characterised by a long tail of smaller independent players, especially in plumbing, where the top three have quite a small market share, as well as the larger markets of floor tiles and bathroom retail.

Norcros has a ‘super-mature’ pension scheme, which until this year had been in deficit by up to £63m, as at March 2017, which was a material negative at the time considering that the market capitalisation at that point was only £101.4m. Since then, the deficit has trended lower and stood at just £6m at the end of September 2021. However, as discount rates and the Retail Price Index measures have edged up in 2022, this deficit has now become an IAS 19R surplus of £19.6m. Therefore, the pension should no longer be viewed as the negative it clearly was five years ago.

At the last triennial actuarial valuation in March 2021, the actuarial deficit stood at £35.8m (2018: £49.3m), and it was agreed that the company would make deficit repair contributions of £3.8m each year from April 2022 to March 2027, increasing with CPI, capped at 5%.

Following the sell-off in the shares over the last 12 months, Norcros is trading at the low end of its long-term forward P/E range, suggesting that a lot of bad news is priced in. In fact, it has only traded materially below the current rating for a period in early 2020 during the pandemic. We value the stock at 314p/share based on the average of a P/E-based valuation of 295p/share and our DDM, which implies a value of 333p/share.

The chart below details the progression of Norcros’s forward P/E over the last cycle. The range at the extremes is a low of 4x post COVID-19, and the high is c 12x at the end of 2013, before the Brexit hiatus. Over this period and outside the extreme ratings, the ‘real’ range has arguably been 6–9x and the average over the whole period is 7.5x.

If we apply the 7.5x forward P/E multiple to our estimate of FY23e diluted underlying EPS of 39.4p, we arrive at a value of 295p/share, implying c 30% upside to the share price. Arguably, this method gives little credit for future acquisitions which are part of the company’s strategy and may be forthcoming. We note that Norcros’s stockbroker currently has a target price of 365p/share, which implies a P/E of 9.25x when applied to our FY23e diluted underlying EPS of 39.4p. Other brokers currently have target prices for Norcros well in excess of 365p.

A DDM based on our FY23e dividend of 10p, applying an 8% cost of equity and a 5% growth rate, implies a valuation of 333p/share, which is not materially different to our P/E-based valuation of 295p. 333p/share implies a forward P/E multiple of c 8.5x, which could be justified if one was to consider the potential acquisition-led growth that is arguably not reflected in the current forward P/E ratio.