Norcros — On track for expected progress in FY20

The latest trading update pointed to flat underlying UK trading and modest South African progress supplemented by the newly acquired House of Plumbing in the Q1 period to end June. As ever, the detail is more illuminating as management notes share gains in these leading territories, which both remain fairly challenging markets to operate in. In overall terms, group revenue was ahead by 4.9% on a reported basis in Q1 and the company’s expectations for the full year are unchanged.

Market conditions in the UK remain subdued but the seven Norcros operating companies collectively delivered a 3.0% like-for-like (LFL) increase in domestic UK revenue compared to Q119. We believe this to be a genuine read on progress; the step down in Johnson Tiles’ B&Q supply had already occurred in Q119 and there has been no discernible recovery in business in this channel. In fact, without highlighting any specific names the AGM update referenced ‘some UK customer de-stocking’ suggesting a slightly stronger headwind. Triton, Merlyn and Abode had the best trading momentum in the second half of FY19 and we would expect these companies to be the main contributors to the reported year-to-date progress.

Domestic sales accounted for c 80% of UK revenues in FY19, which implies that export sales were down in the 10–15% range y-o-y in Q120 to achieve a flat overall UK position for this period. Exports rose in the corresponding period in FY19 so tougher comparators may be part of the reason for this, but export sales can also be lumpier and often project-specific. Vado is probably the portfolio company most exposed to this and a weaker export performance was noted here in the FY19 results. Triton’s export exposure to the Republic of Ireland is also significant and it is seen as a leading consumer brand more than a commercial project one, so performance here may have been relatively robust. It appears that sterling weakness is yet to have had any meaningful impact on overseas sales but this may change if rates persist at recent lower levels.

The Q1 update contained no direct comment on House of Plumbing trading (acquired 1 April) but it has made a meaningful contribution to South African rand sales in the year to date. It will take a while to align systems, common supply chain, map the customer landscape and develop expansion plans from the current three-branch footprint, but first impressions appear to be positive. For the record, our model incorporates a c 24% South African rand revenue uplift in FY20, with House of Plumbing accounting for c 17% of total sales for the year.

The existing three operating companies in South Africa delivered good like-for-like progress in aggregate across FY19, so the comparative Q1 period was likely to have been strong. Moreover, local market conditions are again described by management as challenging. Hence, a positive like-for-like start to FY20 is encouraging; we would expect the primary drivers to have been Tile Africa carrying over end FY19 momentum and possibly Johnson Tiles South Africa, though the effect here may be more at the EBIT level arising from improved manufacturing performance.

Norcros delivered group revenue growth and enhanced operating margins in FY19 (on reported, constant currency and like for like bases) resulting in uplifts in Edison normalised PBT (c 27%), EPS (c 8%) and DPS (c 8%). Behind the headline numbers, underlying UK profitability clearly improved despite some mixed market trends, while South Africa’s contribution was constrained by returns from its tile manufacturing and supply activities. A strong cash flow performance especially in H2 drove a meaningful reduction in net debt; on a pro forma basis – including the post year-end c £10m acquisition of House of Plumbing in South Africa – net debt of c £45m was still below the end FY18 level.

Headline revenue progress in the year was chiefly due to the first full year of ownership of Merlyn (acquired November 2017), while movements in the other six operating companies more or less offset each other in aggregate. As a general comment, progress was seen in the leading UK segments (ie trade and specialist/independent retail, which together accounted for 70% of revenue), but channel exposure to the DIY sheds was a negative influence, while export performance was mixed. At the EBIT level, the Merlyn effect was supplemented by a stronger Triton contribution and a turnaround at Johnson Tiles. Of particular note, the rate of underlying profit growth increased in H2 (as the year-on-year revenue shortfall narrowed) and operating margins improved in both half years. Also bear in mind that the UK divisional result is reported after share-based payments, which rose, and internal M&A staff costs (treated as exceptional in prior years) were absorbed above the line in FY19.

Triton, Merlyn, Vado and Johnson Tiles are the four largest operating companies in the UK accounting for almost 80% of revenue generated in FY19. The first two of these – shower and shower enclosure suppliers, respectively – increased sales in both domestic and export markets (where both have good exposure to the Republic of Ireland). Implicitly, in a subdued consumer spending environment, both companies gained market share in the UK and Merlyn (which itself increased underlying revenues by 13.8% y-o-y) may also have seen early benefits from being part of a wider group and referral network. Vado (taps, mixers and valves supply) also grew UK sales but this was offset by a weaker export performance leading to a small overall top-line decline. These three companies have limited exposure to the UK DIY sheds, but this sector has historically been more significant for Johnson Tiles. As previously announced, this company lost business during Kingfisher’s supply chain consolidation programme (‘One Kingfisher’, which included B&Q) and undertook a series of cost reduction measures at the start of the financial year. After a fall in H119, revenue was flat year-on-year in H2 and the business moved from a prior year loss into profitability. Triton and Merlyn also increased their profit contribution in FY19, although Vado saw a small decline (given the export sales performance and some P&L investment in new products).

Among the smaller UK companies, Abode, Norcros Adhesives and Croydex saw contrasting FY19 performances, with the former two companies increasing revenues by over 20%, while Croydex declined by 10%. Historically, retail has been the largest segment for Croydex’s bathroom accessories lines and weak trading by Homebase/Bunnings affected the company’s UK sales. Export revenue actually declined by a larger percentage with a number of contributory factors, not least a challenging prior year comparator, and the underlying trend is still considered to be upwards here. In an interesting development, Metlex, a sister brand from elsewhere in the group, is now the commercial sub-sector brand managed by Croydex, which addresses the washroom and leisure sectors, which naturally have more of a trade bias. Abode’s sales kicked on following significant new tap and brassware product launch activity at the beginning of the year including extended ranges, which facilitated some new retail listings and strengthened others in the trade sector. Lastly, Norcros Adhesives perversely saw a stronger retail sector performance including new product listing effects and softer overall trade demand, while export became a more material contributor to revenue following multiple Middle East project wins. In aggregate, we believe that the profitability of these three companies declined year-on-year with growing pains (and a small loss) at Adhesives and a small decline at Croydex being partly offset by an uplift at Abode.

We estimate that underlying (ie excluding Merlyn), UK domestic revenue grew by a creditable 1.0–1.5% in challenging overall market conditions. Indeed, the rate of progress in the second half, once the Johnson Tiles/B&Q effect had annualised out, is likely to have been somewhat firmer. We have already discussed DIY shed travails (where there has also been management change at Kingfisher, an ownership change at Homebase and weak Q4 calendar 2018 trading at Wickes), but other newsflow also illustrates the point. Specifically, competitors BCT (the only other scale UK tile manufacturer) and Astracast (sinks & taps) both went into administration in the final quarter of the financial year, while Bathstore (not previously a significant Norcros customer also briefly went the same way before being acquired by Homebase in July. It should be noted that the retail channel in its wider sense was actually a source of growth for Triton, Adhesives and Abode. Meanwhile, the reported results of UK quoted companies such as Travis Perkins, Grafton and Howden bear out the relative strength of the trade segment, while the housebuilders (and we acknowledge some overlap here) are also reporting growth albeit at slower rates than in recent years. So, Norcros group companies’ positioning across these segments with good supply chain disciplines has stood the company in good stead. It has not been immune to problems seen in DIY/retail though it has countered weaker demand with share gains in some areas.

UK outlook: With the range of products and sector positions that the Norcros UK companies occupy, it is difficult to generalise across the whole portfolio. However, notwithstanding subdued consumer demand, we suggest that new product/new listing momentum, further group integration benefits and opportunities arising from competitor problems all provide grounds to expect further progress in UK divisional performance in FY20. As ever, it will be for the individual companies to capitalise on their specific market attributes.

As seen at the interim stage, divisional revenues in local currency rose by just over 7% for the year (pared back to sub 4% growth in sterling terms following small adverse FX translation effects). All three operating companies again contributed to this outturn though lower rand profitability year-on-year in this division was chiefly due to manufacturing constraints at Johnson Tiles South Africa. As the acquisition of RAP Plumbing Supplies (trading as House of Plumbing) occurred after the year end, the underlying local currency changes shown in Exhibit 1 above are all organic.

A fairly even rate of headline revenue progress for the division across the year was not also mirrored at the individual operating company level. Tile Africa (bathroom products retail outlets and smaller commercial projects) actually accelerated top-line growth in H2 to over 9% yo-y. It appears that B2B activity contributed meaningfully to this growth, including a larger share of project value through the supply of multiple rather than single product lines. Joint product and supply chain development work with Vado has also benefited in store sales we believe. These two drivers of FY19 progress represent benefits of being part of a larger group, building on the existing supply of tiles and adhesives manufactured by sister companies in South Africa. Though still positive, TAL (adhesives) made more modest progress in H2 with export weakness (Zimbabwe) mostly offsetting further growth in the local South African market. The revenue performance of Johnson Tiles South Africa (JTSA) was somewhat counterintuitive with a two-week shutdown to improve plant efficiency/capacity in H1 and grid power supply issues in H2 not preventing year-on-year sales increases of c 39% and c 10%, respectively, in FY19. While H2 progress was more in line with that for Tile Africa, we suggest that the pass through of third-party imported tiles saw a significant increase in the year, boosting headline growth.

In terms of profitability, the inferred tile manufacturing disruption at JTSA referred to above resulted in an estimated halving of EBIT at this company and was substantially seen in H1. This was JTSA’s first earnings decline for a number of years; given capacity constraints, the planned efficiency upgrade investment was warranted in our view, albeit at a short-term cost, while the power supply variability was obviously outside JTSA’s control. We believe that Tile Africa and TAL broadly maintained their operating margins and so registered small local currency EBIT increases over the course of the year.

South Africa outlook: The recent general election, which returned the ANC to power with a reduced majority, may have been an unhelpful trading backdrop in the second half of FY19. While it should hence be less of a distraction now, a contraction in Q1 GDP (which straddled the election) suggests a stagnating economy in the near term. At face value, this could have an impact on project activity levels. However, the post year end acquisition of RAP Plumbing Supplies (a specialist plumbing products distributor; see Edison’s April update note) increases local exposure to the trade channel and also represents an additional potential outlet for other group products. The integration of this business and building further linkages with other group companies with Tile Africa are leading agenda items for management. In the absence of further unplanned business interruption, we believe that it is reasonable to expect some bounce back in JTSA profitability in FY20.

At the end of March 2019, group net debt of £35m was just over £12m lower than the level a year earlier, after a c £2m adverse cash balance translation.

Seasonally stronger profitability in H2 – enhanced by a full six-month Merlyn contribution – and a working capital inflow in the period led to a very strong operating cash inflow in the second half of the year. For the year as a whole, EBITDA rose by over £7m to just over £42m overall and, although the H1/H2 pattern was different, the c £2m working capital outflow was at a comparable level to the prior year. Non-trading cash outflows (ie £2.6m pension deficit recovery payments and just over £2m on acquisition-related spend) were as expected and netted operating cash flow generated in the year down to c £35m.

Consistent with higher average net debt (following the acquisition of Merlyn in November 2017), interest payments increased though cash tax was slightly lower compared to the prior year despite rising group profitability, presumably due to timing effects only. In aggregate, these items accounted for just over £6m of cash outflow. Capex was over £2m lower than both our expectations and the prior year at £5.5m. We understand that this was also largely a timing effect and there has been no reduction in commitment to new product development (NPD) and associated equipment spend. We consider that NPD has been a core business growth driver and a common discipline across the operating companies so spend in this area is a useful metric to monitor. (Expensed R&D costs were just under £4m, in line with the prior year.)

After these items, group free cash flow came in at c £23m, which we believe to be a record level. Save for the H119 dividend payment (£2.3m), outflows relating to deferred consideration and treasury share purchases were largely as reported at the interim stage. These items totalled £9.4m, leaving cash generated for the year overall at c £14m.

Cash outlook: The acquisition of RAP Plumbing Supplies for £9.7m from existing South African cash balances took place after year end; on a simple pro forma basis (adding end FY19 net debt and the RAP consideration) the start FY20 net debt of c £46m is equivalent to our expected EBITDA in the year.

We expect FY20 to be characterised by increases in all the main cash flow categories and also in pension cash contributions following the latest triennial review, working capital and capex. The post-acquisition phase for RAP obviously contributes to this in a number of areas. With a less favourable expected working capital outturn, our free cash flow projection for this year is lower year-on-year at c £17m. After a dividend uplift and c £1m treasury share purchases, this net inflow is in the order of £9m (pre RAP). In other words, group net cash generated in FY20 is expected to be broadly equivalent to the RAP consideration, so we only expect a small year-on-year increase in net debt at the year end. Beyond this, we currently project free cash inflow to exceed £20m again in FY21 and FY22, which is sufficient to fund a rising dividend, and – in the absence of further acquisitions – substantially reduced balance sheet net debt on hand. Management’s aspiration is of course to track towards £600m revenue by 2023 so further M&A is clearly on the agenda though not currently factored into our estimates.

Shortly after the end of FY19, we increased our earnings estimates for the following two years by 3–4% following the completion of the RAP Plumbing Supplies acquisition. FY19 results themselves were pretty much in line with our expectations and save for a small revenue uplift on the back of the pre-close trading statement, we make no changes to existing headline estimates, while adding FY22 for the first time. Consumer demand in the two leading markets looks set to remain subdued overall, though some of the addressed segments may continue to do relatively well. In underlying terms, our model incorporates UK revenue growth of 3.7% – boosted by expected Merlyn progress – and c 2% UK revenue growth thereafter and modest operating margin improvements. We believe that sterling weakness is likely to result in input price rises feeding through into higher selling prices. In South Africa, similar underlying and margin improvement comments apply save for some anticipated bounce back in JTSA EBIT margins in FY20 and, of course, the maiden contribution from RAP.