Thrace Plastics — Progress through adversity

The FY20 results represented the culmination of an investment-based strategy (as outlined in our initiation note in June 2019) directed towards organic growth and margin expansion through the capture of greater value from the materials processed by the business. As well as investing for growth, restructuring actions taken in the last two years reduced exposure to less profitable lines (eg exiting US non-woven production and certain other activities in Bulgaria and Scotland). As a result, FY20 group ROCE rose above 20% (from c 5.5% in the preceding year).

Thrace’s latest strategic phase aims to build on recent successes. Value capture and margin expansion1 are ongoing core drivers. An evolution of the current offering includes opportunities to move downstream (as seen in face mask production), lower production costs and develop products with better margins. In addition, the newly created chief entrepreneur role (Konstantinos Chalioris, chairman, leading shareholder) has a mandate to identify new business opportunities in existing and adjacent sectors, which may include synergistic acquisitions potentially. Through a rolling five-year planning and annual budget cycle, we expect Thrace to direct resources and balance output in accordance with the opportunities identified through the execution of the above strategy.

Thrace’s FY20 results presentation also brought ESG2 considerations more explicitly to the fore to its external stakeholders. In our opinion, the company already has a strong established positive track record with regard to its societal responsibilities, examples of which include local community support near to the Xanthi manufacturing facilities, a comprehensive Annual Report employee section and, in FY20, the donation of company-produced surgical masks during the pandemic.

With regard to governance, Thrace’s rigorous financial planning, management and reporting are very visible disciplines that have clearly stood up well to the challenges thrown up by the COVID-19 pandemic. The management board has evolved over the last two years, including the separation of the chairman and CEO roles; Dimitris Malamos, formerly CFO for 10 years, became CEO role in October 2020 (having been made deputy CEO six months earlier) and Dimitris Fragkou was an external new CFO (non-main board) appointment. These moves retain continuity and financial discipline while also allowing the chairman to apply deep industry knowledge to the role of chief entrepreneur. The main board also comprises nine non-executives (NEDs) who bring a full range of relevant local and international career experience. Two independent NEDs (of four) stepped down at the beginning of 2021 and three new ones joined. The Thrace board service of the other NEDs ranges from three to 10 years. As well as having conventional audit, remuneration and nomination committees, Thrace has recently established committees for Strategy & Investment and Human Resources, and appointed a new chief sustainability officer to drive alignment with the UN’s Sustainable Development Goals and the circular economy.

Regarding the company’s environmental impact, Thrace already considers its polymer-based plastic products to be 100% recyclable in some form. Having used c 7,000 tonnes of recycled input materials in FY20 (c 6% of the total), Thrace has committed to raise this to in excess of 8,500 tonnes by 2025 through linkages with supply chain and customer partnerships. Lastly, Thrace proposes to reduce conventionally produced energy through investment in new production technologies and photovoltaic energy sources at its facilities. (Outside of its two main divisions, Thrace owns c 51% of a JV which produces hydroponic vegetables in a greenhouse system powered by geothermal energy.) The company is actively engaged in measuring its existing carbon footprint and expects to set targets for reducing this during 2022.

Trading in the first three months of FY21 set another record for group quarterly revenue and profitability (at the gross profit, EBIT and EBITDA levels), exceeding previous peaks reached in Q3 FY20. The group-level financial headlines were:

The Technical Fabrics division was the primary driver behind this performance, but Packaging also delivered good year-on-year progress against Q120. This resulted in further strong cash generation in the period, leaving group net debt at very low levels (ie c €6m on a pre-IFRS 16 basis or c €9m including lease finance). More detail on the FY20 trading performance is shown in later sections.

Technical Fabrics: against Q120, divisional revenues increased by c 65% with gross margins more than doubling to 43.6%. As previously noted, sales of fabrics and finished products (such as face masks) into the medical/personal protective equipment (PPE) sector have been a significant contributor to profit growth since early 2020. Divisional EBIT rose by c €27m y-o-y in Q1 and PPE accounted for €20.5m of this increase (and at the same time exceeded the sector’s €19.5m profit contribution for the whole of FY20). In context, PPE sales only began to ramp up in Q120 as the COVID-19 outbreak became a pandemic and Thrace also invested in new PPE line capacity during 2020, which drove much higher run rates as that year progressed. We believe that other contributors to strong Q121 trading include a higher FY20 year-end raw materials inventory position ahead of a surge in polymer prices at the beginning of FY21 both facilitated divisional sales in a period of tight supply and also allowed some widening of margin spread. The objective of capturing greater value for the materials produced by targeting specific sectors is clearly working. To this end, further capex on finished PPE lines was undertaken in Q1.

Packaging: divisional sales grew by c 19% in Q1 and a slightly better gross margin versus Q120 was amplified by good opex cost control, resulting in a 190bp improvement in EBIT margin (to 13.3%) and a c €1m EBIT uplift (to €3.8m). The key positive trends driving Technical Fabrics – ie PPE sector sales mix and margin enhancement – only had a marginally favourable effect on the Packaging outturn for the quarter.

This was a good start to the year by the Packaging division in what is typically one of its quieter quarters (along with Q4). Noting that the gross margin settled back at Q120 levels following higher peaks in the middle quarters of FY20, it remains to be seen whether FY20’s stronger June and September quarterly gross margin pattern can be repeated in FY21.

Cash generation: unsurprisingly, operating cash flow in Q1 was very strong at c €39m – including a c €2m inflow from working capital – representing excellent cash conversion levels. Given the c €32m net debt position (pre IFRS 16) at the end of FY20, net cash inflow for the quarter of c €26m served to virtually eliminate net borrowings on hand on the same basis at the end of Q1.

Outlook: company comments accompanying the Q1 results were generally positive with a ‘satisfactory trajectory’ anticipated for profits and liquidity in Q2 and an optimistic outlook for the remainder of the year. This said, with less visibility into H2 – normal for this stage of the year but also with uncertainties regarding post-pandemic macroeconomic performance in the countries and markets served – an understandable note of caution was also struck with respect to prospects later in the year.

The excellent performance delivered by Thrace in FY20 was in line with our upgraded revenue estimates, with stronger gross margins and good opex control together resulting in normalised PBT of €56.1m, c €4m better than we had anticipated in November. The EBIT mix favoured a stronger Q4 from Technical Fabrics than we had expected. Core bank net debt was also €3m better than we were looking for at c €32m (€38m including IFRS 16 leases) and less than half of end-FY19 levels, even after a special dividend payout in December.

International developer, manufacturer and distributor of technical fabrics, industrial yarns, fibres and composite materials used in a wide range of applications (including construction, infrastructure, personal protective equipment, landscaping, floorcoverings and agri/horticulture) produced mainly from polypropylene (PP) using a wide variety of different processes.

Strong trading momentum noted earlier in the year continued throughout H2 and although Q4 revenue was below the record quarterly peak of c €70m in Q3, profit levels were substantially maintained. Consequently, for FY20 as a whole, the Technical Fabrics division delivered a c 15% revenue uplift with EBIT up almost fourfold. Of the €33.9m EBIT increase, €14.4m was generated from the normal course of operations and represented a 165% increase on the total FY19 divisional EBIT. Management has attributed the other €19.5m to product sales into the medical sector which saw an exceptional demand increase related to the COVID-19 pandemic.

The divisional sales volume from continuing operations was just over 79,600 tonnes in FY20, up 2.7% versus FY19. Hence, the revenue benefit from higher average selling prices was around 12% y-o-y. Thrace was able to substantially maintain its underlying pricing structure but also improve the product mix to drive overall realised divisional average selling prices higher. Given that input unit costs were lower on average for the year, this resulted in significant operating profit leverage on a comparatively small volume increase. The FY20 divisional gross margin reached 30.8% for the year as a whole, which compared very favourably to the 19.3% reported for the prior year.

We note that the comparable H1 sales volume was down by 3.6% y-o-y (and revenue was down by a similar amount), but profitability rose which is a clear indicator of mix improvement in the early part of the year We believe that this favourable mix effect developed further in H2, and was supported and amplified by implied year-on-year volume progress of c 6.5%. Given that investment in new medical sector lines largely occurred in H1 (and also captured additional value through vertical integration) and new non-woven material capacity came on stream as the year progressed (notably relocated US lines in Scotland and Greece – in September and Q4 respectively), an H2 volume bias is logical.

Mix improvements come from a number of different areas, most obviously from increasing the proportion of revenues of higher margin products in any given period. Taking a more dynamic view, developing new, higher margin product offerings and capturing more of the value chain by supplying finished goods rather than components (eg moving from PPE fabrics to finished masks) over time also serves to enhance profitability. At the same time, reducing costs through production line improvements (such as reducing changeover times) and restructuring provides additional margin leverage from operational gearing particularly in higher volume market scenarios. We can see why medical sector growth enhanced divisional margins, although we had underestimated the magnitude as evidenced by a number of significant earnings upgrades in the second half of the year. Other factors, such as increasing sales of laminated materials (ie more than one fabric combined in layers) and a reduction in certain woven product lines also contributed to the mix and margin improvement witnessed in H2.

European manufacturer of containers and packaging in both rigid and form mainly using polypropylene and polyethylene feedstock with injection moulding (including in mould labelling), blown film extrusion and thermoforming being the primary production processes.

This division operated without any significant structural changes (such as exiting lines or capacity investment/realignment as seen in Technical Fabrics) and so the progress delivered was from a similar capital base to the prior year. The good start to FY20 continued and strengthened further in H2 leaving full year revenues up c 11%, with EBIT more than doubling to €16.1m. There was a smaller value impact from medical sector exposure in the division; management flagged that this accounted for €3.2m of the €8.6m EBIT increase.

Full year sales volumes rose by 1.8% (at c 36,000 tonnes) so there was a favourable year-on-year average selling price comparison, approaching 10%. We believe that mix improvements were the primary driver behind this development, with an increasing proportion of higher-value small food container products and a reduction in larger products sold into the catering/hospitality industries. As in Technical Fabrics, this division has been migrating its product mix towards higher-value sectors for some time now, supported by investment, and a continuation of this trend was also likely in underlying terms.

Divisional revenues grew year-on-year in each quarter of FY20, with particularly strong progress achieved in Q2 (+9%), Q3 (+25% to a record c €31m revenue) and Q4 (+8%). We believe that the year-on-year price effect noted above was more pronounced in H2 and contributed to these relative growth percentages. An already very respectable divisional gross margin (of 21.5% in FY19) improved slightly in Q120 and then gapped up for the remainder of the year – reaching almost 35% in Q3 – buoyed by the top-line gains. Interestingly, H1 sales volumes were up by 2.8% y-o-y, which infers that H2 declined by c 1% on the same basis. Given the revenue progression, this lends further weight to our earlier point regarding mix improvement, coming through in both higher average selling prices and gross margin contribution on a relatively static H2 volume picture.

Curiously, the EBIT drop-through pattern for the year was somewhat counterintuitive, being stronger in H1 (when the year-on-year operating profit increase of €3.4m exceeded the revenue uplift of €2.9m) than in H2 (in which the comparable figures were +€4.8m and +€8.0m respectively). Clearly, there was an accompanying one-off increase in opex in H2/Q4 that resulted in a relatively more constrained EBIT drop-through in H2 despite the very strong top-line and gross margin performance. Nevertheless, looking at the year as a whole the combination of strong revenue growth and gross margin gains across a broadly similar operating base resulted a very commendable doubling in operating profit for the Packaging division in FY20.

The significant increase in group profit fed through to a material reduction in group net debt, which stood c €32m (pre IFRS 16 basis, c €38m IFRS 16) at the end of FY20 from c €74m a year earlier.

Although group profitability was larger in H2 (around two-thirds of EBIT generated), underlying1 operating cash flow of c €76m (before interest and tax) was pretty evenly spread across the two halves of the trading year. The primary reason for this was a c €21m underlying working capital difference (ie c €13m H1 inflow, c €7m H2 outflow).

An overall working capital inflow for the year despite significant uplift in revenues during FY20 is a notable achievement. A net inventory reduction of almost €2m was due to a sharp, demand-driven decline in semi/finished goods being partly offset by an increase in raw materials. This tactical position enabled Thrace to continue to maintain strong service levels with customers in Q121 a period in which industry-wide tight supply and price increases were seen. The other contributing factor to an even H1:H2 operating cash flow split was higher exceptional cash outflows in H2 (ie c €3m versus c €1m in H1), which related to restructuring actions, exiting/relocating US non-woven production and, relatedly, changing the production mix at Don & Low in Scotland.

Cash interest costs at €3m were over €1m lower year-on-year as one would expect given the cash generated in FY20, while minority dividend income was slightly lower (€0.5m). Cash tax payments increased (to €3.6m); this was significantly below the P&L charge for timing reasons only and the gap should be expected to narrow as payments follow raised profitability.

Thrace has invested at well above its depreciation charge in recent years and FY20 was no different. Gross cash capex was over €28m for the year as a whole (compared to c €16m for owned asset depreciation) with expenditure relating to relocating and commissioning two non-woven production lines from the US and new investment in PPE lines (manufacturing and finishing) in several locations the most significant items, we believe. Taking into account the receipt of US property disposal proceeds in H13 and other small asset disposal proceeds, net capex recorded in FY20 was c €19m.

After the above line items, Thrace generated c €51m free cash flow in FY20. This was clearly able to fund the usual annual €2m ordinary dividend payout and also supported a further €2.5m special dividend payment at the year end. After treasury share purchases (approaching €0.8m) and lease capital repayments (of €4.4m, which compared to €2.7m depreciation of leased assets) net cash generated for the year was €42m. This enabled Thrace to pay down c €23m of bank debt on its balance sheet, leaving €73m on the balance sheet, together with c €41m cash on hand, at the year end.

Cash flow outlook: in FY21, some investment in finished goods inventory is likely and while we expect cash tax payments to rise, as things stand, we also anticipate a step down in capex as utilisation of the relocated non-woven lines rises. Thrace has undertaken significant multi-year capex programmes in the past and, with net debt:EBITDA (pre IFRS 16 basis) of 0.4x at the end of FY20, the company clearly has scope to make both organic and acquisitive investment subject to opportunities arising. As things stand, on our revised projections (see below) we expect Thrace to move to a net cash position by the end of FY21, with significant cash inflows thereafter. For now, we have modelled gross capex slightly above depreciation in each of our estimate years. Note that our model also assumes that the deferred Linq property proceeds are received; this will be confirmed or otherwise by the end of June.

Following the FY20 results announcement, the importance of medical sector demand in financial terms was quantified. In FY20 itself, €22.7m of the PBT generated in the year came from the medical sector, largely in Technical Fabrics. As Thrace already had a presence in this segment, it is likely that not all of the figure indicated was incremental, although we are unable to quantify the pre-existing baseload level of profit derived from this end-market. Q121 results also contained a €20.6m PBT contribution overall from PPE/medical products (substantially in Technical Fabrics).

We recognise that the demand for PPE may well start to tail down towards more normal levels at some point in the second half of 2021. Thrace has already reported that Q1 demand was firm in this segment with a positive outlook for Q2. In broad terms, we have been expecting strong medical sector strength year-on-year

in H1 to be balanced out in H2 of FY21, leaving overall volumes at similar levels. The scale of the Q1 contribution now suggests that FY21 will be ahead of FY20 in this sector in our view. While annualised sector-specific volumes may drop from FY22 – although the ongoing market size is likely to be above pre-pandemic levels with Thrace taking a larger share also – Thrace will be aiming to develop alternative high-value market segments and applications over this time horizon. It is important to note that Thrace did not experience significant variation in demand from its other core Technical Fabrics sector exposures (apart from the managed reduction in weaving operations) during FY20.

Higher polymer prices were noted in Q121 and will inflate revenues as they are passed on to customers though have settled back from recent peaks. Our gross margin expectation for FY21 has increased based on the reported Q1 performance but beyond this we have been more conservative on gross margins in the light of the separately identified scale of the medical sector contribution. Note that we have factored in some reduction in average selling prices in FY22, reflecting an expectation of lower input prices and medical sector volumes in the mix.

It is important to note that these are working assumptions; we generally do not take views on pricing (ie we typically assume that they – and FX – are stable across estimate years) but with visible spikes in polymer prices at the end of FY20/beginning of FY21 plus exaggerated mix effects in Technical Fabrics seen during FY20 also, we have chosen to represent potential impacts of changes in these positions in the above way. We will of course adapt our model when differences in actual prices and mix become apparent over a sustained period.

As shown in Exhibit 2, the above assumptions translate to a further increase in expected group profitability in FY21 before settling back below FY20 levels. We have increased our earnings expectations for FY21, conservatively lowered FY22, and introduced FY23 estimates for the first time. It should be noted that our FY22 and FY23 estimates are well ahead of levels of profitability reported by Thrace prior to the exceptional FY20 and FY21 years boosted by medical/PPE sales.

At a high level we expect FY21 to be characterised by ongoing firmness in demand from the medical sector for much of the year and the two relocated non-woven machines represent incremental capacity, ramping up into the following year also. With regard to FY22, we have not explicitly modelled the medical sector contribution, but our working assumption is that there is underlying profit growth and the c 42% (c €42m) y-o-y group EBITDA reduction in that year is more than accounted for by a lower PPE/medical sector demand run rate.

The level of FY22e and FY23e profitability compared to the preceding two years serves to illustrate the exceptional level of earnings in FY20 and FY21e driven by the COVID-19 pandemic’s impact on PPE demand, which has been pushed to unprecedented levels. In context, our FY22 and FY23 EBITDA expectations are around two times higher than levels reported in the four years prior to FY20. Thrace has invested in higher value-added production lines in both of its main operating divisions and also undertaken some restructuring actions (mainly in Technical Fabrics) such that the group has both enhanced its market positions and increased operating efficiencies over this time period. If we also consider that net debt has also reduced significantly (from peak levels of around €78m at the end of FY18 to c €9m at the end of Q121), Thrace has strengthened its investment proposition from several perspectives.

The wide range of actual and expected earnings outcomes over the last five years covering some exceptional market conditions – which themselves have also inflated equity market risk premia –leads us to employ a DCF matrix approach that broadly covers experience and our expectation.

In Exhibit 3, our selected EBITDA range extends from €40m to €80m; our FY22e and FY23e projections are around the middle of this range. We have previously used a c 6% WACC for Thrace; equity market risk premia have risen and, using and end-market weighted approach, our core company WACC input is now 6.9%4.

Based on our DCF inputs, our observations are:

Put simply, the current share price appears to be factoring in a larger step down in group EBITDA as the business volume mix normalises (ie exceptional medical sector volumes reduce) than we are currently projecting. In fact, compared to reported FY20 EBITDA of c €76m, this inferred difference (of €32m) is considerably greater than the €22.7m medical sector contribution in that year, as highlighted by the company. Therefore, this is discounting no underlying (ex medical sector) growth in future – and actually an EBITDA contraction – which looks overly conservative in our view. Thrace has clearly shown an ability to adapt quickly and take advantage of faster-growing, higher-value applications and we feel that this will be a key driver to the future growth in group profitability.