Carr’s Group — Update 9 November 2015

Divisional revenues declined by 5% year-on-year reflecting lower commodity prices. Divisional profit before tax rose by 6%. Sales of feed blocks in the US continued to rise, supported by a recovery in the beef industry following a period of protracted drought, and market share gains following the commissioning of a low-moisture feed block plant in Iowa in July 2014. However, demand for feed blocks in the UK was adversely affected by the availability of forage and constraints on farm incomes. Retail sales rose by 9% (5% like-for-like). This growth was supported by the acquisitions of B E Williams in July 2014 and W M Nicholls in October 2014, both of which strengthen the group’s presence in south Wales, as well as investment in the Country Store portfolio, with redevelopment of the facilities in Appleby and Selkirk. Volumes of feed sold increased by 4% as Carrs took market share, but margins were under pressure in localised areas because of the dip in farmgate milk prices and increased competitive activity relating to Mole Valley Farmers’ new mill in south-west Scotland. Low milk prices globally mean that dairy farmers in both the UK and the US were less incentivised to boost milking cows’ productivity, so there was a reduction in demand for high-margin AminoMax bypass proteins in both regions.

In the longer term, we expect the division to benefit from the adoption of more sophisticated feed regimens for dairy and beef cattle across the developed world. Nearer term, management expects commissioning of the low-moisture block line in Nevada to be completed this month. This will give access to the significant West Coast dairy market. Management continues to consider locating a feed block production facility in New Zealand, where sales are already in excess of 1,500 tonnes annually. This programme has been delayed because the proposed New Zealand partner has recently undergone substantial organisational changes. The group has recently engaged personnel in Brazil to develop this potential market for feed blocks. We expect further retail sales growth arising from a new store in Rothbury, which opened in July, and the acquisition in June of Reid & Robertson, which has a country store and two satellite outlets, strengthening the group’s presence in west Scotland. We note that the division is less dependent on demand for dairy feed than NWF Group because it also sells substantial volumes of sheep and beef cattle feed. Given the location of the rural areas that Carr’s serves in the UK, the division has little exposure to the arable sector, so it has not been affected significantly by a reduction in demand for arable inputs such as fertiliser, pesticides or seeds caused by low wheat prices.

Noting continued low commodity prices, we maintain our divisional FY16 revenue estimate at £291.7m, giving a 2% divisional revenue reduction year-on-year. We expect growth in demand for feed blocks following commissioning of the Nevada feed-block manufacturing facility to offset margin pressure on feeds, so we maintain FY16 profit before tax at FY15 levels (£12.7m) rather than raising FY16 divisional profit before tax to £13.0m as previously.

Divisional revenues declined by 8% year-on-year. Volumes increased by 5% as the two northern mills won new customers. The investment programme is key to attracting new business. Customers require the highest levels of flour quality, food safety and service levels. They are attracted by the state-of-the-art equipment in the Kirkcaldy mill, which commenced production in September 2013 after a £17m investment programme. As capacity here has been filled, there has been investment in the Silloth mill to ensure compliance with newer food-handling standards. Divisional profit before tax grew by 6%, reflecting improved operational efficiencies on higher volumes. Both the northern mills benefit from port-side locations, which reduces freight costs. During H115 this enabled them to source imported wheat cost-effectively, the 2014 UK harvest being generally of insufficient quality for producing bread-making flour. By contrast, the 2015 UK harvest was of consistently good quality, so the mills were able to ship wheat from Kent in a cost-effective manner. The reduced freight costs and improved operating efficiencies have helped offset pricing pressures caused by intense competition between supermarkets.

Management expects pricing pressures to continue. It also notes a reduction in demand for white sliced bread, as consumers switch to other formats such as tortilla wraps. This is beneficial for the Maldon mill, which specialises in ethnic flours, but unhelpful for the northern mills, where a significant proportion of milling relates to flour for ordinary white loaves.

Noting continued low commodity prices and margin pressure, we reduce our divisional FY16 revenue estimate from £81.4m to £75.0m and our profit before tax estimate from £2.7m to £2.2m. This gives a 7% reduction in divisional revenues year-on-year and a 10% reduction in divisional profit before tax.

Divisional revenues rose by 25%. This was partly the result of a full year’s contribution from Chirton Engineering acquired in April 2014. It was also the result of high levels of utilisation at Bendalls as it worked on a £9m contract to deliver 33 pressure vessels for the BP Shah Deniz gas pipeline in Azerbaijan. Wälischmiller and Carrs MSM, both of which are focused on the nuclear industry, continued to perform well. By contrast, a lack of capital investment by Chirton’s customers in the oil exploration sector had an adverse impact on order intake, resulting in low utilisation levels. This was exacerbated by delays in moving the business to larger premises. Divisional profit before tax reduced by 17% year-on-year.

Although cutbacks in the global oil and gas industry will continue to affect the division’s profitability in the short term, management expects this to be more than offset by a recovery in the UK nuclear sector, which is already reflected in the order books at Bendalls, Carrs MSM and Wälischmiller. We note that historically a relatively high proportion of Bendalls’ order book was related to the UK nuclear industry, with the business pursuing lower-margin work in the oil and gas sector more recently to make up the shortfall caused by a slowdown in the UK nuclear energy programme. Chirton has the greatest exposure to the oil and gas industry. We note that post-acquisition it has started to supply machined parts to Wälischmiller and has submitted joint tenders with Bendalls for projects in the nuclear industry, which have yet to be awarded. Management has begun to develop a design function in the division, which will not only generate profits from providing design services, but also promote the engagement of the other engineering businesses in the group for the contracts on which it is engaged.

Noting the intake of orders relating to the nuclear industry, we raise our FY16 divisional revenue estimate from £32.8m to £36.5m and our divisional profit estimate from £3.2m to £3.6m. This gives a 9% rise in divisional revenues year-on-year and a 16% increase in divisional profit before tax.

Group revenues reduced by 4% year-on-year to £411.6m, in line with our estimates, reflecting lower commodity prices. Profit before tax (adjusted for amortisation, share-based payments and exceptional) rose 6% year-on-year to £18.1m, also in line with our estimates. Profit gains in the Agriculture and Food divisions offset a comparatively weak performance from the Engineering division. DPS was raised from 3.4p to 3.7p.

The changes to divisional estimates discussed earlier result in the revisions at group level summarised in Exhibit 2. The net effect is for group revenue estimates to reduce by 2% year-on-year to reflect low commodity prices and for group profit before tax to remain at FY15’s record levels instead of increasing further. We note that the FY15 retirement benefit charge (see Exhibit 1) was anomalously low because of a credit and expect a higher level going forward. We expect the group to maintain its progressive dividend policy.

Net debt reduced very slightly, by £0.2m during the year to £24.4m. Net capital expenditure was lower at £5.5m (FY14 £6.5m), as the previous year included costs related to completion of the new factory and offices for Wälischmiller in Germany and the Kirkcaldy flour mill. Capex was lower than expected because some of the costs of completing the Nevada Springs facility were deferred until FY16. The retirement benefit surplus reduced from £2.1m at end FY14 to £1.8m at end FY15. Gearing reduced slightly during the year, from 31% to 28%.

Looking forward, we expect the inclusion of some of the Nevada Springs costs to push FY16 capex to a relatively high £8.4m. Our model shows net debt reducing by £2.2m to £22.2m at end FY16. Net cash generation then improves during FY17 and FY18 as capital expenditure requirements reduce, leaving the group in a net cash position (£1.0m) at the end of FY18.

Our valuation is based on a sum-of-the-parts analysis of the group and sees fair value at 199p/share (previously 203p). We have determined an appropriate prospective P/E ratio for each division and then calculated a blended P/E multiple, which is weighted according to the proportion of pre-tax profits contributed by each division. The prospective multiple for the Agriculture division, together with the associates and JVs, which are primarily involved in agricultural supply-related activities, is based on the mean for our sample of companies engaged in agricultural supply-related activities. The prospective multiple for the Food division is based on the mean for the UK Food Producers and Processors sector (Bloomberg). The prospective multiple for the Engineering division is based on the mean for the German Industrial Engineering sector (Bloomberg), where the majority of the division’s profits originate.