Norcros — Update 12 December 2016

In headline terms, group revenue growth of 8.5% was driven by UK acquisitions and good South African organic growth. The latter performance effectively delivered all of the group EBIT uplift even after a slight FX headwind in the period. Increased underlying EPS (+9.3%), DPS (+9.1%) and reduced net debt (down £5m to £27.5m) were other H117 highlights. Our revised estimates are effectively in line with pre-results levels and incorporate some regional mix changes.

First half trading was characterised by somewhat difficult conditions for the two largest and longest-standing UK operations, compensated for by increased profit contributions from more recently acquired companies. The channel experience has varied for individual businesses but, as a general comment, we believe that the retail segment – which progressively softened during FY16 – remained subdued while trade de-stocking was a key driver of weaker H117 performance in the larger businesses. In context, we believe that UK domestic revenues are split broadly 50:50 between these channels, while c 15% of total revenues are exported on a full year basis.

Overall, revenue performance has clearly varied across UK operating companies – both within and across the channels served. Having a multi-product, multi-channel portfolio does provide some resilience to individual customer and market vagaries, but not every period will also have positive y-o-y acquisition effects for Norcros. The common theme across all of its UK operating companies, with a range of different business models, is new product development. This is referenced repeatedly and allows product ranges to be updated and expanded, providing a regular stream of opportunities to grow with both new and existing customers.

Norcros has an integrated business model in South Africa with tiles (manufactured and sourced) and related adhesive products (manufacture only) supplied to Tile Africa and to other, independent retail and commercial entities. Tile Africa sources other bathroom range products externally with increasing ties to Norcros’s UK operations. In H117, revenue grew by 10% in local currency terms – all organic, with all three companies progressing – driving a 380bp EBIT margin increase to 7.2%.

Note that the reported revenues for TAL and Johnson Tiles South Africa shown below are those made to external customers only. Intra-group sales are eliminated on consolidation.

As with the UK, different business characteristics have led to a range of revenue growth across the South African companies in a market that was considered to have shown moderate growth overall. Tile Africa growth clearly has pull-through benefits for its two sister product supply operations and we believe that all three companies increased their y-o-y profit contribution in H1. The product offering in tiles and adhesives is evolving, but our sense is that the biggest strides forward are currently being taken in retail through refreshed formats, range development and planned store expansion. As the size of the Norcros group increases, so do the opportunities to develop trading ties between portfolio companies. Vado is already supplying product into South Africa with further ranges to be sourced from its supply chain. Croydex has also recently introduced certain products into Tile Africa. Hence, we believe that further growth prospects are present in this market and, if taken, a decision to add a third tile kiln at Olifantsfontein would accelerate this.

At the end of September, net debt stood at £27.5m, a reduction of £5m over the first six months of the year. Of this, c 80% was generated from cash flow, the remainder from a positive translation effect on South African cash balances.

Trading cash inflow in H1 was almost £1m above the prior year at £13.8m. This was similar to the EBIT uplift; on a simple basis EBITDA for the period was £14.8m or, after factoring in a slightly higher pensions cash payment (see more below), an adjusted EBITDA of £13.6m. While exceptional cash movements switched from a credit in H116 (£0.7m, a net gain resulting from a favourable property outcome) to an outflow in H117 (£1m, a number of small acquisition-related items). This was substantially offset by a £1.4m better working capital outturn across the two halves, driven by a larger positive creditor effect, which may have been partly due to being a larger group and partly timing effects.

Interest, tax and dividend payments in aggregate were slightly lower y-o-y at £3.1m. Cash interest costs rose due to prior year acquisition consideration, a cash tax credit was received following on from a South Africa-related tax benefit in FY16 and the dividend cash outflow represented the FY16 final payment.

Capex and depreciation are both naturally rising as the size of the group increases; spending rose at a faster rate in the first half to £4m (or 1.3x depreciation), although no major capital items were highlighted in these results. Lastly, deferred consideration of £2.5m representing the final Vado payment formed the majority of a £2.7m acquisition cash outflow in H1, the remainder being a deferred part of the Abode acquisition.

More on pensions: the balance sheet showed a significant uplift in retirement benefit obligations with the IAS19R gross deficit moving from £55.7m at the end of FY16 to £97.8m by the end of September. This was chiefly due to a 130bp reduction in the discount rate assumption to 2.25%. (Other companies reporting with period ends after the Brexit referendum result have also commented on the sharp drop in underlying bond yields.) This movement has partly reversed more recently and Norcros notes that a 0.1% (or 10bp) increase in bond yields reduces the scheme deficit by £6m, other things being equal. Under the current triennial valuation, Norcros has an agreed deficit recovery cash payment of £2.5m plus annual CPI per annum into the scheme. The next triennial review is due in March 2018; the scheme is very mature (comprising 66% members already of pensionable age, with an average age of 77) and annual pensioner payroll cash payments are c 10% from the expected peak level. On this basis – and subject to sensible stewardship of pension scheme assets – we would consider there to be limited upward pressure on cash recovery payments. Of course, actuarial experience, asset performance and prevailing assumptions at the time of the next review will all be important factors also.

Cash flow outlook: the split of underlying profitability normally has an H2 bias – which can be amplified by the timing of acquisitions – and we assume a c 46:54 split for EBIT in the current year. Countering this, the working capital cycle tends to decline in Q3 and builds again in Q4 of the company’s financial year, resulting in an outflow overall for H2, and we expect this to be the case again in FY17. After taking into account similar cash interest and capex in H2 versus H1, a normalised cash tax payment and the declared H117 dividend cash outflow, we expect Norcros to end FY17 with net debt of c £27m, marginally lower that at the interim stage. This represents less than 0.9x our expected underlying FY17 EBITDA, which itself is c 20x expected bank interest cover (or c 16x on a P&L/EBIT basis). Subject to available opportunities, we would expect to Norcros to be looking to add to its portfolio of operating companies, sticking to the strategy of acquiring in related business areas where synergies can be generated across the wider group. The company has a £70m RCF plus a £30m accordion facility; these banking arrangements run to July 2019.

There are reasons for both caution and optimism regarding the trading outlook for Norcros. UK residential RMI spend has been patchy and, in our opinion, is likely to remain that way in the near term. While UK employment levels are high, house prices firm and interest rates low, the prospects for real average earnings growth appear to have diminished and so do not suggest that a broad increase in consumer spending is likely to occur in the near term. That said, momentum with newer operating companies appears to be good and Norcros does have commercial sector exposure also (c 40% UK sales), where demand should be relatively robust and exports (c 15% UK sales) should benefit from sterling weakness. As previously noted, higher inbound component and product costs are hedged; upward pricing pressure can be expected as the hedges roll forward and we would expect mitigating actions to be taken to protect margins in UK operations. South African real GDP growth is projected to pick up over the next three years, growing by between 1-2% pa. The OECD suggests that investment – with improved electricity reliability – and consumption will support this progress. That said, a number of economic and structural challenges remain and so we would suggest the scope for sharply improving markets for Norcros in South Africa is limited. Hence, a continuation of the strategy to deepen market penetration, gain market share and improve operational efficiencies will be the key drivers of success.

As Exhibit 2 shows, we have modestly increased PBT estimates for the current year, with subsequent years unchanged. In all cases, this is the net product of lower UK profit growth expectations with estimates for South African operations raised, supplemented by more favourable FX translation (now at £/ZAR18.0 in all years). Our FY17 EBIT estimate splits roughly three quarters UK, one quarter South Africa (versus 81:29 in the prior year). Overall, we do expect to see some UK EBIT progress in all three years, albeit fairly modest in FY17, following a flat H1 outturn. Progress in South Africa should be fairly broadly based across all three operating entities there.

Our estimates now use a 23% tax charge on PBT as defined by Norcros – in line with H117 – compared to c 20% previously. (Note that the effective rate was 15% in FY16; the step-up to more normal levels in the current year means that our expected FY17 EPS is lower than in FY16.) Although not shown in the table, note that we have also nudged up our FY17 DPS expectation by almost 3% to +9.1% for the year, in line with progress declared for H1. Subsequent years are unchanged at this stage.