Epwin Group — Raised estimates and margin upside potential

Epwin’s FY21 revenues were in line with our expectation, but PBT came in £1m ahead of our (slightly increased at year end) estimate,2 driven by F&D profitability. Behind this performance, the divisional mix was also more in favour of F&D than we had anticipated – at both revenue and EBIT levels – partly offset by a softer E&M contribution. Year-end core net debt was in line with guidance at c £9m, broadly half of the level seen at the start of the year.

Group revenues saw a16.8% uplift versus FY19, around half of which was generated from increased selling prices and surcharges, c 30% from higher volumes and c 20% from acquisitions. Against the same comparator, group gross margin declined to 28.1% (down 340bp) given input cost pressures and pass-through lags, although this was partially mitigated at the underlying EBIT level (5.6% margin, down 190bp) with some evidence of tighter opex control. Specifically, administration costs only rose by 4.7% and, while distribution expenses increased by 14.8% (including fuel and transportation cost inflation), this was still below the rate of revenue progress.

We understand that the net impact of higher input costs (ie after taking higher selling prices and surcharges into account) effectively more than explained the gross margin movement. Positive volume drop-through effects, acquisition contributions and other items collectively exceeded wage cost pressures in the period (which would have fed into both COGS and opex). Divisionally, F&D hitting and sustaining record EBIT margins (of 6.6%) was the clear trading highlight, while E&M performance was clearly more subdued largely due to input cost pressures. Lastly, we note that group central costs have been flat now over the last three years, which will have partly contributed to the limited administration cost uplift referred to earlier.

Manufacturing operations continued to generate the largest share of group profitability in FY21, although below pre-pandemic levels in absolute terms. Compared to FY19, divisional revenues rose by c 14%, while EBIT was over one third lower, generating an EBIT margin of only 6.0%.

Following the broad pandemic lockdown in H120, the constituent businesses largely recovered well from the second half of 2020, benefiting from strong volume demand. While this continued into 2021, a related uptick in input cost inflation right across the building materials product spectrum gathered momentum, arising from below normal inventories in distribution networks, raw material production lagging demand and some transport constraints. In Epwin’s case, its cellular (eg roofline, cladding), rainwater and decking lines fared relatively well with product availability and pass-through of higher input costs. In contrast, window systems was more challenged, factoring in additional logistics strains which affected service levels, lead times and probably pricing leverage to some extent. In other words, the rate at which input price increases were passed through is likely to have seen a greater lag here than elsewhere in the group. In order to limit any further short-term impacts on customer supply, the final relocation of finished window profile inventory into the new purpose-built warehouse facility at Telford was put on hold, to be completed in FY22.

Excluding the pandemic-affected FY20 trading year, the E&M division has historically reported EBIT margins in the low double-digit, 10–13% range, so we believe that the FY21 result should be seen as an aberration for the above reasons. Rebalanced inventory, reduced order backlogs and full use of the new warehouse facility should all serve to normalise customer service levels during FY22. As an illustration, restoring a 10% EBIT margin on maintained FY21 revenue levels would generate an incremental c £8m of EBIT for the division. However, virgin polymer costs firmed again in March. So, while we consider it reasonable to expect some improvement in divisional margin in FY22, with some ongoing lag on pass through to selling prices, historic levels are unlikely to be attained this year in our view.

At the headline level, the F&D division delivered FY21 revenues almost 22% higher than in FY19, with EBIT ahead over 80% on the same basis and a 220bp EBIT margin increase to 6.6%, all of which represented record levels. Epwin made three in-year acquisitions,3 which contributed £9.5m to the top line and £1.1m to EBIT; excluding this, the underlying revenue and EBIT increases from ongoing operations were c 13% and c 60% respectively.

Distribution accounts for around 60% of divisional revenues and the fabrication of windows and doors makes up the majority of the remainder (with decking installation a small contributor also). We believe that these larger activities grew underlying revenues by similar, low double-digit percentage points in FY21 versus FY19. Within this, trade fabrication subsector growth was especially strong, but diluted to some extent by slower progress in the social housing subsector, which started the year more slowly with housing association budgets more focused in other areas. Distribution underlying revenue growth improved slightly as the year progressed, which may have been due to a strengthening price effect to recover input cost increases. Incremental revenues from acquisitions (see above) would also have skewed headline revenues a little more towards H2.

The achieved 6.6% EBIT margin was particularly noteworthy, a new record level despite supply chain cost pressures and achieved in both the first and second halves of FY21. Excluding acquisitions, the underlying margin was c 6.2% which was 100bp+ higher than the best previously reported for the division. This was further enhanced by acquiring existing customers, capturing incremental distribution revenue and profit contributions. Otherwise, effective management of price lists and further harmonising product lines and IT platforms across the distribution branch portfolio is likely to have aided margin improvement. (Note that an exit from sealed glass unit fabrication at the beginning of 2019 was reported as a discontinued operation in that year, so should not have affected the FY19/FY21 margin comparison.) Overall, the margin outturn for the year compared favourably to our own illustrative level, recently used as an input into our investment case for generating record group profitability. Specifically, based on historical levels and work undertaken to improve performance, we highlighted a 4–6% F&D EBIT margin range as a reasonable medium-term expectation, using a 5% midpoint as a building block in support of a potential record level of group profitability proposition. Hence, we see the FY21 performance as a strong endorsement of the F&D potential in this context.

Epwin ended FY21 with £9.4m core net debt (pre IFRS 16) down from £18.5m 12 months earlier. With asset disposal proceeds effectively matching cash acquisition spending in the period, underlying cash generation comfortably funded a resumption of dividend payments.

Although FY21 EBITDA (excluding right-of-use asset depreciation) at c £25m was c £4m lower than in FY19, operating cash flow for the year on the same basis was comparable at c £25m. In other words, the net effect of very modest working capital investment and non-cash adjustments was negligible in the latest year (but a net outflow in FY19). The composition of working capital flows included a £10m inventory investment arising from a relatively low position at the beginning of the year and build-up of a buffer position at the year end, amplified by rising input costs. The c £6m absorption in H2 was more than matched by good receivables collection and a further increase in payables, which partly reflected and offset the inventory movement.

Cash interest and tax combined saw a £2m outflow (bank interest costs being stable at £1.5m while tax of £0.5m was in line with the P&L charge). Gross capex totalled £5.5m and was substantially spent on maintenance of owned tangible assets, with no specific new projects highlighted. This was almost matched by the final net proceeds from the new Telford (Hortonwood) warehouse sale and leaseback as that facility was completed. After the above items, free cash flow for the year was c £22m (or c £17m underlying excluding the Telford site proceeds).

Epwin spent just over £5m cash on the three acquisitions referenced earlier and distributed £4m in the form of cash dividend payments in FY21. The net cash outflow associated with reported IFRS 16 line items (ie right-of-use asset depreciation and associated interest and capital repayments) was £3.5m in the period. Consequently, overall net cash inflow for Epwin was c £9m, which almost halved core bank debt on the balance sheet to £9.4m at the year-end compared to a year earlier. For the record, £77.5m of IFRS 16 leases were on the balance sheet at the end of FY21.

Cash flow outlook: on our revised estimates (see below), we anticipate EBITDA to improve in each successive estimate year. However, we assume normalising cash tax payments, capex ahead of depreciation and a step-up in dividend payments also. As a result, we expect Epwin to generate net cash inflows in the single-digit million pounds across our estimate years, progressively rising from FY22 levels when we have factored in further working capital investment. No further acquisitions are included in our estimates at this stage and, on this basis, we expect Epwin to be effectively ungeared by the end of FY23. This said, M&A opportunities remain on management’s radar.

Management outlook comments referred to y-o-y revenue growth so far at the beginning of FY22, in line with company expectations, although this was not quantified. Price inflation should continue to feed through, although underlying volume growth is likely to track below the prior year levels in our opinion. We would expect residential spending on repair, maintenance and improvements to continue to be supported by the lag effect from high housing transaction levels (especially to mid-2021), as well as increasingly established home-working drivers, although rising living costs (and interest rates) will provide a less benign backdrop. For the other subsectors served, residential newbuild activity looks to be robust and the social housing sector appears to be showing signs of improving.

We have increased our group revenue and EBIT expectations, chiefly due to the performance of the F&D division in FY21 and the ongoing effects of price inflation. Conservatively, our estimates include some improvement in E&M margins (although not back to historic levels) and F&D margins towards the upper end of our previously described 4–6% range expectation.

Investors should also note that the stronger FY21 final dividend declaration versus our expectations has caused us to raise our projected DPS for FY22 by c 23% and by c 6% for FY24. Despite this faster rate of increase (in FY22 in particular), we expect dividend cover to remain at around 2x.