De La Rue — Venezuela costs dearly

The implications of the FY19 results announcement are far reaching and lead to a sharp reduction in expectations for FY20e and beyond. Our assumption is no longer valid that a managed reduction of the bank note overspill supply to Venezuela is possible, mitigating pricing pressure as additional new contract volumes were brought in and costs progressively reduced. While volumes in FY20 are still expected to be around 7bn as lower-margin contracts already booked fill most of the shortfall. However, as De La Rue and its largest competitors try to alleviate the cessation of supply, the now spare capacity is likely to result in further significant pricing pressure in FY21 as available contracts are competed aggressively.

De La Rue will now complete the optimisation of Banknote Print lines that overspill activity had deferred, reducing capacity to around 6bn notes per annum from the current 7bn by FY21. However, the costs savings are likely to only mitigate pricing pressure on margins. As De La Rue has about 12 months’ visibility on contracts, we expect greater selectivity of contracts pursued to lead to further revenue declines for Currency in FY21, despite growth in both the Polymer and Security Features subsegments. Our margin expectations for Currency now remain below 10% for even our long-term forecast period, compared to a previous expectation of double-digit margin maintenance.

The decline compounds the already expected exit from the UK passport contract which will see a reduction in revenues for IDS of around £40m and a contraction in margin. The contract transition period has now been negotiated which is expected to lead to a slightly later than expected start to volume reductions in November 2019 providing a modest boost to expectations for FY20.

The new tax stamp contracts in PA&T for the UAE and Saudi Arabia will provide a major boost to the division in FY20m, adding significant high-margin revenues in excess of £20m. The FY20 profit increase should also benefit from the absence of £3.1m of non-recurring costs incurred against the contracts in FY19.

The changes to our estimates are summarised in Exhibit 1 below, which indicates that we have reduced our earnings expectations at the EPS level by 22.2% in FY20 to 34.4p and we expect them to remain flat in our newly introduced FY21 estimate.

We maintain our expectation that the dividend will be held at 25.0p but note that an incoming CEO may take a different view given the now reduced free cash flow expectation resulting from the adverse Currency market development.

Free cash flow in FY20 will continue to be burdened by pension deficit closure payments, capex and restructuring cash costs all of around £20–25m. The dividend would cost a similar amount, so even with a neutral working capital as guided by management, there will be another significant outflow in FY20. While net debt remains significantly higher than our previous expectations, the company remains well within its liquidity headroom and covenants with strong interest cover and net debt/EBITDA rising to 1.9x on our FY21 forecast, with the dividend support maintained.

FY19 results were presented after adopting IFRS 15, which added £12.2m to revenues and £6.9m to operating profit. Prior year numbers are not restated. Management came close to meeting our revenue and earnings expectations, although the divisional contributions were not what we had anticipated. Excluding Paper, which we classify as discontinued, the key highlights were as follows:

In Currency, revenues increased by a better than expected 16%, although this included £11.9m of revenues essentially pulled forward from delivery recognition in FY20 by IFRS15. Adjusting for the effect, growth was still 13% for the division. However, the adjusted operating margin fell by 140bp to10.4% due to more complex and lower margin contracts during the year as well as increasing competitive pressures. The operating profit IFRS benefited the division by £6.6m, so the 3% improvement in adjusted operating profit was a 13% decline before that adjustment.

The 12-month forward order book was down 26% to £202m (FY18 £272m), with a further £87m of orders on hand for future years, excluding future year orders against the Bank of England contract.

Banknote Print volumes increased 3% to 7.5bn largely due to increased overspill demand from Venezuela. Around 0.45bn of the total volume was satisfied through outsource partners. However, an exceptional bad debt provision of £18m has been taken against receivables for Venezuela following the tightening of sanctions that has prevented payment for work performed being transferred. Most of the FY19 payments had already been received.

Market share in Polymer was 20% (FY18 11%), with substrate volumes rising 23% to 998 tonnes (FY18 810 tonnes), of which 667 tonnes were direct sales to customers. The activity continues to move towards profitability.

Security Features volume rose 24% to 4.7m square metres, supporting a 38% increase in revenues.

Revenues for IDS were broadly flat year-on-year, with international ID volumes falling and a spike towards the year end of higher margin UK passport activity. The result was a 200bp rise in adjusted operating profit margin to 16.2% ignoring the prior year write-off of the UK passport contract bid costs, although profit also benefited from a £1.7m provision release following a customer settlement, which more than accounts for the remaining improvement.

An exit plan has been agreed from the UK Passport contract, with production ending by the end of FY20 and volumes expected to start declining from November as activity transfers to the new supplier.

Revenues grew by 2% and adjusted operating profit fell by 39% to £5.7m. Management states that the division performed to its expectations, but adjusted operating profit was some way below our £11.3m estimate, even after adding back £3.1m of non-recurring costs. These consisted of £1.2m of upfront costs for the major new UAE and Saudi Arabian tax stamp contracts and £1.9m impact of transferring manufacture for the division from Gateshead to Malta.

The main development for PA&T for FY19 was the order flow driven by the World Health Organisation’s Framework Convention on Tobacco Control (FCTC) and the EU Tobacco Products Directive (EUTPD). The Digital Tax Stamp system for the UAE is now operational and the five-year tax stamp contract for Saudi Arabia starts delivery in FY20. In addition, PA&T has won contracts to supply more than 3.5bn tax stamps annually to various European countries.

Combined with continued growth in brand authentication markets, these government revenue solutions (GRS) contracts support the doubling of PA&T revenues over the next three years with very healthy margins attached.

Martin Sutherland is to leave the company following the latest disappointment, but remain as CEO until a replacement is found, which will probably take at least three months. The strategy therefore continues to evolve from his existing plan and a new, two-division structure is being proposed (Currency and Authentication) to provide greater strategic focus with market-facing operations. Security Features will transfer into Authentication, which also includes PA&T and IDS operations. A reduction in overhead and greater efficiency should also result and the reorganisation is to be accompanied by a cost reduction programme aimed at saving a further £20m by FY22.

Management is highlighting significant headwinds for Currency in the year ahead as Venezuela is abruptly curtailed, increasing competitive pressure across the oversupplied marketplace. However, PA&T is expected to see strong high margin revenue growth as the new contracts build volume and IDS will not see a major tail off from the UK passport business until H220.

For FY20 the board expects revenues to be similar to FY19 and operating profit to be “somewhat lower”. We feel our revised estimates reflect these expectations.

The reduction in our estimates severely curtails cash flow delivery for the group. Our capped DCF valuation for the group, rolled forward to the new FY20 basis, currently returns a value of 568p per share compared to 663p per share when we initiated despite a more favourable calculated WACC of 7.6% (previously 8.3%), reflecting the lower equity valuation and increased debt.

The sensitivity of our DCF value per share to terminal growth rates and WACC is shown in the table below, with our assumption highlighted in bold.