Norcros — Explicit growth aspirations

As flagged in a year-end trading update, FY18 trading was in line with management expectations and PBT c £0.6m higher than we had anticipated. Both reporting regions achieved constant currency l-f-l revenue growth over the year with a mix slightly more in favour of South Africa rather than the UK than we had anticipated. Year-end net debt came in below our expectations at c £47m, largely due to a better working capital performance and was c £7m better than we had expected. Save for a slightly higher tax charge going forward (100bp higher than we had previously modelled), our estimates are substantially unchanged.

UK: Good performances outside the retail segment

The majority of the UK operating companies performed very well; l-f-ls excluding Johnson Tiles (JT) were: H1 +11.4%, H2 +8.4% and FY +9.8%. This was well ahead of the underlying repair, maintain and/or improve (RMI) market, which was flat at best according to most commentators (eg Travis Perkins in general merchanting). Those with a higher trade/lower retail (including DIY) channel mix and export exposure were the better portfolio performers in FY18. There will also have been some positive pricing effect on revenues given rising metals price indices passed through during Q4. After a flat couple of years, Triton progressed in all of its market segments, achieving high single digit revenue growth and improved profitability. This also applied to the smaller Abode business which was even more strongly ahead (sales +20.8%). Both Triton and Abode benefited from new product launches. Vado was also very active in this regard, driving a 15.3% sales uplift and while profitability was held back by supporting business development investment this lays the ground for further progress. Croydex was hindered by its retail exposure but did advance in its trade and export channels. Merlyn’s maiden (c 18-week) revenue contribution for the year was £11.7m with above average margins for the division. JT revenue fell by 11.5% y-o-y to c £47m; H2 was lower sequentially compared to H1 and c -23% y-o-y reflecting sharply lower demand from the large DIY sheds. Consequently, its H1 trading loss widened for the full year. Having reconfigured production during FY18 (mothballing one kiln, converting another to small-format tiles), a more wide-ranging business restructuring is underway; a £2.1m exceptional charge (cash outflow in H119) is expected to generate annualised savings of at least £2m. With some benefit to flow in FY19 and with possibly lower CrystalGrip support costs, we would expect this action to result in a break even or better run rate by the year-end. Excluding Merlyn, we believe that underlying divisional profitability was marginally lower chiefly due to JT and, to a lesser extent, business development activity in a number of companies as outlined above.

South Africa: Broadly-based organic growth

The achieved growth rate was all organic and equated to +5.9% in constant currency terms (comprising H1 +4.8%, H2 +7.2%) in still sluggish local economic conditions. We note an acceleration in growth in H2 which came from faster rates of progress from manufacturing businesses TAL Adhesives and Johnson Tiles SA (JTSA) both of which cited improved operational performance. A project to increase capacity at JTSA by c 10% got underway in October and is expected to conclude during H119. This should result in improved factory yields and allow a higher volume of sales of higher-margin, own-manufactured product both independently and through sister company Tile Africa’s stores. Retailer Tile Africa broadly maintained a mid-single digit revenue growth rate throughout the year, including some benefit from two new store openings in FY18 and from accessing the group sourcing supply chain in certain product lines.

Overall, a very good outturn from South Africa with all three operating companies increasing both revenues, profitability and, we believe, margins and there was no discernible impact from widely reported regional drought conditions. This underlying performance was amplified by favourable FX translation which contributed £5.1m to revenue and £0.3m to divisional operating profit. Lastly, we note that business confidence improved towards the year end compared to H217 following political change in February 2018.

Net debt came in almost £7m better than we had anticipated at £47.1m which was a c £23m increase y-o-y, being the net effect of positive cash generation more than offset by the acquisition consideration paid for Merlyn in H2.

Operating cash characteristics were similar to the prior year including a small working capital investment to support growth (a £2.8m outflow versus £1.8m in FY17). Hence, in underlying terms, the operating profit increase substantially flowed through into a c £32m operating cash inflow. We had expected a larger working capital outflow and this explained most of the difference between our projected year-end net debt and the actual position. Net interest and tax both rose (to £1.1m and £4.9m respectively) reflecting acquisition activity and rising profitability and a reduced tax loss benefit compared to FY17. Capex was broadly flat y-o-y at just under £8m with no major items of spend highlighted; new stores and manufacturing improvements in South Africa and new Vado distribution facilities in the Middle East were some of the areas that featured we believe. Before the effect of non-trading items, underlying free cash flow was above £18m. Non-trading cash outflow was in excess of £8m with pension cash outflow of £2.5m (in line with FY17) and the remainder split broadly equally between Merlyn acquisition expenses and JT restructuring costs. Merlyn consideration was c £59m which was part funded by c £30m new equity raised, giving a net £29m cash flow/net debt impact. Finally, increased cash dividends – due to rising DPS and increased shares in issue – of £5m completed the group cash flow picture.

We currently anticipate a net debt reduction of c £9m in FY19 followed by £13m+ in each of the following two years. Note that the FY19 calculation includes some further cash restructuring and a deferred consideration payment (both c £2m) and a flagged step-up in capex to £10m. Otherwise, the annualised effects of owning Merlyn for a full year together with underlying progress is expected to drive increases in profitability and some of the other line items highlighted above.

In headline terms, we have made only modest changes to our earnings projections for FY19 and FY20. We have made small adjustments to the mix of revenue (lower overall due to JT) and operating profit (no net change) following the reported FY18 performance. A slightly higher expected tax rate (ie 22% against 21% previously) nudges down our EPS estimates with no change to expected DPS. We have added FY21 forecasts for the first time. Overall, our three year EPS CAGR to FY21 is now 6.4% and 7.7% for the DPS equivalent (with cover reducing slightly to 3.3x by FY21). Updated group strategy (see below) suggests that management is targeting a run rate ahead of this. M&A forms part of the growth aspirations and we will factor in any transactions as and when they are announced.

A capital markets day (12 April) followed the trading update and included presentations from CEO Nick Kelsall and five business MDs representing almost 90% of annualised group revenues. As well as highlighting business breadth, common core characteristics and collaboration-driven synergies across the portfolio, this event was used to set out management’s medium-term aspirations, as follows:

In our view, the overall strategic thrust and direction outlined above is unchanged from before. These updated targets indicate that the management team intends to build on the current platform and has significant ambition to grow revenue and profits.

Some regional perspective: the capital markets day provided information on the group’s current primary markets, which are most obviously the UK (c £2.3bn annual market value in the widely defined bathroom and kitchen products sector at manufacturer’s selling prices), South Africa (c £0.9bn), as well as the Middle East (specifically UAE and Qatar, c £1.1bn). As a broad illustration, based on the information presented, Norcros’s current portfolio addresses sectors that make up roughly three-quarters of these markets.

The UK market has the most balanced spread of subsectors (the largest – mixers, taps and controls – being c 20%), while South Africa has a more significant tile bias (around one-third, the remainder spread) and the specified Middle Eastern markets more so (60%+). In these overseas markets, we think it reasonable to expect an increasing demand for improved specification fittings, etc, over time, broadening beyond the high-end residential and commercial (hotels, apartments, offices) customer sectors. We also note that the two overseas markets both have a significant local player with a diversified portfolio: Italtile1 in South Africa and RAK Ceramics2 in the Middle East. As a reminder, Norcros has strong, branded number one or number two positions in its sectors in both the UK and South African markets. It has also sold into the Middle East for a number of years and, following 2016 distributor changes, now has a regional sales office and stocking capability centred around the Vado and Norcros Adhesives offerings.

We highlight below some of the characteristics that we feel each of the individual businesses that presented at the CMD have in common; together, they provide the essence of the group business model.

Our perception is that portfolio companies typically have leading market positions – usually with a single brand used by each company across the sectors it serves – and a mid/upper end bias, although not exclusively so. (We understand that some white-label manufacturing takes place to varying degrees around group companies, but this is not thought to be material in aggregate.) Pulling together provided data, market shares are:

In support of their market-leading positions, each company is clearly mandated to be active in new product development (NPD) and for this activity to make a material contribution to revenue. In largely established market segments this includes adding new features, updating appearance, range extensions, enhancing user experience and improving installer convenience. Regularly moving the product offering forward represents a constant challenge to competitors but also provides opportunities for margin consolidation/expansion from both cost (through design-for-manufacture and parts/sourcing commonalities) and pricing perspectives. We understand that in aggregate c 2-3% of annual group revenues are expensed or capitalised as NPD.

The following examples illustrate the significance of NPD at individual company level, noting percentage of revenue derived from products introduced in a specified time period (number of years in brackets):

In overall terms, the equivalent figure for all existing UK operations is c 25% (three years). Merlyn, while being below this at the point of acquisition, already had new product momentum and is moving towards this UK average. Across the portfolio, there are examples of inter-company product development (eg Triton/Vado electric showers range, Vado/South Africa tap range), which further highlights the potential benefits from shared group expertise. Apart from the product portfolio fit, an ability to innovate and refresh the product range and potential to collaborate are clearly important considerations in making acquisitions.

Norcros’s operating companies have a range of different business models. Four of the seven UK businesses (ie Vado, Croydex, Abode and Merlyn) supply products that are internally designed and effectively externally sourced, except for some light assembly activity. Triton undertakes full final product assembly of its proprietary shower designs, for which the cover, sub-assemblies and components are bought-in. Consequently, supply-chain management is a critical discipline and Norcros has an extensive Chinese sourcing network including 35 locally based employees across a number of locations. Even if they were entirely independent, there would still be economies of scale in collective transportation and shipping arrangements. In fact, there are a number of product group overlaps such that group purchasing synergies can also be achieved. Some of the major product groups include:

Clearly, where acquisitions also fit this model, this brings opportunities to improve supply terms for the acquired company and potentially for the wider group. Glass panels and shower trays form the largest value elements of Merlyn’s offering sourced from China; while there is limited overlap with the rest of the group in these areas, we would expect some group sourcing benefit to be extracted.

JT and JTSA both have significant tile manufacturing facilities but, to broaden their offering, also source and import a significant proportion of revenues from third-party products and are able to share market intelligence and supply contacts (eg in Turkey, Spain, eastern Europe). Only the surface preparation product companies (ie Norcros Adhesives, UK and TAL Adhesives, South Africa) are pure manufacturing operations, largely for their local markets. Tile Africa is the only group retail business; it obviously relies heavily on JTSA and TAL for tiles and adhesives, respectively, but also accesses group supply chain capabilities in sourcing its brassware and fittings requirements.

Norcros typically hedges its expected FX cost exposure on a rolling nine-month basis. As a result, exchange rate fluctuations should have limited impact on in-year estimates; although, of course, as existing covers rolls off, prevailing rates become more relevant to future period forecasts. We are not aware of any hedging relating to underlying commodity pricing (eg metals) and believe that customer pricing is adjusted periodically – albeit with a lag – to take account of such movements. Imports form a significant proportion of the products sold in Norcros’s market segments in both the UK and South Africa, and competing suppliers are likely to face similar challenges, we believe.

Exhibit 2 summarises Norcros’s business portfolio together with the subsector focus of each constituent company.

From FY13 to FY17, through relative subsector performance and portfolio additions, the UK FY17 revenue split (as reported) by distribution channel evolved as follows:

Triton has traditionally had a good export presence (especially in the Republic of Ireland) with Johnson Tiles and Norcros Adhesives also having some exposure. At the point of acquisition, Vado had c 40% revenue generated overseas, but this has since been diluted to some extent by strong UK growth as part of the group.

The most notable swing during this period was into the other categories and away from DIY retail. Soft markets and sourcing changes by larger customers have affected JT especially, but also Triton and Croydex in this subsector. More positively, greater penetration of specialist retail and the new housebuilding (served through trade) segments – partly through acquisition and partly through NPD – have more than offset DIY pressures. The inclusion of Merlyn, (acquired in November 2017), further boosts exposure to these two channels, which continue to offer better growth prospects in the near term.

As things stand, there is less complexity in Norcros’s channels in South Africa. Most obviously, Tile Africa is essentially a pure, domestic market retailer, although some smaller contract work is also conducted through its stores. JTSA and TAL Adhesives both supply product into Tile Africa but also to other independent retailers and wholesalers, commercially specified projects and export to sub-Saharan markets. In aggregate, exports – chiefly to contiguous countries – accounted for 19% of JTSA and TAL’s reported FY17 revenue. We estimate that domestic sales in South Africa have risen by a c 12–13% CAGR in the last five years and all three businesses have achieved growth rates around these levels, while export growth of manufactured products to third parties have seen a 19% CAGR. It is important to note that these growth rates have all been achieved organically.

Norcros’s UK distribution channel presence is clearly illustrated by listing the multiple formats belonging to three quoted building materials supply-chain customers supplied by the group, ie

The detail is more nuanced than this, with both channel depth (multiple suppliers to each segment) and diversity (more than one segment served by each individual company). This provides access to a wide range of end-customer types within both residential (directly through DIY/specialist retail, indirectly through trade) and non-residential (trade, commercial projects/specification sales) sectors. Some other examples of customers in each segment who are all served by more than one group company are shown below.

In-depth channel knowledge aids the identification of new market opportunities such as product gaps and cross-referral of group companies. NPD activity and associated investment decisions are advantaged by the scale brought by these established market positions.

A collective consideration of the common attribute discussions above brings a useful perspective on the Norcros group business model, which we summarise in Exhibit 3. It operates in established and competitive markets; constantly evolving the product offer avoids commoditisation, and sustains brand differentiation and relative pricing power. Underpinned by co-ordinated supply chain and cost management, this forms the basis for healthy profit generation.

It is clear that the company has a strong and broadly based platform from which to address its new 2023 targets. Business fit is a key criteria and this provides a framework with which we can appraise potential future expansion.

Some thoughts on acquisitions: having referenced acquisitions in a couple of places above, we now make a few observations on potential fit with the existing portfolio and include some examples pictured in the capital markets day presentation. (We took these to be illustrative rather than definitive.) We categorise the opportunities as follows:

A year ago, we commented on the potential for re-rating at Norcros based on a low rating starting point, our conservative estimates and a perception that pension risk fears were overdone. We now return to address each of these points.

Partial re-rating seen: As noted on the first page of this note, the current year P/E and EV/EBITDA (adjusted for pension recovery cash) for Norcros are still only 7.5x and 5.4x respectively even after a 58% share price uplift over the last twelve months. A year ago, the then equivalents for FY19 were 6.2x and 3.6x, so an initial re-rating phase has taken place.

Solid delivery against estimates: Underlying group profitability has been solid to modestly better overall in our forecasts with a higher expected South Africa contribution largely matched by a UK reduction. This has been enhanced by the acquisition of Merlyn which has performed well so far and, hence, Norcros now has a higher earnings base.

Earnings outlook: Our earnings estimates generate a three year EPS CAGR of 6.4% to FY21 (versus 5.5% a year ago to FY20) with DPS on the same basis of +7.7% (previously +5.3%). The underlying CAGR drivers are:

We note that a 2019e PEG ratio of 1.3x – which can be interpreted as anticipating faster earnings growth – is in line with the level a year earlier. It also fits the strategic theme of driving forward top-line progress although, of course, we do not factor in any future M&A activity that may contribute to this. At the end of our forecast period, the core valuation multiples reduce to 7.0x on a P/E basis and 4.4x for EV/EBITDA adjusted.

Low financial risk: Net debt to pro forma EBITDA (annualising Merlyn’s contribution) was c 1.2x at the end of FY18 and, as noted earlier, we anticipate positive cash generation/net debt reduction in each of our forecast years. Bank interest cover in the P&L is at least 17x in FY19 and rising. Consequently, we consider that Norcros is carrying a very manageable level of debt and low financial risk.

Pensions note: Norcros reported an IAS 19R deficit of £48m on its UK pension scheme at the end of March 2018, equivalent to just over 10% of scheme liabilities. The corporate covenant has improved since the last triennial valuation (in 2016) given:

While group net debt is higher than at March 2016, the ability to service this is at very healthy levels, as noted above. The company currently pays in annual pensions recovery cash of £2.5m+ CPI, or approximately 6% of FY18 annualised EBITDA, which we do not consider to be onerous and adjust for in our EV/EBITDA calculation. The latest triennial valuation review (dated 1 April 2018) is underway and a new recovery plan is to be agreed.

Summary: Our current estimates could not expect to attract strong, high growth-oriented P/E multiples. However, we consider that a solid earnings outlook, track record of delivery and conservative financing position all point to a robust platform from which management can drive towards the new strategic 2023 targets, which implicitly require higher rates of growth to achieve.