Severfield — Positive start to FY22

Severfield specialises in the design, fabrication and erection of structural steelwork in building construction and is the largest of its kind in the UK, typically as a sub-contract supplier to main contractors on complex projects. It serves a broad range of market sectors that have been enhanced by the acquisitions of Harry Peers (HP; October 2019) and DAM Structures (February 2021). A JV in India (JSSL) undertakes similar activities and addresses the growing local market demand for steel-framed buildings, focusing on commercial (offices, medical, distribution/data centres) and industrial sectors. The construction industry is increasingly taking steps to improve its carbon footprint and Severfield is participating in this through SteelZero and other initiatives.

Severfield is a profitable, cash-generative business that is targeting 8–10% EBIT margins and has typically generated free cash flow (FCF) in excess of £8m in recent years, often more than double this. Our EPS estimates to FY24 equate to a 3.5% CAGR from the pre-COVID-19 FY20; the forecast period includes a partial recovery from FY21 in the current financial year before exceeding pre-COVID-19 levels in FY23 and FY24. The DPS CAGR over the same period is a slightly higher 5.6%. We expect FY22e FCF generation will be at the lower end of the historical range due to working capital absorption and increased capex. These features are likely to recur to a lesser extent in FY23, but we expect significantly higher FCF in FY23 and FY24, sufficient to cover deferred consideration, cash dividends and, in FY24, improve Severfield’s net fund position.

Valuation multiples over our estimate horizon are not stretched with headline FY22 P/E and EV/EBITDA multiples of 10.7x and 7.0x respectively reducing to 8.8x and 5.9x by FY24. Moreover, we believe the multiples for UK earnings only are 0–10% lower than these headline multiples even on a conservative view of the Indian JV value (see later section). Using a DCF methodology, our model suggests the current Severfield share price (80p) is discounting steady-state EBITDA marginally above our FY24 estimate, which could be interpreted as a mid-cycle market view of profitability. The prospective FY22 dividend yield is 3.9%.

Winning work at acceptable margins and executing well against contracts are key commercial disciplines. Severfield has an integrated project control approach, linking operational phases at the tender stage through to contractor delivery to manage risk and contract profitability. Most anticipated project costs are fixed, including non-sterling revenues/costs, when entering a construction contract. UK-based operations generate over 90% of group earnings and 90% of the latest order book is for UK-based projects. The company has exposure to traditionally cyclical construction sectors (eg commercial offices, industrial, retail) and others (eg rail, nuclear, infrastructure) with typically less cyclical budgets. Expertise in logistics/distribution/data centres and stadia represent secular growth and large project work. This sector breadth and project diversity facilitates the balancing of workflows through the company’s six main fabrication facilities and orients new business activity towards stronger sectors. Severfield has historically been a good cash generator (with free cash flow of at least £8m in each of the last seven years and more than double that in three of them), which we expect to continue. We project a broadly net-neutral funds position for the end of FY22 and FY23, retaining a healthy liquidity position throughout, which makes Severfield an attractive supply chain partner.

Before its 1 September AGM Severfield stated that FY22 trading in the first five months of the year had been in line with management expectations and, in reiterating existing guidance, flagged an anticipated one-third:two-thirds split to H1:H2 profitability.

General UK market conditions still appear active and orders on hand for UK delivery were up £85m since June (+34% to £338m); we believe this to be the highest level for at least 10 years. As expected, the new Everton FC stadium was a contributor to this increase as was an additional HS2 award (containing a number of bridge packages). Moreover, management seemed satisfied with the overall spread of projects across its areas of sector expertise, referring to a pipeline containing ‘further significant opportunities’. The Europe portion of the UK/Europe order book (£38m, from £48m in June) suggests projects are cycling through but not being replaced by new business at the same rate. Overall, the UK/Ireland order book is £376m, representing a new record level. No new reference to COVID-19 disruption was made, although we were reminded that higher input costs are feeding into the business.

Encouragingly, projects in the Indian JV are all now back on site after COVID-19 disruption affected the early part of the year and management points to an expected break even H122 outturn (as seen in H121). The inference here is that the exit rate for the half is looking more positive, although no fresh guidance for the full year was provided. In terms of business mix, commercial sector revenues have exceeded order intake in recent months, while the industrial sector order book continues to grow and the overall £135m order book position is only slightly lower than seen in June.

The following sections cover prospects for the UK and Indian JV operations in the context of the Severfield’s FY21 performance.

While H2-weighted updates can sometimes unnerve investors, Severfield has been here before (see FY20) and order book visibility, subject to execution, supports confidence this can be delivered. Our headline estimates are now slightly above their levels at the start of the year. We have reflected higher input costs, seen in higher revenue and working capital outflows. We have also maintained our margin expectations. We expect Severfield to achieve a 7.7% EBIT margin in FY22 and return to its target 8–10% range (both company definition) from FY23; the drag effect of COVID-19 in Q121 on EBIT margins will not recur, although higher input costs, even if fully recovered, are likely to dilute the rate of margin recovery a little in our view. For now, we have nudged down our expected contribution from the Indian JV (to break even for FY22 and a return to profitability thereafter); the impact of a second COVID-19 wave on business activity levels is yet to be seen fully and remains a potential risk, although the scale of the order book on hand also provides scope to operate the Bellary fab at high utilisation levels when market conditions become clearer. So, the changes shown in Exhibit 1 are the net result of a small UK upgrade, partially offset by lower expected Indian JV contribution.

Severfield’s FY21 trading performance was slightly better than we anticipated in most respects. Revenue and reported EBIT were 2.5% and 4.8% above our estimates respectively, with a 7% operating margin achieved, while interest costs and the loss from JV/associates were slightly lower (the latter including a confirmed return to overall profitability, with the Indian JV broadly at break even in H2). Within the operations, UK work streams reflected a good spread across data centres, industrial facilities, sports stadia developments and commercial offices for which the company is arguably best known. Indian JV operations were heavily affected by COVID-19 disruption in the first part of the year and FY22 started in a similar vein but is now improving.

Reported revenues were up 11% y-o-y, of which c 6% is understood to have been organic. Given some disruption to Q1 site operations due to the COVID-19 pandemic, any underlying progress is a very creditable performance. Despite some temporary project site pauses at the beginning of the year, orders won in the preceding 12–18 months sustained revenue momentum at relatively high levels of activity, boosted by acquisitions. Inorganic growth of c 5% infers that c £30m1 of revenue was generated from acquisitions (HP in the prior year and DAM Structures in Q421). Of the acquisitions, HP appeared to have contributed an incremental c £12m revenue y-o-y (to c £26m) which is noteworthy given that its FY19 (pre-acquisition) revenue was reported as £21m.

The market impact of COVID-19 on the group in Q121, an unusual skew to the H1:H2 split in the prior year, the distribution of HP’s revenues across FY21 and the extent to which inter-company workflows occurred make it difficult for us to draw strong conclusions regarding year-on-year and even H2 versus H1 profitability comparisons. A one-off profit in FY21 (on an industrial project paint package) is understood to have been broadly evenly spread across the year and although we do not have visibility on the half yearly split of HP revenues its incremental six-month revenue contribution (c £12m) also boosted profitability year-on-year in FY21. Of course, Q121 COVID-19 disruption had a negative effect on profitability due to unrecovered overheads in this period. Moreover, Severfield did not receive any UK government support for the temporary furlough of some staff at this time and these inter-related effects clearly affected the H121 EBIT margin. No specific project completions were flagged in H2 and the delivered EBIT margin was within the company’s stated 8–10% range. Apart from the discrete items referenced above, our sense is the investment in process, administrative and operational efficiencies in recent years, with Dalton serving as the key fabrication hub, have served Severfield well and enabled the business to respond flexibly to changing market conditions, job scheduling and other requirements.

The acquisitions of HP and DAM Structures broadened Severfield’s exposure into the nuclear and rail transportation subsectors, respectively. As we have commented previously, key new fundamental skillsets brought into the group include accreditation for working on nuclear sites and reinforcement/retention capabilities above and below ground. Both companies are structural steelwork specialists with design/fabrication facilities/erection services business models so the similarities with Severfield’s integrated approach are clear.

Apart from increasing sector diversity, the most obvious synergies to come are through the group’s steel purchasing power, which is larger in scale than all UK-based competition. The significance of this is not wholly reflected in the reported operated margin; we would expect main contractors generally to have good market visibility of steel costs, so see scale materials purchasing as a competitive tendering advantage to Severfield, which is to some extent shared with main contractor clients. HP and DAM probably had their own supply arrangements in place, certainly on live projects and possibly other framework/volume agreements, so the group benefit to these companies should start as these cycle through and/or new projects are won.

We also see some potentially significant strategic benefits from linking operations and fabrication facilities together. For example, Severfield and DAM together have an extensive portfolio of rail projects between them including:

While work packages may not be combined as such, having a group level understanding of projects such as HS2 and Network Rail’s CP6 programmes should be beneficial in individual cases and increase the potential value of work that accrues to the group overall.

We also believe DAM could benefit from Severfield Products & Processing’s steel processing capabilities to support certain of its activities (eg portal frame buildings, façade retention, staircases) and in other areas (eg ground reinforcement/propping) could leverage the larger section tubular capabilities of Severfield’s Lostock facility for its requirements. As a result, DAM has a platform to expand its revenue base without recourse to material additional investment or increasing the amount of outsourced work packages compared to if it had been a standalone business. With regard to HP, in process industries, we also see a fit between its expertise in designing and building modular structures (eg pipework carriers) and Severfield Products & Processing’s operations with an expanding product portfolio including Severstor (steel-framed equipment rooms) and Seversilo/Rotoflo (materials storage/handling systems).

It is clear that in addition to steel purchasing, the enlarged Severfield group can generate post-acquisition synergies in a number of ways, both operationally (eg in-sourcing/re-directing workflows internally, greater control over project execution, factory loading, capex decisions) and commercially (eg broader project oversight, enhanced tendering, increased share of project value). As above, these benefits are likely to be realised gradually, as existing projects cycle through and having aligned operational practices and commercial processes, new integrated ones are tendered for, won and executed. The Dalton, SP&P and DAM facilities are in fairly close proximity (two in north Yorkshire, one in East Riding) and the potential for this cluster of operations to work more closely together is clear in our view.

UK/Europe outlook: at the time of reporting the FY21 results, Severfield’s underlying UK/Europe order book was stable at c £280m, enhanced by £18m brought in with DAM, making £301m in total. The near-term position was similar with c £240m of the total order book for delivery in the coming 12 months (ie stretching into early FY23) and this has been the case for the last year, suggesting Severfield is successfully winning new business and balancing production capacity broadly in line with output. Although higher steel and transportation costs have been flagged by the wider construction industry, we understand this had a limited effect on the overall order book value and any related price inflation effects probably only began to creep in during Q4.

The order book geographic split continues to favour UK projects, which account for over 80% of the total, with the remainder in the Republic of Ireland/Europe. This split has moved significantly in favour of the UK over the last 18 months. Over the same time, the commercial office segment has been stable at around a quarter of total orders, with regional developments featuring as well as those in London. Industrial/distribution accounted for a slightly higher proportion, although this has trended down as some larger projects have cycled through. Severfield effectively entered the nuclear sector with the acquisition of HP and we note that nuclear sector orders on hand had increased to 19% of the total (or c £57m compared to the c £20m that came in with HP). Lastly, stadiums represented 15% of the June order book with the redevelopment of stands at Lords and Fulham football club likely to have been the main components we believe. We should mention the end FY21 balance sheet included c £4m of contract retentions (under non-current fixed assets, expected receipt in early FY23), which we presume are related to a small number of larger contracts that are underway, run well into FY22 and, therefore, form part of the reported order book.

In pipeline outlook terms and presumably informed by workstream activity, management indicated the three largest order book sectors (commercial offices, industrial/ distribution and nuclear) all had stable sector outlooks. At the same time others (ie stadiums/leisure, data centres, transport and process industries) were noted as having improving prospects. In the stadiums sector, Everton and Liverpool both have planning permission for projects and Severfield has now picked up the steelwork package for one of these.2 Otherwise, the nascent electric vehicle (EV) industry appears to be aligning its supply chain and a number of so-called battery gigafactories are at the planning stage (eg Britishvolt in Northumberland, West Midlands/Coventry Airport). The Faraday Institution has estimated that eight such factories will be required in the UK by 2040,3 so this certainly represents a new growth opportunity. Lastly, we note that Severfield’s existing order book included its first HS2 bridge packages in the transport sector, being positioned with several contractor consortia to win further work. If successful, this could add a reasonable baseload of business over a five-year period. Severfield’s competitive position is this sector is likely to have improved given its main UK bridge rival4 is now in administration.

SteelZero: in its pre-close update, Severfield disclosed that it had signed up to a global initiative to speed up the steel industry’s decarbonisation. Signatories (which also include contractors Lend Lease, MACE and Multiplex) are committed to transition towards procurement, specification or stocking of 100% net zero steel by 2050. Severfield additionally has an interim target of reaching the 50% level by 2030. Climate change and environmental considerations have an increasing profile and the construction industry is no exception. Quoted companies have for some time been required to measure and report on relevant environmental KPIs, including emissions and energy usage and sourcing. Using GHG Protocol terminology, this covers direct/Scope 1 and indirect/Scope 2 impacts. Environmental impact assessments are clearly broadening beyond a building’s in-use performance (which can be influenced through building regulation and planning permissions) towards a lifecycle perspective to include the build and demolition phases. Measuring the carbon footprint of a project in its build phase requires the impact of all elements of the supply chain to be included. Severfield’s commitment to SteelZero targets explicitly place an increased onus on steel suppliers to reduce their own carbon footprints and in so doing align the company with commitments by main contractors such as Morgan Sindall to exert a similar influence over their own direct supply chain. In our view, these considerations are likely to rise in importance in the tender process and will effectively serve to filter/pre-qualify suppliers. Hence, while targeting a reduction its own carbon footprint directly by signing up to SteelZero, Severfield is also reinforcing its competitive position in the construction supply chain in this way. We note that Severfield has now been accredited as carbon neutral with regard to its scope 1, scope 2 and operational scope 3 activities by the Carbon Trust, which represents an important third-party recognition of progress made, measured by an international standard.

After a limited initial COVID-19 impact in India in early 2020, daily cases peaked in September and, after declining fairly steadily over the following five months, proceeded to rise sharply in a second wave to a significantly higher 2021 peak in May.5 In this context, after an increasingly difficult H121 trading period, construction industry constraints partly eased in H221 and JSSL was able to deliver a break-even result in the second six-month period.

Site restrictions varied by state and industry progress was exacerbated by reduced manpower availability after some urban flight from conurbations by migrant labour. In such circumstances, when there is scope for supply-chain disruption, having a leading steel producer as a JV partner should be a source of reassurance to clients with regard to the ability to progress projects.

JSSL continues to focus on developing its commercial sector relationships and is aiming to develop strategic alliances/preferred steelwork supplier status in the office, data/distribution centre and medical/hospital sub sectors where it already has a track record and portfolio of successfully completed projects. The commercial order book declined by £16m to £78m between November 2019 and November 2020 (ie beginning H220 to H221) as projects on hand cycled through and were not replaced as quickly when the first COVID-19 wave developed. However, by June 2021 it had rebuilt again to £95m, a new record high and two-thirds of the total order book. Over the same period, industrial orders on hand halved to £20m by November 2020 before rising again to £45m in June 2021, including a capacity expansion project for JV partner JSW Steel’s Vijayanagar facility. We note that JSW Steel has outlined expansion plans to add a further 12.5m tonnes of steel-making capacity (including 5m tonnes at Dolvi and 7.5m tonnes progressively at Vijayanagar) to 30m tonnes per year in total by 2025, which may represent additional opportunities for JSSL.

A survey undertaken by The Confederation of Real Estate Developers' Associations of India6 published in June indicated most developers expected to experience project delays as a result of the second COVID-19 wave. Consequently, it is likely JSSL’s H122 trading period will again be disrupted in our view. That said, a total Indian JV order book standing at a record £140m and the fact that orders have continued to be received during the first half period suggests the business is in a position to re-establish FY20 activity levels once constraints have eased. Our perception of management’s confidence in the future is reinforced by Severfield’s explicit comments that a potential second JSSL site is under review, given the Bellary site is said to be at its limit. This process has been partly delayed by COVID-19 but appears to progressing. No specific location has been named and site selection may or may not be informed by JSW Steel’s own manufacturing footprint.

At the end of FY21, Severfield’s balance sheet showed a £4.4m core net cash position (before lease liabilities). The c £12m y-o-y reduction was more than accounted for by £20m acquisition consideration and other business investments. Excluding this, underlying cash inflow was c £8m for the year. Client advances are understood not to have been material at either year end, so the net cash position and movement for the year are a fair reflection of underlying cash flows in our view. In this regard, it should also be noted there were no deferred tax payments arising from UK government COVID-19 business support schemes at the year end and Severfield did not benefit from the payment of any furlough money either.

Although EBITDA (pre IFRS 16) of c £31m was c £2m lower than in FY20, FY21 operating cash flow of £30m was actually £2m above the prior year. Pension cash outflow and right of use asset depreciation were broadly similar and (the latter line item being slightly larger) in both years, while other non-trading cash flows (being acquisition costs and share based payment adjustments) were c £2m lower in FY21. There was only a marginal working capital outflow in the year (versus c £2m in FY20). A sharp reduction in current receivables days from 46 to 31 alongside a cycle through and dip in contract assets appeared to be a key driver of this outturn and both elements are likely to reflect favourable timing effects. Partly countering this, we noted non-current retentions on the year-end balance sheet were c £4m, which, by definition, are not expected to turn into cash during FY22. Overall, working capital stood at c 2% of sales, which is very low and below the more normal 4–6% target.

Net interest rose slightly y-o-y (to £0.7m) following an increase in gross debt levels associated with acquisitions while cash tax declined (to £4.6m) and was in line with the underlying P&L charge for the year. Capex was £6m for the fifth year running and c £2m above owned asset depreciation, chiefly driven by site expansion and new production equipment for Dalton. Other factory upgrades were also made. Including this growth capex and the other items above, Severfield’s FY21 free cash flow (FCF) was c £18m.

Cash dividend payments accounted for half of the FCF generated in the year and IFRS 16 lease repayments were just below £2m and similar to the prior year (Severfield ended FY21 with c £11m IFRS 16 leases on the balance sheet, slightly down year-on-year). While DAM Structures was the only in-year acquisition, deferred consideration was also triggered for HP, giving rise to cash payments of c £11.5m (ie c £17m gross less c £5m cash acquired) and £6m respectively. In addition, Severfield made a £2.4m new equity investment in its CMF joint venture (also matched by the other shareholder partner) to enable that company to enter and equip a new facility.

In summary and in simple terms, the overall £12m group cash outflow for FY21 equated to the initial consideration for DAM Structures with underlying cash generated sufficient to make the other investments and dividend payments noted.

Cash flow outlook: we expect increased EBITDA generation in FY22 (although a lower expected Indian JV contribution means earnings will be slightly below the largely pre-pandemic FY20 level). Volume growth, a normalisation of receivables/payables days, VAT payment changes and upward pressure on input costs all point towards some absorption of cash into working capital in FY22 and most likely FY23 also. Management has also flagged capex of £10–12m with a degree of catch-up on original FY21 plans plus the acquisition of land at Dalton. Taking these larger items and interest, tax and dividends into account, we expect a c £4m net cash outflow for Severfield in FY22, ending the year effectively in a net neutral funding position. No deferred consideration for DAM Structures is payable in the current year but with £10.6m on the balance sheet as a non-current liability, we have modelled a £7m outflow in FY23 and a further £3.6m in FY24. Nevertheless, we anticipate overall cash inflows in each of these years, contributing towards and core net cash position of around £8m by the end of FY24. It is important to note that Severfield maintains healthy cash balances for trading purposes – with a year-end low of c £10m across our estimate years – and has a committed £25m revolving credit facility (with a further £20m accordion) to October 2023. Consequently, the group retains a strong liquidity position and flexibility to access additional funding if required. The c £21m borrowings on hand at the end of FY21 relate to amortising term loans drawn down to fund initial consideration for Harry Peers and DAM Structures and also run to October 2023.

At this stage, we have made no allowance for additional funding for the Indian JV because the scale of a potential new site/capacity expansion is not yet known, a decision to proceed has not been formally agreed as far as we are aware and the extent to which such an investment could be debt financed is not clear at this stage.

Our model shows Severfield’s earnings approaching their (largely pre-COVID-19) FY20 level in FY22 before progressing in both FY23 and FY24. Valuation multiples over our estimate horizon could not be said to be stretched with headline FY22 P/E and EV/EBITDA multiples of 10.7x and 7.0x respectively, reducing to 8.8x and 5.9x by FY24.

We now make a distinction between UK and Indian JV (JSSL) earnings. For illustrative purposes, we make several discrete valuation adjustments, stripping out our expected JV contribution to group earnings in each case, as follows:

In context, in the pre-COVID-19 FY20 trading year, JSSL generated entity revenue of c £109m and EBIT of £9.3m. As noted earlier, FY21 was disrupted by the pandemic; our estimates conservatively assumes that profitability recovers only gradually over our estimate horizon. The two discrete examples shown above are consistent with DCF modelling using what we believe to be realistic EBIT inputs beyond FY24 and beyond which are slightly above and slightly below FY20 levels.

Based on the above approach, the inferred underlying UK earnings multiples for FY24 are conservatively c 0–10% lower than the headline multiples shown in the opening paragraph. That said, valuing Severfield’s share of JSSL at or below cost is overly conservative in our view; the business has generated a positive EBIT contribution in most of the 10 years or so since becoming formally operational – including a COVID-19 affected FY21 – with post-tax losses in around half of those years attributable to bank finance costs. We do not have full cash flow visibility but, based on the UK model, would expect it to also be cash generative. JSSL has become very established and led an increase in usage of structural steel in commercial buildings in a traditionally concrete-led construction industry. A near-record order book with a favourable mix and a healthy pipeline all suggest a positive outlook and we would argue the full operational gearing benefit of the Bellary expansion completed towards the end of FY20 is also yet to be seen. As an illustration, using the same DCF methodology as above, assuming a £17.5m steady state JSSL entity EBITDA would generate a UK earnings FY24 P/E of 8.2x and EV/EBITDA of 5.1x (c 7% and 13% lower than the headline multiples in the opening paragraph). This does not take into account a potential second fabrication facility, in either capital cost or prospective earnings/cash flow terms, which could represent further upside.

Looking solely now at UK earnings/cash flows and employing a similar DCF approach, our model suggests the current Severfield share price (80p) is discounting steady state EBITDA marginally above our FY24 estimate. This perhaps infers little value is being attributed to the Indian JV and/or (given construction cyclicality) could be considered as the markets view of the company’s ‘mid-cycle’ earnings position. As a reference point, a c £5m EBITDA movement from this point adds/deducts c 10–11p per share to the share price derived from a DCF approach in this way.