Severfield — Converting orders into profitability

Severfield’s FY19 financial performance was in line with (perhaps marginally ahead of) our expectations on most headline metrics, including year-end net cash of £25m. Within the mix, UK operating profit was slightly on the low side compared to our estimates but the Indian JV contribution was clearly stronger. As we had anticipated, no special dividend was declared this year while conventional DPS rose by +8% y-o-y to 2.8p. Our existing estimates are unchanged and, absent any new material investment programmes, we expect the company’s net funds position to build, raising the possibility of special dividend payments in future.

FY19 revenue was similar to the prior year but UK operations delivered a £0.4m increase in reported operating profit and a 20bp margin uplift to 8.5%. (Under our adjustment for share-based payments and pension net finance costs, operating margin was unchanged at 9.2%.)

Tonnage volume was probably at the lower end of earlier expectations; this is reflected to some extent in sequential revenue development from H1 to H2, although Severfield demonstrated a robust and very stable reported margin performance over the year, within its target 8–10% range. (The first part of FY18 benefitted from some good contract outcomes, which also skewed profitability to its H1 trading period.) FY19 was the first full year following the reorganisation of fabrication (fab) facility operations1 and the rollout of the StruMIS IT platform (for fab production and control, integrated with commercial management and project reporting) was completed. The benefits from these actions should continue to accrue gradually; this may not be visible through a step change in margins but could underpin through-the-life-cycle project management and risk control, particularly for new jobs as they are brought onto the order book and progressed through to commercial completion. In support of incremental production efficiencies, Severfield continued to invest in capex; this ran at almost 2x depreciation and c £5m of the £7m total spend concerned production-related equipment.

Project profile: the new Google HQ building is the largest project underway (c £50m value, started end FY19, completion anticipated in FY21) with four others above £20m having cycled – or substantially done so – through the order book. Mid-sized commercial offices in London and the regions, rail, road and pedestrian transport bridges and ongoing healthy demand for logistics/distribution and data centre projects all contributed to FY19 revenues. The order book stands at £295m (versus £274m at the year end and £230m when the H119 results were reported). As previously noted, larger commercial scheme work has dipped in the near term and is around a three-year low in order book terms as are stadia/leisure projects. This partly reflects progress with existing large projects in these sub-sectors and the phasing of opportunities where management considers there is good potential on a two- to three-year view. More positively in the near term, the industrial/distribution sector order position has strengthened to around a quarter of total UK and Europe orders on hand, although data centres have risen to almost the same amount from a much lower level when the interims were reported.

Outlook: management referred to a stable pipeline but softer UK markets. Within the order book development described above, the UK portion now represents just under two-thirds of the total (implied c £186m versus c £228m in November) versus virtually all of the six months previously. This partly reflects the cycle through of larger commercial office projects and an element of delay and deferral such that an activity lull has occurred in this segment and, consequently, the value of orders on hand is around its lowest level for around three years. Similar comments apply to the stadia/leisure sector but brighter prospects are flagged in both areas on a two- to three-year view. The overall order book increase therefore has been driven from Europe (including the Republic of Ireland) with an uplift of £100m+ from very low levels over the last six months. The company’s European sales office has successfully supported UK tenders for data-centre work and secured a significant scientific research establishment project in Lund, Sweden.

We should also mention that British Steel went into administration in May. Having diversified its supply base in recent years, Severfield has been sourcing around half of its long sections (c 35% of total steel requirements) and no plate sections from this long-time supplier. Arcelor Mittal (UK subsidiary/ European mills) is the primary dual source and we believe has the capability to provide increasing volumes if required. In the short term, British Steel is continuing to trade and supply under its administrators so there has been no near-term disruption. If the volume requirement from Mittal increases, there could be a small lengthening of the supply chain in the ramp-up period. As Severfield is an existing customer, it would be reasonable to expect no major business dislocation. Steel stockholders could also be used as a buffer for small volumes on a short-term basis.

A growth trajectory has been apparent in previous six-month periods but a strong end to FY19 drove record turnover, with H219 exceeding that generated in the whole of the prior year. While operating margins did narrow (see below) the higher revenue base and reduced JV debt meant that underlying profitability and Severfield’s share of after tax profit more than doubled year on year (to £1.2m).

We understand the Bellary fab volume processed was c 44,000 tonnes of c 68,000 tonnes sold in total. In other words, around one-third was outsourced to third parties; management commented that this volume was spread rather than concentrated, which indicates that JSSL has developed an extensive supply chain at the same time as building its own market presence. As the order backlog has built ahead of capacity (c 60,000 tonnes per year, partly depending on workflow type) the benefit of having cultivated local industry partners is now being seen. While the use of third parties could have partly contributed to keener margins, the primary driver was business mix, with a higher proportion of industrial versus commercial work. This includes steelwork on behalf of JV partner JSW, which is investing in its domestic steelmaking capability and capacity. JSSL oversees the fabrication work undertaken by its supply chain partners and retains full control over projects and their progression to completion.

Outlook: the £134m order book position (vs £124m at H1 stage and £149m at year end) is very strong in a historic context. We suspect the reduction seen since March is a timing effect and reflects good existing project progress. Encouragingly, the commercial proportion now approaches 60% of the total; although some of this will be for delivery beyond the current financial year, management has stated it expects the entity’s FY20 operating margin at or above 7%. The c £16m capacity expansion at Bellary is underway (adding 30,000 tonnes to capacity) and is expected to complete within the financial year. The partners injected half of the project capex in equal proportion during FY19 and new loan financing to cover the remainder will be drawn down as required by the build programme.

This cold-rolled steel building products business contributed c £0.4m to Severfield’s PBT, reported under the JV/associate line, in line with the prior year. Established as a supplier of metal decking, through investment Construction Metal Forming’s (CMF’s) product portfolio has expanded to include purlins, rails and framing for steel structures since Severfield acquired its interest. As well as being an adjacent business investment, CMF is able to supply ancillary steelwork that complements Severfield’s core operations and enhances the project package offered to its customers.

Net cash stood at £25.2m at the end of FY19, similar to the interim stage and a reduction of almost £8m over the year. We have already alluded to some of the capital allocation actions taken during the year with growth capex, JV investment and dividend payments all featuring.

EBITDA was comparable to the prior year at just over £29m but reversion to a more normal working capital position and other adjustments resulted in operating cash flow of £18m, c £5m lower than seen in FY18. The main contributor to this was the creditor outflow, which approached £7m for the year; we believe this partly reflected a reduction in advance payments and project phasing (bearing in mind that revenues were flat for the year and lower sequentially in H2). We also understand that retentions were considered to be normal at the year and with no particular impact as some of the larger projects come to a conclusion. Otherwise, c £2m adjustments (eg for share-based payments and asset disposal profits) were similar to the prior year.

Net interest, tax and capex cash outflows totalled c £10m. We highlight that capex was a significant proportion of this movement and note the resulting overall £8m positive free cash flow. Conventional cash dividend payments (boosted by the FY18 special distribution of c £5m, making c £13m in total) and the aforementioned Indian JV investment of c £4m were the major discretionary capital allocations in the year and a small new equity cash inflow (from employee share schemes, as seen in H1) completed the reported group cash movement.

Cash flow outlook: our model includes rising EBITDA and lower working capital outflows than seen in FY19 across our estimate years, which drives significantly higher free cash flow generation of c £14m in FY20 with further small improvements in each of the following two years. This comfortably funds a rising conventional cash dividend. Beyond this, in the absence of any further discrete investments, the c £5-7m per year net cash flow could possibly trigger future special dividend payments at some point although we do not model this.

We should also mention the intended adoption of IFRS16 by Severfield in its new financial year. We have not yet adjusted our estimates to reflect this standard but it will have the effect of increasing both the fixed asset base and headline net debt as lease arrangements and associated assets are brought onto the balance sheet. There may be a small net asset reduction as a result but no net impact on the P&L is anticipated.

Management has reminded us that the company is on track to achieve the 2016 target of doubling profitability by FY20, requiring the generation of £26m or more PBT to achieve this. Our pre-results PBT estimate for this financial year was £26.8m (company basis, after pension net finance costs).

FY19 revenues were modestly below our expectations but, given the UK/Europe order book position, there is likely to be upward pressure on our revenue estimates in the current year with this becoming more apparent in H2. It remains to be seen whether the new international work – requiring additional transportation costs – can be delivered with comparable margins. We also acknowledge that near-term UK market conditions appear softer so, for now, we make no adjustments to this part of our model. With regard to the Indian JV, it should be noted that its FY19 contribution was almost £0.5m higher than our existing projection for FY20. An improving order book mix should support higher margins here. However, some loan financing is going into the JV to part fund capacity expansion and this development phase could to be a distraction to running the existing fab operations so we have also adopted a cautious stance regarding the flow through of benefits at this stage. Consequently, our existing overall group estimates are unchanged and we now project to FY22.