Low & Bonar — H1 profits disappoint but change is underway

First-half trading was affected by rising polymer input prices, production inefficiencies and some competitive conditions but the new management team is taking visible actions to stabilise and improve financial performance. Tighter control of working capital is already evident and we believe that the company is on track to achieve management’s stated target net debt reduction of £10-15m in this financial year. We have reduced our estimates to reflect the recent trading performance and more conservative margin assumptions.

Building & Industrial (B&I) – good underlying performance, integrating Enka

Technical textiles, mats, composites and systems for a range of applications

The expanded B&I business unit now includes the Enka portfolio, including erosion control and drainage products, having been moved across from Civil Engineering. (Note that the reported prior year also included Agro-textiles operations, which were sold on 1 November 2017 but not classified as discontinued, so the headline y-o-y performance is adversely affected by this.)1

On a true underlying basis, B&I achieved a 5.3% revenue increase from a combination of higher volume and some price inflation, although this was not sufficient to fully recover increased polymer input costs in the period. Additionally, volume growth is understood to have mainly occurred in lower-margin European roofing markets, which also contributed to lower overall profitability in H1. Management indicates that the original, continuing B&I operations achieved a stronger underlying revenue uplift (+8.8%) and smaller profit reduction (-18.5%) than the business unit as a whole. The newly included Enka business therefore had a tougher H1 and actually recorded a trading loss, also partly due to input cost pressures. The operational transfer may have been a distraction here and we expect performance to have stabilised somewhat by the end of this financial year by which time Enka is expected to be fully integrated into the business unit. Otherwise, management expects underlying volume growth to continue in B&I.

Civil Engineering (CE) – earmarked for divestment

Geotextiles and construction fibres contributing to groundworks integrity in infrastructure projects

As above, the Enka operations have been moved out of this business unit into B&I. As announced in January and completed at the end of March, the closure of the Ivanka geotextile weaving plant provided a drag on the headline y-o-y revenue comparison as did adverse FX translation.

The ongoing needle-punched non-woven geotextile and construction fibre operations experienced lower volume and selling price pressures in competitive markets, compounded by rising input costs. In this context, the underlying revenue decline (-6.3% or £2.4m) and increased operating loss (by £0.6m to £0.9m) were perhaps not as weak as perhaps they could have been. Comments regarding a slow start to the year and improved Q2 following management changes suggest that exit rate momentum is better than at the beginning of the year. Although we cannot quantify this effect, it is likely to be more cost than revenue driven in our view.

A strategic review of this business unit was initially flagged in October following a period of under- performance with sub-standard margins and returns. Having closed Ivanka and transferred Enka, the second-phase review has concluded that divestment of the remaining operations is in the group’s best interest and a sale process is to be undertaken. Associated goodwill was fully impaired in FY17 and, according to notes accompanying the interim results, the reportable net assets for this business unit were c £29m at the end of May. In the near term, ongoing operational improvement is being targeted and success here should also feed into the disposal process.

Coated Technical Textiles (CTT) – working through production issues

Specialist coated woven carrier fabrics for a range of primarily outdoor applications

Despite some success in increasing sales volumes and prices in the period, an adverse sales mix and production inefficiencies more than offset these effects and led to lower y-o-y profitability in H118. The mix reference primarily relates to reduced project volume for architectural membrane materials. This business unit continues to be bugged by production inefficiencies that we believe are related to changeover processes and the frequency thereof creating quality problems. This can affect margins through both higher unit costs and lower achieved revenue per square metre. In the past, this business unit has regularly earned high single-digit/low double-digit operating profit margins. The 3.1% margin generated in H1 is clearly some way short of this and actions are being taken to improve reliability, efficiency and product quality.

We note that a goodwill impairment charge of c £13m (or around one-third of the amount carried at the end of FY17) was taken in H1. This appears to be the result of an increase in the assumed discount rate rather than change in cash flow projections per se, which we interpret as attaching higher perceived short term risk to achieving those longer-term cash flows. That said, management states that overall market demand is strong and sounds confident that improved margins and profitability will be delivered in H2.

Industrial & Transportation (I&T) – benefitting from China expansion

Leading provider of technical non-woven carpet-backing materials, branded as Colback

Adverse FX translation in I&Ts two primary markets, the US and China, partially masked good underlying revenue growth of 10% in H118 with positive volume and pricing effects. Having established initial manufacturing at Changzhou in H1 FY16, the second Colback production line became operational on schedule midway through the H118. This is likely to have been responsible for most if not all of the activity increase with limited growth in other regions outside Asia Pacific. To build utilisation levels, some of this additional volume included lower margin product. Together with slower pass through of increased input costs, this meant that profit development lagged revenue growth. Management expects this to be a temporary effect, especially when higher utilisation levels are attained on line 2.

In market sector terms, demand in the traditional carpet-backing segment appears to be firm. Some new product innovation here and in the newer wallcovering substrates segment is contributing to revenue growth. Implicitly, there has also been progress in the automotive segment, although growth is said to be ‘slower’. One note of caution relates to additional third-party capacity coming on stream; provided demand continue to develop favourably this should not create a market pricing headwind but this needs to be monitored.

At £140.3m at the end of May, net debt was c £2m higher than the end FY17 and c £9m lower than the end H117 end positions. (The H118 movement was after a £0.4m positive translation effect.)

Overall operating cash flow performance was improved in H118 with a c £19m inflow compared to a c £4m outflow in the prior year. Given that underlying profit reduction led to EBITDA of c £17.1m (c £7m lower than in H117) and exceptional cash cost movements were c £3m higher y-o-y (and £3.5m in total), working capital was the primary factor behind the positive y-o-y variance.

Historically, the normal pattern has been for first half net working capital (NWC) build up, ahead of seasonally stronger second half trading, with a partial unwind by the year end. Indeed, this has been the case in H1 every year for the previous 10 years prior to H118 so an inflow of £5.3m in the latest trading period is notable. In fact the previous two first half years NWC outflows were higher than normal - in excess of £25m – and followed by lower proportionate reversal in their respective second half trading periods. While there can be temporary and/or more permanent reasons for this (eg establishing new facilities in China), there is now clear management acknowledgement that the structural working capital position in the group is higher than it should be. Consequently, indications of better control here are to be welcomed provided this does not affect product availability and service, which is stated to have been the case thus far. Given the changing group structure, input price increases and FX movements, the true underlying NWC performance is difficult to appraise; we believe that improved receivables collection has normalised NWC as a percentage of sales in its historic context. Management clearly believes that further gains can be achieved.

Elsewhere in the cash flow statement, interest costs (at £2.8m) tracked above the P&L charge while a lower y-o-y tax payment (also £2.8m) primarily reflects reduced profitability we presume. Capex was significantly below the prior year level, which was boosted by new facility investment in China (and stood at £6.7m in H118 versus a £7.7m depreciation charge in the period). Ongoing systems integration spend resulted in a further £1.8m cash spend; we believe that this programme is well advanced now and should begin to tail down towards the end of this financial year.

Taking into account all of the above, the free cash movement for the first six months of the year was a £4.7m inflow, a material reversal compared to the c £28m outflow seen in H117. Unchanged cash dividends (£6.6m) meant there was a small underlying cash outflow for H118 overall as referenced earlier.

Cash flow outlook: management has a stated target to get group net debt to below 2x EBITDA (compared to c 2.9x on a latest 12-month rolling basis) including a £10-15m reduction for the current year, at constant exchange rates. As mentioned above, a sustained improvement in NWC is a central operational element of this strategy and capex is likely to be focused more on profitable growth opportunities. Slightly lower pension cash contributions following the latest triennial review and c £3m asset disposal proceeds are also factored into our model and result in our projected c £128m end FY18 net debt position. This would represent 2.6x FY18 EBITDA (on our revised estimates, see below) and we expect to see further improvement in this metric thereafter. The receipt of disposal proceeds for the Civil Engineering activities has not been factored into our model at this stage.

New banking facilities were put in place in May 2018 with a €165m RCF to May 2023 replacing one of the same size maturing in 2019 and on similar terms. A temporary covenant increase (below 3.5x until May 2019 to below 3x thereafter) looks sensible in the circumstances. Total debt facilities include €60m private placement notes (2.57% coupon, repayable between 2022 and 2026) and RMB150m (maturing June 2020) to finance Chinese capex. At current exchange rates, the c €140m end May net debt (excluding China) was well within the total €225m euro-denominated borrowing facilities.

Market conditions are mixed with growth seen in B&I and I&T while CE remains challenging. Internal production issues have constrained CTT’s development but, once addressed, should improve its competitive position. Management expects to see a calmer input cost environment over the rest of the year with polymer pricing stabilising at H1 levels and a diminished y-o-y headwind during the seasonally important H2 trading period.

We have assumed that the lower y-o-y profitability seen in H1 is not made up over the remainder of the year with some input price pass-through lag continuing in competitive market segments. This will be partly offset by additional expected cost savings of c £2m in H2 resulting from management actions, some of which should benefit central costs, leaving a net group EBIT margin reduction of c 150bp (to 7.0%) in FY18 versus our previous estimates. We have also lowered margin expectations beyond the current, with a smaller adjustment, substantially driven by the CE and CTT business units. Note that our estimates include CE as a continuing business; it has been earmarked for divestment and, subject to a successful disposal, is likely to be treated as a discontinued activity at some point.

Given our reduced earnings estimates and the company’s focus on net debt reduction, we consider that future dividend progress is likely to be constrained over our estimate horizon. We now assume flat DPS in FY18, consistent with the interim dividend and limited uplifts in the following two years, rebuilding cover back to 2x by FY20. On this basis, the FY18 dividend yield is still an attractive 6.0% covered 1.7x on both earnings and free cash flow bases.