Low & Bonar — Update 18 February 2016

FY15 results came in in line with expectations after a year of mixed market conditions. Overall, four out of five business units made both revenue and profit progress in constant currency terms (Civil Engineering was the exception). Year-end net debt stood at c £102m (in line with that at H115 and up c £14m y-o-y), with investment a key theme of the year. In terms of outlook, market conditions are expected to remain variable across the divisions, but the new organisation structure implemented during FY15 is expected to have an increasingly positive commercial impact as a range of initiatives and practices become embedded.

Civil Engineering (FY15: 21% of group revenue, EBIT margin 3.6% -70bp y-o-y)

Geotextiles and construction fibres contributing to groundworks integrity in infrastructure projects

The acquisition of Texiplast at the end of FY13 extended Low & Bonar’s product portfolio in this sector into higher-specification materials. This business needed to be bedded in initially and weaker European infrastructure construction activity levels since have hampered the company’s ability to develop a more technical, solution selling approach subsequently to some extent. Management change and enhanced commercial focus under the new group GBU structure are both designed to provide greater impetus in this area, generating sales growth and share gains. This requires stronger relationships in the civil engineering construction supply chain (with specifiers and contractors) and the process of raising the company profile with these decision makers is underway. This GBU’s FY15 trading performance reflected lower sales volume in subdued market conditions in H1, followed by greater stability in H2, with a comparable EBIT contribution to the previous year in the second half, despite lower revenue. The overall EBIT margin for the year of 3.6% was down y-o-y – due to production inefficiencies also and lower levels of demand – and clearly short of the 10% GBU target, although we expect improvement from these levels. Increased macro fibre capacity at Zele should support volume growth and margin recovery.

Building & Industrial (FY15: 16% of group revenue, EBIT margin 13.5% +70bp y-o-y)

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

Product revenue in this GBU is broadly classified in two groupings: building materials (chiefly roofing membranes, barriers and systems) accounts for around two-thirds of the total with one-third in industrial/agricultural applications (including air and liquid filtration and crop covers). The range of products and intermediate carrier materials are manufactured from the GBU’s core technologies and processes. This division aims to migrate its technical expertise into other significant niches and may also seek complementary technologies that enable this to occur. The FY15 trading performance echoed comments made at the interim stage with strong roofing product demand in the US, higher agricultural screen cover revenues and increasing penetration of filtration products. Underlying revenue growth was c 3% in both half years and the full year EBIT margin increased by 70bp (to 13.5%), again with y-o-y improvement in both periods. This performance included some drag from production inefficiencies at Lokeren and some gain from declining materials costs, especially in the first half, although we cannot quantify these effects at divisional level. Looking ahead, all three of the market sectors highlighted above have been earmarked for development and management has flagged investment in capacity, product development and sales resource in these areas, spread across the US, Europe and China.

Interiors & Transport (FY15: 23% of group revenue, EBIT margin 14.7% +330bp y-o-y)

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

This division addresses two primary markets: backing for flooring (carpet tiles and carpets), which is around 80% of revenue, and automotive interiors (moulded car carpet backing) the remaining 20%. Low & Bonar has traditionally had a strong presence in Europe and the US with dominant market shares in the region of 70%. During FY15, the construction of a new greenfield facility in China was substantially completed. The I&T GBU had a particularly strong year in FY15; US and European capacity was effectively sold out during H2. A strong market position and high plant utilisation rates in what we perceive to have been a tight market were reflected in the achieved margin for the year. To date, Low & Bonar has supplied the Chinese market via customers exporting from other countries and, more recently, through establishing a direct sales presence. The new facility in China adds c 15% capacity to the division; this shortens the supply chain for the local market and, we expect, the delivered cost. Product for the local market has now been certified and those for overseas markets are being sought. Given the high levels of demand, management deserves some credit for managing this major investment project, while also delivering a strong trading result. This GBU could now be considered to be a global supplier of flooring backing materials and this brings strategic sourcing flexibility to the group. As well as ramping up production in China during FY16 further Colbond capacity investment is under consideration.

Coated Technical Textiles (FY15: 30% of group revenue, EBIT margin 10.6% -10bp y-o-y)

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

This GBU has been a separately reported business for some time. Its manufacturing footprint (ie three European sites) is unchanged and, as with the other GBUs, responsibility for supply chain, production and logistics efficiencies is now overseen by a group operations director. The appointment of a new global business director in 2015 was designed to increase commercial focus. As a Europe-centric business, euro weakness against sterling led to lower reported revenue and profitability in this GBU. In underlying terms, there were mixed market conditions among the subsectors served, but y-o-y progress was achieved overall in local currency. A traditionally strong position in trailer side curtains was rewarded with healthy demand levels throughout FY15. This was partially offset by softer order development in markets outside Europe for tensile architectural membrane (in the Middle East) and specialist container structures (from Russia). Directly or indirectly, both of the latter were affected by falling energy prices. Nevertheless, GBU margins were maintained at broadly stable levels overall. Notwithstanding softness seen in the period in segments other than trailer curtains, the development of this GBU is likely to be characterised by building a presence in higher-margin niches both in and outside the traditional European base.

Sport & Leisure (FY15: 10% of group revenue, EBIT margin 3.1% +60bp y-o-y)

Artificial grass yarns and woven carpet-backing yarns

Before establishing a new JV in Abu Dhabi in 2010, this business produced both of the main product groups in Dundee. The JV began with a line producing monofilament grass yarns and, after Low & Bonar took on full responsibility for the facility (having acquired a 25% minority stake), consolidated all grass yarn manufacture to this facility in FY15. This move generated c £0.3m of cost savings in the year, which broadly equated to the year-on-year profit improvement. As Exhibit 1 shows, sales growth was positive throughout the year and stronger in H2 than in H1. This GBU is considered to have some good market positions and an innovative track record, although variable demand and industry capacity have restricted profit development historically (margin +60bp to 3.1% in FY15). That said, the return to profitability has now been confirmed and, with a greater balance of supply and demand in the industry, further margin progress is anticipated in FY16.

In total, Low & Bonar recorded an exceptional charge of £10.1m in FY15. The majority of this related to charges against the Saudi JV investment. A lot of time and effort has been put into establishing this facility in conjunction with JV partner Natpet. Having commissioned the plant in FY14, the rate of market penetration has been slow, which we believe is due to the product certification process and rate of local acceptance of the higher-specification materials. A collapse in the oil price has led to a significant deterioration in construction and infrastructure work in the region. Consequently, Low & Bonar has elected to write off the value of its investment (including outstanding loans) in full. This comprised £3m equity carrying value and a £5.2m loan receivable. Low & Bonar recorded a loss of £1.8m in FY15 (ie its 50% share of the total); management has clearly stated that no further cash will be injected into the business and action will need to be taken to reduce or eliminate losses in the absence of any improvement in local market conditions. Our sense is that it needs to develop new markets fairly rapidly for this to be retained as a viable facility in the medium term. The other non-recurring costs were as follows:

Exhibit 2 shows the direct cash costs incurred in FY15, while the loan receivable write-off represents a cash receipt that we had anticipated in FY15, which will now no longer be repaid.

End-FY15 net debt stood at c £102m, which was in line with that at the interim stage but c £14m higher than at the end of the previous year. Investment has been the theme of the year, with a new Colback facility in China and additional construction fibre plant in Belgium being the most notable projects. In total, Low & Bonar spent £33m on tangible capex; of this c £23m was classified as expansionary/capacity increases, largely allocated to the Chinese project highlighted and non-woven capacity in Hungary (c £14m and c £6m respectively). Group depreciation was £12.4m.

Cash flow was mostly as expected, although a debtor outflow and the absence of a Saudi JV loan repayment (see above) were the major variances. At the operating cash flow level (after £4.5m pension cash contributions), there was a £35.2m inflow. Of this, £21m was paid in interest, tax and dividends and, together with total capex (including intangibles) of £33.7m, resulted in a headline cash outflow of £20.5m before financing. A favourable translation of euro-denominated debt reduced the movement in reported net debt to a £14.1m increase for FY15 as a whole.

FY16 is to be another year of investment, with total capex of c £28m including completion of the new China facility (which is already substantially complete) and probable further Colback capacity expansion. The GBU structure and, more specifically, the integrated management of supply chain, production and logistics across the group, is expected to yield some working capital benefits in due course. These effects are expected to be modest in FY16, but become more visible in FY17. Allowing for a gradual increase in dividends also (maintaining cover at or above 2x), we currently expect Low & Bonar to end FY16 with a slightly higher net debt position, before edging lower in the following couple of years if the investment programme remains well above depreciation.

Management reiterated confidence in its expectation of progress in FY16 at the time of reporting results. Market conditions are expected to remain variable across the divisions; Europe to remain difficult, Middle East to remain subdued or worsen and a slowing Chinese economy. That said, the new organisation structure implemented during FY15 is expected to have an increasingly positive commercial impact as a range of initiatives and practices becomes embedded.

Our overall GBU profit estimates are unchanged, with a higher contribution from Interiors & Transportation matched by trimming our Civil Engineering and Coated Technical Textiles expectations. At the group level, an increase in central costs (of c £0.6m, reflecting the FY15 base level) and a similar, but slightly reduced trading loss from the Saudi JV are now anticipated in FY16, reducing further in FY17. These effects result in c 3-4% lower PBT expectations compared to our previous estimates.

A slightly higher tax rate (reflecting the geographic mix of profits) is the primary reason for a larger movement in EPS estimates.

We note that the euro and the US dollar have both strengthened against sterling since the beginning of FY16. If sustained, this could bring profit translation benefits to underlying estimates, although there may also be some partial adverse transaction implications also.