Low & Bonar — Update 15 February 2017

Reported FY16 normalised PBT came in £0.7m ahead of our estimate at £29.2m, due to more favourable Q4 FX translation effects than anticipated (with a £3.4m favourable net impact for the year as a whole). Implicitly, underlying earnings were slightly below the previous year, entirely attributable to weak profit performance in one business unit (Coated Technical Textiles) in contrast to very good progress seen in each of the other three. The year ended with net debt at £111m versus £102m a year earlier, including c £17m adverse translation of non-sterling debt. Artificial grass yarn business disposal proceeds more than offset underlying cash outflow in the year, substantially due to higher inventory investment at the year end.

Building & Industrial (18% FY16 revenue, 27% pre-central cost EBIT; margin 14.9%, +140bp)

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

This business unit delivered a consistently good revenue performance across the year in local currency terms, enhanced by favourable translation effects as the year progressed. In profit terms, margin performance was also healthy in both half years with a normal H2 bias. Building-related products (membranes, barriers and systems mainly for single dwelling and multi-occupancy residential use) are the largest contributor to sales and North America saw the strongest regional demand, especially for roofing systems in H2. That said, management reported growth in all markets with the developing filtration segment also growing well with some, more modest, progress in agricultural screens also. As in H115, European volume in screens was affected by production issues at Lokeren during H2 but, once resolved, made up some ground in Q4.

Management states that the FY17 outlook is positive for each of this business unit’s segments. Depending on mix and subject to the ongoing performance at Lokeren, there may be further scope for margin improvement. Consequently, we are not surprised that further business investment has been made here. Development of the Asian market is a stated target given the new Colback facility in China, and the post year-end acquisition of Walflor (for US$3.6m initial consideration – plus up to US$0.9m contingent deferred – for c US$0.5m annualised EBITA) fits in with the existing US residential focus and adds a west coast presence to improve service capability.

Civil Engineering (23% revenue, 10% EBIT; margin 4.6%, +100bp)

Geotextiles and construction fibres contributing to groundworks integrity in infrastructure projects

Taken at face value, revenue performance was subdued to disappointing for the year at local exchange rates. At the same time, operating profit margins recovered from the FY15 dip to slightly above FY14 levels. The normal seasonal trading pattern was seen in the year (ie stronger H2 revenue and profit) and we note that margins improved y-o-y in both half-year periods. Demand from European markets has remained stable at lower levels for 18 months or so now and this business unit is in the process of migrating to a more specification-led sales model. Additionally, work to move the product offering to meet incoming industry standards was also undertaken during the year. We believe that a softer y-o-y H2 revenue performance was largely due to selective withdrawal from certain lower-margin, more commodity end-business and pass-through effect of lower polymer prices. Consequently, this will have masked underlying revenue growth in other areas – most notably in construction fibres, following FY15 investment – but at the same time benefited reported margins. Further investment was undertaken in FY16 with an expansion and consolidation of non-woven geotextile membrane capability in a new Hungarian facility. To us, these elements come across as tangible evidence that the stated strategy is gathering momentum and there is increasing confidence internally that it is well-founded.

Management also noted some progress in North American markets with opportunities cited in Asia. These markets can contribute to future revenue gains for this business unit as the presently dominant European market is not expected to improve significantly in the near term. Consequently, we factor in modest top-line growth – to come from share gains and expansion outside Europe – and further margin improvements arising from positive mix and operational effects. As things stand, our model includes margin development towards 7% over our forecast horizon and we note that management has reaffirmed a 10% target level (albeit with no timescale given).

Coated Technical Textiles (33% revenue, 21% EBIT; margin 6.6%, -400bp)

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

As highlighted at the half year stage, Coated Technical Textiles (CTT) performance detracted somewhat from progress elsewhere in the group. A quiet market for higher-margin tensile architectural fabrics was largely compensated for by other segments in revenue terms but, as well as adverse mix effects, brought challenges to coating operations, which further affected margins. Hence, while these factories were busy, the line performance was suboptimal and we suspect that reported profit reflects additional costs incurred to service orders on hand. It also seems likely that, in the short-order cycle segments, some market share loss occurred. CTT is a well-established business unit within Low & Bonar and, against a longer visible trading record, it has been an atypical performance. To its credit, management has not shied away from providing a clear, logical and consistent commentary on operational issues.

There were some signs of internal progress – though perhaps not as much as was anticipated at the interim stage – with improved H2 margins. More robust operational performance is likely to be a key driver of increased profitability in FY17. Sales efforts into higher-margin segments have been redoubled and a new sports stadium roof-related order may start to feed through in the second half of this year. This may be balanced out by the desire to regain lost market share elsewhere. That said, management has clearly flagged expected margin improvement in FY17. We have taken a conservative view on the rate of recovery to just above 8% by FY19, in comparison to the c 10-11% levels achieved between FY13 and FY15.

Interiors & Transportation (26% revenue, 42% EBIT; margin 16.1%, +190bp)

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

Investment has supported revenue growth in the Interiors & Transportation (I&T) business unit, although falling polymer prices had a dampening effect on revenues as the year progressed. At the same time, market pricing discipline enabled this to also have a positive impact on profitability. The successful commissioning of the new greenfield China Colback facility during H1 was a major achievement and it generated c £10m of revenue (some of which substituted previously imported final products). This factory was initially established to service local carpet tile manufacturers – both foreign implants and indigenous players – where demand continues to grow. Colback materials are also produced in Europe and North America and used in other business units. The local China presence is likely to be used to widen the global sales base of these areas (including building products and air filtration media).

Equipment orders for the second phase of expansion have been placed and this will, effectively double local capacity at a cost of c £21m (resulting in total fixed capital investment approaching £50m), and is expected to be commissioned in Q118. Given phase I experience, increased local market knowledge and product acceptance, we view this as a relatively low-risk exercise. In the first instance, we would expect local carpet tile demand growth and further import substitution to underpin the workflow of the second facility when it comes on-stream. We have factored in local currency revenue growth of c 4-5% in each of the next three years and, while we expect reported profits to continue to grow, we assume that – in the absence of raw material pass-through benefits – margins step back to nearer FY15 levels.

Low & Bonar’s underlying cash inflow of £8.4m for FY16 was slightly below our expectations, but only modestly so. For the year as a whole, we estimate that sterling weakness had a c £17m adverse translation impact on reported net debt, which came in at £111m (versus £102m at the end of FY15). This represented 2.1x EBITDA generated in the year, a shade lower than the FY15 multiple.

Operating cash flow of c £34m was at similar levels to previous years. That said, FY16 contained some encouraging indications for future periods, in our view. We have already discussed the improved operating profit performance and this was struck after a step-up in the depreciation charge following business investment, especially in China. Consequently, EBITDA moved up strongly, by c £7m y-o-y to £52.8m. Other smaller earnings cash adjustments were modestly positive in aggregate for FY16 and pension cash recovery payments of £4.6m were slightly up on the prior year. We commented on Low & Bonar’s working cycle pattern (typical H1 outflow, largely reversed in H2) at the interim stage. At that time, three unusual items were highlighted (all leading to inventory build but for different reasons) with an expectation that they would unwind in the second half. In the event, the working capital outflow for the year of £15m was c £9m higher than we had modelled; this included the pending receipt of proceeds from the grass yarns disposal and a tail of manufacturing issues to be resolved at Lokeren but also build in advance of expected volume increases in Q117, including at the new China Colback facility.

Against our model, this higher working capital build was balanced by lower plant and equipment spend than expected at c £19m versus £27.5m anticipated (and £33m in the prior year). This investment profile reflected completion of the first stage of the new Changzhou, China facility in the early part of FY16 and later timing of spend for the commencement of phase two. This regional expansion is a significant development for Low & Bonar, but it has not been at the expense of investment elsewhere – especially at construction fibre and geotextiles facilities in eastern Europe – and capex again exceeded depreciation (of £16m). Additionally, the preparation for implementing a new group-wide ERP system got underway in FY16. Other free cash flow line items were as expected and for the year as a whole Low & Bonar saw an overall free cash outflow of £4.3m.

After taking into account a receipt of £21.7m for the disposal of the artificial grass yarns business (announced on 4 July, completed on 2 September), £9.2m cash dividend payments made and a small equity proceeds inflow, Low & Bonar saw an £8.4m net cash inflow for FY16. Disposal proceeds were the most material item in H2, but they were almost matched by underlying cash inflow, giving a total inflow of c £41m for the period.

Cash outlook: on revised estimates (see below), we expect a good uplift in profitability in FY17 with further progress thereafter and a broadly neutral working capital performance to translate to strong operating cash flow performance over the next three years. (In the near term, there is an argument for cash to be released from end-FY16 inventory; for now we have assumed that year-end position is required to support rising demand levels.) A commitment to continue to invest in areas with higher growth opportunities will see capex running significantly ahead of depreciation. With Colback China phase two beginning in FY17/running into FY18 plus the ERP system roll-out, we assume c £35m group spend in the current year and £27m thereafter. Also, the acquisition of Walflor in January will result in a c £2.9m cash consideration outflow. Consequently, while we expect Low & Bonar to be free cash flow positive in all three years, allowing for (rising) cash dividend payments and Walflor, net debt is likely to end FY17 at a similar or slightly higher level than end FY16, before beginning to gradually trend down over the next two years. In principle, we favour reinvestment of cash generated into the business to enhance group profitability and returns. For FY17, our model indicates net debt to EBITDA of c 2x, interest cover of c 9x (13x on a cash basis) and that the company is operating well within its current €246m total banking facilities. We also factor in DPS CAGR of 4.8% over our forecast horizon.

Management’s market outlook comments were mixed, with Europe expected to remain challenging, more favourable conditions in North America and ongoing development opportunities in China. Overall, guidance was for c 5-6% underlying revenue growth which, at current rates, will be supplemented by c 5% beneficial currency translation effects, and our estimates are consistent with this.

Taking into account the above market outlooks, FY16 trading performance and individual business unit comments, we have revised our estimates upwards, as shown in Exhibit 2. At group level, the majority of the profit uplift in FY17 is FX-related with additional underlying improvement to come in FY18. Within the mix, GBU level changes were most favourable in Interiors & Transportation and Building & Industrial and while we have factored in improving margins at Coated Technical Textiles the assumed rate is below previous levels. Including slightly higher interest costs (a combination of higher prevailing debt levels and FX effects), the net result is a c 4-5% increase in our FY17 and FY18 EPS expectations.

Low & Bonar’s dividend yield is already above the market average; our DPS estimates are unchanged for now and represent a three-year CAGR to FY19 of 4.8%, with cover above 2x and rising.