Severfield — Momentum to be informed by order intake

Delivering PBT in excess of the FY16 strategic target with strong operating performance in the second half was the major achievement of FY20. The acquisition of Harry Peers further diversified Severfield’s sector exposure and reduced the year-end pre-IFRS 16 net cash position to c £16m. With FY21 trading to date seeing the impact of COVID-19 restrictions, we have assumed no final dividend will be declared, although the board has yet to announce whether this is the case.

Exhibit 1 shows the reported P&L development for the company over the last four half-year periods. As the Indian JV (and CMF associate) earnings are equity accounted, the figures shown represent the performance of UK-based operations.

Early in the FY20 trading year, management flagged a significant expected H2 bias based on the likely progression and phasing of project contracts in the order book. In the event, the underlying H1:H2 splits of revenue and reported operating profit were 42:58 and 27:73 respectively. The half-year contribution from Harry Peers amplified this effect slightly (to 40:60 and 26:74) in reported terms.

While the full-year adjusted EBIT margin was 30bp below the FY19 level – and remained within the company’s 8–10% target range – the profit contribution generated and margins earned in H2 were noteworthy. We believe that pre-acquisition H2 revenue and EBIT margin were the highest in any six-month reporting period for more than 10 years. Project mix and stage of completion/profit recognition effects make it difficult to assess a drop-through/gross contribution margin by looking at the delta between H2 and H1. We feel the proportion of later-stage work/completed projects was certainly above average in the second half of the year. That said, the cumulative effect of a number of contributing factors will also have had a bearing on this outturn, including:

We have covered active projects in previous notes and FY20’s results commentary also names some of the work undertaken in the year, so we will not repeat it here. Our key observation is that sector breadth remains an important business characteristic with commercial offices (London and regional), data centres, distribution centres, industrial facilities, bridges and sport stadiums all featured on the project list in the year. Several projects were also undertaken outside the UK chiefly in the Republic of Ireland with one in each of Finland and Sweden also. At the time of reporting FY20 results, all UK and European project sites were said to be open.

Harry Peers was acquired on 1 October and made a full six-month contribution to second-half trading, including £14.4m revenue and EBIT of £1.3m (both c 7% of H2 revenue and EBIT). The company’s position in the nuclear sector added further sector diversity to Severfield and we understand that Peers has achieved a higher level accreditation since being acquired. Its other industrial sector specialism is process industries (including petrochemicals, pharmaceuticals, waste to energy plants) with particular strengths in modular pipe racks and building structures. Severfield management has made positive noises about the internal capabilities and external customer relationships since owning the business. Although Peers primarily operates in different market segments, order selectivity (assessing scope to grow) and potential referrals of higher volume packages of related work are two group benefits that have already been identified. Peers brought in an order book of £20m and it stood at £17m eight months after completion. Given positions on frameworks at Sellafield, a degree of order book stability should be expected.

Order book: unsurprisingly with a significant spike in revenue in H2, Severfield’s total UK/Europe orders on hand reduced to £293m at the year-end (from £323m at the beginning of November). We believe the geographic mix at this time was similar to November, being just over half on UK projects, just under half in Europe/Eire. The latest order book reading was £271m at 1 June; the industrial/distribution sector combined accounted for 45% of this value (probably more weighted towards distribution), while commercial offices were 24%, data centres/other a further 15%, with a tail of other sectors/projects. (Noting that two months of the FY21 trading year have already passed, £243m of orders on hand are for delivery within the next 12 months.)

The last time the order book was around this level in June/August 2016 it was followed by similar FY18 revenue of c £270m. To be strictly accurate, FY18 also included work on Bishopsgate 22, a significant project that did not come into the order book until November 2016. While this was a major project, it serves to demonstrate that a simple order book value does not provide the complete picture. More typically, some work is shorter cycle and may contribute to revenue without having been part of an initial order book position at a point in time. Of course, we are not in normal times and pipeline dynamics (eg rates of new project development, tender conversion rates and decisions to proceed) are being stress-tested now under what is likely to be a recessionary outlook, or at least not as strong on a two-year view as one might have expected at the beginning of calendar year 2020.

As pointed out earlier, sector diversity is a Severfield strength, although it would be reasonable to expect relatively busier ones to attract competition if volumes shrink in other areas. Scale, sector portfolio/track record and main contractor relationships are all inhibitors to perfect substitution of switching supply across sectors. The smaller volume end of the market with the widest number of potential suppliers is traditionally where price competition becomes most visible. That said, capacity utilisation at larger fabricators can influence pricing on larger-scale projects. Before allowing for relative raw materials purchasing power, tighter pricing usually means tighter margins and/or reduced contingency with greater onus on execution. The appetite for – and pricing of – risk are key drivers of market dynamics in lower-volume trading environments. Access to near European markets provides Severfield with additional opportunities to diversify its project selectivity over and above prospective UK-based work.

A step forward in profit generated, a rising proportion of commercial sector work and the completion of an extension to the Bellary facility were all good milestones for JSSL (Severfield’s JV with JSW Steel) in FY20. That said, we are unlikely to see the full benefit of additional capacity during FY21 given a more pronounced COVID-19 lockdown effect on the local construction industry.

Financial performance: JSSL delivered a strong uplift in revenue and profitability in FY20 including an EBIT margin slightly ahead of that generated in the UK. Average exchange rates were broadly the same so this performance reflected sustained increased volumes over the year and an improved business mix. Improving the proportion of commercial work compared to lower-margin industrial work contributed to the margin uplift; while other factors come into play (such as contract phasing) we note that, on comparable revenues, the EBIT margin in H220 was 210bp above its prior-year equivalent level. We note also that JSSL achieved an 8.5% margin in both half years. Interest costs rose year-on-year in FY20 primarily due to increased borrowings for capacity expansion. The net result was a £1m uplift in Severfield’s share of post-tax profit to £2.2m (reported as part of the Share of results of JVs and associates in the group P&L, along with a smaller CMF contribution).

Trading performance: the initial COVID-19 lockdown phase began in India on 25 March, right at the end of Severfield’s financial year and therefore is unlikely to have had any material impact on FY20 trading performance. Looking at company presentation materials and the Indian order book development we note that:

Some of the above projects in both sectors are ongoing and form part of the current order book (see below). The value of Industrial orders peaked in June 2018 at £79m, running down steadily – implicitly with a book to bill ratio below 1x – to c £20m at the year end. This work has provided a good baseload for JSSL’s Bellary fab facility enhanced and now exceeded by successfully winning new business in Commercial.

Order book: over FY20, JV orders on hand declined from a record £149m initially to £112m at the year end. We estimate that c £5m of this reduction is attributable to the translation effects of relative sterling strength versus the rupee. Adjusting for this, with FY20 revenue of c £109m, the implied new business order intake for the year was approximately £75m. The mix development is of particular note for two reasons:

Apart from these key points, our other observation is that Hyderabad (Telangana state) appears to be an important focal point for major project work both for ongoing projects and those in the pipeline. In this regard, management has highlighted four non-industrial prospects in two sub-sectors being commercial offices (for two separate Indian conglomerates with construction and real estate interests) and data centres (so-called hyperscale facilities for two separate international clients, Colt and Amazon). As in the UK, we consider the diversity of clients in sectors of demonstrated expertise for the group to be a strong indicator of JSSL’s now established position in the Indian structural steel market.

JV capacity: as previously reported, JSSL successfully increased its annual Bellary fab capacity by 30,000 tonnes to 90,000 tonnes as FY20 concluded. The detail of this is included in our February note, which provides more background context for JSSL’s prospects. Near-term trading will clearly be heavily influenced by the rates at which COVID-19 effects recede and the Indian economy and corporate sector recover. The opportunities arising from an increasing penetration of steel structures compared to more traditional concrete construction methods in India remain undiminished in our view.

Severfield’s end-March pre-IFRS 16 net funds position was above our expectations at £16.4m – which included c £1m client advances, in line with the prior year – and represented a reduction of almost £9m y-o-y. This was the net result of good free cash inflow and deployment into the acquisition of Harry Peers and dividend payments. (Note that this is the group net debt position and does not consolidate any debt carried in the Indian JV.)

The company generated EBITDA (IAS 17 basis) of c £33m in FY20, an uplift of c £4m consistent with the EBIT progress described earlier. Although the relationship is not linear – and more dictated by the phasing of projects and contract payments – the c 14% organic increase in revenue saw an absorption of working capital (c £2m for the full year, driven by a c £4m H2 outflow). Inventories/work in progress was at the lower end of year-end levels seen historically but larger movements were seen in receivables outflows consistent with a busy H2 trading period and partly offset by increased payables. The year end coincided with the initial UK COVID-19 lockdown period, but this does not look to have had a material bearing on working capital in the balance sheet. Net working capital on hand at the year-end was 3% of revenues, in line with the prior year and below management’s typical 4–6% target. Non-trading cash outflow items totalled c £3m and included a c £1m pension cash contribution (similar to the prior year) and c £0.9m acquisition costs (relating to the Harry Peers deal). As a result of the above items, the trading cash inflow in FY20 was c £28m.

Cash interest and tax payments totalled £6.6m, up almost £3m y-o-y with increases in both line items reflecting acquisition-related debt on hand and higher levels of profitability respectively. Gross capex was at similar levels to the prior year and included both capability enhancement (eg in paint facilities in the Ballinamallard fab in Northern Ireland) as well as spend on more efficient replacement equipment. Net of modest disposal proceeds, capex in the year was just over £6m and FY20 free cash inflow was a healthy c £15m.

The Harry Peers acquisition had a headline initial consideration of £18.9m on a company cash-free/debt-free basis. In cash terms, this required a £13.4m payment in the year. In addition, Severfield assumes responsibility for delivering steelwork services for which Harry Peers had received c £5m early working capital payments, which may flow out as cash in future periods. Dividend payments of almost £9m were the other significant application of funds and IFRS 16 lease repayment cash approached £2m.

Cash flow outlook: Severfield did not make use of the UK government furlough scheme and there was no timing benefit from taxation payment deferrals either. At present, the decision regarding whether to declare an FY20 final dividend has been deferred until nearer the AGM, which was in early September last year. Otherwise, management has flagged a near-term capex expectation of c £4-5m focused on replacement items. We also note that a year-end balance sheet provision has been made for the Harry Peers deferred consideration payment (£6.7m discounted to £5.8m), which, subject to the acquisition terms, is scheduled for FY21. Of course the key driver behind future business cash flows is underlying profitability; since the initial UK COVID-19 lockdown at the end of March, we have elected to withdraw our estimates pending greater market clarity. Although more market data are beginning to emerge, this remains the case for now.

As far as the trading environment so far in FY21 goes, some temporary site closures were reported in the UK in the early part of Q121; at least half appear to have been operational throughout and by the time FY20 results were reported on 4 June all project sites were live again. We understand that new working practices in the light of COVID-19 guidelines are only having a minor impact on live workstreams with the impact being felt more at site access points and common rest areas. Our sense is that other trades perhaps may be more affected – which could affect overall project progress – although we are unable to validate this to date.

With regard to future orders and pipeline conversion, we feel it is reasonable to expect significant project delays in those sectors most obviously affected including airports and retail. Elsewhere, the changing financial picture for landlords, tenants and developers alike is likely at the very least to require careful consideration of future staff and space requirements and the associated economics leading to lengthier decision-making processes. The cost of finance remains at very low levels and some sectors look set to be more robust. These include infrastructure (eg road, rail bridges) and nuclear, while new stadium opportunities are also visible. Distribution and data centres could both be said to have been critical backbone sectors during the lockdown phase, although there was also good momentum beforehand.

A survey by the Construction Leadership Council – which has also been an all parties focal point for return to site protocols – found that a c 10% reduction in the construction workforce was anticipated by respondents at the beginning of June. Upstream project participants such as architects (eg BDP), consultants (WS Atkins) and contractors (Mace, Multiplex) have been making redundancy announcements. These recent anecdotal news items may not be directly relevant to Severfield’s pipeline but do provide evidence that the construction industry is preparing for lower overall activity levels.

India imposed lockdown restrictions in March around the same time as in the UK and began the first unlock phase on 8 June (with a second on 1 July) although containment-zone restrictions still apply where COVID-19 incidences exceed limits. Since the lockdown began, the Reserve Bank of India has reduced its repo rate twice and to 4.0% from 22 May. We understand that JSSL JV partner JSW Steel re-started production during April and reached 85% capacity utilisation in May driven by government-related demand. However, construction site activity is said to be effectively shut down. A report by KPMG,1 admittedly more focused on infrastructure, has flagged a likelihood of rising labour costs but also lower input costs in its May assessment of the outlook for construction in the country. The rate at which India emerges from the COVID-19 pandemic, and its impact on inbound investment in particular, will clearly be different to that in the UK.