Severfield — Update 18 July 2016

Severfield’s FY16 results were ahead of our expectations on most measures including revenue, profit, earnings, dividends and cash generation. We believe that the outlook remains positive for further progress across each of these metrics.

Good double-digit y-o-y revenue progress was delivered in both half years, with improved operating margins in both periods also. From a reported low of £168m in May 2014, the June 2016 order book stands at £270m, having been broadly stable around £185m between November 2014 and November 2015. Allowing for lags, we note that the rate of revenue growth in FY16 exceeded that of the order book in CY15.

In FY15, Severfield increased profitability despite a c 13% reduction in revenue; greater project selectivity and improved operational performance were cited as reasons for this. With a significant increase in revenue in FY16, the headline achievement for Severfield was the delivery of a company reported EBIT margin of 5.7%, at the upper end of the 5-6% target range established in 2013 and up 120bp versus the previous year. We understand that the company’s H2 performance was not distorted by an unusual concentration of favourable final account settlements and should be considered as a normal trading pattern. While operational gearing will have contributed in part to the full year margin performance, we suggest that it also underlines the earlier points concerning selectivity and more efficient operations. Maintaining good business control disciplines in a higher-volume environment is a positive affirmation of the enhanced and more integrated practices and processes introduced in the last three years, in our view. These include more rigorous tendering, reduced fabrication costs and effective site execution. Together, this translates to managed risk exposure and project delivery performance – on both original terms and subsequent variations – such that the retained margin is in line with or better than predicted.

We now look at the development of Severfield’s order book in the context of the last three years.

Exhibit 2 shows the recent reported order book uptick after an extended period of stability at lower levels. We understand that, of the £270m orders on hand as at 1 June, Severfield expects around £211m of work to be undertaken in the next 12 months. This provides good forward cover for factory scheduling in the current financial year, with higher than normal visibility into the following year also. There are more of the larger, longer-gestation projects coming through now. Not having worked on any projects valued above £20m in H116, Severfield now has three in its order book, being Goldman Sachs’s new London head office, the new Tottenham Hotspur FC stadium and the replacement roof for Wimbledon No.1 Court, as reflected in the increasing proportion of the higher order book accounted for by the commercial and stadiums & leisure sectors shown in Exhibit 2. We would expect fuller order books to support ongoing project selectivity and further margin progression subject to maintaining the project management disciplines outlined above at higher steel tonnage throughput levels.

The outlook for this JV was reviewed around two years ago, since which time financial performance has stabilised with small post-tax losses reported in FY15 and now FY16 validating the platform. The operation has scale capability (up to c 60k tonnes of fabrication capacity) and the potential for it to contribute to group profitability remains. Severfield only includes its share of the 50:50 JV’s PAT in its P&L; in FY16 this was a loss of £0.3m, compared to a £0.2m loss in the previous year. Behind these numbers, the JV delivered c £40m revenue and EBIT of c £2.8m (down c 6% and c 25% respectively), but also an implied reduction in finance costs from a combination of lower average net debt and falling interest rates (with no tax charge in either period due to deferred tax loss adjustments). The sterling/rupee cross rate was broadly stable and did not have a material impact on the reported result. A higher proportion of commercial work (c 30% of the total c 36k tonnes processed versus c 20% and 48k tonnes in the prior year) contributed to revenue per tonne and an achieved c 7% EBIT margin, despite the lower throughput. This demonstrates some resilience in the business model. At the same time, c £2m of term debt was repaid (leaving c £13m outstanding) from internally generated cash flow. With an order book of c £33m, near-term prospects remain relatively subdued, although India’s requirement for a new convention centre ahead of hosting the G20 nations in 2018 represents a clear target. Management has outlined an illustrative three- to four-year scenario in which the JV could attain a c £60m revenue level and c 10% EBIT margin with much reduced interest costs. If we assumed a normalised c 30% tax charge, this would imply a c £1-2m share of JV PAT for Severfield, which would contribute to the group-level target of doubling underlying FY16 PBT by 2020.

Severfield ended FY16 in an £18.4m net cash position compared to £6.1m a year earlier (and £12.9m at the interim stage, all excluding unamortised debt fees). At the headline level, the associated £12.4m cash inflow was almost double that of the previous year. In underlying terms, free cash flow rose by almost £9m y-o-y (to £18.8m), driven primarily by increased operating profit (up over £5m) and stronger working capital performance (£2m+ higher inflow). Lower financing costs and gross capex in the year also contributed to this outturn.

Severfield’s working capital performance (a net inflow of £7m, with year-end levels around 2-4% of annual sales) was flattered by a c £3m favourable debtor profile at the period end. We should also point out that almost £4m of provisions for Leadenhall Building remedial work were used up in FY16 (and are now substantially consumed). So, in fact, the reported working capital movement actually understated the underlying inflow modestly, in our opinion. That said, with residual cash provision outflows to come and the unwinding debtor position, cash working capital is unlikely to be as favourable in FY17. For the record, management expects invested working capital to run at between 4-6% of annualised revenue. As far as fixed capital investment is concerned, gross capex continued to run above depreciation (at 1.3x), reflecting a drive to upgrade factory and site equipment to improve operational efficiency. In addition, Severfield invested £4.1m to take a 50% stake in CMF (a supplier of metal decking and other cold rolled building products), as announced in November. FY15 cash flow benefited from the disposal of an investment property that did not recur in FY16, although £0.7m other asset disposal proceeds were received. Lastly, Severfield made £3m of cash dividend payments in FY16 versus none in the previous year.

We expect another good free cash flow performance from Severfield in FY17, albeit below FY16 levels. After taking into account higher capex, c £0.5m pa deferred CMF consideration and rising cash dividends in each of these years, our estimates show a net c £4m cash inflow this year, rising to c £13m by FY19. Management has prioritised future cash allocation to include growth in working capital and a rising core dividend. Further strategic investment (following CMF) has also been flagged subject to opportunities and the retention of a good (unspecified) balance sheet net funds position. After these aims have been met, there is a willingness to return surplus cash to shareholders. With a rising net cash position and term debt facilities in place (of £25m plus a £20m accordion, both out to 2019), there is a clear agenda for organic and acquisitive earnings growth and above average dividend progression, with funding already in place to achieve this.

Management sees a fairly stable, modestly growing UK economic backdrop and expects this to be supportive of growth in the construction sector. Severfield’s order book currently stands at £270m (up 57% y-o-y) and the pipeline of prospects is understood to be healthy. With a strong end to FY16 in both revenue and EBIT terms, supported by a healthy order book, we have increased our operating profit expectations by £0.5m for the next two years (on unchanged revenues) and added an FY19 estimate for the first time, which shows further progress.

Note that our estimates currently include a zero contribution from JVs (ie JSW Severfield and now CMF also).

FY16 results were announced on 15 June, before the referendum and Brexit outcome were known. In the past European markets, especially the Republic of Ireland have been more significant but represented less than 4% of FY16 revenues. The vast majority of Severfield’s costs (including materials) and revenues are in sterling. Severfield’s order book typically runs up to 18 months out and the targeted projects or pipeline can have long gestation periods. Our high level views on the impact of Brexit on the company’s prospects are as follows: