Severfield — Update 7 December 2016

First half results both reinforced the margin progress message and included a further step-up in the UK order book. This translated to an EBIT uplift of c 60% y-o-y – a little more at the PBT/EPS level – a further increase in the net cash positon and a 40% rise in the interim dividend. We have increased our FY17 estimates on the back of this performance.

UK revenue was in line with the previous year. The significant y-o-y EBIT increase confirmed that the margin uplift delivered in H216 was well founded and effectively sustained in H117 (company-defined EBIT margin +270bp to 70%). In H116, Severfield worked on “over 80” projects and stated that an equivalent H117 number in H117 of “over 90”. We are aware of a number of larger contract awards, but conclude that workflow in the period was dominated by smaller ones cycling through the order book. Following this logic, the larger projects – with the possible exception of the London development project (a new London HQ in Farringdon for a major investment bank) – are early stage or yet to start, which provides a good, visible underpin to the order book.

The foundation for improved margins lies in the original estimation-tender-negotiation-award contract phase. The extent to which the target margin is achieved (or leaked) obviously depends on project execution. As previously commented, enhanced operational and commercial processes put in place over the previous three years have successfully addressed these phases as evidenced by ongoing margin improvement over this time. As far as the H117 trading performance is concerned, management identified improved workflow through the factories using new equipment and the commercial relationship with new JV partner CMF1 (supplying a range of metal decking products) as having additional positive margin effects. Also, better management of contract variations had a favourable impact and reinforces the perception that integrated contract management across the group has taken root.

A split of revenue by sector is not provided. Taking the November 2015 order book breakdown as a guide, we believe that commercial offices, industrial/distribution, power/energy, transport and, to a lesser extent, stadia were the dominant project types. Some examples include:

This demonstrates a range of project capability and regional diversity. There is also spread of main contractors behind these projects.

Looking ahead, Severfield’s UK order book – having risen to £270m in June - stood at £315m in November versus £185m a year earlier. The sectors that have made the strongest contributions to this increase are stadia & leisure (including the new Tottenham Hotspur stadium, Wimbledon No 1 court) and Commercial (22 Bishopsgate). These two sectors together accounted for 76% of orders on hand and there are further opportunities in the pipeline in both. This is not to say that work in other sectors has dried up; industrial/distribution remains strong with retail and transport (ie bridges) also having a favourable outlook, although with a lower average project value compared to the two leading sectors. This base load of work should facilitate good levels of utilisation across all four UK fabrication facilities where a programme of rolling out an upgraded production management IT system is underway. Sherburn is now using this for new contracts, to be followed shortly by Dalton/ Lostock with Enniskillen to be upgraded thereafter. This is designed to improve the visibility and timeliness of project status information to relevant staff members and link into other software, further tightening project and margin control. The current group order position may also enable a greater degree of contract selectivity in choosing the pipeline opportunities to bid for that intrinsically have higher margins or fit particularly well with other workflow.

In financial terms, this investment contributed a small (share of after-tax) loss in H117, in line with the prior year. Against H116, achieved revenue was slightly lower (c £18.5m vs £20m), while operating margin was slightly higher (ie 7.6% vs 7.4%). Repayment of the entity’s debt began last year and is scheduled to be complete in FY19. Consequently, the associated net interest – currently slightly above generated EBIT – should be trending down.

Operationally, fabricated volumes in the period were 21,000 tonnes compared to 18,000 tonnes in H116. As these projects progress, this may support improved revenue and margin performance. This will partly depend on project mix, which we understood to include both industrial and commercial work. The order book has remained stable at £35m and we sense that more complex commercial projects are in the identified pipeline, which includes opportunities outside India (eg Oman). We currently assume a neutral contribution to our estimates from the Indian JV, but reducing interest costs and/or higher activity levels represent upside potential here.

At the end of September, Severfield’s net cash position had grown to £24.4m (including £0.2m unamortised debt arrangement fees), an increase of £5.7m since the end of March. (In context, this cash has all been generated organically in the 30 months subsequent to the FY14 year-end, where the balance sheet was effectively in a neutral funds position.)

Severfield generated a trading cash inflow of £12.3m, c £1m higher y-o-y, although the composition was rather different. Consistent with the EBIT progression, EBITDA was up by over £3m in H117. Moreover, cash outflows associated with Leadenhall remediation work last year (which we estimate to have been in the order of £2m) were not repeated this time. Conversely, a reversal of a favourable end-FY16 receivables position and build-up of activity levels together led to a c £7m debtor increase, compared to a c £7.5m inflow in H116. There was also some absorption into work in progress this time, but not materially so. These items were more than offset by a c £10m increase in payables – again consistent with rising activity levels – including some advances. So, while the overall working capital cash movement was positive, the inflow was lower than the prior year (at £1.7m and £8.2m respectively) which offset most but not all of the relative improvements in cash flow described earlier. Net interest and tax together came to £1m. Net capex of £2.1m was slightly above depreciation in the period and an outflow of c £0.4m represented the completion adjustment on last year’s CMF investment. Lastly, the dividend cash payment of c £3m (for the FY16 final) was twice the H116 level. Hence, the overall cash movement for the group was an inflow of £5.7m.

By the end of FY17, we expect the net cash position to have reduced slightly to c £23m. We would highlight capex of in excess of £3m (including c £2m for new welding equipment at Lostock to facilitate deeper bridge sections) and a substantial reversal of the end-H1 creditor/advances inflow as the primary elements of this H2 movement, notwithstanding further profit progression over H1. The actual year-end working capital position will depend on the stage of projects on hand at that time and the agreed contractual payment schedule. Beyond FY17, our estimates project increasing net cash balances (FY18 +£10m increase, FY19 + £12m). Management has reiterated its strategy and unchanged investment priorities, ordered as:

Management feels that cash balances in the order of £20m are currently satisfactory and provide commercial benefit. Our estimates indicate net cash building well above this after normal trading cash requirements. It should be pointed out that there is no automatic trigger point or quantum for additional shareholder returns, but we consider that the prospects for core dividend growth (where our expectations are raised) and special/one-off returns (none currently projected) are good.

Note that our estimates still include a net interest charge despite the net cash position. Obviously, the deposit rate is very low currently. Severfield does have a £25m RCF in place to July 2019 and the associated amortisation, and non-utilisation fees, together with some small finance lease costs, explain the group charge.

Sentiment towards London property, including commercial space, has cooled since the Brexit result in June and leading property companies such as British Land (16 November) and Land Securities (15 November) have commented on this. That said, projects such as 22 Bishopsgate support reasonable activity levels for now, while planning activity (eg 1 Undershaft, Paddington Cube) and a prospective new Google HQ at King’s Cross indicate a pipeline of distinctive projects. Outside London, regional office markets looks to be firmer and demand for new, large-scale distribution facilities around the country appears to be undiminished. Severfield has also highlighted a number of potential prospects. In the medium to longer term, road and rail infrastructure (especially bridges) and large retail schemes (eg Croydon, Brent Cross) may translate to new work in due course.

We believe that the increased order position will start to feed into current year revenues and we have raised our revenue expectations here, along with a 40bp EBIT margin uplift (to 7.1%, per company definition). This is partly offset by factoring in fee-related financing costs and higher expected share-based payments but the net result is +9.5% uplifts in both our FY17 PBT and EPS estimates. Reflecting some sector uncertainty, the revenue adjustment beyond this is more modest at this stage and, consequently, the effects described above cancel each other out, leaving our FY18 and FY19 headline estimates unchanged.

Note that we have lifted our full year dividend expectations following H117 results by between 19-21% for each of the next three years.