Trifast — Update 9 November 2016

Trifast is a specialist designer, manufacturer, procurer and distributor of industrial fasteners. While its origins were in the UK, the group has built a global presence, extending initially into Asia, but more recently into continental Europe and, to a lesser extent, into North America. Trifast differentiates itself from its global competitors by operating its own manufacturing plants, principally across Asia and in Italy, which contribute to the group’s ability to offer specialist design support as part of a high-quality, comprehensive and tailor-made supply chain management service. Management is constantly broadening the product range, while recent acquisitions have introduced businesses in Malaysia, Italy and Germany.

Trifast’s share price has risen by 30% since our June report, published at the time of its FY16 results; the market is starting to recognise the group’s consistent trading performance over the past six years. A rating of 15.3x CY16 prospective earnings is some 30% below the 22.0x average of its larger peers, but at a premium to other smaller distributors. We believe that the re-rating is fully justified in the context of recent investment in people, plant and acquisitions, which ought to enable management to sustain consistent further earnings growth over the medium term.

Distributors of industrial components bear the brunt of destocking and restocking, which tends to accentuate the impact of shifts in economic cycles. This is true for Trifast at extreme stages of the economic cycle, but the group’s operational flexibility and product development/design skills enable management to use strong relationships with its major customers to anticipate and respond early to these challenges. Similarly, management responds to the ongoing risks encountered by all distributors to the industrial sector, such as cost-down pressures, fluctuating raw material costs, exchange rate movements, stock obsolescence and the migration of global manufacturing capacity to lower-cost territories, as part of the day-to-day challenges of the business.

Trifast is the leading UK-based global manufacturer and distributor of industrial fasteners. The group lost focus during the lead-up to the 2009 global recession. The response involved the restoration of a former successful top management team, which rebuilt the group’s reputation for quality of product and customer service. This involved remotivating the workforce, reintroducing basic disciplines and restoring the balance sheet, through more effective capital investment and management of working capital. Seven years later, these disciplines remain the essence of a revitalised group that has been extended through strategic acquisitions in Malaysia, Italy and Germany. Group strategy involves organic growth, especially from building its share of business with its global multi-site customers, supplemented by acquisitions, which can offer new technologies, products and customers, building the group through investment and cross-selling.

Trifast was established in 1973 as a distributor of industrial fasteners, beginning commercial manufacturing in the UK three years later. By the early 1990s, when floated on the London Stock Exchange, Trifast was firmly established as a specialist manufacturer and distributor of fasteners for high-technology industries. At that time, the group was already managing inventory for a small number of leading global customers.

The group was forced to retrench some 10 years after flotation, when a large part of the technology sector went into reverse. Management responded to the challenge, by significantly broadening its manufacturing and customer bases, with a combination of organic growth and strategic acquisitions.

Today, Trifast remains principally (65% of revenues) a distribution business. It aims to differentiate itself from its main competitors by the quality of service offered to customers – the group claims unique design advisory skills to complement its recognised logistics expertise. A comprehensive product range includes standard products, specials (designed or adapted to meet customer requirements) and a range of specialist branded products, which have been developed by the group and are supplied mainly to OEM customers, but also to other distributors.

Manufacturing operations (35% of gross revenues), which are principally in South-East Asia, are fundamental to group strategy and are particularly suited to producing complex high-volume parts to specific customer drawings, in a variety of metals and metal alloys. The group’s technical team extends this service, by offering pre-design support to ensure that fasteners are manufactured with the optimum levels of strength, flexibility and durability for the planned application. The group’s Italian business (acquired in 2014 for £22.5m) introduced a sizeable European manufacturing arm to augment a small UK operation, which concentrates on niche higher value-added products.

Procurement is fundamental. Trifast has a small group of reliable suppliers, which supply around 65% of group throughput, especially for standard products. Many of these suppliers are well known to management, having worked with the group for a number of years. They have been chosen because of their consistent quality of product and reliability of service.

Logistical support is an essential part of customer service. Trifast’s Vendor Managed Inventory (VMI) system was established more than 20 years ago, but has been progressively developed. Management believes that its systems still set an industry standard in offering tailor-made solutions to customers’ requirements. These can range from simple lean manufacturing systems through to direct line feed, involving fasteners and related components supplied direct to customer production lines, to align with manufacturing schedules.

The group’s UK business is mature and remains the largest part of the Trifast operation in revenue terms, with significant internal export sales. The group is the UK leader, with around 10% of the industrial fasteners market, supplied through a network of eight regional depots, which are supported by a small but specialist manufacturing and sub-assembly operation adjacent to the group head office; this strengthens the flexibility offered to customers. In recent years, the business has been the subject of considerable restructuring, involving the rationalisation of the number of depots and strengthening the focus of local teams. Current improvements involve the gradual introduction of the ‘lean-lift’ inventory and stock-picking system across the distribution network.

Until recently, the strategy for continental Europe has involved the use of existing group customer relationships to build a local presence organically. The main operations were in Holland (6% market share), Ireland (2%), Scandinavia (Sweden 5%, Norway 2%) and Hungary (3%); toeholds were also developed in Poland and France, serviced by the existing European group depot network, notably in the UK. The group has also established a strategic presence in both Italy and Germany, with the key acquisitions of Viterie Italia Centrale (VIC) (2014) and Kuhlmann Befestigungselemente (Kuhlmann) in 2015, lifting the group’s profile with domestic appliance and engineering machinery manufacturers. The Italian operation is supported by its own major manufacturing presence, which largely complements longer-standing group manufacturing operations; Kuhlmann is purely a distribution business.

Over the past 12 years, Trifast has responded to the global shift in manufacturing to lower-cost territories, by acquiring and then building a major and growing manufacturing and sales presence in South-East Asia (trading as TR Formac) to meet the specialist local requirements of the group’s principal customer base. The first acquisitions were in Singapore and Malaysia (1997), followed by Taiwan (2001), and then a new green-field development opened in 2006 in China. More recently, in 2011, the group made a major investment, acquiring Malaysia-based Power Steel & Electro-Plating Works (PSEP) for £15m – the deal effectively added some 50% to Asian revenues, broadening both the group customer base and its manufacturing capability.

Managed from Singapore, the Far Eastern businesses have comprehensive local manufacturing and sourcing skills. While the initial objective of moving into Asia was to supply the local subsidiaries of group customers, each business has also built/extended its relationships with other Asian manufacturing businesses, which now represent a major part of turnover.

There is a distribution business/warehouse in Houston, supplying mostly to locally based electronic OEMs, including the largest individual US customer, Hewlett-Packard, for which the group provides global VMI logistics support. There is also a distribution business for the group’s self-clinch branded products, which has established national coverage through a number of third-party distributors. Trifast also operates a small unit in Mexico.

In the aftermath of the 2008/09 recession, which laid bare a combination of issues at the company, an approach was made by certain key shareholders to Malcolm Diamond and Jim Barker (former chief executives) to return to Trifast. The rebuilding of group performance involved a strategic overhaul of the sales and marketing functions, a slimming down of the management hierarchy and the re-establishment of divisional structures. Strict controls on working capital and other expenditures were also quickly introduced; the balance sheet was revitalised and new terms negotiated with the group’s bankers. The rehabilitation of Trifast was completed well within the planned three-year timescale, with management also establishing a clear strategy for building the group over the medium term. Major acquisitions in 2011, 2014 and 2015 raised the group’s global profile, with Trifast becoming a key player in the consolidation of the global industrial fasteners industry. More significantly, management training and development policies have been introduced as part of the rapidly evolving succession strategy.

Jim Barker retired just over a year ago, having achieved far more than his original objective of restoring the group to health, spearheading a programme to develop organic and acquisition-based growth. He was succeeded as chief executive by Mark Belton. Mark had joined the group in 1999 as group accountant and was promoted to the board as finance director in 2010 – his close involvement in the key decisions of recent years, especially the reorganisation and the acquisitions, made him a natural successor. He was replaced as finance director by Clare Foster, who had joined the group from KPMG early in 2015 as group financial controller. Malcolm Diamond has announced his intention to relinquish his executive responsibilities early in 2017, although continuing to lead the board as group non-executive chairman.

Manufactured goods require the assembly of components to create a finished article. Such assembly will invariably involve either adhesives or fasteners. The most common forms of fasteners are nuts and bolts, but there are vast numbers of specialist products used to hold components together. Adhesives tend to be more appropriate on items with a short life, especially when there is unlikely to be a need for the product to be dismantled for either repair or transportation. All other end-products will almost certainly require fasteners of some kind.

Fasteners are invariably of very low cost relative to the overall cost of the end-product, but are essential components; for example, production lines are likely to be held up in the absence of appropriate fasteners. There is a need for a wide variety of fastener types to reflect the physical and chemical pressures to which a joint may be subjected. Fasteners are made from a wide range of metals and composite materials – strength, anti-corrosive properties, flexibility, conductivity and heat-resistance are among the many factors that have to be taken into account when assessing the appropriate fastener.

Successful fastener manufacturers and distributors need to be in touch with changing consumer and manufacturing trends to ensure that they are able to respond quickly and effectively to the varied needs of their customers. In an efficient environment, the distributor and the manufacturer work together to assess the properties associated with each new business development. Trifast has indicated that the overall global market for fasteners is valued at around £50bn, half of which could be available to the group. Industry sources suggest that the market is growing at some 4% pa in volume terms over the medium to longer term, although fluctuations in the global economy over the past few years suggest that this figure may be optimistic.

The global market is highly fragmented, with no single player controlling even 5%. There are numerous large businesses, especially in Europe, which are parts of major distribution groups, privately owned or with external equity investors. The majority of the market comprises commodity-type products, manufactured in low-cost/high-volume factories and distributed by local merchants. However, there is a growing perceived need among manufacturers for specialist or critical components/products and employ sector specialists with a high level of technical and logistics skills. As in all businesses, the rewards go to those that can offer the quality of service required by customers. Product failure or delivery hold-ups can have a disproportionate impact on manufacturing efficiency levels. Consequently, the distributor/manufacturer that can be seen to guarantee no defects and precise delivery schedules can command a premium price.

There have been several acquisitions/mergers across the sector in recent years, initially with market leaders battling for the major contracts, but more recently as a defensive measure when trading conditions fluctuated. We believe this process of consolidation will continue into the foreseeable future, with Trifast having already established itself as one of the acquirers.

Trifast has again performed strongly during the six months to September 2016, with a positive trading performance enhanced by the impact of favourable currency movement in Q2. An 8.1% rise in revenues at constant exchange rates (CER) was converted to a rise of 14.9% to £89.7m using actual exchange rates (AER). Similarly, a £1.0m increase related to exchange movements accentuated the rise in underlying PBT; benefiting also from a £0.6m contribution from the previous year’s Kuhlmann acquisition, an 8.0% CER profits increase was converted into a 20.3% AER rise from £8.3m to £9.9m. This was comfortably ahead of our £9.0m estimate.

There were no exceptional costs. Separately disclosed items, largely comprising the IFRS2 charge and intangibles amortisation, rose from £0.9m to £1.5m, before tax adjustments up from £0.2m to £0.3m. Diluted adjusted EPS rose by 24% from 5.05p to 6.27p. The group is raising its interim dividend by 25% to 1.0p; we would anticipate a minimum unchanged final payment of 2.0p, making a total of 3.0p, covered 3.9x by adjusted EPS.

Gross margins rose by a further 230bp to 31.6%, reflecting a combination of higher margins at recent acquisitions and the continuing policy of disciplined pricing on new contracts. In addition, last year’s adverse movement of the US$/€ exchange rate on gross margins at VIC was partially reversed. We remain confident that gross margins can be sustained at around 30% in the foreseeable future.

United Kingdom: trading conditions in the UK remained challenging, with the group delivering a nominal 1.7% rise in revenue to £32.6m. The aggressive policy towards renegotiating or walking away from lower-margin contracts has continued, with Trifast replacing rationalised turnover with better-quality new business. Investment in a new computer-controlled ‘lean-lift’ stock storage and picking system, plus a number of key appointments (including a new sales director) has lifted the cost base, so that operating margins narrowed slightly by 50bp to 9.6%; UK operating profits slipped back by 3% to £3.13m.

We believe the benefits of the investment will come through to the bottom line over the next two to three years. Sales to the UK automotive industry continue to rise, as do deliveries into distribution businesses in continental Europe. We look for a sound H2 performance, although rising feedstock prices stemming from recent sterling weakness will sustain margin pressures.

Mainland Europe: the weakness of sterling relative to the euro was a feature in group operations in mainland Europe. There was a strong recovery in Hungary, while progress was sustained in Scandinavia, especially Sweden. Both of the recent acquisitions, in Italy and Germany, delivered sound progress. Revenues grew by 35.7% to £32.6m; Kuhlmann contributed 11.6%, organic growth contributed 10.5%, with the balance of revenue growth related to exchange movements. The movement in the €/US$ exchange rate led to a reversal of the previous year’s cut in margins at VIC and was another factor behind the sharp rise in regional operating profits from £2.9m to £5.3m.

Investment remains the key to future profits growth. Both VIC and Kuhlmann have already started to make progress in lifting their exposure to the automotive sector – new machinery at VIC is more adaptable to the needs of the sector, while both companies have extended their sales teams to meet the challenge. Trifast has opened its first branch in Spain, with deliveries expected commence early in calendar year 2017. Management remains optimistic about the immediate and longer-term potential of the group’s mainland Europe operations.

Asia: factors outside management control stopped the group building on the progress delivered in the first half of the previous year. Revenues rose by 9.6% (AER), but operating profits fell by 12.3% to £3.3m. With the exception of PSEP in Malaysia, each of the businesses performed well, with particularly good growth delivered in China and Singapore. However, the £0.5m benefit derived in the previous year from the devaluation of the Chinese yuan was reversed with a negative movement of £0.2m. Difficulties in Malaysia stem from disappointing demand from local automotive manufacturers. Investment aimed at broadening production capabilities and introducing export opportunities in the automotive sector (notably into Japan) point positively to the future.

The second-half outlook for the group’s Asian businesses again looks mixed, with the benefits of the Malaysian investment unlikely to emerge before next year. On the other hand, the other businesses look set to sustain their progress, with the newer operations, in India and Thailand, moving towards profitability.

United States: the group’s relatively small US business continues to move forward. Revenues advanced by 25% to £2.9m, but operating profits slipped back by a third to £0.17m. Trifast continues to develop US business with a small number of its major global accounts, notably Hewlett-Packard, but investment in strengthening the team ahead of a push into automotive business has lifted the cost base, to the detriment of short-term profitability.

The group should deliver some improvement in the second half, but the impact of new business may not be seen until FY18. We remain optimistic about the medium term, but material progress is unlikely without a major investment decision or an acquisition.

We remain confident about the medium term. Management has invested in developing the global sales and marketing team, appointing specialist engineering sales personnel, with the objective of raising the group’s share of business with its top 50 global customers (60% of group revenues). The benefits of these appointments are already starting to emerge, with a number of new contracts, but the full benefit will develop over the medium to long term. There is a clear strategy to lift returns by offering a quality service and charging customers appropriately.

A prime example of this is the close relationship developed with automotive sector design teams, where Trifast has secured several important contracts related to vehicle upgrades, both directly with the OEMs and tier one suppliers. These deals will only become revenue earning when the new models go into production, suggesting progressive incremental revenue over the medium term. Trifast has, however, been quite prepared to walk away from opportunities, especially in the US and China, because they do not offer sufficient margin. As mentioned above, VIC has already started diversifying its customer base, while Kuhlmann, PSEP and the new Spanish venture all look likely to be prime beneficiaries of this trend over the next two to three years.

Organic growth will involve strategic capital investment projects and new products in adjacent markets; plastic fasteners were introduced three years ago and have shown encouraging successes. More recently, Trifast has successfully introduced enclosure products for IT/telecoms cabinets. We have mentioned the investment in the UK distribution systems; manufacturing capacity in Taiwan was raised by 15% earlier this year, while current investment at PSEP in Malaysia will broaden its capabilities to meet the needs of certain key customers. Investment to extend VIC’s Italian capacity is planned for completion early next year.

The group has now opened its new business in Spain. We understand that Trifast has started with a small technical sales team, supported by the Holland warehouse team. The team will be expanded, as opportunities are developed, while the group may also look to make a strategic acquisition if suitable targets can be found and secured.

Acquisitions remain firmly on the group agenda. The ideal target will typically have sales of up to £30m and already be well managed. It will need to offer a combination of new key customers, adjacent technology/products or help provide critical mass in a territory hitherto not covered adequately by the group. Trifast has an extended shopping list, but none of the companies on the list is openly available for sale – group management is constantly looking at opportunities, but will only move when the potential can clearly be identified and its management has expressed a clear desire to become part of the Trifast group.

Trifast shares have performed strongly over the past year, especially since its pre-close trading update in early October, when management confirmed trading ahead of market estimates, with an added boost related to currency movements. The peer group has split into distinctive groups, with the larger more broadly based distributors continuing to perform well, and securing a progressively higher rating, while the smaller, more tightly focused distributors have seen cautious trading statements and weaker share prices. Electrocomponents, Diploma and Bunzl have delivered an average 15% appreciation since our report published at the time of the Trifast interims in June. Share prices of the other companies have fallen.

Trifast’s share price has risen by 30% over this period, as the market seems to be recognising the group’s consistent trading performance over the past six years. A rating of 15.3x CY16 prospective earnings is some 30% below the 22.0x average of its larger peers, but at a premium to the other smaller companies. We believe that re-rating is fully justified in the context of recent investment in people, plant and acquisitions, which ought to enable management to sustain consistent further earnings growth over the medium term.

The global trading climate remains challenging: mainland Europe is still failing to sort out its endemic problems, while there is growing caution about South-East Asia, where indicated growth rates are being constantly revised. Moreover, the Brexit referendum result has increased uncertainty levels. Nevertheless, management has indicated a strong order pipeline, especially related to the policy of working more closely with the group’s top 50 multinational customers. The current year will benefit from a full contribution from last year’s Kuhlmann acquisition, while there is a strong ongoing benefit from the Q2 weakness of sterling. Underlying H1 PBT of £9.9m was comfortably above our £9.0m target

We lifted our FY17 underlying PBT target to £17.3m at the time of the October trading statement, choosing to remain conservative in the light of fluctuating exchange rates. These figures and the encouraging statement suggest a further rise in our estimate to £18.1m – we are naturally cautious about currency-related rising UK feedstock prices and continuing uncertainly in exchange markets, but we are optimistic that the next trading statement, due in January 2017, will at least reinforce these revised estimates.

We remain positive about the medium-term outlook, with the clear strategy likely to deliver ongoing consistent earnings growth. We are lifting out FY18 estimate from £17.9m to £18.7m – again, we are hopeful that this will prove conservative.

Net borrowings were reduced by £1.8m to £14.2m over the six months to September 2016; gearing stood at 15% of shareholders’ funds. The group generated £9.0m from operations, despite a surprisingly modest £2.0m rise in working capital. With taxation, interest and dividends absorbing a total of £3.8m, there was £5.2m available for investment. Net capital spending was £0.7m, while the deferred consideration for Kuhlmann amounted to £1.5m. The principal other factor was the impact of exchange rate movements on the translation of overseas cash and borrowings into sterling; together with a few minor adjustments, this led to an adverse movement of £0.9m.

In the absence of further acquisitions and assuming unchanged exchange rates, we would expect to see a net reduction in net borrowings up to £4.0m over the full year to March 2017. Our current FY17 estimate of net borrowings of £12.1m would indicate gearing of 12.6%.

New facilities have recently been agreed with the group’s bankers. A £5m rise in the RCF implies a total of £50m, plus a £20m accordion facility. This would enable management to act quickly in response to appropriate investment opportunities, without affecting the working capital requirements of a growing business.