Walker Greenbank — Update 13 April 2016

Walker Greenbank is a tightly focused and vertically integrated interior furnishings business, targeting its products at the quality end of the market. Each of its established brands (Sanderson, Morris & Co, Harlequin and Zoffany) is aimed at a distinct market segment, with consistent investment in design and product development enabling it to meet customer aspirations. Principal products comprise woven and printed fabrics, and wallcoverings. Printed fabrics and wallcoverings are produced in house by specialist manufacturing businesses, which also supply a number of leading third-party customers; woven fabrics are imported from specialist suppliers. The Scion and Sanderson Home brands, introduced successfully in 2012, supply a younger, aspiring audience. Anthology, aimed at export markets, was introduced in 2014. Other branded household goods are produced and marketed by a series of licensees, which contribute substantial royalty income.

The relative rating of Walker Greenbank shares when compared with its peer group is complicated by ongoing costs associated with the flood. On the basis of market estimates for the current year, the shares look expensive; if, however, the group is able to consolidate a realistic loss of profits payment from its insurers, as it did in the year under review, the shares appear to be rated at a modest discount (16.0x:16.9x) to the majority of its peer group. This does not reflect the group’s impressive record and potential – it may take some time for this potential to be fully recognised in the rating of the shares.

While the group supplies into the more inelastic upper end of the market, it cannot be immune to major changes in consumer spending. Shifts in consumer preference can often be more important, as they can cause fluctuations in the perceived attraction either of the group’s brands or its manufacturing skills. Management has addressed this potential difficulty by consistent investment in design skills to establish a more comprehensive range of collections across the brand profile, adapting house styles to anticipated fashion trends. Similarly, group manufacturing operations have also been the subject of consistent investment, enabling them to offer a unique blend of design, production and printing skills, appropriate to their market segment.

As indicated in the pre-close trading update, Walker Greenbank has responded impressively to the challenges presented in the year to January 2016, delivering ahead of market expectations. Trading conditions remained challenging throughout the year, with the strength of sterling holding back the rate of progress in a number of overseas markets. More significantly, the group had to contend with a serious flash flood in early December, which caused considerable damage and halted production at the fabric printing business for the remainder of the trading year; the impact was also felt in the downstream Brands business where stock shortages affected sales of both the fabrics and other orders dependent upon their availability. Despite the disruption, group revenues rose by 5.4%, to £87.8m. Underlying PBT rose by 10.0% from £8.13m to £8.95m, materially above our estimate of £7.40m. This estimate had been adjusted in the aftermath of the flood, from £8.7m, to reflect the estimated related loss of profit. The group earned underlying PBT of £7.54m (slightly above our estimate) from operations, boosted by a consequential loss payment of £1.41m from its insurers, which was credited as other income to the P&L account. The resultant PBT of £8.95m beat our earlier estimate by 3%.

As in the previous year, there were no exceptional items, although the LTIP charge was again high, down modestly from £1.01m to £0.92m. The tax charge was slightly higher at 16% of underlying PBT. Underlying fully diluted EPS rose by 8.3% to 12.13p, covering the increased dividend of 2.89p (2.31p) per share 4.2 times.

There was revenue progress both in the UK and overseas, although with home sales up by just 3.7% to £57.5m, the main momentum was overseas, with revenues 8.6% higher at £30.3m. There were challenging conditions in continental Europe, Japan and the former Eastern Bloc, exacerbated by the impact of currency movements. The group, nevertheless, delivered 10.4% constant currency sales growth in continental Europe, although this was negated by the movement of the euro. There was also sound progress both in the Middle East and the Far East, while the previous year’s refurbishment of the group’s New York showroom and a strong dollar contributed to a substantial 19% rise in North American revenues.

Momentum improved consistently as the year progressed, reflecting the quality and popularity of a number of new collections. However, the progress was severely disrupted by the flood. Production ceased immediately and has only started to be restored since the end of the trading period; the first machine was recommissioned in mid-February, with the business moving towards full production by the end of April. This is loss of business is reflected in the 32% fall in Manufacturing division profits.

Harlequin (incorporating Scion and Anthology) is the most successful and largest of the group’s brands. Its products are aimed at the mid-level of the premium market, with price points typically £22-89 per metre/roll. Its collections include a distinctive range of contemporary styles, which have enabled the brand to establish itself as UK leader in its chosen market segment. Harlequin is the leading independent supplier to the John Lewis Partnership (6% of group revenues), but is also gaining further recognition among interior designers and decorators. The brand was extended in 2012 with the introduction of Scion, a new contemporary brand with lower price points (£21-49), and targeting younger age groups. Anthology was added in 2014, as a new standalone brand, aimed mainly at the export market, through the Harlequin distribution network.

Harlequin delivered 9.3% revenue growth to £31.7m, over the full year; at the interim stage, revenues were running 15.6% ahead. The reduced rate of growth during the second half stemmed from a number of factors; the timing of new product launches, which were particularly prevalent in the Scion and Anthology brands, boosted first half sales, as did the 2014 upgrading of the Chelsea harbour showroom, which had benefited the previous year’s second-half result. In addition the availability of printed fabrics will also have held back progress in the final quarter.

The outlook remains positive despite tough trading conditions in certain overseas markets, especially Russia and Eastern Europe (up to 10% of revenue). Disruption will have continued in the first quarter, but with all three brands introducing important new collections, we anticipate useful revenue progress in the current year.

Arthur Sanderson (incorporating Morris & Co) is the oldest of the group’s brands, dating back to 1860. It is targeted at the mid to upper end of the premium market, with price points of up to £120 per metre/roll. It is an internationally recognised brand, with a royal warrant and a distinctive and unique archive. Morris also has a similarly long heritage, based on the skills of the acclaimed designer William Morris; product is also supplied into the mid to upper end of the premium market, its price points are above those for Sanderson. Morris & Co and Sanderson designs lend themselves to printed fabrics, providing considerable upstream work for the group manufacturing operations. The introduction of Sanderson Home in 2012, targeting a slightly younger market segment with somewhat lower (£21-50 price points and represented a significant extension to the brand.

Last year’s trading saw a reversal of the previous year’s trends, with a 2.1% reduction in UK sales almost balanced by a rise in export revenues; overall sales were just 0.9% lower at £21.5m. Again there was a better first half performance, with UK sales probably more severely affected by the flood because of the higher proportion of printed fabrics in its product offer. We sense that second half overseas sales were less severely affected because of the longer supply pipeline.

The current year will benefit from a number of new collections, especially ‘Woodland Walk’ for which there have been very positive reviews. Morris is also benefiting from a subtle change in design strategy. Difficulties related to fabric availability will undermine the performance in the first quarter, but we look for revenue progress over the year as a whole.

Zoffany is aimed at the upper end of the premium market. The style tends to be historically based, with many patterns adapted from the furnishings found in certain stately homes. It is the youngest of the group’s brands, established just over 30 years ago, but has quickly become recognised for the quality of its rich weaves and elegant designs. Price points start at £42 per metre/roll, but are typically more than double those of other group brands and can be as much as £240 per metre/roll.

Revenues recovered by a further 4.7% last year to £11.7m, with useful growth in both UK and overseas sales. The outlook continues to improve – increased support from the strengthened central design team has led to new collections with more subtle colour schemes. Early indications from interior decorators suggest that there will be useful growth again in the current year. With Zoffany typically using woven fabrics, the flood should not be a factor.

Standfast & Barracks is the last remaining successful UK-based high-quality fabric printer. It has unique design skills and extensive fabric preparation and finishing processes, which ensure the highest quality of product, combined with the ability to print effectively on a comprehensive range of base fabrics, including cotton, linen, silk, wool and velvet. In addition to supplying the group requirement for printed fabrics, some 60% of output is produced for third-party, high-quality furnishing fabric houses, such as Osborne & Little and Designers Guild. The introduction of digital printing has added to the flexibility and, hence, the profitability of the plant since 2010. It has also created opportunities to supply product more widely, such as into the apparel industry – the company has supplied Liberty for some years, while discussions are ongoing with a number of other potential customers.

Standfast’s performance last year was severely affected by the flash flood in early December, which led to severe losses of inventory, machinery and, of course, profits. The group does not disclose the profits of individual businesses, but to put the performance into context, first half revenues were up by 16% to £9.6m, while second half revenues fell by 30% to £6.1m; over the full year, revenues slipped back by 6.3% to £15.7m. Third-party sales grew nominally, but in-house revenues fell back sharply by 12.9%.

Production restarted in a small way in late February and has progressively increased. It is planned that the business will be close to full production capability by the end of April 2016. In house business is being restored as the company’s capabilities are being restored. The timing of the restoration of third party business is more difficult to predict. The complete closure of the factory for almost three months has, naturally, led to several customers looking elsewhere for supplies of printed fabric. The speed with which this business is regained will depend on the performance of their new/temporary suppliers, the terms of their new contracts and the strength of the relationship with the company. Walker Greenbank management believes that most of the lost business will be regained, but is conscious of the fact that most alternative suppliers will be overseas based, suggesting that the process may take several months, possibly going into 2017. We understand that the lost digital printing capacity will be replaced with new machines, two of which will be of higher specification than their predecessors.

Anstey is one of few remaining UK wallcoverings manufacturers, and the larger of two specialists at the quality end of the market. The company is able to use a wide range of paper and vinyl bases, and employs a full range of printing techniques to meet the varying needs of a specialist customer base. The plant is equipped to concentrate on shorter runs and is building an impressive third-party customer base (estimated 50% of sales).

Revenues grew by just 1.7% last year to £18.6m, with a substantial rise in third-party sales more than compensating for a 14.5% reduction in in-house sales. The latter was already evident at the interim stage, when management cited a major inventory investment in the previous year, to cover the introduction of a number of new collections, notably for the Anthology brand. The recent investment, broadening the manufacturing capability, suggests further progress in the current year.

Macro issues – demand for all types of consumer goods will be affected by shifts in the economic cycle in the various territories where the group’s products are sold. Group products are targeted at the upper and premium end of markets, where cyclical movements in demand tend to be more inelastic. While the two new brands, introduced in 2012, involve lower price points than previously, the group is not involved in the more volatile higher-volume/low-margin products.

Consumer preferences – during the move towards minimalism, consumer preferences shifted away from wallcoverings towards painted walls and less-distinctive furnishing fabrics. The demise of considerable competition during this phase has created an opportunity now that fashion trends have become more broadly based. Group manufacturing operations have benefited from a move back towards colour, where printed fabrics offer more scope to the designer.

Design skills – a fashion business is only as good as its latest collection. While many group products tend to have a shelf life of up to five years, there is a constant need to reinvent, adapting the archive bases to meet the changing needs of the marketplace. Features of the rebuilding of group brands have been the strengthening of the various design teams and consistent investment in new product; more recently the group has appointed a design director, promoted from within. The breadth of product now offered to the market is sufficient to absorb the occasional disappointment.

UK manufacturing – there is a perception that UK manufacturing cannot compete with similar businesses in lower-cost territories. However, the flexibility in techniques and ability to adjust production schedules at relatively short notice offers considerable attractions both to the group brands and to the division’s external customers. The fact that several competitors employ the group’s manufacturing operations is a testament to the product quality, the strength of the arm’s length relationship with group brands and the sustainability of the businesses.

Pension deficit – the group operates a defined benefits scheme, which is closed to new entrants. Management acted some years ago to control the level of risk. The January 2016 balance sheet shows a deficit of £4.3m, down from £10.4m 12 months earlier; the reduction largely stems from a higher discount rate being applied because of increased bond rates.

Walker Greenbank’s shares have continued a period of consolidation at just above 200p that has now lasted some two years. They were fundamentally re-rated over the two previous years and stand at almost four times the level prevailing at the beginning of 2012. During that time, earnings estimates have been regularly beaten, with the group delivering consistent growth in the face of a challenging trading climate. Management has invested in several new brands, upgraded its websites and transformed the printing capabilities of its unique manufacturing operations. Meanwhile, it has continued to generate cash.

Perhaps surprisingly, the share price has continued to hold firm in the aftermath of the major flood. However, management indicated from the outset that the group was effectively insured, a judgment that was reinforced by the £8m interim payment announced in early March. Because our estimates consolidate no further loss of profit payments, the above ratings for 2016 and 2017 may well be overstated; on the basis of our ex-flood estimates for the current year, the annualised ratings for the two years would be 16.0x and 15.7x.

On this basis, the shares are currently rated at a discount to four of the other five members of the above peer group. We believe that such a rating does not recognise the consistent earnings and cash generation mentioned above, let alone the investment which points positively to the future. However, we concede that the market may require further proof that the group is fully recovered from the impact of last December’s difficulties before pushing the shares much higher.

Walker Greenbank has delivered double-digit growth in underlying pre-tax profit in each of the past six years. It has established three new brands since 2012 and has consistently invested in new and innovative collections, whilst at the same time extending the capabilities across its manufacturing operations.

The current year has started encouragingly, with brand sales running 0.9% below those of the corresponding period of last year; a 3.8% drop in UK brand sales is almost balanced by an 8.7% rise in export sales. This has been achieved in a period when the fabric printing facility was initially closed and then slowly building up its production. We cut our current-year profit estimate from £9.4m to £7.5m when the extent of the flood damage was becoming clear. Indications from management suggest that demand remains robust and in line with earlier expectations, with several new collections adding to the immediate potential. Of the two major launches mentioned by management, the fourth Anthology collection does include fabrics, but these are woven and should not be affected. Fabrics for the ‘Woodland Walk’ collection emerging from Sanderson are printed and will involve the Standfast plant. The statement also refers to the likely impact of last year’s appointment of a new licensing director – several new licensees have recently been signed up, suggesting that licensing revenue, which has plateaued for the last two years, looks set to start moving ahead again.

We do not propose, at this stage, to adjust our £7.5m current year adjusted PBT target and suggest that we may have to await the interim results in October, before management is in a position to give a clearer indication of the impact of the flood on the group bottom line. Presumably group insurance premiums will rise, while there will also be some capital costs incurred to mitigate against a similar situation occurring in the future. However, on the assumption that the group will receive a further loss of profits payment in respect of the current year (to be consolidated as other income), it is quite likely that our earlier £9.4m target (Edison Outlook report – October 2015) will be delivered.

The impact of the flood on the next year’s trading to January 2018 will obviously be less marked. The factory will be fully operational, although as mentioned earlier in this report the speed with which third-party business is regained is difficult to predict. We are introducing a target of £9.8m underlying pre-tax profits, which should prove conservative.

Net cash balances at Walker Greenbank increased over the year to January 2016 from a nominal £2,000 to £2.31m. We had been looking for a modest net inflow, but the impact of the flood was always going to be difficult to assess.

As we indicated, there was a positive impact on operational working capital, balanced by the loss of profit and the impact of immediate expenditure to preserve the plant. Inventories were reduced by £3.9m; this reflected a combination of the natural run-down of finished goods and the writing off of damaged materials, while the previous year’s balance sheet had seen inflated stocks ahead of a number of new collections. Similarly, there was a sharp, £1.6m, reduction in creditors stemming from the reduced raw material intake, while debtors rose sharply by £5.0m largely as a result of expenditure incurred, but recouped from the group’s insurers after the end of the trading period.

After a sharply higher depreciation/amortisation charge, including plant impairment related to the flood, funds generated from operations were effectively doubled from £3.5m to £7.1m. With the increase in the dividend and the ending of the group’s tax holiday, interest, tax and dividend payments rose sharply from £1.4m to £2.2m, while capital investment remained high at £2.5m.

The current year has already benefited from the initial £8.0m insurance receipts, £4.7m of which was incurred and expensed during the year to January 2016. Our current estimates indicate a further increase in net cash of at least £2.0m by end January 2017.

Banking facilities were renegotiated in December 2015. The group has a multi-currency RCF of £12.5m, with an additional £10.0m accordion facility, providing ample headroom to cover foreseeable requirements.