Norcros — Well placed to gain market share

The recent interim results highlighted the robust nature of Norcros, though we have taken a more cautious stance on estimates given the uncertain outlook in FY24 and FY25. However, we believe Norcros is well placed to expand the business, particularly when economies stabilise, based on a number of growth themes. We touched on some in our July note, and there are other potentially interesting themes like legislative changes, geographical expansion and leveraging off the Grant Westfield acquisition that can be supportive. Furthermore, one of the key historical issues faced by Norcros, that of its historically large pension deficit, remains well under control as the fund has been in an accounting surplus at the last two half years. Norcros is a leading player in its field and with the stock trading on a P/E of just 4.9x, we believe there is significant upside from the current depressed price level.

H1 revenue grew 9.5% y-o-y at the headline level to £219.9m. This figure was up 1.1% y-o-y on a constant currency basis and up an impressive 19.8% on the same basis versus H120. Underlying operating profit was flat at £22m, but was up 26.4% versus the same period in 2019. The margin slid from 11.0% to 10.0% largely due to the pass through of input cost inflation. However, this lower margin was still comfortably higher than it was in both H120, pre-COVID-19, and H121.

Underlying PBT declined 4.8% as interest costs rose due to the higher levels of net debt reflecting M&A financing, and diluted EPS slid 10.9% to 17.8p, affected by the higher number of shares in issue. An interim dividend of 3.4p was declared, compared to 3.1p last year. Net debt was £58.9m, versus a modest net cash position last year, again reflecting the acquisition of Grant Westfield.

Overall, current inflationary pressures are not as severe as they have been previously, with copper, glass and aluminium cost increases moderating versus more energy intensive materials like polymers, sand and cement. Freight costs are also moderating as container shipping costs have fallen materially from the peak of the market. Monitoring these cost pressures is a key focus for all of the Norcros businesses, and management has successfully implemented several price increases across the business units so far, albeit there can be a lag of around one to three months.

With regard to energy, Norcros is almost fully hedged for FY23 and c 50% hedged for FY24. It continues to closely monitor what further price increases will be required this year and next, while also watching the US dollar sterling foreign exchange rates, which will also have an impact on supply costs.

In the UK, which accounts for 65% of revenue, Norcros generated revenue of £142.8m, up 9.2% in total and up 13.5% versus 2019 on a like-for-like basis. On a like-for-like basis, UK revenue slipped 3.4% against a very strong comparator with the trade sector proving resilient, offset by a combination of softer retail demand and destocking at larger retail customers. Export revenue was weak across many markets, while Grant Westfield generated revenue of £16.5m in the four months, representing positive like-for-like growth. The margin slipped year-on-year, largely due to the exceptional peak in 2021, and Norcros reported underlying operating profit of £16.3m down from £17.0m in H122. The decline reflected the exceptional performance last year, rather than weakness this year. Norcros generated a profit of £12.5m in 2019 (H120).

The two largest UK brands, Triton and Merlyn, declined 2.9% and 2.1%, respectively, in total as modest UK growth was offset by materially weaker Irish markets. However, like-for-like revenue was up 27.7% and 35.1% respectively versus 2019. Both brands reported lower operating profit year-on-year, largely due to stronger comparators but were up. Vado and Croydex both reported double-digit declines in revenue; Vado because a recovery in the trade segments was offset by weaker retail and challenging export markets, particularly in the Middle East, and Croydex for similar reasons that included destocking and lower offtake from the United States. Both brands reported underlying operating profit lower than last year and 2019.

Grant Westfield, the recently acquired leading manufacturer of high-end waterproof bathroom wall panels, performed well, reporting revenue growth of 8.1% for the four months that it was owned by the group in the period. The business has been integrated ‘seamlessly’ and since acquisition has launched the Multipanel Tile collection, a grout-free alternative to ceramic tiles. Norcros remains confident that it can realise significant new business wins due to new product introductions as well as leveraging off the broader group distribution channels. Underlying profit performance was in line with expectations.

Abode grew revenue 6.5% as it benefited from new products and therefore took an increased ‘share of wallet’. It also benefited from strong market positions with key customers and investment in new design studio space focused on the trade channel. Abode’s operating profit was ahead of both last year and 2019.

Johnson Tiles reported revenue growth of 8%, mainly due to increased selling prices to reflect higher input costs, mainly energy in the production process. The retail sector faced challenging trading conditions and some destocking, which was offset by selling price increases and good stock availability. In trade, revenue grew well aided by good relationships with the national house builders and the supply to a number of major contracts. Exports were weak, largely due to withdrawal of low-margin business. Underlying operating profit was marginally behind H119 and the prior year.

Norcros adhesives reported flat revenue in H1 as a weak retail sector was offset by improved trade revenue. Raw material costs increased and although this was offset by selling price increases, there was a lag that resulted in the division reporting a loss in the period. Management is implementing a programme of measures to improve the H2 performance.

The South African business, which makes up 35% of revenue, grew 10.0% y-o-y and was up 9.7% on a constant currency basis to £77.1m, versus a very strong comparator. Norcros continued to take market share despite reduced consumer confidence due to the rising cost of living. On a like-for-like constant currency basis, revenue was up 31.8% versus H119, with Tile Africa performing particularly well. Operating profit increased 14% to £5.7m and the margin expanded by 30 basis points to 7.4%.

In contrast to the mixed performance of the UK based brands, all of the South African brands grew on a reported and a constant currency basis, with the House of Plumbing being the stand-out revenue performer, growing revenue by 29.7% due to its expanding network of branches, which now stands at eight. Its focus on providing expert technical plumbing advice to the civil engineering, mining and agricultural sectors supported growth, but despite the good top-line performance, profit was marginally lower than last year and also lower than in 2019.

The biggest Norcros brand in South Africa is Tile Africa, which accounts for 51% of divisional revenue. It benefited from improved operating discipline and superior stock availability, which led to market share gains in both the retail and commercial sectors. It also benefited from a new and re-energised product range, which resulted in operating profit that was ahead of the prior year and ‘significantly ahead of 2019’.

TAL and Johnson Tiles South Africa (JTSA) grew revenue by 2.7% and 13.3%, respectively. TAL was held back by a slower recovery in the commercial sector, which contributed to a lower profit in H123 versus last year and H119. JTSA grew due to the repair, maintenance and improvement and new house building segments, which resulted in higher profits versus last year, but below 2019.

In our last Norcros note, we focused on the company’s key strengths and its growth potential via acquisition and channel expansion, its potential to move into other verticals in its wider core bathroom market and to cross-sell products from right across the group to existing clients. There are also additional initiatives and opportunities open to Norcros that we address below.

The UK government has said that from 2025, the Future Homes Standard will deliver homes that are ‘zero-carbon ready’. This means that new homes will no longer be built with fossil fuel heating such as a natural gas boiler. This legislation creates an enhanced opportunity for Norcros’s electric shower and associated products from Triton, leveraging Norcros’s strong relationships with house builders.

In addition, the growing need for key customers like the housebuilders and Screwfix to have strong ESG credentials on products from their suppliers are becomingly increasing important. In particular, a key component for Norcros would be the energy and water saving nature (and hence lower usage costs) of the products such as electric showers. A great example of this is Triton. Triton’s sustainability credentials including its online cost saving calculator is here.

A couple of examples that illustrate the point are Triton’s win of the Screwfix ‘Sustainable product of the year award 2022’ and Johnson Tiles’ involvement in Barratt Developments ‘zed-house’.

Norcros is also introducing plans to drive demand synergies by integrating the recently acquired Grant Westfield business into the wider Norcros distribution channels, like it did with Merlyn. There is a large potential opportunity with some of Norcros’s key accounts and in due course the housebuilders. In addition, we believe Norcros has further opportunities in the social housing segment, working closely with Triton, and with pod manufacturing within Vado, which has strong relationships in this area.

Norcros has been in South Africa since the 1950s and has a market leading position that could be enhanced via M&A in this fragmented market. Expansion into other geographies have been and would be considered if the strategic investment case was compelling enough (ie markets/products/market position/management/growth opportunities etc). Norcros has reviewed many opportunities across Europe and the Middle East and some other niche markets like the Nordics. We believe these markets are potentially much more attractive than markets like the United States or Germany, which are dominated by much larger competitors like Kohler and Masco.

Norcros has a ‘super-mature’ pension scheme, which until this year had been in deficit by up to £63m, as at March 2017, which was a material negative at the time considering that the market capitalisation at that point was only £101.4m. Since then, the deficit has trended lower and stood at just £6m at the end of September 2021. On an IAS 19R basis, the pension fund swung into a surplus of £19.6m at the end of March 2022, and despite the volatility in markets, especially in the autumn, remained in a modest surplus at the end of September as the fall in the value of the fund’s assets was nearly matched by the decline in liabilities as gilt yields rose. Therefore, the pension should no longer be viewed as the negative it clearly was five years ago.

At the last triennial actuarial valuation in March 2021, the actuarial deficit stood at £35.8m (2018: £49.3m), and it was agreed that the company would make deficit repair contributions of £3.8m each year from April 2022 to March 2027, increasing with CPI, capped at 5%.

Given the levels of economic uncertainty that pervade, particularly in the UK and to a lesser extent in Europe, we have lowered the overall growth expectations in our forecasts. For example, in the UK for FY23, FY24 and FY25, we have lowered our revenue growth expectations from 5%, 8% and 5%, respectively, to 1% in each year. In South Africa, we have raised FY23 revenue growth from zero to 6% this year given the growth recorded in H1, and maintained revenue growth expectations in all other forecast years at 2% pa. Overall, this implies a modest lowering of revenue expectations in FY23e, and a 4.8% reduction in FY24e.

Lower revenue and potentially higher cost pressures are likely to have a disproportionate impact on profitability and we have therefore reduced ‘normalised’/reported operating profit by 1.5% and 13.8% in FY23e and FY24e, respectively. Lower profits lead to reduced EPS and DPS expectations especially in FY24e. Net debt remains below 1x net debt to EBITDA.

We believe that Norcros is well placed to offset weaker than expected demand. The business generally operates on a capital-light model and can be flexible in times of declining demand. This can be seen particularly in H121 during the pandemic, when demand fell and the business was run for cash. Norcros reported a net debt position of £36.4m at 31 March 2020, which reduced to net debt of £7.3m by the end of September, and swung to a net cash position of £10.5m just 12 months later.

The wider point about declining demand is how well placed Norcros is versus its competitors to take share, as it is well capitalised and new product focused, with good stock availability and customer service. Many competitors have leverage, squeezed working capital to the detriment of customer service and will not have the infrastructure in China to manage the ongoing supply chain challenges. It is possible that some of the competition would not survive in a downturn and that Norcros is well placed to benefit from any opportunities to gain market share.

Following the hard sell-off in the shares over the last 12 months, Norcros is trading at the low end of its long-term forward P/E range on 4.9x, suggesting that a lot of bad news is priced in. In fact, it has only traded materially below the current rating for a brief period in early 2020 during the pandemic. We have lowered our valuation from 314p in our last note as our earnings estimates, particularly in FY24, have reduced, and the discount rate in our DDM has increased. Our P/E based valuation implies a value of 253p/share based on our lowered diluted underlying FY24 EPS of 33.8p/share. Our DDM model implies a value of 250p/share and if we take the average of the two, we arrive at 252p, implying c 40% upside.

The chart below details the progression of Norcros’s forward P/E over the last cycle. The range at the extremes is a low of 4x reached briefly post COVID-19 and again recently, and the high is c 12x at the end of 2013, before the Brexit hiatus. Over this period and outside the extreme ratings, the ‘real’ range has arguably been 6–9x and the average over the whole period is 7.5x.

If we apply the 7.5x forward P/E multiple to our lowered estimate of FY24e diluted underlying EPS of 33.8p, we arrive at a value of 253p/share, implying c 40% upside to the share price. Arguably, this method gives little credit for future acquisitions, which are part of the company’s strategy and may be forthcoming.

Our DDM supports the P/E valuation of c 250p share, down from 333p/share in our previous note. In this revised model, we have raised the risk-free rate by 200bp to 3.0% reflecting the higher rates that now prevail. However, we have maintained the base dividend of 10p/share even though we are aware that our dividend estimates decline in the short term. We are confident that forecasts are likely to rise in the longer term given the numerous growth channels available to Norcros, justifying our 5% long-term growth estimate.