Interactive Investor

Stockwatch: Cautious rating may tempt trade buyer

22nd June 2018 09:12

Edmond Jackson from interactive investor

Can a steadily rising trend in the small cap shares of showers, taps and tiles group Norcros continue?  

I initially drew attention as a tuck-away at 143p in October 2016, given it looked cheap, the UK would muddle through Brexit and the Bank of England avoid jacking up interest rates.  Then again at 170p in April 2017 as a classic value stock, the company being well-established in its markets with a respectable financial record, albeit on a forward price/earnings ratio (PE) of about 6.5% with its yield rising over 4.5%.  

Despite fund managers saying they nowadays avoid stocks exposed to UK discretionary spend, Norcros has steadily climbed to 225p, and its latest prelims to 31 March 2018 show underlying pre-tax profit up 15% to £26.3 million on revenue up 10.7% to £300 million, or 4.4% like-for-like at constant currency.  

The group benefits from weaker sterling given about a half of revenues derive from abroad, a third of revenue/profit representing South Africa.  Against this I've wondered what higher cost of importing items made abroad, like in China, but updates haven't made an issue of it.

Overcoming two key aspects of negative sentiment

Management is exacting quite decent organic growth, enhanced by acquisitions, whereas investors had fretted that bathroom/kitchen re-fits were exposed to cyclical downturn and South African political risk required a steep discount.  

Possibly rises in stamp duty have made people do more re-fits instead of move home, and/or such improvements eventually boost the sale process and price.  Certainly, the quality and expectations regarding showers have risen drastically over the years, so that many homes have two dedicated installations and quite high-powered.  

The South African operations, mainly ceramic/porcelain tiles, are doing very well: underlying operating profit up 38% to £8.8 million (of which £0.3 million is the benefit of stronger currency), helped by market share gains, better sourcing and cost control.  Management continues to acknowledge country risk e.g. unrest prior to the election of the new president, however "the medium-term outlook in South Africa remains positive, providing for the group to continue to grow its market share."

Within the last five years the stock had bear phases in 2014 (from 252p to 149p) and in 2016 (from 198p to 138p), but the underlying commercial trend has been pretty good: operations have leading market positions and there is continued new product investment within an overall goal to expand market share.  

Despite the REFS table showing a dip in the group's 2017 year performance, revenue was 4.1% higher on a constant currency like-for-like basis, and underlying operating profit was up 11.7%, helped by an improvement in South Africa and an acquisition.  Management now proclaims a ninth consecutive year of growth. 

Outlook is fair, barring unexpected surprises

The market is thus re-appraising Norcros from fears that it's a late-cycle stock and that Brexit would kill discretionary consumer spending.  To remain sceptical you'd have to assume its progress correlates with exceptional monetary stimulus; the UK upturn since 2009 must eventually reverse; and interest rates could rise sooner/higher than expected.  

Meanwhile, the chief executive's outlook statement already acknowledges "the UK market remains challenging" yet "the drivers of demand in our industry in the medium term remain strong...with continued investment, re-aligning costs and further opportunities from the £60 million Merlyn acquisition (shower enclosures/trays)...our UK business is well placed to grow further."  

It would seem to need a shock by way of interest rate rises, but, after inflation hit 3% last September to January, it declined to 2.4% in April/May.  The Bank of England is, therefore, likely to keep monetary policy accommodative with Brexit underway.

Operations narrative may continue to improve

Its chief problem has been Johnson Tiles where revenue swung from being 1.6% ahead in the group's first half year to a sharp 23.4% fall in the second half.  You could say 1) market leading positions don't mitigate a downturn and 2) it shows visibility is very short, so take outlook statements with a dose of salt.  

Preferably Johnson's loss should be disclosed but, this being a £180 million group with around 10 segments to report on, the operating review segments tend only to quantify revenue changes.  A further restructuring of Johnson Tiles means the loss of some 50 jobs at an exceptional cost of £2.1 million, albeit annualised savings of at least £2 million, "and we remain confident this decisive action will return the tile business back into profitability in the current year."

Last November's £60 million acquisition of Merlyn Industries, the UK/Ireland's leading supplier of shower enclosures and trays, has seen 13% revenue growth, within which its UK retail sales jumped 18.5% due to acclaimed new products.  It shows positive surprises can also happen, as a result of attention to quality.  Management is upbeat about Merlyn's opportunities for cross selling and development across group businesses.

Excluding Johnsons Tiles' H2 weakness UK like-for-like group sales would have been 9.8% ahead in the last financial year, and management reckons it has stemmed problems there - if so then the narrative should improve and the company is looking a bid target for another consumer/building products group to expand share.

Norcros - financial summary           Estimates
year ended 31 Mar 2014 2015 2016 2017 2018 2019
Turnover (£ million) 219 222 236 271 300  
IFRS3 pre-tax profit (£m) 5.8 11.0 15.4 11.5 13.5  
Normalised pre-tax profit (£m) 7.8 16.1 18.8 16.5 26.3 26.9
Operating margin (%) 4.3 7.8 7.8 7.2 9.1  
IFRS3 earnings/share (p) 16.0 13.1 20.8 13.4 14.1  
Normalised earnings/share (p) 19.3 21.4 26.3 27.8 29.5 30.3
Earnings per share growth (%) 34.0 10.9 22.7 5.7 6.1 2.7
Price/earnings multiple (x)         7.6 7.4
Historic annual average P/E (x) 10.3 8.7 6.9 7.7 7.8  
Cash flow/share (p) 17.6 24.3 27.4 37.2    
Capex/share (p) 4.8 11.1 10.9 13.1    
Dividend per share (p) 4.8 5.3 2.6 7.2 7.8 8.4
Dividend yield (%)         3.5 3.7
Covered by earnings (x) 4.3 4.3 4.6 3.2 3.8 3.6
Net tangible assets per share (p) 65.3 43.2 3.9 19.3 7.0  

Source: Company REFS      Past performance is not a guide to future performance

Bold five-year targets to 2023  

Revenue of £300 million is way short of the £420 million target set in 2013, to double it by 2018, yet management has the audacity to proclaim £600 million by 2023.  Implicitly, acquisitions will play a strong role and a "well-developed pipeline" is cited, so expect news in due course.  

Versus the REFS table showing the operating margin trending up from about 4% to over 7%, the latest results show it up (before exceptional items) from 8.8% to 9.1%, similarly the underlying return on capital employed to around 18%.  If management can sustain such performance ratios, then another step-change in revenues by acquisition and investment bodes well; it doesn't have to double.

Operating cash flow shows more modest growth of 4% and underlying diluted earnings per share (EPS) by 6.1% to 29.5p - although representing a PE multiple of just 7.6 times.  The board proposes an 8.3% rise in the dividend to 7.8p per share, hence a yield around 3.5%, albeit maintaining substantial earnings cover.  

Yes, they are investing actively, but may also be wary to avoid the need for any dividend cut if consumer spending does fall away.  Goodwill and intangibles, accumulated from acquisitions, have also eroded net tangible assets per share, so you can't really look to the balance sheet for support either.  Its current ratio is a strong 1.8 times however, and net debt a modest £47.1 million which creates a total £1.4 service million costs, £4.5 million total finance costs reflecting movement on value of derivatives. 

The narrative, therefore, needs to stay robust, while the H2 downturn at Johnsons shows you never quite know.  Thus, Norcros remains an above-average risk stock; forecasts are cautious and even then the prospective multiple of underlying EPS is only just over 7 times.

But it's just the kind of modestly rated UK listed company with quality operations, foreign buyers keep snapping up.  Add.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.


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