Interactive Investor

Stockwatch: a new catalyst for this erratic small-cap share?

13th September 2022 10:26

Edmond Jackson from interactive investor

Near a four-month high after rallying 40% since July, there’s already interest in this £200 million business. Analyst Edmond Jackson discusses the odds of extending the winning streak.

Does replacement of banknotes across the Commonwealth, not just the UK, offer a potential step-change for banknote printer  De La Rue (LSE:DLAR)?

Currency banknote production remains the dominant 75% contributor to group revenue, otherwise it’s chiefly “authentication” such as security printing and track-and-trace.

Last Thursday afternoon, speculators chased the small-cap stock up 13% to 98p in anticipation of King Charles III notes, although it appeared to trigger others disillusioned with De La Rue to sell into the rise.  

The overall chart context involves huge frustration for long-term holders, given a slump from 960p exactly 10 years ago, so the rise from a May 2020 low of 43p hardly constitutes a break-out.

Cheap on an earnings basis, if forecasts are fair 

Around 99p currently, De La Rue is capitalised near £195 million which is only 0.5x consensus revenue of around £370 million for the current financial year to March 2023.  

Profit assumptions are erratic, however. Flat net profit around £21 million is anticipated, albeit a 25% decline in earnings per share (EPS) to 10.7p, rebounding to 15.4p in the March 2024 year. The last time the share count materially increased was a dilutive 2020 equity-raise of £100 million.  

If that is an approximate fair scenario, the forward price/earnings (PE) is a mid-single-digit multiple, while a 4.9p dividend in respect of March 2024 implies a 4% yield with nearly 4x earnings cover.  

De La Rue - financial summary

Year-end 26 Mar201720182019202020212022
Turnover (£ million)462494565467397375
Operating margin (%)15.224.95.69.23.77.9
Operating profit (£m)70.212331.542.814.529.7
Net profit (£m)41.593.617.034.16.021.5
Reported EPS (p)46.684.917.230.23.610.5
Normalised EPS (p)46.222.145.616.625.814.3
Earnings per share growth (%)2.4-47.8107-63.755.50.4
Return on total capital (%)40316258.736.46.511.0
Operating cashflow/share (p)57.056.4-5.94.5-4.68.3
Capex/share (p)25.422.022.515.112.114.4
Free cashflow/share (p)31.634.4-28.4-10.6-16.7-6.0
Dividend per share (p)25.025.025.00.00.00.0
Covered by earnings (x)1.80.91.80.00.00.0
Cash (£m)15.415.512.214.625.724.3
Net debt (£m)12148.410711664.282.5
Net assets (£m)-151-29.6-39.178.095.0144
Net assets/share (p)-148-28.9-37.768.648.773.7
Source: historic Company REFS and company accounts

Mind, the financial summary table shows a poor record on free cash flow, with capital expenditure consistently ahead of operating cash flow. Last March’s net tangible assets were around 64p. 

This company’s history also involves a warning in late 2019 about its “going concern” basis as cash burn coincided with rising debt and weaker trading. A lucrative UK passport contract had been lost abroad, prompting a re-focus. 

The current CEO of three years says the group is significantly de-risked, although last May’s annual results had to caution about headwinds continuing from the second-half-year.  

The CEO said in May 2022: “In particular, supply chain inflation is anticipated to increase group operating costs by an additional net £5 million this financial year, and there is a possibility that disruption may affect revenue. For this reason, adjusted operating profit is expected to be broadly flat, and second-half-weighted.” 

Furthermore, energy costs appear to have jumped since this outlook statement, and while the government is acting to support citizens and small business, it remains to be seen to what extent costs to wider industry are mitigated.  

Déjà vu on “turnaround plan completed”  

In May 2021, it was said that turnaround plan savings had been completed – with a total £36 million annualised cost savings. This helped adjusted operating profit rebound from £1.4 million to £28 million - subsequently revised to £38 million – for the March 2021 year.  

It triggered my sense that De La Rue has said this kind of thing before; and looking back to how it fared over the last major recession, the 2009 annual report declared: “De La Rue has now completed its transformation…”  

Might it reflect an industry where periodic shifts are required, and relatively high levels of capex maintained?  

In fairness – if a global recession is now likely – the group proved resilient in 2008/09, with revenue 7% ahead and profit measures up modestly. For the March 2010 year, revenue advanced 12% and all profit figures rose.  

The sector does appear resilient although a stagflation scenario would mean higher costs. 

In the March 2022 year, authentication achieved 16% revenue growth to £90 million while currency eased 2% to £281 million. Polymer volumes up 40% did not offset banknote demand easing after higher demand during the pandemic. That looks a quite exceptional factor. 

Profit derivation was more balanced, authentication advancing 44% to £16 million and currency by 20% to £20 million, whereas the smaller identity solutions business slumped from £11 million to £600,000. 

I suspect a mixed narrative is likely to continue, with management hoping to sweeten a reinforced message on higher costs with hopes for “jam tomorrow” from banknote replacement.  

Replacement timing and overseas competition are key 

There is anyway a natural replacement cycle for banknotes over five years, hence incremental change of UK banknotes may not make a huge difference to demand. We can but wait to see what the Bank of England and De La Rue determine. 

Given what appears inherently material levels of capital expenditure, a boost to demand could push capex up further. 

Moreover, printing a substantial set of new notes would effectively bring forward future revenues, leaving a relative fallow patch thereafter.  

Stock traders may be able to capitalise on the “story”, but longer-term investors end up with another bout of earnings volatility. 

While one might assume the Bank of England would not humiliate De La Rue, similarly as it lost the Brexit-blue passports contract abroad, Commonwealth countries may well seek a competitive tender. Australia and Canada also have their own banknote printers. 

So, there are plenty of moving parts to demand from new banknotes, and it’s unclear quite whether extra capex in a context of rising costs means a net positive outcome for value. Until there is more detail, it is speculative. 

Takeover target following sterling devaluation 

Such a mixed narrative, combining with modest valuation criteria and sterling under pressure, may however lead to overseas banknote/security groups examining De La Rue. 

You might think the British pastime for flogging off assets would halt at banknote production; that the government or Bank of England would hold some kind of golden share - De La Rue being the sole UK banknote printer since the 19th century. 

Yet 12 years ago, De La Rue rebuffed a bid from French giant Oberthur Fiduciaire. Germany’s Giesecke & Devrient and Crane Currency of the US are possible suitors also. If costs are becoming an industry issue, there’s an argument for consolidation, such as removing a plc’s head office. This is a sub-£400 million revenue company; a rival could pitch an opening offer at 150p and weary shareholders might capitulate somewhere up to 200p – still representing sub 1x sales.   

I do not mean to push a speculative case here but think takeover prospects are worth bearing in mind. 

Reasonable balance sheet to withstand recession 

A 26 July announcement, ostensibly regarding a settlement to terminate its long-term supply agreement with Portals Paper, cited March 2023 net debt expectations of £88 million to £92 million. 

This is in context of £162 million net assets last March, 23% of which constituted intangibles. £24 million cash was in context of a 1.6x ratio of current assets to current liabilities, with trade payables/receivables in fair balance. 

Mind, a circa £120 million actuarial pension deficit is not adequately presented (under accounting rules) via the balance sheet, which shows a £32 million pension fund asset. The financial review cites annual deficit recovery payments of £15 million up to March 2029, which could be a modest “poison pill” deterring mid-size bidders. 

My concern is that the next trading update constitutes “profit warning number two” due to higher costs, following the admittance in May that March 2023 profit would be second-half-year weighted. Sentiment may however be bolstered by hopes for new banknotes. 

The stance is therefore affected by your risk appetite but, overall, I consider De La Rue merits averaging into. Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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