Interactive Investor

Stockwatch: share slump is chance to buy this small-cap cheaply

25th November 2022 11:37

Edmond Jackson from interactive investor

Business has been disrupted by events outside its control, but an activist investor could stir things up and the CEO is a turnaround specialist. There is risk, but analyst Edmond Jackson continues to back this company.

What should you make of an auditor qualification to the interim accounts of De La Rue (LSE:DLAR), a leading currency and security printer? Is it chiefly company-specific, or a tell-tale sign about how financial market optimism this month is premature?  

We could see more such warnings in months ahead, potentially welcome for equity buyers able to stand back from kerfuffle and consider the overall odds. 

Auditors are doing their job when, according to their opinion, a possible scenario warrants caution. That is especially true where a company carries significant debt and we may be entering a serious downturn. 

It is ours to weigh the probability of such, just like risk factors in a flotation prospectus. If people actually read them all, few would actually invest in a fast-growing business. 

Back near a six-month low which looks overall cheap 

With De La Rue’s stock in a high 70p area – down 24% from 100p prior to Wednesday half-year results - this is now a circa £150 million company albeit reporting a material operating profit of £9.3 million – even if “adjusted” and down on £17.7 million for the six months to late September 2021. Exceptional items of £19.3 million relate mainly to terminating a banknote paper supply relationship with Portals. 

After £23.7 million net profit was achieved in the March 2022 year (including non-controlling interests) consensus has eased to making just over £16 million for the current year and £20.5 million to March 2024.  

That implies earnings per share (EPS) over 8p and 10p respectively, hence a single-figure price/earnings (PE) ratio, although I am wary of a 3p-plus dividend targeted by other analysts for 2024.  

As I will explain, the balance sheet is not exactly a prop. But at this valuation and late-stage in a three-year turnaround – with weary frustrated shareholders – De La Rue is a sitting duck for a takeover bid. 

Given £84 million of net debt and tighter monetary policy, I doubt a private equity operator will have a go at this (normally, to gear up firms and squeeze them for cash) but a French digital security company did so 12 years ago, when De La Rue turned down a then 905p offer that valued it at almost £900 million. 

A 12% revenue hit on the main currency side 

Weaker revenue is blamed on a post-Covid lull in demand across banknote printing. Management cites early signs that high inflation is renewing use of notes, although it is early to call a return to normality.  

Input prices rose on this side of the group, exacerbated by the Ukraine crisis, but its rise in adjusted operating expenses was kept below 5%. 

The authentication side of the business is effectively flat amid mixed performance, with identity solutions too small to limit an 8% group revenue slip. 

Cost of sales as a percentage of revenue eased from 27% to 25% which mitigated a 14% fall in gross profit; then a 5% rise in adjusted operating expenses saw adjusted operating profit fall 47% to £9.3 million. 

Better operating profit and free cash generation (i.e. after capital expenditure) is guided for the March 2024 year, given additional annualised savings of £24 million from March 2024, also greater productivity targeted. 

Last May’s final results flagged tough conditions  

Management said the new financial year from late March involved further headwinds and despite underlying progress “the external environment is providing a substantial degree of uncertainty in the outlook.” It could disrupt revenues when supply chain inflation was adding around £5 million extra costs. Adjusted operating profit was guided as flat for the March 2023 year, and a “second-half-year weighting” was a mild profit warning. 

It shows the risk with “event-driven” ideas currently, like when I drew attention to De La Rue last September at 99p, given the medium-term prospect of King Charles III banknotes across the Commonwealth. But in suggesting the stock overall was one to consider averaging into, I did say the next trading update could involve another profit warning. 

Rise in debt contributes to auditor wariness 

Net debt has risen 20% on last September, with existing facilities (£38.5 million undrawn currently) extended to 1 January 2025.  

Further efficiency actions are expected to help manage this, but the auditors still added a going concern “material uncertainty”.

Auditor Ernst & Young said: “Based on our review procedures, which are less extensive than those performed in an audit...we draw attention to note 1 in the financial statements, which indicates that in the severe but plausible downside scenario, if key currency contracts are not won or fall outside the going concern period, and the group is not able to secure alternative contracts, without sufficient and timely cost mitigation the group would breach the adjusted EBIT/net interest covenant on its revolving credit facility.” 

This is quite surprising given the group’s 12-month order book has risen 9% to £178 million since end-March 2022, yet the full-year audit was not qualified.  

With economic prospects darkening this autumn, it may well have focused auditors’ minds to cover their own backs.  

De La Rue’s CEO is quite understandably exasperated given its banks extended credit facilities only within the last week “without expressing any concern about the covenant levels, which have stayed the same”.  

I think this can be explained in terms of the banks considering the overall probability of events; while auditors feel duty bound to point out a worse-case scenario that could lead to trouble. 

I have done this plenty times even when rating stocks “buy”. 

Balance sheet is no great prop going into a recession 

As of 24 September, net assets had slumped 45% over 12 months to £89 million, and of which 48% constitute intangibles.  

Net tangible assets per share are just 23.8p and net gearing on this basis is 236% given £110 million debt (mercifully all long-term). 

The fall in net assets is chiefly explained by movements in the group pension fund, but also a 19% rise in current liabilities and a 19% rise in debt. 

As regards liquidity, however, the ratio of current assets to current liabilities is a satisfactory 1.5x. 

The interim cash flow statement is not great, with negative movements in both pre-tax profit and working capital, such that last year’s interim £26 million interim net cash from operations became £3 million absorbed. 

September cash held still managed to edge up 2% near £26 million. 

De La Rue - financial summary
Year-end 26 Mar

 201720182019202020212022
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

CEO may be as good as it gets for turnaround skills 

An activist shareholder is pressing for chairman Kevin Loosemore to be voted out at a general meeting next Friday, but as for likelihood of the group being broken up and/or sold off, there is no candidate for replacement. 

The chairman is front-line for frustration when a turnaround groans on, inevitably extending to the CEO. 

Yet three years into this role, 52-year-old Clive Vacher has a good track record. He was previously in charge of Dynex Semiconductor, where private equity investors made 10 times their money. He also held senior manager posts for example at Rolls Royce and Pratt & Whitney.   

Main actions for turnaround here look achieved. Higher inflation and disrupted demand are external factors. Attacking management gets a bit like blaming the UK recession chiefly on Brexit. 

The six-year table alone shows nearly £100 million net profit alone, being made in the 2017 year. 

For risk-aware investors, I therefore retain: Buy. 

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

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