Interim results confirm operational fears for Devro

Fears that sausage casings company Devro might be entering a period of “significant operational risk” have been confirmed by Shore Capital, following the recent announcement of Devro’s interim results for the six months to 30 June 2016. 

The ‘transition period’ of delivering a £110 million investment in the US and China has been extended, with ‘complexity’ in the US and the ‘current market’ in China being named as contributing factors.

Operating costs are now expected to be materially higher than was previously expected for the company, with Shore Capital downgrading its short and medium-term profit expectations for the firm.

“Looking back at the H1 2016 performance, Devro actually exceeded our expectations at the EBIT [earnings before interest and tax] level, driven by lower input costs, manufacturing efficiencies in Scotland and Australia and currency translation, leading to a very healthy 210bp increase in the EBIT margin to 15.9% and a 15.4% rise in EBIT to £18.0m. However, elsewhere, the results broadly disappointed,” reported analysts from Shore Capital.

Weak volumes

Seven areas where the company fell short were highlighted:
•    Weak volumes
This was estimated to have declined c8.4% year-on-year on a like-for-like basis
•    Organic sales decline of c8%
Actual sales were flat, which represented currency tailwinds of c6.5pp and a c1.7pp contribution from the Devro BV acquisition
•    Sharp jump in finance costs
This jumped to £3.2m from £1.1m in H1 2015. Higher net debt, lower capitalised interest and “one-offs” contributed towards this. Guidance for the full year has jumped from £3.5m to £6-7m
•    Current pre-tax profit of £14.8m, so flat year-on-year
Before charging £13.4m of exceptional cash costs, split £3.9m in China and £9.5m in the US
•    Underlying tax rate of c22% (against c15% in H1 2015)
This is in line with expectations, reflecting the end of the Czech allowances leading to a decline in EPS of 6.6% to 6.9p
•    A flat DPS of 2.7p
•    Net debt of £147m (£153m including derivative liabilities)
This is up c£22m since the December 2015 financial year-end. The net debt/EBITDA (earnings before interest, taxes, depreciation and amortisation) ratio was 2.9x, sitting comfortably below the recently raised covenant limit of 3.25x.

Shore Capital downgraded its current pre-tax profit forecast for Devro for the full year 2016 by 7.5%. “Looking ahead, we and management expect prevailing trading conditions to remain challenging, albeit we believe volume momentum improved through the period, and we expect such momentum to be sustained, looking for a c4% decline y-o-y through H2, making for a 6% fall over the year. We see limited scope for a change in the price/mix contribution of 0.4pp, though now expect currency to contribute c9-10pp to revenue growth (previously c4pp).

“Visibility on the moving parts behind Devro’s margin is low, though if we look for a further margin increase of 110bps through H2, the leads to a 160bp margin increase across FY2016 to a healthy 16.2% and total EBIT of £38.7m, which is actually a 1% nudge-up to our previous forecast and is in line with management’s unchanged expectations for FY2016 EBIT. However, with higher finance costs we downgrade our FY2016 CPTP forecast by 7.5% to £32.2m, EPS of 14.8p, so a c10% y-o-y fall.”

"Good stuff" versus the "bad"

Shore Capital highlighted that Devro is choosing to book the “good stuff” in the US, and avoid the “bad stuff”. For the second half of the year, the firm is guiding towards a further £6m of “exceptional” cash costs in the US. It is also anticipating a £3-4m saving from the closure on the old plant.

The year-end net debt has been raised to £157m, net debt/EBITDA ratio of 2.7x. “With higher finance and cash exceptional costs, coupled with the impact of the translation of US$-denominated debt, we have raised our forecast for year-end net debt from £145m to £157m, with the net debt/EBITDA ratio falling to 2.7x, so in line with management’s guidance for a strengthening of solvency ratios.”

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