Norcros (NXR)


Stockwatch: A contrarian buy and big dividend

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Stockwatch: A contrarian buy and big dividend
Does a forward price/earnings (PE) multiple of five scream value or trouble ahead? The FTSE Small-cap shares in (mainly bathroom products) group Norcros (NXR) capture the dilemma currently facing investors.

Bank of England governor Mark Carney has just said he is willing to tolerate higher inflation as sterling falls; with luck it could prove a one-off, like the 2010/12 rally in oil prices that did not lead to inflation or a weaker economy.

But if higher import prices spread and workers bargain unsuccessfully for better wages, consumer spending may fall. People will also start retiring with diminishing annuities.

Re-vamping bathrooms and the like are easy projects to defer. If inflation does lead to higher wages, company margins will fall and investment will suffer. With lower output and higher costs, "stagflation" could result.

This macro aspect is a chief reason why the stockmarket is marking down cyclical shares to exact a higher yield for perceived risk. It has simmered for a few months, mainly related to concerns about the European Union (EU) referendum effect on consumer behaviour.

Stock has festered this year

Norcros is also in its eighth year of growth, helped by the housing boom prompting refits. The stockmarket wonders how long this cycle can last, and prices cautiously as UK sales soften.

The recent growth trend benefits from acquisitions funded with debt besides cash flowThe five-year chart affirms a classic cyclical: from 2012-14, Norcros soared from sub-100p to over 250p as quantitative easing (QE) encouraged investors up the risk curve. A reality check brought this back to 150p as margins/profits slipped for the year to end-March 2014.

The stock has just dropped below a two-year range. Yet the table shows profits and earnings growing nicely since 2013/14, backed by strong cash flow per share.

Mind the recent growth trend benefits from acquisitions funded with debt besides cash flow and, while Norcros has headroom for further deals, the market may not take kindly to rising debt if there's a consumer slowdown.

High-profile brands

Norcros is UK market leader in showers through the Triton brand, while Vado makes taps and mixer showers and Croydex offers bathroom furnishings and accessories. Abode makes high-quality kitchen taps/sinks and bathroom taps and Johnson Tiles ceramic tiles. There is also Norcros Adhesives for tiles and stones. In South Africa, Norcros markets mainly ceramic and porcelain tiles, and adhesives.

Results for the year to end-March 2016 were strong on profit measures - up roughly one third - while revenue rose a modest 6.3% on a reported basis, or 11.0% at constant currency.

UK revenues dipped 5.0% in the six months to end-September due to the EU referendumThe UK is important, generating 69% of group revenue and 75% of profit in the last financial year, while South Africa represents 31% of revenue and 25% of profit; hence volatility in the sterling/South African rand exchange rate makes a difference. The rand was plunging a year ago amid mining industry woes, but sterling's fall now means a beneficial translation effect.

A recent trading update cites UK revenues declining 5.0% in the six months to end-September as customers hesitated around the EU referendum.

Norcros has previously cited a softening in the UK DIY market - which I'd also relate to a social trend with people less enthusiastic or able to DIY - and a slowdown in public sector spending, although bear in mind the May government has indicated a switch from austerity to fiscal spending on infrastructure - i.e. there is benefit potential going forward.

Double revenue by 2018

If the board can achieve this with carefully-risked takeovers it should re-rate performance beyond the forecasts.

A second goal is for non-UK revenue to represent about half of group total, although expansion abroad will be costlier amid lower sterling. A third aim is to sustain a pre-tax return on capital employed of 12-15% through cycles, which mitigates downside risk.

Norcros need only be reasonably successful with this strategy to achieve upside from a current share price of 143p - representing a forward PE around five times, yielding 5% and nearly four times covered by earnings.

As with various cheap stocks there is a pension fund deficit lurking - £73.5 millionA UK downturn is certainly a risk, but it would likely make acquisitions cheaper. If earnings per share (EPS) were to flatten to around 20p it still implies a PE of just seven, thus the stock is already pricing in a worse-case scenario.

As with various cheap stocks there is a pension fund deficit lurking - £73.5 million - due to low gilt yields decimating returns. A recovery plan has been agreed for annual contributions of £2.5 million plus inflation for the next 10 years.

The cash flow statement shows £3.6 million paid out as dividends in 2015/16 and with earnings cover being kept near four times, Norcros should be able to bolster its pension fund. However, it puts more reliance on bank debt for expansion.

Fair balance sheet

Acquisitions meant the end-March balance sheet showed goodwill and intangibles up 66.2% to £44.7 million representing 93.4% of net assets. That's not a major risk in itself, just that if earnings soften then investors will query the extent of tangible asset-backing. It could mean the market exacts a yet-higher dividend yield.

This is an investment-grade stock with leading positions in its marketsAgainst £5.9 million cash there was £38.4 million chiefly long-term borrowings, in context of £100 million debt facilities agreed to July 2019.

Mind that while the balance sheet shows a £55.7 million pension deficit, on an actuarial basis it's up 18.7% to £73.5 million. Overall it's not a risky balance sheet, just less than ideal.

Director selling

Another factor undermining sentiment has likely been the chief executive exercising 163,720 nil-cost options at end-September, then selling all those shares at 154.5p, while retaining his holding of 795,424 shares. Perhaps he needed the money, but don't we all when business gets tougher? Whatever the truth, it didn't help.

So there are a few amber lights around Norcros, presenting a dilemma for conviction investing.

This is, however, an investment-grade stock with leading positions in its markets: one to accumulate when sentiment is against. While it's tricky to guess the economic outlook, this has created an opportunity to average-in on a low rating.

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Norcros - financial summary Consensus estimate
year ended 31 Mar 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 200 200 219 222 236    
IFRS3 pre-tax profit (£m) 9.4 5.2 5.8 11.0 15.4    
Normalised pre-tax profit (£m) 10.2 8.4 7.8 16.1 17.9 21.0 22.7
Operating margin (%) 5.9 4.8 4.3 7.8 8.0    
IFRS3 earnings/share (p) 16.0 9.0 16.0 13.1 20.8    
Normalised earnings/share (p) 17.4 14.4 19.3 21.4 24.8 25.8 27.6
Earnings per share growth (%) 23.4 -17.2 34.0 10.9 16.0 3.4 7.2
Price/earnings multiple (x)         5.7 5.5 5.1
Annual average historic P/E (x) 6.5 11.2 11.1 8.7 7.2    
Cash flow/share (p) 6.6 7.4 17.6 24.3 27.4    
Capex/share (p) 11.6 7.2 4.8 11.1 10.9    
Dividend per share (p) 3.8 4.4 4.8 5.3 6.0 7.0 7.5
Yield (%)         4.2 4.9 5.3
Covered by earnings (x) 4.6 3.4 4.3 4.3 4.3 3.7 3.7
Net tangible assets per share (p) 82.3 56.9 65.3 43.2 4.8    
Source: Company REFS

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.