Norcros (NXR)

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Stockwatch: A classic value investment

What does it take for Norcros (NXR) to break out of a stubbornly sideways trading range? This £105 million FTSE Small-Cap manufacturer of showers, taps, bathroom accessories, tiles and adhesives, is in a genuine commercial space: capitalising on home improvements as rising property prices encourage people to upgrade interiors, also to avoid transaction costs of moving home.

Helped by acquisitions, its five-year financial record is respectable with profitability doubling on revenue up about 18%. The dividend has doubled, too, covered 3-4 times by earnings and with cash flow nowadays exceeding earnings.

Yet the trend in annualised average price/earnings (PE) shows a decline from 11.6 times in 2013 to 6.6 times this year, the stock in a volatile downtrend after it peaked at 238p in early 2014. It has overall trended down this year from about 185p to 147p.

At just over 170p after a robust trading update, the shares trade on a forward PE of about 6.5 times with the yield rising to over 4.5%. Forecasts involved appear rather cautious given the update's tenor.

In principle, a classic value investment

The touchstone is a company well-established in its markets, with a respectable financial record, discriminated against by investors. Norcros indicates revenue for the latest year to end-March up 14.9% to £271 million, 10.6% higher on a constant currency basis and 4% higher on constant currency like-for-like. This is helped by acquisitions, specifically Abode sinks and taps on 31 March 2016, as shown by overall UK revenue up 11.7% albeit only 1.8% like-for-like.

Within this 1.8% growth rate, the first half-year fell 5%, then a strong all-round recovery meant an 8.3% rebound in the second half, reflecting consumer caution ahead of the EU referendum that later relaxed. While a one-off political event, this does show how discretionary goods can be sensitive to confidence.

Ongoing UK consumer credit expansion probably also helped the rebound. Geographic figures for the latest year aren't yet provided, but the 2016 annual report shows the UK representing 69% of turnover and 75% of profit versus South Africa at 31% and 25% respectively.

South African revenues – mainly selling/making tiles – can be controversial due to political/currency risks and the economy has slowed although last November's interims cited return on sales up from 4.9% to 7.2%. It doesn't look like South Africa is liable to cause a dent; the chief influence on risk/reward is British consumers' behaviour.

In practice, some financial constraints weigh

Mind a split between headline and underlying profits due to exceptional items, the UK pension fund being the chief recurring issue. Its gross deficit jumped from £55.7 million to £97.8 million over the six months to end-September 2016 as a result of the EU referendum pushing bond yields (already depressed by quantitative easing) to historic lows. This could be seen as the cost aspect of QE alongside the benefit of boosting consumer confidence.

Yet the stock did not flinch in response to the deficit rise when revealed at last November's interims; it rose progressively from about 145p to 185p during the rest of 2016. Management says defensively, Norcros has over £100 million distributable reserves with just over £2.5 million paid into the scheme annually: the interims cite a "£1.0 million IAS 19R finance cost" taken above the pre-tax profit line, but which is ignored for "underlying" profit.

The market is still reading between the lines because this is a recurring circa £2.5 million cost, albeit a modest 10% of profit. Possibly conservative analysts are including it in their definition of normalised profit.

Furthermore, the latest update cites a £2.3 million reorganisation of the UK tiles business, as a cost to the latest financial year albeit which is expected to pay back in cash terms within 12 months. It does, however, beg questions as to price competition and why Norcros hasn't pre-empted this earlier. The cynical view is that listed plc's wait until absolutely necessary to achieve efficiencies then bung the costs of doing so into "exceptionals".

Another cost aspect is the foreign exchange impact of importing goods manufactured overseas if sterling persists relatively weak in the Brexit years. Norcros doesn't properly clarify its manufacturing profile, referring only to operations in the UK and South Africa, although a lot of bathroom products are made in China nowadays. One feels it will only get clarified in the scenario of reducing margin.

So there are various reasons behind cautious forecasts if possible to take the view they are more than priced in if the UK economy muddles through. This would appear the rationale for Miton fund managers (Gervais Williams) raising their stake to 12.25% straight after the update, which shows conviction, owning a near £13 million stake in a small-cap cyclical.

Dividend is a prop, but don't rely on the balance sheet

Norcros's recent chart suggests the 7.4p to 8p forecast dividend is effective support, but mind the overall consumer environment is positive. While the IMF has raised its UK growth forecast to 2% in 2017, if the UK does end up in stagflation from a messy Brexit then there's no real support from Norcros's balance sheet.

At end-September 2016 there was £45 million goodwill/intangibles and £35.5 million mainly long-term debt versus £8 million cash, in context of £22.5 million net assets. At least the current ratio was a satisfactory 1.8 times. Not a groaning balance sheet, albeit with some chunky liabilities and acquisitions-related goodwill. Quite often with "quality cyclicals" a predator will snap them up when the economy turns down and investors flee, although the pension fund may be an obstacle here.

A recovery case pans out

Despite recent volatility the stock is up about 20% since I first drew attention last October at 143p when you could have secured a yield nearer 6%. That's at least an episode of the market realising its treatment of Norcros has been harsh.

Like any cyclical the stock is broadly a macro call: some slowdown remains priced in at around 170p and the extent of dividend cover supports expectations for dividend growth.

Norcros is unlikely to appeal to traders seeking a chart context, confirmation patterns etc, but its update for the financial year just closed affirms the sense of a tuck-away - with the UK muddling through Brexit and the Bank of England avoiding any serious interest rate rise. The early 2014 peak of 252p was probably down to QE assisting most cyclicals back then, but a return to the 2015 peak of 225p looks a fair medium-term objective.

Norcros - financial summary               Consensus estimates
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 20.1 21.8
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 24.4 26.3
Earnings per share growth (%)     23.4 -17.2 34.0 10.9 16.0 -1.6 7.8
Price/earnings multiple (x)             6.9 7.0 6.5
Historic annual average PE (x)       11.6 11.1 8.7 7.2 6.6
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 7.4 8.0
Dividend yield (%)             3.5 4.3 4.7
Covered by earnings (x)     4.6 3.4 4.3 4.3 4.3 3.3 3.3
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.