Steady growth, with strategic development opportunities
Macfarlane Group is the leader in its chosen market, generates cash (in part
through the modest capital employed in its operations) and is growing through
both organic and acquisition-led expansion. The Packaging division (82% Group
sales) exhibited organic growth of 4% in 2014, accelerating into 2015. Our
estimates allow for reversion to the lower rate, though we see no evidence of
a slow-down. Indeed – at the margin – there are specific drivers to accelerating
the growth rate. EBITA margins are exhibiting a modestly upward trend.
Strong financial footing: Stable gross margins of between 30.2% and 32.0%
have been achieved in the past five years and indeed in 2009, under a more
difficult business environment, 32.4% was achieved. This robust gross margin
base, allied to top line expansion and controlled costs, imparts upward
momentum to EBITA margins.
Growth: The acquisitions of 2014 enhance the steady and rising organic growth.
The AGM in May stated that 6% organic growth was achieved for the Packaging
Distribution division, with minimal growth in Labels, translating to 5%
Groupwide. The UK economy is a driver to these metrics, but it is noteworthy
that approaching 20% sales are to the growing and demanding UK internet
retailing sector and Macfarlane is also growing its national accounts.
Valuation comparables: Packaging drives a key comparator, RPC, which stands
on 16.8x historic PE and 11.5x historic EV/EBITDA. RPC is a manufacturer not
distributor and is a larger business, with a higher margin model, thus not entirely
comparable – but illustrates that Macfarlane’s rating is far from demanding.
Risks: Macfarlane has a £13.9m pension deficit. There is a conservative balance
sheet and the growth, allied to cash generation, has high visibility levels.
Investment summary: The leading market share, 13% CAGR in PBT over the
past five years and modest 1.3x EBITDA/debt ratio provides a robust platform
upon which to expand, including via newer growth areas and acquisitions.
Strategic positioning
Macfarlane’s proposition, in its dominant packaging distribution division, is to at least maintain its gross margins whilst positioning itself to capture growth within a market which is robust albeit not intrinsically high growth. Macfarlane holds a UK market share of some 20% in packaging distribution. By optimising returns from its established national infrastructure, Macfarlane is leveraging growing top line and growing EBITA margins from its established market positon.
Group revenue derives 97% from the UK. It has modest exports (in the Labels business) and small operations in Sweden and Ireland, with a small level of US sales. The Group derives 82% sales from packaging distribution; the remainder is equally spread between the design/manufacture of packaging products (for protection of higher value items) and the design and printing of labels for the fast moving consumer goods market.
It operates 18 Regional Distribution Centres (“RDCs”) providing a national network to support customers’ packaging fulfilment needs. Macfarlane buys in product from the manufacturers such as DS Smith, Sealed Air, and so forth – hence this division is a distributor not manufacturer. Each Centre is separately assessed as a profit generator. In addition the Group operates four specialist manufacturing centres, two in Packaging Design and Manufacture and two in Labels.
Macfarlane was founded in 1949 and has built its leading share in the UK packaging market primarily organically but also by a series of smaller acquisitions of established local businesses. Macfarlane is the only dedicated national operator.
Recent growth has been a mix of additional sales to existing clients, new customer wins (organically, over and above the circa 4% pa attrition in customer numbers) and acquisitions – in that order of size quantum.
In 2006, Macfarlane embarked in an acquisition programme, re-launched in 2012. Between 2006 and 2008 Macfarlane acquired three regional protective packaging specialists and successfully integrated them to the UK network. The two most recent acquisitions, Network (September 2014) and Lane (May 2014), add just over £10m annual sales and comprise Wolverhampton and Reading based businesses – both being well-established and (particularly for the former) with strong product innovation.
Strategically, Macfarlane is positioned to optimise growth and predictability, hence the judicious use of acquisitions to optimise the benefits of the national network which is in place and the close monitoring of each RDC and tight control of costs.
Trading
Summary:
Macfarlane has a well-established market share in a market which is relatively competitive and exhibiting modest growth. As previewed in the Board’s Outlook comment accompanying the 2013 results announcement, starting from Q4 2013 and as 2014 progressed, the trading background modestly improved.
Overall sales growth was 4% in 2014 but an exit rate of 6% in Packaging Distribution was achieved and appears to be being maintained. Our numbers allow for a more modest growth, to be conservative.
Towards October /November 2015, visibility as to a continuation of this recent higher rate of growth will increase significantly. This is because we note that both with the expansion in internet retailing and also to a degree with the Network business acquired, there is a slightly increasing trend towards Q4 seasonal bias. Internet retailing visibility is reasonably strong well ahead of Christmas – circa early November.
The market is expecting another year of good, steady progress.
Sales:
One key driver to the organic sales growth is National Accounts, which was a healthy 14% in 2014. As yet National Accounts is a modest proportion of the total. Internet Retail is around a fifth of sales and this has potential to outpace group-wide growth, albeit 2013 growth in this area was a relatively modest 3%. Manufacturing operates in an environment of flat to declining demand, but we consider that Macfarlane can counter pricing pressure and may seek incremental opportunities for example in export as well as UK markets.
Our estimates are predicated on 3% organic revenue growth (i.e. 4% in Packaging, nil in Manufacturing), albeit we consider the 2015 outcome should be in excess of this level and that 1H15 is likely to see an outcome in the region of 4-6%.
We note 2012-2015E sales CAGR is 5.1% and on a per share figure the basis is 1.8%. Whilst we consider our 2015E revenue figure to be conservative, we would seek a rise in the 1.8% per share revenue CAGR as the fuller benefits of the acquisitions, exposure to growth areas and a generally supportive macro-economic background are felt.
Margins:
EBITA margin growth has derived in recent years from cost control, allied to leveraging the established group network, capturing as much incremental gross margin (be it derived through organic growth or acquisition) as possible.
Stable gross margins of between 30.2% and 32.0% have been achieved in the past five years and indeed in 2009, under a more difficult business environment, 32.4% was achieved. Gross margins within Manufacturing Operations have improved as 2014 progressed, due to the focus on composite transit packaging. Our model assumes flat gross margins but there should be scope for upside.
After strong cost rises in 2010 (which were broadly passed on to the market),
input cost trends have been muted. Generally changes in cost are shared with
clients, within a modest time delay. This translates to EBITA margins of between
3.5% and 4.3% in the past five years (3.5% in 2011 and 4.3% in the 2014 period).
Consensus estimates are for EBITA margins of 5.0% in the current year, with
5.2% 2016.
Margin trends, particularly at EBITDA and EBITA levels are rising. Importantly, to
a degree this is assisted by the Group infrastructure being in place to support
the national network and so, particularly with growth enhanced by judicious
acquisitions, the overhead coverage ratio is a figure we would anticipate
becoming increasingly efficient.
In addition to the greater coverage of overheads, assisted by acquisitions and
organic growth, there is a target to improve performance of each Regional
Distribution Centres. Macfarlane stated in its 2014 Accounts: “In 2014 we had
13 of our 18 RDCs performing above the target return on sales level of 5%. The
remaining 5 RDCs continue to demonstrate improvements that indicate their
ability to achieve the target return on sales.” For reasons of 1) confidence on
margins on a centre-by-centre basis, 2) top line momentum, 3) benefits of
recent acquisitions, we consider our model to be making conservative
assumptions. It should not be overlooked, however, that most markets being
supplied are showing modest if any growth.
Sensitivity/risks
Forecasts are sensitive to the performance of the recent acquisitions which are
trading in line with expectations and have been integrated well, both being
established, successful businesses.
Cost inputs may see a time lag between Macfarlane’s paying of the changed costs and clients reflecting this in their buying prices. These costs are paper and polymer, both of which showed rises but where the trend in 2015 has tended to be a slight reversal of some of the rises.
Strong Sterling is not a significant issue, as pricing reflects trends which include the global nature of physical packaging input costs but Macfarlane slowly and steadily is capturing some of the ‘service’ value added provided over and above the physical product.
Macfarlane states examples with certain customer ‘case studies’. In any case, Macfarlane is the market leader and indeed customers’ find that the physical packaging cost (ie the Macfarlane products) comprises some 20% of total packing/storage/ damages etc costs. Macfarlane is deepening customer relationships through ‘consultancy’ advice.
Macfarlane also has instigated and is broadening pan-European partnerships, which would have the effect of reducing risk in two regards. This enables Macfarlane – especially with its national accounts – to offer robust pan-European solutions. It also is treating the UK as less of an island regarding global packaging customers.
Investment Conclusion
Through a balance of organic and acquisition growth, annualised PBT has grown 15% CAGR over the past six years. The markets addressed are relatively stable but low-growth and fairly competitive. Macfarlane has a strong competitive position thereby ensuring reasonably high visibility of robust gross margins.
- PBT growth is driven by the leverage of the existing strong market presence as regards ability to:
- Enhance sales without proportionate rise in costs of the UK-wide network
- Continuing the focus on growing sub-segments
- Continuing the cash generative nature of the business model
- Investing that cash into tuck-in acquisitions, delivering an explicit programme
- Some equity has been issued, to accelerate the point above, but we see no need for significant issuance in the short/medium term.
In this context, we note from the 2014 accounts: “Following the acquisition of Network Packaging, the Company undertook a share placing to provide additional funds for its acquisition programme. The placing was well supported by new and existing institutional investors”
The dividend is set to continue steady growth and the pension deficit issue is not one to compromise any of the growth drivers. The balance sheet and cash generation are robust. EBITDA and free cash flow are steady. The 2014 free cash flow reduction is entirely resulting from investment into the pension fund.
Valuation and comparables:
Valuations have risen from a low point of 17p in July 2012. At that stage the shares stood on a PE (to current year (i.e. forward rating) PE 5.0x; EV/EBITDA 3.7x vs current PE 9.3x; EV/EBITDA 6.6x (to 2015E)
We note the rise in EV/EBITDA (i.e. the reduced apparent attractiveness in valuation) for 2014, which is in part a statistical feature only. This stems from the rise in EV as a result of acquisitions, which led to a rise in debt at year end but a partial year’s trading benefitting the revenue account. 2015 sees the benefit of the full year’s trading.
Packaging drives a key comparator, RPC, which stands on 16.8x historic PE and 11.5x historic EV/EBITDA. RPC is a manufacturer not distributor and is a larger business, with a higher margin model, thus not entirely comparable – but illustrates that Macfarlane’s rating is far from demanding.
Disclaimer
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