Shard Market Eye: Macfarlane Group


Macfarlane Group  (LON:MACF)

2016E and 2017E EPS raised 6% this calendar year

Macfarlane Group reported interims on 25th August. It is the leader in its chosen market, generates cash, is seeing estimated 3% organic sales growth this year and next and EBITA margins are exhibiting a modestly upward trend. Acquisitions have proven a steady increment to profits. Long term, broadly half growth is from acquisitions and we note that in calendar 2016 to date, our 2016 PBT estimate has risen 8.5% (and EPS nearly 6%), predominantly from this source.

H1 reported: 3.7% rise in Group sales, with 5.5% rise in the dominant Packaging division and manufacturing down (as expected) by 9%.

Organic sales growth: This was achieving a peak of 7% at start 2015 and runs at 3% through 2016 despite UK GDP growth slowing. We see 3% organic growth 2017E. Operating margins are rising.

Valuation comparables: As per our previous research document we see the distributor, Diploma, as the business giving an appropriate ratings benchmark. Diploma stands on mid 20x historic PE, with its shares at an all time high.

Risks: Macfarlane has a conservative balance sheet. Without bolt-on acquisitions, growth would be slower, but we see scope for more. Whilst exposure to UK is dominant, we are in no way tempted to downgrade our organic sales and profit growth 2017 estimate of 3%. Further, Macfarlane (through a European sales partnership) is not at risk regarding losing clients who might require a pan-European solution.

Investment summary: This business exhibits steady growth, strong cash flow and regularly beats estimates. Indeed our 2015 PBT estimate of £7.3m was exceeded by 4% and so far in 2016 we have increased 2016 EPS from 5.1p to 5.5p (after some acquisition-related share issuance). For 2016 and 2017 we slightly raise our estimate of free cash flow, to just over 5p per share. Our model assumes no further acquisitions, but we would anticipate a large proportion of the free cash flow to be invested in bolt-on acquisitions. The record on delivery of anticipated returns here is very strong.

Investment case overview

Acquisitions remain a successful plank to PBT and EPS growth. We upgrade 2017E figures (vs our estimates stated as of end February, post FY2015 results). Group organic revenue growth 2017 is estimated at 3.0%, or some 3.7% organic 2017 sales growth within Packaging. The upgrades derive from the three acquisitions made so far in 2016. 2016 and 2017 estimates see 60% (or just over) and c55% (respectively) of the sales growth deriving from acquisitions. Clearly, the predominant UK exposure and slowing UK GDP will have some likely impact as this year progresses and into 2017. Nonetheless we maintain our Packaging division sales and profits numbers prior to the positive increment from the additional acquisitions. We are confident Macfarlane will not be noticeably affected (vs prior estimates) unless UK GDP slows to negative territory.

EBITA margins continue to rise. They stood at 4.5% in 2013 (pre exceptionals), achieving 5.0% by 2015. H1 2016 there was a further (small) positive trend. For full year we estimate 5.4% and 5.6% 2017E.

The main trends we foresee during H2 current year are the robust margin advance, continued organic growth and a strong contribution from the three 2016 acquisitions. Good cash flow will be generated, taking end June 2016 debt of £16.9m down to £11.3m debt end 2016 (post the benefit of the equity raise post interim balance sheet).     

The message remains remarkably similar to our last research document of 25th February. Further, our confidence is underpinned by the fact that no individual acquisition is material enough to prove a risk to the group, that cash flow is strong and financial gearing low, and that acquisitions of previous years have been integrated well. One sign evidencing this is the steady growth in operating margins, due in no small measure to the benefits of the expansion on the existing network of the group, albeit we do not consider all margin enhancement in recent years comes solely from acquisition benefit. 
The 18% CAGR in PBT over the past five years, modest debt and good acquisition opportunities provide a robust platform even were the broader economy to slow. With a c.20-22% UK market share there is still a road to be pursued regarding more of the same in acquisitions.
Organic growth is a material aspect and we anticipate organic sales growth to remain ahead of UK GDP for some years to come. This is in part through the successful market presence in growing retailers who for example are exploiting opportunities through e-commerce. We estimate a circa 10% pa customer ‘churn’ which tends to validate the positioning and pricing across the board. Importantly, packaging sees the macro-driver as much more UK consumer and changes in patterns of buying, rather than for example any capital goods trends which might affect businesses in very different other parts of the ‘distributors’ market sector. Further, as outlined, Macfarlane is more a new economy stock than many other distributors. We would certainly not over-emphasise this, but growth ahead of GDP allied to the steady characteristics displayed, is all important in building potential for further ongoing re-rating of the shares.

We note Macfarlane comments regarding the continuing growth in internet retailers. This has benefitted H1 but primarily runs through to H2, as there is a bias seasonally towards the months’ running up to the year end holidays.

We also note the deliberate reining back of revenue in manufacturing from some lower margin contracts. Both these trends had been expected but H1 saw if anything, a greater effect from this, whilst the internet retailers will positively impact H2.

Packaging Distribution dominates Group. Sales grew 5.5%, operating profit 9.7%. Sales to internet retailers account for 22% of the total in the division. There is an innovations centre (Milton Keynes) which supports customers in this marketplace.

Manufacturing division sales fell to £13.65m from £15.00m; operating profits to £0.22m from £0.26m. Designing and printing self-adhesive labels for FMCG customers is not a growth business, albeit Macfarlane seeks new business in the branded sector and key industries such as aerospace, medical and others. Re-sealable labels is a rising divisional component.

As we wrote in February: “we would anticipate small(er) acquisition(s) to be funded by debt but more significant ones to be more along the lines of 50/50 debt and equity.”

Further, within these figures, we have raised gross margin estimates from 31.2% to 31.8%, mostly resultant from the reduction on Manufacturing sales from low margin contracts.

Full year 2016 estimates

We estimate Group organic sale growth of 3.0% and within this, 4.5% organic growth within Packaging revenue, an acceleration from low positive H1 numbers. Margins are rising. 2016 estimates see a little over 60% of the sales growth deriving from acquisitions. Clearly, given the predominant UK exposure, slowing UK GDP is relevant. We see no 2016 impact, with some recent positive order momentum. 

Full year 9.0% sales rise (estimate) compares to 3.7% H1. Given the slight reduction at Manufacturing (revenue) we estimate nil organic sales rise to have taken place in H1, whilst the acquisition-derived H1 growth is much less than H2 (given acquisitions in April, May and July 2016). It is noteworthy, nonetheless, that H1 organic growth was a little below what we had anticipated – after a very strong 2015, which registered 5%+. 

Packaging contributed 91% 2016 Group operating profits in H1. Rigorous control of the small Manufacturing division keeps it making decent profits. These trends are anticipated to remain in place H2.

Gross margins trended exactly sideways H1 in Packaging and manufacturing saw an increase from the lower levels. We see this trend maintained for H2 and a sideways move thereafter, notwithstanding the modest rise in costs in the very limited number of areas affected by the fall in £.

Operating margins are supported by this gross margin trend and enhanced by the greater coverage resulting from expansion. There are also a small number of modest cost initiatives which assist ratios slightly into future years. As stated: “cost reduction opportunities will continue to be pursued through productivity improvements as well as in [our] property portfolio.”

2017 estimates

We downgrade organic sales (but not profit) for 2017E by £2m, half in the Manufacturing division where H1 2016 has seen low margin work exited.

2017E sales grow 5.6% or £12.5m. An estimated £7m of this growth is from acquisitions, which is to say the revenue increase 2017 vs 2016 from those acquisitions. This is the full year rather than simply the part year registered in 2016. 2016 of course benefited from a full year of the 2015 One packaging business (as opposed to part year 2015).

This therefore is 3% organic growth in sales (we assume slightly more in Packaging vs the much smaller Manufacturing businesses in 2017).

Whilst, with the slowdown in the UK economy, this will require some work to achieve, we are confident the track record and the winning of work in ‘newer-economy’ retail will warrant confidence. The upgrade of 5.5% to estimated 2017 revenue (vs our estimates stated as of end February) does derive entirely from acquisitions made since the original (February 2016) estimates were made.

Gross margins (up in H1 2016) we estimate unchanged in 2017 but operating margins up from 5.4% to 5.6%.

Cash flow is set to remain positive. We estimate £0.3m cash payment (final) for deferred/contingent acquisition consideration. Capital expenditure is set to run at 55-70% of depreciation. In the past, Macfarlane has made top-up payments to its pension scheme but we do not anticipate further as the rise in the deficit is kept to under 10% despite falling bond yield (discount rates).

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