Essentra (OTCPK:FLRAF), which supplies a mix of components to other industries, posted its H1 results on 28 August for the six months ending June 30. The results were disappointing but didn’t seem to surprise the market too much, as the shares actually “gapped up” on opening, although they then proceeded to fall into the red by close of trading. Essentra is facing numerous headwinds surrounding its core businesses, and this doesn’t look set to improve anytime soon. Adding the H1 results to its recent $666k settlement with the US Department of Justice over bribery allegations in Dubai linked to North Korea, I see neither value nor opportunity in the company at current levels. Although Essentra’s share price has fallen by 60% in the last five years, I still consider it overvalued and am staying away from the shares.
The most prominent statistic to come out of the results was the huge collapse seen in the company’s profitability over the first half. Operating profit fell by 75% to £15.6 million compared to £60 million the prior year. Like many other companies, margins have been squeezed significantly during the COVID-19 crisis, leading to a sizable decline in profitability. Revenue actually only declined 11.7% for the period, while adjusted net income fell around 50% to £17 million.
Looking deeper into the results, Essentra’s revenues are split into 3 different segments: components, packaging and filters. Revenue in the company’s largest segment (packaging) actually grew in comparison to the prior year at a headline level, up from £176 million to £185 million (+4.8%). However, this was boosted by acquisitions, and “like for like” sales were actually down 3%. Although the packaging division is the largest segment of the company’s business, it has the worst operating margin out of all its businesses. Even after the revenue improvement in H1, squeezed margins meant that “adjusted operating profit” actually fell 39% year on year to £4.9 million.
In the company’s two other core businesses, both revenues and operating profits fell over the period. Both of these businesses offer higher margins and cash generation for the group when compared to the packaging division. Adjusted operating profit fell to £23.9 million for “components,” while “filters” fell to £10.8 million. The filters division (primarily selling filters for cigarette manufacture) is the company’s second-largest division, and here, sales fell 11%, with operating profits down 35% year on year. Finally, the components division also disappointed, with “like for like” sales down 13% and operating profits down 26% year on year.
Components remain the biggest segment of concern for me, as it represents over 50% of Essentra’s operating profit but is facing what the company describes as:
The volume impact of a softer macro environment along with the dilutive impact of the acquired business (Innovative Components), partially being offset by continued successful pricing management and cost control actions.
This suggests to me that price increases and cost reductions are propping this division up, but I wonder if this is simply a band aid and cannot be a sustainable strategy in the long term.
Back in 2016, a profit warning caused Essentra shares to sink, and this was primarily driven by reducing demand for the company’s cigarette filters. In more recent years, prior to the pandemic, filter sales have remained robust and stable, with a lack of new competitors allowing Essentra to remain largely unchallenged. However, the pandemic has caused short-term instability in this division, and looking at this segment over the longer term, vaping will apply significant pressure to this filter business as more people move towards vaping from smoking filter-tipped cigarettes. The major tobacco companies have encouraged the shift to vaping by acquiring and launching with their own vaping subsidiaries, but Essentra doesn’t have a vaping-focused business and looks underprepared for this long-term shift.
My predominant concern for Essentra is not only the near-term headwinds in relation to COVID-19 and how that has affected demand, but also where the growth catalysts for the company will come from. Cutting costs and improving margins could deliver greater profitability, but sales will have to hold up better than they have in recent months. Much of Essentra’s business is focused towards slow growth or contracting industries, so the opportunity for significant revenue growth isn’t really there. This has been a prominent issue over the last 5 years, as the company has struggled to increase revenues over this period. Revenues have been constant since 2015, consistently standing at around £1 billion. Given there have been a series of acquisitions over this period, this fact points to poor underlying performance in the core of the group.
Essentra also doesn’t offer itself as a value play anymore due to the large fall in profitability. Peel Hunt now forecasts an EPS of 14.9p for this year. At current prices, that would stick Essentra on a P/E of 22 for the year. Whilst not extremely pricey, I certainly wouldn’t call this deep value territory, so it can’t be argued that the company is a value play currently. There is an upside opportunity if revenues can see a swift recovery, but the industries it operates in are unlikely to deliver this. Dividends were also suspended as the company looked to preserve cash. It was a necessary step to increase the headroom, but it means reduced cash returns for shareholders.
Net debt rose by 23% to £297 million, and this is an area that investors should ensure they continue to monitor. Increasing debt levels may restrict the ability of the company to give strong cash returns to shareholders or to continue its acquisition strategy. The company did say that it may recommence dividends in H2, however, I believe this is unlikely unless the pick-up in demand is swifter than I expect.
To make matters worse, the pandemic has caused the company’s margins to be squeezed, meaning any improvement in the margin will be a long way off now. The market understands the near-term concerns related to demand in both its filter and packaging segments, and Essentra shares are down 10% from the start of the crisis, which is a recovery of over 50% from the lows seen at the end of March. Although on the face of it Essentra is only slightly down from the start of the crisis, the shares actually entered free fall before the crisis, when disappointing final year results with a fall in adjusted EPS by 10% triggered a sell-off.
One of the main areas of optimism for Essentra shareholders could be the company’s diverse revenue streams, which allow it to adopt a more defensive approach. However, COVID-19 has left the company exposed to significant external headwinds, where 3 months of disruption have taken a huge toll on profitability. With a forward P/E now standing at 22 and large uncertainty remaining around the core businesses, I am avoiding Essentra.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.