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Bangers for your buck at Devro

With investment coming to fruition, now could be the time to take a bite of the sausage case maker
January 14, 2016

With a three-year transformation plan about to come to fruition, we think shares in sausage casing maker Devro (DVO) are set to sizzle.

IC TIP: Buy at 281p
Tip style
Growth
Risk rating
Medium
Timescale
Short Term
Bull points
  • Strong growth forecast
  • Emerging markets demand
  • Transformation completing
  • Cost savings expected
Bear points
  • High debt
  • US double-running costs

Over recent years Devro's shares have been a dull investment, but there has been plenty going on behind the scenes and we think 2016 is the year when shareholders should start to reap the rewards of a £100m investment splurge, although, the major earnings jump is expected in 2017.

 

 

The vast majority of the sausage-skin maker's big capital expenditure programme should have been completed in the 2015 financial year, meaning investors should not have to contend with much spending by the group this year and additional exceptional costs should prove limited, too. Importantly, we believe the money has been spent wisely, particularly in building what chief executive Peter Page calls the "most modern and efficient" site in China.

China is an increasingly important market for Devro and accounted for much of its £34m of sales in the Asia Pacific region in the first half. The region as a whole generated 30 per cent of the group's first-half sales. And while there might be huge fluctuations in Chinese stock markets, the march of the country's middle class - which is increasingly developing a taste for western-style food such as sausages - is likely to prove on a far more resilient upward trend. Indeed, a key factor in constraining first-half growth from this region was manufacturing capacity limits. Meanwhile, Homi Kharas, of the OECD Development Centre, wrote in a paper that the emerging middle class could almost double by 2020 and triple by 2030. Most of the growth, he predicted, would take place in Asia, with the bulk accounted for by China and India.

Besides Asia, Devro has also invested in building a new plant in the US to replace its existing facility. This should produce savings in the region of £8m, but there's a short-term catch. In the first half of 2016 Devro will have to run both its old and new plants concurrently, which will add to costs. While this means the true impact of the new site will not be felt until 2017, the benefits should start to become evident in the final six months of this year. What's more, £5m of costs that have been taken out of Devro's operations in Scotland and Australia should help mitigate the first-half impact.

The investment should result in a rapid drop in the earnings multiple at which the shares trade, with broker Numis Securities forecasting that 2017 EPS should be more than two-fifths above the level reported for the 2014 financial year at 20.6p. The broker is also forecasting that the dividend will increase in 2017 to 10p following several years held flat at 8.8p.

Creating this growth potential has cost money and net debt is expected to have peaked at about £140m before slowly coming down in 2016, followed by a more substantial drop to £120m by the end of 2017. While debt is high, it looks comfortable as long as trading holds up. Indeed, covenants attached to Devro's borrowing facilities demand a minimum cash-profit-to-net-interest-payable ratio of four times and a maximum net-debt-to-cash-profit ratio of 3.25 times. Midway through 2015 with net debt standing at £106m, the cash-profit-to-net-interest-payable ratio was 13 times and the net-debt-to-cash-profit ratio was 2.2 times

Contributing to the expected rise in Devro's net debt in the second half of 2015 was the €12.5m (£9.4m) acquisition of PV Industries, a manufacturer of collagen gel products. PV provides Devro with product-innovation skills that should support growth in emerging markets as consumers move towards edible collagen and away from gut.

Group finance director Simon Webb will step down this year, which brings some succession risk. However, there is plenty of time to find a replacement as Mr Webb has said he will leave towards the end of the year and the departure is not being viewed as connected with any operational issues.

DEVRO (DVO)
ORD PRICE:281pMARKET VALUE:£469m
TOUCH:281-284p12-MONTH HIGH:328pLOW: 265p
FORWARD DIVIDEND YIELD:3.1%FORWARD PE RATIO:18
NET ASSET VALUE:79pNET DEBT:80%

Year to 31 DecTurnover (£m)Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)
201224141.420.28.5
201324341.021.98.8
201423228.114.68.8
2015*23531.816.18.8
2016*24834.415.98.8
% change+6+8-1

Normal market size: 1,000

Matched bargain trading

Beta: 0.4

*Numis Securities forecasts, adjusted PTP and EPS figures