Stuff Devro into your portfolio

After being spun out of Johnson & Johnson in 1991, Devro has consolidated its position as the world's leading supplier of edible collagen casings for sausages and hams. Using collagen to make sausages is becoming increasingly necessary due to a shortage of traditional gut casings and the increasingly industrial nature of food production, for which natural products are sometimes unsuitable. However, the quality of collagen-based products is improving, and sheep and pig gut still account for around two-thirds of all sausages, so there is plenty of scope for Devro to grow its market share.

Besides, changing dietary habits in emerging markets may accelerate the shift to collagen products - demand for higher-protein foods may make gut shortages more acute and prompt even greater industrialisation of the food chain. That's already apparent in Devro's trading - the bulk of its sales come from overseas, and business is growing particularly quickly in China and Latin America, which saw volumes climb 38 per cent in its first half of 2009 as customers shifted from gut to collagen. That's partly why the company was recently able to announce that sales this year will be ahead of the City's expectations.

Devro is enjoying both volume growth and higher average selling prices. In the first half of 2009, volumes climbed 5.6 per cent, adding £2.4m to profit, while price increases added 4.4 per cent to sales and increased profit by £3.7m. And because 80 per cent of its business comes from overseas, it is also benefiting from sterling's weakness. Indeed, the impact of currency translation should be greater in the second half than the first, when it added £14m to revenue, which, all told, rose 27 per cent from £83m to £105m. That said, the impact of exchange-rate movements only had a minimal effect on operating profit.

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Meanwhile, input costs are also easing. Devro's main raw material is the animal hide from which collagen is derived, and skins shortages in the latter part of 2008 saw skin costs rise, adding £3.6m to overall costs in the first half of 2009. The recovery of the automotive industry - a large consumer of leather and a supplier of offcuts to Devro - has seen this situation ease in recent months, while Devro has also been working to secure alternative sources of supply. So while prices are still high relative to 2008, there should be scope for cost reduction in future years. Energy costs were also £3m higher in the first half, but are stabilising.

Profits will also be boosted by improved efficiencies across it manufacturing facilities. It has shifted some production from higher-cost factories in Scotland to the Czech Republic, where it has installed new high-speed lines that will save £2m a year. Devro is also investing in additional capacity next year to cope with burgeoning demand.

However, investing in capacity is expensive. Management has spent £3m on two new lines in the Czech factory, and will have invested almost £20m by the year end. However, Devro has more than enough headroom on its balance sheet to absorb the expenditure - net debt at the half year stood at £29.5m, down from £34.5m at the end of 2008, and annual finance costs of around £1m are well covered by cash flows. While analysts expect debt to rise again in the second half of the year, as capital spending increases, the cash-generative nature of the business means it should fall in 2010.