De La Rue needs to cash in fast

Brits have been stuffing their mattresses. 

The coronavirus pandemic may have accelerated the adoption of digital payments, but somewhat counter-intuitively, the uncertainty is also prompting many people to stock up on cold, hard cash. According to the Bank of England, by September the total value of banknotes in circulation in the UK had increased roughly 10 per cent, compared with the same month in 2019.

Supplying our need for the comfort of physical money is De La Rue (DLAR), the world’s largest commercial producer of banknotes. 

The Hampshire-based company, which supplies the Bank of England, as well as other central banks around the world, said in its most recent annual report that on an adjusted basis, revenues in its core currency business crept up 2 per cent in the year to March. Coupled with massive cost-cutting and an improved mix of products sold, this lifted the division from a loss during the previous 12 months to an adjusted operating profit of £16.2m; a profit figure that excludes substantial restructuring charges. During its second half, printers were running at full capacity.

So it seems De La Rue has cashed in on the economic crisis. It could also benefit from the aftermath. With central banks boosting money supply to support the global economy during the pandemic, the word on many economists’ lips is now ‘inflation’. If such predictions prove correct, it should mean customers need higher volumes of cash. In an update on its ongoing turnaround plan last June, De La Rue said it was preparing “to take advantage of large, highly profitable ‘overspill’ orders that come to market when countries experience high inflation”.

However, the London-listed company needs to deliver on an ambitious turnaround strategy in a tight timeframe for shareholders to reap the rewards.

‘Material uncertainty’

The past few years may have been the most turbulent in the history of the two centuries-old company, which very recently looked on the brink of collapse.

Its problems came into real focus in 2018, when the UK government decided to hand De La Rue’s work printing British passports to Gemalto – a French rival. The failure to win the new £490m 10-year contract eradicated a key part of De La Rue’s identity products business.

Then the company’s currency division, responsible at the time for nearly four-fifths of overall sales, also hit trouble. After securing an initially lucrative contract to supply banknotes to an inflation-ridden Venezuela, De La Rue reported in May 2019 that the country’s central bank had failed to pay an £18m bill. Then, just two months later, it disclosed that it was the subject of a Serious Fraud Office investigation relating to “suspected corruption in the conduct of business in South Sudan”. The investigation was later closed due to insufficient evidence.

To make matters worse, De La Rue’s profitability was also being squeezed. In the five years to 2019, its operating margin more than halved (see chart) as competition encroached on its high-security money-printing business.

In November 2019, De La Rue warned “material uncertainty” had cast doubt on its “ability to operate as a going concern”. It was dangerously close to breaching debt covenants. One of London’s oldest listed companies, its market value had deteriorated from more than £1bn in 2012 to less than £150m. Some speculated that lenders might pull the plug.

The turnaround plan

But De La Rue, which has been credited with developing the modern fountain pen and the English playing card in the nineteenth century, is not a stranger to reinventing itself. Now, after appointing turnaround specialist Clive Vacher as its new chief executive, the printer is in the process of rebuilding its business once again.

Firstly, the company plans to shake off the competition by focusing on its leading position as a producer of plastic polymer banknotes, which are used in the UK and at least 30 other countries. Along with cost-cutting, this higher-margin work should continue to boost profitability in its currency business.

De La Rue will also focus on driving growth in its higher-margin authentication products – such as holograms for passports and tax stamps for cigarette packs – which were responsible for a fifth of the group’s ongoing sales last year, and just over two-fifths of adjusted profit. Its identity business, deprived of the British passport contract that made a final contribution to profits last year, has been sold for £42m.

Each of these steps takes the company in the right direction.

After first-half contract delays that were blamed on Covid, the authentication business had a strong second half and recently announced a number of contract wins. The progress has been enough for management to stick by a target of £100m in revenue this year, despite just 5 per cent growth last year to £78m. There should also be plenty of profit to be squeezed out of polymer banknotes given a growing number of countries are expected to switch from paper notes. 

The headline targets for the three-year turnaround, which was unveiled in February 2020, include cost savings of £36m and the creation of a company capable of growing sales at a compound annual rate of 9 per cent, accompanied by a mid-teen adjusted operating margin before central costs. The changes aren't coming cheap. Capital spending on growth is expected to come in at £80m during the three-year turnaround and the bill to achieve the cost savings is £16m.

Raising fresh money to fund the turnaround has also been costly. The sale of 91m new shares at 110p raised only £93m after costs, compared with about £100m of gross proceeds. Add in the fees associated with new debt facilities and total refinancing costs hit £15.3m last year. 

But given the alternatives, shareholders were only too ready to give Vacher's plans the nod. That includes activist investment trust and 13 per cent shareholder Crystal Amber Fund (CRS), which hoovered up about a fifth of the recently issued shares. 

The clock is ticking

However, De La Rue is in a race against the clock to complete the ambitious restructuring. Last July it secured a three-year extension to its £275m credit line, which will now run to December 2023. While that borrowing facility could be renewed again, its lenders are likely to look for material signs of improvement from a company that has already spent much of the time allocated to execute its turnaround in the midst of the Covid crisis.

Another party that will also be watching closely is the trustee of the group's pension scheme, which recorded a £190m deficit at its last triennial valuation in April 2020. Pension top-up payments have been reduced to £15m a year whilst the company funnels cash into the turnaround, but this is set to rise to nearly £25m a year from April 2023 through to 2029.

While management says De La Rue is “on track” for its three-year plan, the associated costs means debt is building. While year-end net debt excluding lease liabilities of £52m was well down on £103m 12 months earlier, it was well ahead of the £22m reported at the half-year stage. Broker Numis thinks net debt will hit £93m by the end of the current financial year before falling to £77m the next year and £59m by the end of March 2024. Achieving this depends on solid execution of the turnaround. Sentiment was not have been aided by a near £20m cash outflow from to increased trade receivables in the 12 months to the end of March, which was largely put down to slower payment on some material customer contracts.

Should progress falter, the company may not have Crystal Amber as a supportive shareholder in waiting in the wings.

The investment trust faces a continuation vote at its next annual general meeting (AGM) which is expected to take place in November. It needs approval from 75 per cent from its shareholders to continue in its present form. It is under fire from an activist shareholder of its own. New York-based Saba Capital has acquired more than a quarter of the trust's shares has said it will vote against continuation. Other sometimes activist shareholders on the trust's register include 1607 Capital Management, with a 13 per cent stake and 5 per cent held by Weiss Asset Management.

Saba also upped its short position against De La Rue last month to 2.2 per cent of the company's shares.

If, as seems possible, Crystal Amber is forced to dump its stock in De La Rue, the money-printer’s share price and its ability to raise further capital could be severely diminished. That is a cause for concern when the company is still bleeding cash into its pension scheme and restructuring efforts. True, if everything comes off and Numis' forecasts are right, the company could offer investors a 7 per cent free-cash-flow (FCF) yield come 2024 along with significant growth potential. All the same, while in times of crisis stuffing your mattress with cash may be ill-advised, right now we think it looks less risky than banking money on De La Rue.

Last IC View: Sell, 148p, 26 Feb 2020