Essentra's high-margin strategy is taking shape

Essentra (ESNT) is at tipping point. Management has completed the sale of its packaging and filters business, enabling it to pay off its debt and leaving it as a pure-play components business. With the economic cycle near its trough, and revenue growth now expected, we are about to see whether this was the right call.

The logic behind the reorganisation is that the injection-moulded components arm is high-margin. The EMEA business gross margin is 50 per cent, falling to 37 per cent in the Americas and 34 per cent in APAC. For manufacturing, this is relatively high, and means that if management can cut out centralised costs there is room for operating margin expansion.

In the past year, management has been able to halve continued central corporate costs from £12.1mn to £6.2mn. Combined with price rises for its customers, this contributed to the 52 per cent adjusted operating profit increase to £23mn, despite a 5.5 per cent revenue decline.

This left the company with an adjusted operating margin of 13.8 per cent, up by 520 basis points from last year. The medium-term aim is for this to expand to 18 per cent. This will be driven by increased cost-cutting, helped by new plant in Mexico, and from volume growth generating more operational leverage.

The hope is that revenue growth will return when the economic cycle turns, but the timeline for this is unclear. China’s economy hasn’t bounced back as quickly as hoped. Meanwhile, Europe is the largest and most profitable region, so any stumbles there would be damaging.

Broker Numis is expecting Essentra’s earnings per share to rise to 13.4p next year, meaning it is trading on 12 times 2024 earnings, and points to the fact its valuation is below peers’. The strong gross margin is appealing, and the company has the potential to improve its valuation, but we need to see evidence of volume growth returning. Stick to hold, for now.

Last IC View: Hold, 244p, 17 Aug 2022