This small cap’s rally has further to run

The recent drop in housebuilding activity has been dramatic: housebuilders have recently experienced a 25-35 per cent fall in demand. However, the slump in RMI work has been more sustained, with the post-pandemic DIY boom having petered out in the first quarter of 2022. Share prices in the sector had started to turn six months before that in the autumn of 2021. 

This was certainly the case for Norcros (NXR), a Cheshire-based supplier of bathroom products. Its shares hit their highest point in a decade in October 2021, before sliding by more than 60 per cent over the following two years.

During this time, revenue and operating profit continued to climb, although the business has the acquisition of wall panels maker Grant Westfield to thank for this. Norcros shelled out an initial £80mn for the company in May 2022, and the 11 per cent increase in full-year sales to £441mn last March was almost all down to this deal – like-for-like sales rose by just 1.5 per cent.

Things look set to be a little tougher this year. Group revenue at the half-year stage was down 8 per cent, and underlying operating profit had fallen by 3 per cent. The FactSet consensus forecast is for full-year operating profit to decline by 10 per cent on the back of a 7.5 per cent slide in sales.

And yet, since their mid-October nadir, the shares have rallied by more than 40 per cent. Admittedly, some of this movement is the result of a sector-wide reappraisal, fuelled by the hope of interest rate cuts, which would make home loans more affordable. But there is also evidence that Norcros has outperformed.

Undue pessimism 

Norcros sits somewhere between a manufacturer and a distributor. It doesn’t have the overheads of the former, but the fact that it owns a stable of brands and designs products in-house means it enjoys an element of pricing power not available to the latter.

“That takes us apart from some of the value distributors that just buy stuff off the shelf and move it around,” chief executive Thomas Willcocks told the IC in November. He also argued that product innovation – 25 per cent of Norcros's range has been designed in the past three years – helped it to grow market share and maintain revenues in the first half.

Norcros mainly does business in the UK and South Africa. In South Africa, it manufactures and sells tiles directly to the consumer via its own retail chain, Tile Africa. Disruptions to electricity supplies plague the country and, while Norcros is equipped to deal with the disruption, these outages have knocked consumer confidence and hurt the housebuilding market.

The South Africa arm's performance has been a drag on Norcros’s shares, but Zeus Capital analyst Andy Hanson argues that the division is “misunderstood”. In the first half of the current financial year, when it faced “the worst electricity load-shedding in recent history” and a big depreciation in the value of the rand, it still managed to be self-sustaining, generating positive cash flow and profits.

Over the past 10 years, the division has delivered double-digit compound annual revenue growth and a “robust” level of profitability, Hanson noted. In the medium term, the South African government’s decision to strip state-owned utility Eskom of its monopoly and open the market to competition “will drive higher demand” for Norcros's products as confidence in the reliability of the grid and the overall economy will grow, he added.

This could take time, though, and the short-term decline in profit expectations from South Africa is the main reason why analysts expect group profits to decline.

The UK – where the company generates about 70 per cent of sales – is a different kettle of fish. In the six months to September, sales held steady in a declining market and underlying operating profit hit a new high of £18.7mn on the back of higher margins. 

Forecasts for the UK are muted, with the consensus for operating profit in the UK basically flat for the next three years. Shore Capital recently lowered its forecast on the basis of “general market uncertainty and downgrades from other companies with similar exposures”.

Analysts may be unduly pessimistic, however. Norcros’s UK operations have held their own and continue to generate ample cash: the group reported a 70 per cent increase in underlying operating cash flow of £27.4mn in the first half of FY2024, or 121 per cent of its cash profit.

This involved an element of inventory unwind but is “representative of what we do in terms of cash management at our group”, chief financial officer James Eyre said on a recent Equity Development webinar.  

“Over the last 10 years, that [cash conversion] has historically been at 80-90 per cent-plus, which has helped us to reduce leverage in the past and will do so going forward,” he added.

Net debt (excluding leases) came down to £46.6mn at the half-year stage, which equates to around 1.0 times forecast cash profit and is £12.3mn lower than last year's figure. It can therefore either keep paying off this debt, which would strengthen earnings, or acquire other potential targets to boost growth.

It would do so conservatively. Management is willing to increase leverage to 1.5-1.75 times cash profit “at most”, Eyre said. Given the company’s current share price, it would also be wary of raising any new equity unless a deal is deemed to be both earnings accretive and “strategically compelling”.

When Norcros does buy, it generally makes a success of it, as the long-term trend in the company’s underlying return on capital employed indicates.

Despite this, Norcros shares trade at just six times forecast earnings, below a miserly five-year average of seven times and about half that of its peer group, which includes Grafton (GFTU) and Travis Perkins (TPK). The company’s current market capitalisation of £165mn is also less than 80 per cent of its book value of £212mn.

The RMI market has cratered over the past two years so the downside risks look fairly limited, and it shouldn’t take much in the way of positive news for a re-rating. Improving growth prospects for South Africa should help – the International Monetary Fund has forecast economic growth of 1 per cent this year, which is an improvement on its 0.6 per cent estimate for last year.

Given the size of the discount to peers, an eventual re-rating could be significant, Zeus’s Hanson has argued. On an enterprise value basis, peers trade at a year-ahead multiple of almost 13 times operating profit. Applying such a metric to Norcros’s shares implies a share price of 460p – a gain of almost 150 per cent.

This is unlikely to happen overnight, given the subdued outlook for the home improvement market. But rising real incomes and growing mortgage availability should mean investors won’t have to pray for a rate cut for the current rally to be sustained. In the meantime, Norcros offers a chunky dividend yield of almost 6 per cent.