Devro will be severely affected by a 10% decline in sales in 2017


What does Devro do?

Its a sausage skin maker using collagen, which is a protein found in animal connective tissue.


What are the issues?

The firm embarked upon upgrading its plant in the U.S. while expanding in China. The good news is the company has completed its capital investment (this totals £110m in two years). The bad news is coming at a time when profits and sales targets are below management expectations. To make matters worse, Devro borrowed money to fund its expansion.


Management has raised these concerns with investors and taken the following actions:

  1. It concludes that the transition period for the new plant to contribute additional sales will take longer than expected. They don’t know how long it will take.
  2. It has written off £13.6m of exceptional costs in H1 2016 causing operating profits to collapse to £4.6m from £11.6m last year. However, it reported net operating cash activities at £7.3m, an improvement from £6.1m.
  3. There are further exceptional costs of £8m to be charged in the second-half of 2016, this will lead to accounting full-year earnings collapse.
  4. The good news is capex spending is much lower this year than last year, as half-year spending dropped to £11m from £33m.
  5. Most important of all are Devro’s management failing to explain the expected 10% decline in sales volume for 2017, which leads to under-utilisation of capacity. Therefore, investors should brace for higher expenses.

Putting aside the trading update, and given the shares have half, is Devro a value play?

It requires an in-depth analysis of Devro to reveal if the market has priced in future underperformance or not.


Long-Term Assessment of Devro’s Business


Devro’s historical market valuation since 1996

Source: Devro’s annual reports and Yahoo Finance.

Since 1996, Devro has made no progress on growing its market capitalisation, and it’s because the company was a bigger entity twenty years ago. Sales in 1996 reached £302m, compared to today’s turnover of £230m.

Prior to 2001, Devro operated three divisions:




It sold its cellulose business in 2000 for £4.8m resulting in a massive exceptional loss of £54.5m. With fibrous division also sold off, Devro had renamed its plastics division as the collagen. It had sales £150m in 2002, which is half the total turnover.

One interesting observation to note is when a firm shrinks in size investors tends to sell the stock aggressively, knowing the smaller entity would produce lower earnings (as in the case with Devro). And, according to the (P/B) and (P/S) ratios, you see this:

Source: Devro’s annual reports and Yahoo Finance.

The market is valuing Devro at fair value over the twenty-year dataset. With the shares having half, you should ask: “Have they fully priced in the bad news?”

Remember, Devro’s management expected a fall of 10% in sales volume, this would result in a £24.1m loss output (based on the FT sales forecast in 2017). Skimming over their 20-year sales record, it’s the biggest decline since 2001. Back then, Devro’s sales were £208m with a market capitalisation below £100m and trading at £0.53/share. In 2016, Devro’s sales likely to reach £238m with a market capitalisation of £282m.

This set the tone for my analysis of Devro with the comparison of its operating and financial status today, with that of 2001.


Quality of Devro’s business is in decline

Source: Devro’s annual reports.

At first glance, you could attribute Devro’s asset quality to the build-up of capacity which requires time for economies of scale to kick in. By putting aside 2014 and 2015 asset turnover numbers, the trend is one of decline. Add in the account payable to total assets ratio graph over asset turnover it implies two things:

One, there is an overvaluation of Devro’s assets or, two there isn’t a lot of growth in its business.

The recent £20m of impairment charges by Devro’s management suggest that both cases are true, but are the write down enough?

The £20m represents 5% of total fixed assets. When you consider a 10% drop in sales for 2017 coming, the impairment charges would be bigger because 2016’s turnover is forecast to grow. Therefore, don’t be surprised if Devro impairment charges would range between £30m and £40m, if not higher.


The impact of a 10% cut in sales by 2017

No one knows what a 10% reduction in sales could affect Devro’s profit margins. As far as I’m concern, any decline in sales would induce further impairment charges which would push the business into a net loss (first time since 2001).

A better comparison metric is to use net cash flow from operating activities. Since 2012, its revenue has fallen by less than 4.6% in four years. During that time, its operating cash earnings decreased by 40% from £42m to £26m.

Therefore, a sudden drop of 10% in sales could potentially see it report a “negative” net cash loss!


Is Devro’s debt out of control?

Yes, because its operating cash flow covers less of the company’s debt and its debt to equity are at an all-time high. Also, the financial leverage resembles that of 2001.

Source: Devro’s annual reports.

But, if you overlay the above graph with Devro’s share price, you get this:

Source: Devro’s annual reports.

The sensitivity of the share price to increasing debt to equity and decreasing operating cash flow coverage is evident here. The current market capitalisation is £285m, which is £200m than 2001. Therefore, the likelihood of further share price declines looks likely to continue.

N.B.: Before exceptional costs, operating profits for both 2001 and 2015 were £19m.

On a separate issue, Devro’s debt maturity has duration between five to ten years. But, the issue lies in its debt covenants.

Devro’s debt covenants are as follows:

Net Debt/ EBITDA – <3.25 times.

EBITDA/ Net finance costs – >4 times.

Based on my calculations its net debt/EBITDA touches 3.4 times in 2015. However, the company reported it as 2.6 times. My calculation workout is:

EBIT (£19.2m), plus Depreciation and amortisation of £17.6m, giving EBITDA of £36.8m and using the company’s net debt of £125.5m, therefore net debt/EBITDA is 3.41 times, not 2.6 times.

By the way, 2.6 times would mean EBITDA is £48.3m. Also, its debt covenants are about to get stricter with net debt/ EBITDA going back to 3 times!

Below is Devro’s historical net debt/EBITDA ratio trend.

Source: Devro’s annual reports.


The big question mark is: Can Devro affords to continue to sustain dividends payout?

Source: Devro’s annual reports.

Devro’s current dividend yield is 5.5%. But notice the trend in its dividend yield it doesn’t go below 2.7%. Also, it is likely to mark the top of its market value. I use net operating cash earnings to see how much this covers dividends. That coverage has fallen below two times (for the first time) and is likely to go lower, given the sales forecast.

Also, investors shouldn’t assume it has wiggle room on their undrawn credit facilities because there are none! Referring to their 2015’s annual report it has $100m (£78.7m) and £110m in borrowings facilities giving a total of £189m. Devro’s total debt (2016’s interim results) is £164m!

With a weak operating outlook, the £14.7m dividends look is at risk of seeing a big reduction or cancellation.


Capital investment savings and the Z-score

As mentioned earlier, Devro has completed upgrading its plant in the U.S. and building a new one in China. Therefore, future capex is likely lower.

Source: Devro’s annual reports.

You can see how the much the huge capex has affected free cash flow in the past two years (a total of £53.1m). But, the double sword (as mentioned before) is cash earnings could turn into cash losses meaning Devro could see negative free cash flow.

Given the negative sentiment towards the sausage skin maker, are they going to go bust?

According to the Z-score:

Source: Devro’s annual reports.

The score of 2.1 puts Devro in the grey zone meaning its neutral, and it’s above the bankruptcy score of 1.1. However, there is a chance the Z-score goes lower from here.  This is because EBIT, Sales, Equity and Retained earnings (all components of the Z-score) will decrease.


How would you value Devro, based on market outlook?

Devro is a good business that somehow found it to be a cylindrical company. The dividend yield is an interesting observation because the current 5.5% yield is at their highest (this would be 8%-9%) which is similar to 2001, but with a caveat. Let me explain:

The dividends payout in 1999 was £15.2m, and by 2001 it fell to £6.9m, and despite the 60% drop in dividends, the market has sent its share price even lower (an 84% decline), which help it to yield 8%-9%.

(N.B: The dividend payout bottomed out at £3.2m in 2002, by then the shares were it “full” recovery mode.)

Therefore, an 8%-9% dividend yield on today’s current dividend payout would cause the shares to drop to £1-£1.10/share.

Devro’s debt situation plays havoc on its ability to fund their dividends. The current share price has not taken into account the increasing risk of further debt build-up and lower cash earnings coverage. Again, it gives the market another reason to downgrade Devro’s share price.


Lasting thoughts

Given the past market performance of Devro and the sensitive, allergic reaction to the company adverse fundamentals, I conclude that there are further falls to its share price in the next 12 months.

When you take into account the deteriorating balance sheet (record level of net debt), a high probability of a dividend cut (because of the lack of borrowing capacity) and further impairment write down in 2017. I believe the shares would trade near £1/share, giving it a dividend yield of 8%+, based on current dividends payout.


However, I have illustrated the fact that it broke their debt covenants last year (See Is Devro’s debt out of control?), there is a risk the banks would renegotiate its borrowings arrangements. In this scenario, this threatens its dividends (with the suspension a likely outcome), and management would need to draw up a plan to pay off its loans via cost-cutting to give financial institutions confidences.

The likelihood of this scenario playing out is 50/50 because management has said sales are EXPECTED to fall by 10% which see it affect net operating cash flow. In this situation, the share price could trade around 50 pence/share, valuing it at £80m.