New Middle Market Coverage: Shrinking Currency Market Erodes De La Rue’s RCF Covenant Headroom; Company on Cost Drive; Transformation Plan Due Q1

 

Relevant Documents:
HY 2020 Earnings Call Transcript
HY 2020 Report
HY 2020 Presentation
FY’19 Annual Report

U.K. security printed products manufacturer De La Rue is facing a decline in the market for banknotes that is eroding its covenant headroom and forcing the company to cut costs. The group’s most recent half-year report highlighted going concern risks and showed that adjusted revenue for currency dropped 29.5% year over year to £128.7 million. CEO Clive Vacher told investors that he expects it will take some time for the market to normalize, though De La Rue’s board has reviewed a budget and plan for full-year 2019/20 that indicates that the group will operate within its banking covenants.

A summary of the company’s results is below:
 
Levered cash flow from operations on an LTM to Sept. 28 basis was negative £26 million. The company has burned cash in the last three halves - translating into LTM levered free cash flow of negative £50.7 million. At the end of the first half on Sept. 28, the company reported contracted capital commitments over a one-year period from March 29, 2018, of £548.7 million. Included in this is an amount related to the sale of a 90% stake the group’s paper business Portals De La Rue Ltd. to EPIRIS Fund 2 for around £61 million. Based on the terms of the agreement, De La Rue has a remaining commitment of approximately £519.7 million over the next decade.

A breakdown of the company’s reported revenue is below:
 
A summary of the company’s order book is below:
 
As of Nov. 26, 2019, De La Rue’s net debt-to-EBITDA ratio was 2.72x and EBIT to net interest payable was 9.9x, both below their bank covenants. De La Rue has a £275 million revolving credit facility that matures in December 2021. The RCF has a maximum debt-to-EBITDA ratio of 3x and a minimum interest coverage ratio of 4x. The original lenders of the RCF signed in 2017 include Santander, Barclays, HSBC, Lloyds and RBS.

CFO Helen Willis told investors in a recent earnings call that the board has reviewed a plan that shows that the group will operate within its banking covenants for the foreseeable future. However, a directors’ report attached to the group’s half-year results noted material uncertainty that casts doubt on the group’s ability to continue as a going concern.

Risks include the adverse trading environment and the binary nature of the large currency contracts that underpin the group’s business model. The largest risks relate to the timing of revenue recognition on jobs for delivery in period 11 and 12 of fiscal-year 2020, a failure to deliver cost savings, and cash-flow risk associated with the unwinding of the group’s working capital build from the first half 2019/20.

The directors noted that: “If more than one of these were to occur concurrently without mitigation the group would breach its net debt/EBITDA ratio.” In mitigation, the directors have suspended future dividends and management is focused on delivering a company turnaround plan by the end of the first quarter of 2020.

The turnaround plan will involve a review of the company’s market position and sales strategy, research and development projects, site footprint, supply chain and contract bid strategy.

The company’s capitalization is shown below, which excludes the sale of International Identity Solutions (detailed hereunder), which would increase cash by £42 million:
 
Outside of currency, the company is focusing on other security products such as passports. Identity revenue was up 10.2% year over year to £44.2 million driven by increased volumes within the U.K. passport business.

Following the sale of International Identity Solutions to HID Corp. £42 million, the group has few options for further divestment. The segment has made relatively stable operating income over the last five years. Management said the sale would allow the group to refocus on identity-related security features and components where the market opportunities are more accessible and that stronger synergies in technology and customer relations between identity security features and the rest of the group would facilitate better returns on investment. Furthermore, the sale proceeds will strengthen the balance sheet and provide De La Rue flexibility for investing in other growth areas. The sale agreement included terms whereby De La Rue agreed to provide printing services to HID Global until March 2022. The U.K. passport contract is outside the scope of this agreement. In July De La Rue lost out to Gemalto for the contract to provide the U.K’s post-Brexit passports.

Identity Solutions’ historic adjusted operating profit, from the annual report, is as follows:
 
In the short term, management is focusing on making cost savings. In May 2019, management outlined a target of £20 million in cost savings over the following three years. In the most recent earnings call, Vacher said the business review aims to “go beyond” this target.

According to Vacher, immediate actions to cut costs include: a reduction in discretionary spend; deeper control of cash items such as inventory management, accounts receivable and operational efficiency drivers; an acceleration of its restructuring plan [to make savings beyond £20 million]; and a reduction in the cost of goods sold through renegotiations with suppliers. Vacher expects to see results in the second half of 2020.

As a result of these initiatives, management expects a full-year 2019/20 adjusted operating profit of between £20 million and £25 million.

In July, the U.K Serious Fraud Office confirmed it had opened an investigation into the company regarding suspected corruption in South Sudan.

-- Connor Lovell, Jacob Parker