McBride: Private Label Care Product Maker Will Benefit From Margin Improvement

| About: McBride Plc (MCBRF)
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Summary

McBride is Europe's leading manufacturer of private label products in the household and personal care categories.

Company has been suffering from gross margin erosion and lower UK sales that deleveraged its fixed cost base.

Current P/E of 15 on depressed net margin will prove very cheap once gross and operating margins rebound.

Lower input prices for oil-derived materials and cost savings in the UK make it a big opportunity.

(Editor's Note: Investors should be mindful of the risks of transacting in securities with limited liquidity, such as MCBDY and MCBDF. McBride's listing in London, MCB.L, offers stronger liquidity.)

McBride (OTC:MCBDY) (OTC:MCBRF) is a leading European manufacturer of private label household and personal care products. The company was founded in 1927 and reportedly is the largest manufacturer in the category in Europe. It has a listing on the London Stock Exchange under the ticker symbol MCB. Its home market in the UK accounted for 34.8% of total sales in 2014 and has seen significant pressure on its business performance, because of the difficult retail environment in the UK. For the past fiscal year (ended June 30th) UK sales dropped by -9,5% and operating profit turned into negative territory on its deleveraged fixed cost base and asset impairments. Its other business segments consist of Western Europe and Rest of the World and have as a whole been doing much better; sales rose by +2.3% and +0.8% in those segments respectively, while its operating profits leaped forward. However, restructuring and reorganization costs as well as asset impairments pushed the company's overall reported operating and net profit into the red. On an underlying basis the company trades near a P/E of 15 and pays a dividend as well. Its business is low margin and doesn't really have strong competitive dynamics. However, the company is cheap if the turnaround of the UK business succeeds. I will take a closer look at the business, its changes for improvement in the UK and will calculate a valuation based on those and some of its other prospects.

(Picture: a small selection of the company's products as displayed on the company website at mcbride.co.uk)

Business

As stated, McBride has its origin in the UK and its domestic business formerly was the largest segment of the company. Last year's sales decline in the UK combined with modest growth in Western Europe has propelled the latter to become the largest segment of the company. Although the company does business in many markets on the European mainland the primary ones are France, Spain, Italy and Germany, as well as Poland in the RotW (rest of the world) segment. Especially in Germany and Poland McBride has seen good growth of its business over the past few years, mostly because of new business wins with retail customers. Germany's retail market is characterized by the dominance of domestic discounter chains Aldi and Lidl, which often carry only limited amounts of branded products and a wide store brand assortment. This has made the private label category in Germany very well accepted amongst consumers, creating a good business environment for McBride. In Poland meanwhile McBride benefits from the increasing share of supermarkets and hypermarkets in the retail trade, as well as the ability to grow private label market share of the care product categories of its current low base. In the table below I have compiled the company' sales and operating profit on a per segment basis, as well as showed growth rates and contribution to total company sales and profit. All numbers on an underlying profit basis (excluding one-time charges).

(Table is the author's own work showing data from the company annual report of 2014. Operating profit per segment is before corporate expenses; company operating profit after corporate expenses.)

Glancing at this table it becomes immediately clear that the company's troubles were mostly confined to the UK in 2014, where the decline in sales led to a strong operating profit decline. Results from the UK were compensated in part by the strong recovery of operating profit in the Western Europe and Rest of the World segments. Modest sales increases in both segments provided strong increases in operating profit performance, helped by restructuring in prior years which lowered the company's cost base in those segments. Overall this resulted in a sales decline of -2.26% at company level while operating profit dropped almost -7% (underlying basis). The poor performance in its UK operations finds its cause in two interconnected circumstances: 1) the UK retail trade is currently under intense pressure from the entrance of foreign discounters Aldi and Lidl into the category. 2) Economic pressure on the consumer has stimulated promotional offerings on branded products.

Because retail discounters such as Aldi and Lidl generally run low cost operations with limited assortments they can undercut the competition's pricing, which has forced traditional players Tesco (OTCPK:TSCDF), Asda, Morisson's (OTCPK:MRWSF) and Sainsbury's (OTCPK:JSNSF) to follow suit or face declining market share. The big four of British retail have actually cut their prices substantially and have still lost market share despite of it. Unsurprisingly this had put pressure on their suppliers as well, who have seen volume drops/stagnation in their deliveries to the traditional players and probably demands for pricing cuts as well. Because a lot of branded supplier businesses are underrepresented in the discount channel they have moved to stimulate demand by increasing their promotional offerings in the traditional supermarket channel. For McBride the most important branded competition in the British retail trade consists of Unilever (NYSE:UL), Reckitt Benckiser (OTCPK:RBGPF) and Procter & Gamble (NYSE:PG). The economic pressures on the consumer has therefore had the somewhat unexpected result of driving consumers in the traditional channels back to branded products because they are on promotion so often, thereby lowering the price gap with private label products. This had led to capacity under-utilization among private label manufacturers, which has put additional pressure on their pricing.

McBride has a high fixed cost base in their UK operations with four different manufacturing sites, a shared services center and its headquarters, as well as legacy costs such as pensions. The sharp decline in its sales has severely deleveraged this cost base and thus resulted in the -71% drop in UK underlying operating profit. The circumstances in the UK retail trade obviously are outside the company's influence and seem likely to persist for a while at least. Seemingly, the only thing that the company can do is to adjust their operations to a smaller, lower-cost base and restore profit margins to more acceptable levels. That is exactly what they decided to do this year. They have already closed down one manufacturing site (in Burnley), cut the number of support functions in finance, IT, administration and HR (which are now combined in the Manchester shared services center) and also closed the head office in London (now located at the manufacturing site in Middleton) in October of 2013. A further lowering of the cost base was announced in June of this year and will focus on production shift rationalization and further support cuts. This restructuring led to exceptional costs that consisted of redundancy and consulting costs of £7.9 mln and impairments of £20.7 mln which caused reported operating profit to drop to £-24.6 mln in the UK. These actions are estimated by management to result in £12 mln in annual savings in the UK operation by June 2016 (which is the next fiscal's year-end).

Results in the Western Europe segment meanwhile were driven to a large extent by the company's performance in Germany, where it saw private label sales growth of +35% on winning new customers/accounts. Private label sales growth in France remained subdued at +0.3%, while Italy and Spain saw declines of -12% and -8% respectively. The economic crisis has affected consumer demand at retail to a very large extent, especially in Italy and Spain. Private label sales in other countries of Western Europe went up by +7%. Unfortunately the company does not provide sales numbers on a per country level so I can only provide you the percentage growth. Given that sales in this segment overall went up by +2.34% I'm assuming the fast-growing German sales do not yet constitute a large part of total segment sales. However, it should be noted that the company also engages in contract manufacturing (for branded companies for instance): McBride has cut out the marginally profitable business in the past years and focused on manufacturing consolidation instead in order to bring its capacity more in line with demand. Although the company doesn't report separate numbers for private label and contract manufacturing sales, management has stated that the latter have dropped because of their own increased priority on margins. It is conceivable that this has held back sales in the Western Europe segment as well. Given the strong discounter presence in Germany I think it is likely that McBride will be able to increase its sales in this country going forward. Visibility on the southern European markets is quite low, but the category may be able to benefit from economic improvements in general. Currently, a lot of product categories are depressed in the retail markets of Spain and Italy. It seems likely that the demand is still there but goes unfulfilled because of high unemployment. In case the economic situation in those countries improves consumer spending could return to many product categories at retail.

The Rest of the World segment meanwhile consists of sales made in all countries outside Western Europe and the UK. This includes Eastern European members of the European Union such as Poland as well as certain countries in Asia such as Australia. Growth in this segment has been driven in the past year by sales in Poland, where the company also maintains a recently expanded manufacturing site. Demand in Poland for private label is rising and the company has benefited from this trend. There are four important drivers behind private label sales growth in emerging markets in general, and Poland in particular (some of which overlap). First of all is the consumption shift that takes place in developing economies from traditional outlets to supermarket chains. Whereas the traditional outlet usually consists of small family-run shops that do not have the resources to contract private label manufacturers, the growing supermarket chains of course do. This is also the case in Poland where the traditional trade is still an important part of the retail sector, but is losing market share in a rapid pace to modern chains such as Jeronimo Martin's (OTC:JRONF) Biedronka chain. Consumer acceptance of private label products is sometimes influenced by cultural factors as well as the nature of the retail trade. Because of low marketing spend behind private label products its manufacturers often benefit from a symbiotic relationship with large retailers: private label can be marketed under the retailers' brand for instance or profit from the retailers own efforts to promote private label products. Because private label often offers better margin for the retailer, as well as wider choice for the consumer and competitive offerings versus branded products, chain retailers are oftentimes eager to carry private label products.

Secondly, the historic dominance of the traditional retail trade means that private label products generally have low market share in developing economies. This means an important opportunity for growth; private label can benefit from the marketing efforts of branded multinationals which have stimulated category growth for products such as dishwasher liquids or deodorants etc. Thirdly, despite their strong economic growth in recent years countries such as Poland still have average income per capita that is way below that of developed market economies. This means that potential consumer demand for value-for-money products such as private label is very likely to be significant. Fourthly, consumer acceptance of private label products already seems good in Eastern Europe but will probably benefit further from the ongoing rise of modern retailing. McBride's sales in Poland went up by 9% during the year (constant currency).

The investment case

McBride's share price currently resides in the 79p area which gives the company a market capitalization of roughly £143.5 mln and an enterprise value around £228 mln. Its trailing EV/EBITDA is very low at 5 and its price/sales ratio is also very low at 0.19 (also on a trailing basis). If McBride succeeds in improving its performance in the UK segment the company's current valuation may prove to be very low. The most important catalyst for share price appreciation at McBride is operating margin recovery. I believe there are four potential drivers for this to happen at McBride. I will discuss them in order of deemed importance below.

  • Cost reductions in UK business will push operating margins higher

I already mentioned in the UK segment's discussion that management is already executing on plans to lower the cost base of its UK operations. I will include management's target of £12 mln in annual savings in this segment to estimate its operating profit improvement into the coming years (this will follow in the valuation segment below). This cost reduction is included in the management's goal to push the company level operating margin to 5% from its past fiscal's 2.96% (underlying).

  • Drop in oil prices will benefit gross margin

Some of the company's most important input materials are oil-derived chemicals/plastics such as PET (polyethylene terephthalate) and HDPE (high-density polyethylene). Both of these materials are primarily used to make bottle containers for the company's products such as laundry detergents, liquid soap and household cleaning products. Oil prices have dropped by a large percentage since peaking at the end of June 2014 near $115 per barrel. Since then the price for oil has come down by almost -40% (London Brent oil) which I believe we will see back in the company's gross margin as soon as this fiscal year (I have used Brent oil since this is an important pricing metric for North Sea oil which seems most appropriate given that the company's manufacturing base is largely situated in Europe). For example: HDPE for blow molding (which I assume McBride to use) was slightly over €1400 per metric ton during 2014 (average). Currently this price has come down to €1233 (Central European prices: via plasticker.de). Because the company operates on thin margins any improvement in gross margin will have a potentially large impact on the bottom line.

  • Germany and emerging markets provide growth opportunity

Although the strong growth in Poland, Germany and Australia failed to drive strong growth in their respective segments because of other countries displaying negative growth, the growing importance of these countries means it becomes increasingly likely they will enable stronger revenue growth for the company in the coming years. The 50% capacity expansion McBride undertook in its Strzelce, Poland manufacturing site provides it with low-cost production capacity to grow its business in these territories. As stated earlier new business wins in Germany and Australia and modern retail channel growth in Poland and other Eastern European countries will provide McBride with market opportunities to grow its sales.

  • Underlying growth of the private label category

While the performance of private label in Western Europe has suffered in some countries like the UK and Italy, the category as a whole is as vibrant and relevant as it ever has been. McBride is the largest private label manufacturer of care products in Europe and prides itself on being the first second-to-market, meaning it usually is the first private label manufacturer to introduce its own variations of branded product innovations. In fiscal year 2014 it introduced the first private label dual compartment laundry sachet in Europe; this quick innovation ability makes it a valuable partner to retailers in and outside of Europe and provides it with a margin opportunity in new product categories (which will be positioned against its relatively new premium priced branded counterparts while initially lacking private label competition). The fact that the company is currently a supplier of 49 of the 50 largest retailers in Europe supports that reasoning. The rise of discounters in Europe as a whole is another trend that stimulates private label growth. Forecasts for the growth of private label as a whole can be seen in the table below, which is from the company preliminary results presentation for 2014 and is based on market research by Nielsen among others. As can be seen in the table emerging markets like Poland, the Czech Republic and Turkey have low private label shares which provides the segment with a growth as well as a margin opportunity (since there's no large established private label industry yet)

(Private label market share per country (estimated): table from McBride's preliminary results presentation 2014. The private label category is estimated to record growth in the period between 2010 and 2015 for all countries shown)

In addition to these catalysts for sales growth and margin improvement there is also the possibility of the European economy improving. Because the prospect for that is still very uncertain I have not included this as a bullet point. However, consumer demand seems likely to improve at some point especially since the categories that McBride participates in are generally considered quite defensive; they will be among the first to pick up if demand does improve. In Northern European countries such as Germany and the Benelux countries the situation is much better than the hard hit southern European countries. Demand in countries such as Italy and Spain has suffered mostly because of high unemployment rates, but it's not inconceivable that this ship will start to turn at some point. McBride's business in those countries will be among the first to benefit if this happens.

Valuation

Using my four margin and growth drivers mentioned above I will model the company's performance 2 years out in two different scenarios; mediocre and good performance. First off, I will use management's guidance for cost savings in its UK business but not its overall operating margin target of 5%. This is because given historical performance it seems quite an ambitious target to be achieved by FY2016. I will however use management's stated £3 mln in cost savings for the UK business in the current fiscal year. Next I will assume the retail environment in the UK to remain very difficult and model negative sales growth in that segment of -5% (mediocre scenario) to -3% (good scenario) per annum, while assuming continuing growth in Germany and Poland to drive results in the Western Europe (1%-2% p/a) and Rest of the World (2%-3% p/a) segments. Gross margin will be modeled to improve slightly over the next two years, given the recent drop in oil prices, the company's position as first mover in NPD amongst private label manufacturers and its somewhat shifted manufacturing footprint to lower-cost territories (closure of one UK facility and expansion of the Polish facility). General operating costs and other costs will be estimated to increase by 2% (mediocre) to 1% per annum in the optimistic scenario (on an underlying basis, excl. cost savings). All results will be calculated on an underlying operating basis, excl. impairment charges and restructuring etc. The tax rate in the model will also drop versus the current rate of 33.53% because of the scheduled lowering of the UK corporate tax rate to 20% by April 2015 and on the basis of its much lower historic tax range (25%-26% over the past few years).

In the table below I have plotted the company's gross margin performance over the past fourteen years against London spot prices for Brent crude oil for the same period. What becomes clear immediately is that McBride's gross margin trend appears inversely correlated to the direction of crude oil prices. Early in the prior decade the company enjoyed a gross margin that was several full percentage points higher (36%-38%) versus that of the last years (31%-33%). The last Brent price I saw last Friday was $69.07, which means the company could potentially benefit from a similar oil price environment as the one that existed between 2006 and 2007. In that period gross margin averaged between 33.6% and 34.1% which I will use to estimate gross margin for future years. I will assume a modest amount of value engineering to have taken place in the meantime, which seems reasonable since oil-derivate materials are mostly used as packaging materials at McBride, which usage can be rationalized (for example through thinner packaging, materials replacement etc).

(Above table is the author's own work: Gross margin (blue line) should be read against the left vertical axis, while Brent prices (red line) should be read against the right vertical axis. Data on gross margins is from company annual reports 2002-2014, Brent spot price data is comprised of yearly average prices from the US Energy Information Administration at eia.gov).

In the table below you can see the model I have compiled for fiscal years 2015 and 2016. The mediocre scenario will see revenues fall even further at McBride due to continued negative sales growth in the UK (-5%). Growth in Western Europe (1%) and Rest of the World (2%) will fail to offset the UK decline in this scenario. In this scenario McBride's operating margin recovery will be driven by a slightly risen gross margin, which benefits from lower oil prices. For 2015 I have subtracted the £3 million in UK cost savings as well as £12 mln for 2016. The combination of these factors will drive operating margin lower in 2015 but higher in 2016 (which will benefit strongly from both the increased cost savings and the increasing gross margin). Finance costs will be largely steady in the mediocre scenario, while the tax rate will revert back to the historic 25-26% range, helped by lower corporate tax rates in the UK. Overall, net margin will rise in both 2015 and 2016, which will fail to benefit EPS in 2015 but will strongly benefit the EPS in 2016. I have used the current P/E of 15 to multiply future earnings as well, since it seems an appropriately moderate number given on the one hand the defensive nature of McBride's products and on the other its relative lack of a competitive moat versus its branded competition. If the mediocre scenario were to unfold as described investors can expect strong share price appreciation of 55% (even though earnings will initially weaken in 2015).

(Table is the author's own work using data available from the company's annual reports 2002-2014 and results presentations from fiscal years 2013-2014, as well as the author's estimates which are accompanied by argumentation in the text).

In the good scenario McBride would benefit from modest sales growth, as well as gross margin recovery, cost savings and a lower tax rate. Its UK sales would still decline but at a more modest -4% per annum, which will be offset by growth in Western Europe (2% p/a) and Rest of the World (3% per annum). Gross margin in this scenario will recover more strongly and reach levels last seen in the relatively low oil price environments of 2005-2006 and 2009-2010. The same cost savings targets of £3 mln and £12 mln are included in administrative costs for the years 2015 and 2016 as in the mediocre scenario. When combined, this will result in stronger operating margins versus their mediocre scenario counterpart years to reach levels for 2015 at 3.22% and 2016 at 4.74%. Finance cost will drop modestly in both good scenario years to £7.1 and £7 mln respectively. The tax rate will drop to 25% in both years, driven by the reduction in the UK corporate tax rate to 20% in 2015. This is one percentage point lower than in the mediocre scenario. The tax rate is very difficult to prognosticate since it will depend in large part on the geographic earnings mix the company will achieve*. Given the decreasing UK tax rate and expansion of production in low-tax Poland I expect the underlying tax rate to drop.

The range of 26%-25% I used for both scenarios seems reasonable to me given the company's historic range (as seen in right side of the table). The tax rate in 2014 was unusually high because of the reported loss in the UK; most of the impairment charges the company took in that segment were non-deductible. In the good scenario net profit will benefit from a combination of moderate sales growth, cost savings and higher gross margin as well as a lower tax rate. Because of the company's depressed underlying net margin of 1.3% in 2014 the modeled recovery to 2.5% and 3.5% in both good scenario years will drive strong EPS recovery. At a stable P/E of 15 this earnings recovery will result in very strong share price appreciation if this scenario unfolds. Given the very modest sales growth achieved in that scenario and the reasonable basis for recovery in both gross and operating margin (through cost savings) I believe the good scenario outcome is achievable for McBride. In that case the investor could benefit from upside potential of 32% (2015) to 122% (2016) over the next eighteen month to two year period. The company's current dividend rate of £0.05 is excluded from both scenarios. Please be aware that the company issues its dividend in B shares, which can be converted to cash before certain set dates. Its B shares are explained in a company document here.

Conclusion

The upward potential in the optimistic scenario seems quite extreme but one should consider that McBride is currently weathering a perfect storm: high input prices, a very difficult domestic market and serious pressure from branded competitors as a result of this. These factors in combination with its already very competitive industry have driven its 2014 net margin to an incredibly low level. The margin improvement as detailed in both scenarios, combined with the modest sales growth in the optimistic scenario can produce a very extreme result precisely because of its current depressed valuation level. I think the margin opportunity I described has a high likelihood of being realized by the company, especially since it can be realized in both the gross margin through input cost decreases and the operating margin through cost savings. When you combine those factors with sales leverage I think the result can be very rewarding. The current market valuation of 15 x the depressed earnings realized on a 1.3% net margin fails to consider the company's margin recovery potential.

Of course there are risks associated with an investment in this company as well. Especially when sales declines were to continue at the company level the impact of cost savings would be diminished by the further deleveraging of the company's cost base (even while being scaled back). The difficult retail environment and depressed consumer spending in Europe is therefore a thing to consider before investing in McBride. A large rebound in the oil price is another factor that would work against McBride's turnaround. Finally, the company has considerable gross debt near £120 mln, although offset in part by cash holdings of £34.9 mln. Net debt to EBITDA is <2 while the company had free cash flow of about £5.5 mln after taking into account considerable gross capital expenditures of £18.8 million. All these numbers are based on McBride's annual report 2014 of the fiscal year ended June 30th and its current share price near 78-79p.

*Statutory corporate tax rates in the company's most important markets are currently as follows: France 33,3%, Germany 29,8%, Poland 19%, UK (2015) 20%, Spain 30% and Italy 27.5%.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.