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Buy Essentra ahead of transformation into a higher quality business
Support services firm Essentra (ESNT) is on the cusp of a transformation which could address the discounted valuation associated with its current conglomerate structure. This should also address longstanding environmental, social and governance concerns and free up management to focus on its most profitable division.
Investors should buy now to benefit from these potential catalysts, with the shares trading on a modest 13.2 times 2022 forecast earnings per share.
A FORGOTTEN STOCK
Stockbroker Davy says Essentra had become a ‘forgotten stock’. The shares trade at less than a third of the level they reached in 2015, stung by a disappointing operating performance amid the unravelling of an M&A spree under previous chief executive Colin Day.
Now, under the leadership of his successor Paul Forman, the former CEO of industrial threads business Coats (COA), the emphasis is switching from unfocused acquisitions to a much more streamlined approach.
Formerly part of FTSE 100 peer Bunzl (BNZL), the business was spun off as Filtrona in 2005 before being renamed as Essentra in 2013. Historically the main line of business was the manufacture and distribution of filters for cigarettes – and this explains in part why the stock has been unloved, given investors’ increased focus on ESG considerations.
The modern-day incarnation is made up of three divisions: a filters business, a packaging arm and a components unit which makes and distributes plastic injection moulded, vinyl dip moulded and metal items. The packaging unit sells to the health and personal care sectors and focuses on cartons, leaflets, self-adhesive labels and printed foils used in blister packs.
On 27 October the company announced plans to potentially divest the filters and packaging operations and focus on the components arm which has by some distance the best recent growth rate and strongest levels of profitability and cash flow.
For the three months to 30 September 2021, for example, the components business saw adjusted like-for-like revenue growth of 28.5% compared with a 6.1% decline for the packaging arm, hurt by delays to elective surgeries and lower prescription levels due to Covid-related disruption, and just 2.8% growth in filters.
The components business is just the right kind of boring. It specialises in items like caps and plugs, cable management products, printed circuit boards and other electronics hardware as well as a variety of tools and precision instruments.
These are typically low-cost items but nonetheless essential to the business’s 80,000-plus customers who are mainly equipment manufacturers. This should enable Essentra to pass on extra costs resulting from the current global supply chain crisis and protect margins in the short and long term.
Also encompassed within the components division is hardware supplies specialist Reid Supply which addresses a customer base that is principally located in the US Mid-West.
An efficient set-up, led both by internal manufacturing and sourcing from third parties, is backed up by a sophisticated IT platform.
According to investment bank Berenberg, despite being a leading operator in components, it has just a 4% market share. This reflects the fragmented nature of the market and highlights the opportunity Essentra might have as a consolidator, backed by any funds it generates from the potential sale of the packaging and filters arms.
The company is expected to conclude its strategic review around the middle of 2022, with further details on its break-up plan likely to be supportive to the shares.
Risks in the near-term include supply chain pressures, which it appears to be managing effectively for now, while longer term there is uncertainty over the company’s ability to realise a decent price if or when it sells the packaging business and, in particular, the filters division.
Mitigating this is the progress the group has made in improving performance on the filters side, led by expansion into eco-friendly products and a larger footprint in China. The packaging arm should benefit from a return to some normality in the healthcare space as we emerge from the pandemic as well as some self-help measures introduced by the group.
The balance sheet looks reasonably robust at a net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) of 1.7 times, and Jefferies forecasts this ratio to drop to 1.0 times by 2023, regardless of any disposals.
This underpins a modest but likely growing stream of dividends, with the shares on a forward yield of 2.6% based on consensus forecasts.