Devro Plc (LON:DVO): Initial View

Introduction – Devro (LON:DVO) is a fast-growing manufacturer of collagen products for the food industry. The biggest application of their collagen products is casing for sausages (as an alternative to natural casing) but the company also makes related collagen films and gels as well as plastic casings that have medical uses. The company has manufacturing facilities in Scotland, the Czech Republic, the US and Australia with HQ in Scotland. 55% of sales are from European customers with the remainder split equally between Americas and Asia/Pacific. The technology in the product does appear to be of a sophisticated level however, I believe the company’s claim to be a “world leader” is probably unfounded to some degree (although Devro has played an important role in the industry since the 1960s) as Viscofan (listed in Spain) had sales of EUR 633m (around GBP 540m) in the LFY against DVO’s LFY sales of GBP 239m.

Operating Metrics – The most noticeable thing about the above table is the large increase in profits in FY2010 and to a lesser extent, the large increase in NOA in 2010. However, before we look at this more closely we should also look a bit further back as Devro has a more colourful history.

 

What we see from the above is that Devro’s results have been incredibly shaky at some points and that it is only in the past three years that performance has improved significantly. In other words, looking at the past five years alone isn’t too useful. The main issue around 2000 appears to have been an underperforming division which was experiencing shrinking sales with already slim margins. The result was a disposal in 2001 (leading to the gap between EBIT and Net margin) so it is only after 2002 that we are seeing a strictly comparable business.

Since then, the company has experienced compound annual growth of 6.2% in revenue, 3.37% in COGS, 3.77% in S&D (COGS and S&D are the two biggest cost items) resulting in 14.26% compound annual growth in net income. However, the majority of this has been achieved in the past three years. For example, the same figures over the past three years are 8.62%, 1.87%, 9.32% and 50.26%, respectively.

What this highlights is that a major factor behind the company’s success is holding down COGS (by far, the biggest cost line item). In absolute terms, in the last fiscal year revenues grew around £17m whilst COGS rose £3m. Not all of this comes down to the bottom line as S&D and Admin costs grow in line with revenue but this is a key factorbehind increasing profits. We don’t get a full breakdown of COGS and the Accounting Policies doesn’t detail what COGS so it is difficult to say precisely what is behind this. However, we can speculate that someone else in the supply chain is under pressure. In other words, Devro is either getting its supplies cheaper or it is selling to customers at a higher price. I think it is some combination of the two however, I will reserve discussion of competitive positions until later.

The rapid revenue growth has led Devro to increase capital expenditures dramatically. Additions to fixed assets were just under £25m in the last fiscal year and the company reports in the latest interim report that it has £45m of projects on schedule with around £15m of spending completed at current sites in the first half of 2011. The more minor reason for increasing returns (apart from dramatically improved margins) is revenues growing faster than net operating assets. Usually, I would break this out into line items but given the latest dramatic spending plan and the fact margins have been far more important in growing return on equity I will just leave it here.

In terms of operations, what we have is a company that has dramatically improved returns in 2010. The reason for this dramatic improvement in returns is a large increase in margins which we have identified as originating in COGS. Whilst revenues grew substantially in 2010, COGS was flat resulting in a large increase in profits as the improvement in margins filters down to the bottom line. From the latest interim report, it looks like this trend is continuing as the company actually increased margins against the first half of last year. However, there a few points for concern. The company is embarking on a massive capital expenditure program. If revenue growth doesn’t match this growth in NOA the company will experience declining returns. In other words, the company is becoming more leveraged on achieving revenue growth. The other point is that margins aren’t improving due to any operational efficiencies. Rather, margins are improving because someone else is losing money somewhere else in the supply chain.

Financial Position - the company’s financial position is fairly strong. Leverage is very low and the company has maintained a fairly high payout of dividends to shareholders. The only point to bear in mind here is that the company is embarking on this large capital expenditure program. To me, it seems that the company won’t be able to fund this entirely through retained earnings and keep paying out dividends. However, the company is already financed quite conservatively and an increase in leverage may provide some downside protection against declining returns on net operating assets. Either way, I don’t think we should be concerned by anything here.

Recent Trends/Competitive Position – given what we have learned so far this should really be the most revealing.useful section. The only reason to invest in Devro is really that you expect revenues to keep growing and you expect the recent big program of capital expenditures to pay off. The other main issue is the big change in the cost of goods position. As mentioned already, a change in COGS, more than likely, doesn’t come from operational improvements but a change in competitive position somewhere in the supply chain allowing Devro to charge its customers more or for Devro’s suppliers to charge Devro less. I will look at both of these issues in more detail now.

Revenues grow for two reasons: one, the company gains market share against its competitors or two, the size of the market grows allowing all competitors a slice of a bigger pie. Here we have the Collagen Castings Trade Association (CCTA) which helps us in identifying the main participants in the industry. As usual, information is guarded closely and only Devro and Viscofan are listed. However, we do get some useful information from Viscofan (although we don’t know representative of general conditions this is). Revenue growth at Viscofan has been comparable or faster to that achieved at Devro. Equally, Viscofan also appears to be growing gross margins at a broadly similar rate. What this suggests is that there are industry-wide conditions behind both of these factors and that Devro is probably not increasing market share but benefitting from overall growth in the size of the market. One point of comparison is that Viscofan appears to have gone into Latin America whereas Devro has gone into Asia/Pacific. It appears that growth in Latin America has been slightly faster and so we should consider Devro’s geographic concentration which is far more focused on slower-growth developed markets. Regardless, the main issue driving this increase in market size, I would suspect, has been the increase in the raw material price needed to make natural casings. Sausage makers have, therefore, moved over to collagen casings to preserve margins. For consumers, the expense of collagen casings seems to be in terms of quality and so it is encouraging that Devro appears to be investing heavily in producing a higher quality collagen casing replicating the quality of natural casings.

As mentioned already, it is far harder to identify where the COGS improvement has come from. However, I suspect, given what I have discovered already, that it is largely due to an increase of the price that Devro is charging its customers. These new customers are switching over from the more expensive natural casings and so can be charged more. This is confirmed somewhat by the recent interim results in which volumes appear to have been largely flat but revenue is increasing which suggest that prices are increasing. Obviously, the relevant point to make here is that this isn’t genuine pricing power but result of changes in the industry of a substitute product. However, this doesn’t mean it is a cyclical change.

What we are seeing with Devro is then a confluence of some interesting industry trends. The substitute product, natural casing, has become dramatically more expensive allowing Devro to increase the volume of sales and prices. If collagen casings continue to be a good substitute for natural casings then we would expect the company to continue to do well. Whilst the geographical distribution of Devro’s sales should give us some cause for concern we should also be aware that collagen casings will be popular in the fast-growing developing markets as they lead to an end-product competing on price, the most important factor in price-sensitive developing markets. In addition, Devro appears to got a pretty good position in Asia/Pacific although Viscofan has begun moving into the region. The overall point is pretty clear, if we think that trends will continue and natural casings will continue to be uncompetitive for a lot of producers then we should buy the company as it is investing heavily in this outcome. 

Historical Valuation – In the above two tables we are presented with an interesting split of metrics. We see that in terms of earnings we are getting good historical value (the current P/E is 9.24x) whereas in terms of book value the situation is far less clear (the current P/B is 2.32x). I have often been fairly puzzled over what this means as I have seen it crop up again and again when I look the results of an EBIT/EV screen against an expected P/B screen. As I am not really too sure about what is going on here I am just going to decline the opportunity to comment and move on.

Conclusion - The case with Devro is fairly simple (I am not going to bother with a full scenario analysis as a result). In 2010, we seem to have seen a dramatic change in the dynamics in the casing industry in Devro’s favour. Collagen casings became a really competitive profit offering a good deal for sausage makers. As well as revenue growth, Devro seems to have acquired a lot of pricing power and a lot of this new revenue growth came down to the bottom line. RNOA improved dramatically from around 13% in 2009 to just over 23% in 2010.

As a result, the company has begun investing heavily in new fixed assets. The upside here is that with more capacity, the company can produce more sales. However, the downside here is that sales growth doesn’t play out as expected. Put another way, the company’s operations are becoming more leveraged on a certain level of revenue growth as to stop return on net operating assets falling, revenues have to grow at the same rate or faster than net operating assets. Unfortunately, I couldn’t find a breakdown of how that £45m in capex is broken up by year. The company implies though that it will be finished in 2013. So £45m is growth of  25% over three years which means sales have to be at least £300m in 2013 for RNOA to stay at the same level. The past three years, just met this level so maybe this seems a good idea. We should also consider that we are implying no change in competitive position with customers i.e. Devro will continue to sell its collagen casing at what seems, historically, like very wide margins.

Ultimately, this is my problem here. I don’t think all this seems impossible and in fact, it seems totally plausible. In particular, the company’s products should be particularly appealing to customers in developing markets which are price-sensitive and so will prefer collagen casings to natural casings. However, an investment here depends on is a good grasp of the fundamentals of the industry. For example, how will the company compete with Viscofan and what should we read into the lack of volume growth in the interims (as the company is investing in new capacity). The company could achieve some operational improvements to improve margins but ultimately what an investment depends on is understanding Devro’s customers and what they want (growth in overall market size) and the dynamics of competition within the industry(margins). Devro is a really interesting company at an attractive price but there are just too many complicating factors.

Disclosure: No position.