Northern Bear - aiming to emerge from the Property Freeze

In the last couple of years the stock market has taken an axe to valuations of companies exposed to the building and property sector.  The demise of Connaught (LON:CNT) and the well flagged public sector cuts that slashed social housing budgets in two have hit the sector hard.  One of the sector minnows that has seen its share price particularly badly affected is Northern Bear Plc (LON:NTBR)  which now trades on a forecast p/e of barely over three times earnings on a market cap of just £3.3m.  With half year results due in early November, we met with Graham Forrest the group CEO to find out a bit more about the company, their recent difficulties and whether the company presented a turnaround opportunity for contrarians and speculatively minded investors.  

A Brief History

Northern Bear floated on AIM in 2006 with the stated goal of being a 'buy and build' consolidator of smaller support services businesses to blue chip and public sector customers in the North of England.  The strategy relied on the ability to make acquisitions in an earnings enhancing fashion predominantly with cash and debt financing - a strategy which stalled as vendor valuations became unrealistic and the company struggled with its debt burden through the downturn.

The company acquired 13 well established companies through 2007 and 2008 which included specialists in fire protection, roofing contractors, floor joisters, asbestos removal, plumbing, safety and plant hire - all of which are essential support services to the property sector.  The businesses were all well established,  cash generative companies with the owners selling to realise equity while for the most part remaining with Northern Bear as managers.

The financial crisis severely impacted some of Northern Bear’s core business sectors including new house builds and the social housing sector.  It led to a marked slowdown in trading in the second half of 2008 and early 2009 during which there was a fear that the group would breach their banking covenants.  But £6m of new contracts in the second half of 2009 brought renewed optimism and the company managed to renegotiate its banking facilities in December 2009.  While revenues as a whole dropped from £41.8m in 2009 to £35m in 2010, and headline profits dropped from £2.2m to a loss of £1.36m after an impairment charge, the group continued to generate positive operating cashflow of £488k after tax and interest expense.   From a peak of £10.5m net debt during the downturn the company now has 'less than £9m' outstanding and is targeting bringing it down to beneath £5m over the next several years.

Customer Mix

The company’s revenues are split approximately 45%  to the social housing sector, 8-9% to new house builds and the rest from a mix of private contracts including ‘very high margin’ areas such as fire prevention and asbestos removal.  The new build markets have been very poor in recent years and while the company did take steps to reduce exposure to the area Graham Forrest is still negative on the outlook.  “When Northern Rock (LON:NRK) happened, I said it would be 3 years before the banks would be brave enough to lend again and even then it would be another 2 years after that before chief execs and finance directors were brave enough to borrow.  The banks clearly haven’t started lending yet”.  But at only 8-9% of turnover and far less of group profit, Forrest believes the group's exposure is minimal.

Exposure to Social Housing cuts...

At 45% of sales Northern Bear has a significant exposure to spending cuts in the social housing sector,  Forrest believes though that within this cloud there may lie a silver lining. While historically, roofers, joisters, plumbers and other contractors would have dealt directly with local councils, under Labour they became sub-contractors as project sizes grew and the social housing sector boomed.  Companies such as Connaught, Morgan Sindall (LON:MGNS), Kier Group (LON:KIE) and others grew to act as the intermediaries to city councils - parceling out business to the now subcontractors.  The old contractors (such as Northern Bear’s individual businesses) may have now become ‘subbies’ - but as Forrest explained “there was so much money here that even the subbies could have good margins”. But now,  due to the spending cuts, councils only have a fraction of that amount to spend and are looking to make savings wherever they can.    Whereas previously Northern Bear didn’t want to compete with the likes of Connaught as they were their customer, they now believe the timing is perfect.   They are positioning the group to start pitching to councils directly and Forrest is bringing in the necessary expertise to devote the time to the complicated procurement process - a process that was criticised in the Glover Review as ostracising SMEs from public sector work.

Forrest explained that some of the available contracts are so big that Northern Bear as a group might not be able to handle them as local authorities only offer contracts at a maximum of 10% of group turnover when awarding contracts.  Forrest explained “We are talking with two other local groups aiming to set up joint ventures to start bidding for bigger contracts. If we join up in a JV with a similarly sized partner we can pitch for £7m contracts rather than £3.5m.”

Another finding of the 2008 Glover Review showed that money preferentially spent through local as opposed to national companies has a multiplier effect in the local economy, a fact which Forrest sees as playing into Northern Bear’s hands.  “Roofing, asbestos removal, plumbing, forklift truck hire, fire prevention - we provide all these services.  We are a North East based company with North East companies employing 100% people in North East.”

Fall out from Connaught

Northern Bear did have some bad debt due to Connaught but it was capped at slightly over £100k, and Forrest believes they will “get that back via margin on the replacement work”.  Connaught’s work is now being parcelled out to competitors such as Morgan Sindall  who own Lovells that Northern Bear has a very good relationship with.  Forrest believes that the knock on effect from Connaught is that a lot of local roofing businesses who were individually exposed may go bust due to margin pressure,  creating a thinning of the market and possible acquisition opportunities for Northern Bear.

Financing and Outlook

While the banking covenant scare was not welcomed by investors, Forrest explained that recent trading has been ‘far better than it was 12 months ago... and far better than it was 4 months ago’.  With total banking facilities of £10m, the group has brought net debt down to less than £9m and they “are repaying a million per year” with a target for net debt of £5m.   The recent disposal of a loss making plumbing business shows that the management are willing to take decisive action.  “It shows we are on the ball... Institutional investors have been very supportive, but the question they asked was ‘aren’t there any more [businesses] you are going to get rid of?’.  Well there may well be, but there’s no urgency to get rid of anything today as there are no other loss makers”.

Instead, Forrest is still in acquisitive mood with the aim of picking up companies in distress that need a capital injection to be turned around.  “We don’t want to fund them through debt, and our equity is in a sad place right now”.   As a result, the valuation model for acquisitions has been reduced with Northern Bear looking to pay a maximum multiple of less than 2.5 times profit before tax with 35% paid in shares. “Its about being patient.  I don’t think it’s going to get better quickly.  Noone will buy these businesses for £500k....  Valuations are too high.”

Forrest is looking for the company share price to “accurately reflect the prospects for the business.  We are marked down due to net debt, but you have to look at the cash”.  Seymour Pierce the company broker is forecasting a £1.4m profit before tax for the current year;  we asked if Forrest was comfortable with their forecasts -  “Very much so... even if they were downgraded by 10% to lets say eps of 5.2p fully diluted, that’s a p/e of barely over 3.”

As Forrest concedes, the company is suffering from a triple whammy of negatives in the eyes of investors.  They are exposed to building services, government cuts and are also a micro-cap below the radar of most investors.  While Northern Bear has not been the most stable of businesses over the last few years it has managed to so far escape the fates of others.  If the company can prove to the market that it can run a sustainable business in spite of the social housing cuts,  continue to generate cash and pay down debt, then it may present the kind of story that turnaround specialists find attractive.  Interim Results are due in the second week of November.