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INTERVIEW: Why will Zotefoams H2 sales be higher than its H1 record performance?

Zotefoams plc (LON:ZTF), a world leader in cellular materials technology, today announced its interim results for the six months ended 30 June 2019, DirectorsTalk caught up with CEO David Stirling to discuss the results.

David talks us through the highlights, updates us on the three major capital projects to expand capacity, explains more about the potential new projects to push sales and shares his confidence in meeting expectations for the year.

Highlights

· Record Group revenue of £42.30m, up 12% on prior period (2018: £37.89m) and 9% in constant currency:

o 40% growth in High Performance Products (“HPP”), which now represents 30% (2018: 24%) of Group sales

o 3% growth in Polyolefin Foams

o 3% growth in MuCell Extrusion sales

· Profit before income tax up 7% to £4.93m (2018: £4.60m)

· Improvements in cash flows from operating activities:

o Operating profit before changes in working capital and provisions up 11% to £8.29m (2018: £7.50m)

o Cash generated from operations up £5.83m to £5.20m (2018: cash used in operations £0.63m)

· On schedule with the three major capital projects in the UK, USA and Poland to expand capacity and support growth

· Interim dividend increased by 3.0% to 2.03 pence

· Expect to meet market expectations for the full year

Financial highlights

 Six months ended 30 June 2019Six months ended 30 June 2018Change
 £m£m%
Group revenue42.3037.8912
Gross profit15.0312.9216
Gross profit margin35.5%34.1% –
Operating profit5.095.021
Profit before income tax4.934.607
Basic EPS (p)8.558.076
Interim dividend (p)2.031.973

Commenting on the results, David Stirling, Group CEO, said:

“Zotefoams’ ambition is to be the world leader in cellular materials technology in our chosen markets and, in the period, we have again delivered strong organic growth with record Group revenue and half-year earnings.

Potential new projects in MuCell Extrusion and HPP, in particular, offer clear opportunity to grow the Zotefoams business to revenues of £100m and beyond. To hit this milestone in 2020 we need to maintain momentum in business development and technical support of these opportunities to create significant shareholder value in future years.

We expect Zotefoams to deliver further growth in 2019 and meet market expectations, however we are mindful of a difficult current trading environment in European polyolefin foams markets and the less stable political and macroeconomic environment. The Board remains confident in the future prospects for the business.”

Results overview

In the first six months of 2019 Group revenue increased by 12% to a record £42.30m (2018: £37.89m). As indicated in the May trading update, we experienced strong growth in the first four months of the year, with a return to trendline growth rates later in the period. In constant currency, growth was 9%, with particularly strong sales performance in our HPP business and in Polyolefin Foams in North America.

Gross profit margin increased from 34.1% to 35.5%, with a strong positive mix impact from our HPP business growth, some currency benefit and operational improvements since the start-up of US polyolefin capacity in the comparative period. Amortisation of acquired intangible assets for the period amounted to £0.14m (2018 £0.15m).

After continuing to invest in the Group’s cost base to support anticipated future opportunities, H1 2019 profit before income tax grew by 7% to £4.93m (2018: £4.60m). Basic earnings per share increased to 8.55p (2018: 8.07p), with the previous period including only a two-month impact of the equity raise completed in May 2018. The Directors have decided to increase the interim dividend to 2.03p per share (2018: 1.97p), an increase of 3.0%, reflecting the Board’s continued confidence in the Group’s future.

Financial and operational review

High-Performance Products (‘HPP’)

HPP sales grew 40% to £12.70m (2018: £9.04m), or 34% in constant currency. All product lines within HPP delivered growth.

Footwear products, where we have an exclusive relationship with Nike, performed well, delivering 47% growth compared to the same period last year. Footwear is now the largest segment within HPP and is aligned to a two-year customer product cycle which began in late 2017. We therefore expect the remainder of the year to be relatively flat, with a typical tail-off at the end of the current product cycle and an uplift from the next product cycle beginning late this year.

ZOTEK® F fluoropolymer foams, mainly used in aviation markets, also grew strongly with sales increasing by 33% in the period as our portfolio of applications increases. Sales of ZOTEK® N nylon foams increased modestly, with both product lines showing a very positive pipeline of development opportunities.

T-FIT® advanced insulation products sales grew by almost 50% in the period, again with a positive momentum on both short and medium-term development opportunities, predominantly in China, India and Europe.

The segment profit in HPP is an aggregate of products and markets at different stages of development. Within this portfolio ZOTEK® PEBA and ZOTEK® F foams, mainly used for footwear and aviation respectively, have both reached a scale that makes them profitable. T-FIT® insulation has a mixture of profitable lines and earlier stage products, and the Group has continued to invest in operational and sales capability in China during the period, as well as set up a legal entity and sales team in India. We intend to continue with both this investment and that in nylon foam, both of which we believe offer good potential to support our long-term ambition. Segment profit in HPP increased by 67% to £2.80m (2018: £1.68m), delivering a 22% segment profit margin for the period (2018: 19%).

Polyolefin Foams

Polyolefin Foams sales increased 3% to £28.72m (2018: £27.98m), or 1% in constant currency. In continental Europe, our largest market, sales were strong in Q1 but declined in Q2 mainly as a result of challenges faced by industrial users, particularly in Germany which is our largest market for these foams. We expect Q3 this year to see similar low-levels of demand in continental Europe, accompanied by customer destocking, which is common as the supply chain settles into a lower-demand environment. In the UK, revenue was stable, with Brexit-related inventory build benefits experienced in Q1 reversing in Q2 and being subject to continuing uncertainty. In North America, sales increased 12%, supported by the Group’s additional capacity which came on-line in March 2018, despite poor weather hitting the construction sector in particular.

Segment profit increased by 3% to £4.68m (2018: £4.55m). Lower average input costs for our main raw material, low density polyethylene (‘LDPE’) and higher operational efficiency in the USA more than offset the full period impact of additional depreciation and operating costs from the USA capacity expansion. This delivered a segment profit margin of 16% (2018: 16%).

MuCell Extrusion LLC (‘MEL’)

MEL licenses microcellular foam technology and sells related machinery. Sales in the period increased 3% to £0.89m (2018: £0.86m). In constant currency total sales declined by 1%. Operational improvements made in 2018 are beginning to benefit the MEL business, with better organisational control and delivery supporting expectations for a much stronger second half this year. More importantly, we believe the long-term potential of MEL has improved significantly, with further technology development opening up new potential applications. We expect to begin marketing these applications early in the fourth quarter following a successful initial customer launch earlier this year.

MEL reported a segment loss after amortisation costs of £1.11m (2018: loss £0.78m), which mainly reflected the additional cost base to support future growth.

Currency review

As a predominantly UK-based exporter, Zotefoams has over 80% of its sales denominated in US dollars and euros. With most costs incurred in sterling, other than the main raw materials processed at the Croydon, UK, plant, which are in euros, and the operating costs of the Group’s US and Chinese activities, which are in US dollars, movements in foreign exchange rates can have a significant impact on the Group’s results. The average Euro rate was 1.14: £1 for the first six months of 2019 (equivalent 2018 rate 1.14: £1) and the average US dollar rate was 1.29: £1 (equivalent 2018 rate 1.38: £1).

In the period a stronger dollar increased our reporting currency sales and costs of raw materials as well as our operating costs of North American facilities. The net profit effect of this was a benefit of approximately £0.6m. Offsetting this, our transactional hedging generated a loss of £0.41m (2018 gain: £0.19m). In addition, the Group recorded a non-cash translation gain of £0.18m (2018 gain: £0.49m) on foreign currency denominated balances which are not hedged. The combined effects of these are included in administration expenses.

Investment in organisation

The Group continues to pursue its expansion strategy, founded on proprietary cellular-materials technology with an increasing portfolio of differentiated products.

Organic growth, at the rate the Group is targeting, requires continued investment in manufacturing, processing and engineering capability to deliver the required capacity around the world. Within cost of sales, these costs increased by £1.36m in H1 2019 against the previous period, £1.10m of which was in relation to operations overseas.

This organic growth also requires continued investment in, and reprioritisation of, technical, sales-focused and administration resources to create, execute and manage it. Included within distribution and administrative expenses in the Group’s income statement are sales and marketing, warehousing, technical development, finance, information systems and administration costs as well as the impact of foreign exchange hedges maturing in the period and non-cash foreign exchange translation expenses. These costs, excluding the impact of foreign exchange hedges and translation, increased by a further £1.16m to £9.72m in H1 2019 (2018: £8.56m). The Group expects this investment to continue as it progresses its strategy of mix enrichment and completes its ongoing capital investments.

Tax and cash flow

Zotefoams’ estimated average annual tax rate used for the period to 31 December 2019 is 18.79% (actual for the year ended 31 December 2018: 17.99%), which is in line with the UK corporation tax rate for the period of 19%. Cash generated from operations was £5.20m (2018: cash used in operations £0.63m), following a prior period investment in working capital of £6.92m, primarily related to footwear sales. Capital expenditure was £10.92m (2018: £5.75m), related to the ongoing capacity expansion projects in the UK, USA and Poland. Finance costs reduced to £0.18m (2018: £0.42m) as a result of the realised gross proceeds of £20.6m, following the share placing in May 2018 and as a consequence of lower cost debt.

Net debt (cash less bank borrowings and lease liabilities) increased by £10.40m from £12.96m (December 2018) to £23.36m, as a result of the Group drawing down on its existing facility to finance the capital expenditures described above.

Pensions

There have been no material changes in assumptions to impact the net deficit on the Defined Benefit Pension Scheme (“DB Scheme”) as at 30 June 2019. A full actuarial valuation of the DB Scheme was completed as at 5 April 2017 in line with the requirement to have a triennial valuation. The outcome, on a Statutory Funding Objective basis, calculated a deficit of £4.18m. As a result, the Company agreed with the Trustees to make contributions to the DB Scheme of £43,300 per month to meet the shortfall by 31 October 2026, up from £41,000 per month previously. In addition, the Company will pay the ongoing DB Scheme expenses of £15,000 per month (previously £10,600), to cover death-in-service insurance premiums, the expenses of administering the scheme and Pension Protection Fund levies.

Capital expenditure

Zotefoams is proceeding well with its announced capacity increase initiatives across the Group. With the full process capability fully operational in Kentucky, USA since March 2018, following an investment of $33m to acquire and install a high-pressure vessel plus ancillary equipment and infrastructure, as well as acquire a second high-pressure vessel, the Group remains on target to commission this second vessel in Q4, 2019, at an incremental budgeted cost of $9m. Each vessel is estimated to add 20% additional Group capacity.

Since December 2017 the Group has also been investing in additional high-temperature, low-pressure capacity at its Croydon, UK, plant, at a total investment cost of £12m. Although capable of expanding all foams produced by Zotefoams, this is targeted at the fast-growing HPP business. In time and on budget, these assets are now in place and are currently being commissioned. Finally, Zotefoams is also investing in a new foam manufacturing plant in Poland, expected to become operational in 2020 and cost approximately £23m to cover land, buildings and the first phase of capacity. This is also progressing well, to plan and on budget. Interest capitalised during the period amounted to £0.44m (2018: £0.03m).

The Group has adopted IFRS 16 during the period, resulting in right-of-use assets of £1.37m being recognised on the Group’s statement of financial position at the period end. An associated liability of £1.38m has also been recognised at the period end. See note 12 of the condensed consolidated interim financial statements for further details.

Employees and talent management

Hiring and retaining employees with the right skills, and management of these talented people, is very important to Zotefoams as it grows and evolves globally. We have a wide scope of opportunities and need to identify and develop the right people to define and deliver to our potential. Over the past six months we have continued to recruit to meet the needs of our business and now employ 481 globally, 30% of whom are outside the UK.

On behalf of the Board, we would like to thank all our employees for their continued contribution to Zotefoams in the period.

Dividend

Reflecting the Board’s continued confidence in the Group’s future, the Directors have increased the interim dividend by 3.0% to 2.03 pence per share (2018: 1.97 pence). The dividend will be paid on 10 October 2019 to shareholders on the Company’s register at the close of business on 13 September 2019.

Principal risks and uncertainties

Zotefoams’ business and share price may be affected by a number of risks, not all of which are within its control. The process Zotefoams has in place for identifying, assessing and managing risks is set out in the Risk Management and Principal Risks section, on pages 24 to 30, of the 2018 Annual Report. The specific principal risks (which could impact Zotefoams’ sales, profits and reputation) and relevant mitigating factors, as currently identified by Zotefoams’ risk management process, have not changed significantly since the publication of the last Annual Report. Detailed explanations of these can be found in the 2018 Annual Report. Broadly, these risks include operational disruption, global capacity management, scaling up international operations, technology displacement, external and loss of a key customer.

Current trading and prospects

Zotefoams’ business is well diversified both within AZOTE® polyolefin foams and in our HPP and MEL businesses, the latter two being structurally high-growth opportunities.

In the second half we anticipate our sales growth rate to moderate as macroeconomic uncertainty impacts cyclical markets, such as automotive, which is currently in decline. This inevitably reduces demand in our Polyolefin Foams segment, exacerbated by destocking in the supply chain through which we serve such markets. Lower demand for polyolefin foams in Europe seen in the second quarter will undoubtedly continue through the third quarter, in addition to the uncertain effects of Brexit. However, the North American market for polyolefin foams remains strong, augmented by pent-up demand in construction following a slow build season due to inclement weather in the first half of the year.

In HPP we enter the second half of the year with strong positive momentum and confidence in significant growth in our aviation and technical insulation products. Footwear demand is likely to be at similar levels to the second half of 2018 before significant growth resumes in 2020.

In MEL we expect sales to be significantly above the first half, as there is a normal seasonality to this business combined with underlying growth opportunities.

Potential new projects in MEL and HPP, in particular, offer clear opportunity to grow the Zotefoams business to revenues of £100m and beyond. To hit this milestone in 2020 we need to maintain momentum in business development and technical support of these opportunities to create significant shareholder value in future years.

Sterling is currently weaker than in the second half of 2018 and, therefore, net of hedging we anticipate modest transactional benefit for the remainder of the year. Indications are that pricing of low-density polyethylene, our major raw material, will remain at a similar level to the first six months of this year.

Outlook

We expect Zotefoams to deliver further growth in 2019 and meet market expectations, however we are mindful of a difficult current trading environment in European polyolefin foams markets and the less stable political and macroeconomic environment. The Board remains confident in the future prospects for the business.

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Disclaimer: Statements in this article should not be considered investment advice, which is best sought directly from a qualified professional.