Executive Summary
Disclaimer: Long $DVO.
Investment Summary
Current Share price: 1.9£
Market Cap: 323£m
EV: 477£m
Expected IRR through 2023: 17% (base case) - 40% (dream case)
2020 Metrics:
- Sales: 248£m
- EBITDA: 57£m (23% margin)
- EBIT: 36£m (15% margin)
- Net Income: 29£m (9% margin)
Devro is one of the world's leading suppliers of collagen casing for food, used by its customers in a wide variety of sausages and other meat products. Devro is trading at a significant discount compared with the incumbent in the market, the Spanish group Viscofan ($VIS). In addition, the group is tightly managed and has an impressive track record in terms of cash generation and ability to detach a stable and predictible dividend to its shareholders.
The group is also benefitting from several tailwinds which are boosting the demand for collagen casings: shift from animal guts to collagen, growing protein intake in emerging markets (1/3rd of revenue), new products (meat-free sausages)...
Devro offers a compelling opportunity to benefit from a steady low-single digit growth in a countercyclical category, by betting on one of the main challengers trading at a considerable discount to the incumbent (Viscofan) that I don't view as justified.
Investing in Devro gives you the benefit of being paid a stable 5% cash dividend yield, with a free call option on the re-rating of the business arising from quick deleveraging (gearing ratio down from 6.7x Net Debt/EBITDA to <3.0x at the end of 2020, and potentially <2.0x by 2023).
Liquidity is not a problem with DSCR (Debt Service Coverage Ratio) near 7.0x, which is reassuring given that the liquidation approach is not the most flattering for this business (Liabilities Coverage Ratio at c.80% - after applying huge haircuts to fixed assets)
If Devro re-rates at a ~12.5x EV/EBIT multiple compared to ~10.5x today, a scenario that seems plausible, the implied IRR until 2023E is quite high, at 17%. In a dream case where Devro would mostly close the gap in valuation compared to Viscofan (which trades at 17x EV/EBIT), the implied IRR could go as high as 50% until 2023.
Business Overview
Devro is a world leading supplier of collagen casings and gels for the food industry. The industry is very concentrated, and one could describe it as an oligopoly, with the Spanish group Viscofan ($VIS) at the helm of it.
Devro's story started as part of J&J in the 1960s, and not much happened until the 1990s when following a Management Buy-Out, Devro was floated on the LSE to provide an exit.
Devro, listed in the UK is one of the incumbents, with £250m in sales and 2,100 employees around the globe. The manufacturing footprint has evolved a lot in the last 10 years, and Devro currently has production operations in six different countries over four continents (UK, Netherlands, Czech Republic, US, Australia, China). On average, c.3% of revenue is invested into R&D each year, and Devro has a very modern asset base!
Business Model
3Cs is Devro's new commercial strategy named "3Cs" for Customer, Core Profitability & Competencies. It was launched after a period of difficulties arising from a temporary excess of capacity compared to global sales, after capacity utilization dropped from 89% in 2011 to 74% in 2013, before recovering.
Source: March 2017 Investor Presentation
The objectives of the plan are the following:
- Resume top-line growth
- Improve margins by optimizing plants ("the hidden plant") and reducing costs
- Strengthen competencies
Some material progress has been made since the announcement, through partnerships in the snacking sausages space, a premiumisation of brands and investments in the renovation of assets. All these efforts are already showing up in the group's financial data, with an upward trajectory since the beginning of the roll-out of the strategy.
What is Devro's Moat?
1) Leading position in core markets
Most of the companies in the casings space have been what they are doing for quite a long time, and Devro stays true to this image, with an history of over 85 years.
Devro benefits from this long history which allows the firm to have market leading positions in its most important geographies for sales of collagen casings:
- Devro stands at the top spot in North America, Russia and East, Australia and NZ, and Middle East/Africa
- It stands at the second place in Continental and Western Europe, Japan, Latin America and SE Asia
Source: Capital markets Day Presentation
2) Stability of meat consumption per capita... With upside potential in subcategories
The food industry is a stable sector overall, which can withstand most of the global economy's turbulences. The particular sub-segment which is relevant for Devro (meat products) also benefits from several trends (demographic growth, changing consumption habits in emerging countries, conversion from gut...) that help sustain the volume of casings, and even offer the potential of a lasting high single digit growth in subcategories such as snacking:
To illustrate, according to data collected by the OECD-FAO Agricultural Outlook 2020-2029, meat consumption per capital has gone from 32.6kg per capita in 2009 to 34kg per capita in 2019, a growth of 4.3% over 10 years. The average meat consumption is expected rise further to reach 35kg per capita in 2029.
On top of that modest growth overall, Devro is benefitting from a strong dynamism in particular subsegments such as meat snacks and sausages, which are growing at a faster pace.
3) A conservative financial structure & considerable margin of safety when it comes to debt service
Over the last 10 years, Devro has been leveraging up until 2016 (with Net Debt reaching 6.7x EBITDA) and deleveraging ever since (current gearing just below 3.0x). This financial debt was associated with important plant upgrades in Europe and Australia, as well as new facilities opening in the USA and China, which contributed to make Devro well equipped to reap the benefits of a modern industrial apparel.
In addition, it is important to note that this additional debt was not taken at the expense of the company's financial health, with the DSCR (Debt Service Coverage Ratio, or simply put EBIT/Net Int. Expense) sitting comfortably above 2 over the period. The only time it was not the case (2019) can be explained from a ~44£m writedown of company assets triggered by an acquisition and was essentially non-cash. At the end of 2020, the Interest Coverage Ratio was close to 7.0x, showing ample liquidity and margin of safety.
4) A Risk: Threat of replacement by non-casings technologies?
Significant conversion to co-extrusion could be an adverse effect on sales of casing, revenues and profit. Per the latest annual report:
More than 80% of the Group’s revenue is derived from the manufacture and sale of edible collagen casing, primarily for sausages. For many years, several manufacturers of machinery used in the food industry have been promoting “co-extrusion” systems for sausages which do not require casing. Both collagen and non-collagen co-extrusion gels can be used on such systems. In 2020 we have detected a greater readiness for fresh sausage producers to consider noncollagen co-extrusion solutions
Mitigation:
When there has been a conversion to co-extrusion in the past, Devro has been able to supply the collagen gel required for such technique. The group continues to invest in the development of innogative gel (non-casing) solutions as well.
5) Another Risk: Exposure to FX risk and variation in key raw materials (animal hides)
→ Devro has an exposure to key raw materials change in price. Cattle and sow hides represent up to 20% of the group's total COGS.
Mitigation:
The group has long-term contracts with specialized suppliers in various regions of the world
→ Devro's results are exposed to fx variations as the parent company reports in Sterling. In 2020, c.90% of the group's revenues were invoiced in currencies other than sterling.
Mitigation:
Policy of hedging a substantial portion of transactional foreign exchange risks for periods of up to 15 months using forward contracts
Business Strategy: Capitalizing on underlying market trends to expand market share
1) Collagen Displacing gut casings & inedible casings offers another growth opportunity on top of the global meat consumption growth
Source: Devro 2020 Annual report
Collagen casings, derived from animal hides, have been replacing gut casings at a rapid pace. According to figures published by the Collagen Casing Trade Association (CCTA), edible collagen represented only 33% of the total market value in 2010, but this share has grown to almost 50% (46% in 2020).
This displacement opportunity acts as a huge tailwind which creates an opportunity for specialized players in this niche market (such as Devro) to capture topline growth that vastly exceeds the c.0.5% per year that we found in the meat consumption figures.
As penetration approaches the 50% mark, and combined with the overall growth of the category, it makes the edible collagen casings category quite appealing in terms of growth potential, with a CAGR potentially reaching mid to high single-digit rates.
To illustrate the strength of the phenomenon at play here, if look at the growth in Collagen casings and gut casings since over the 2000-2018 period, we find the following:
- Edible collagen casings volumes grew +45%
- Gut casings declined -2%
The compounding effect of a growing category AND a displacement effect created a secular opportunity in the food products industry.
Source: 2019 Capital Markets Day
2) Opportunities in Emerging Markets: Devro's growth engine
Devros has a significant presence in emerging countries (Latam, MEA, Russia, China, SEA) which now represent close to 30% of the group's revenue.
Overall growth in sausage consumption in these grographies tends to be ahead of mature markets in line with GDP growth. The long term growth target is as high as 6-10% p.a.! 2020 showed an exceptional growth in Latam (+76%) for Devro. There are still pockets of nascent markets, with meat consumption still representing a luxury in mainland China and South East Asia, leaving huge pent-up demand from the growing middle class.
Emerging markets represented 28% of the group's revenue in 2020, up 300bps yoy. Therefore, a continued increase of the share represented by Emerging Markets in Devro's revenue would be a positive catalyst, boosting the group's topline.
3) Developed Markets: protecting the bastion and diversifying into dynamic categories
Devro has a strong position in mature markets, which still represent 72% of the group revenue in 2020. These countries offer various opportunities through the continued gut conversion to collagen casings, and the sustained growth in the meat snacks category which has been growing steadily at a c.6% CAGR. Another opportunity lies in potential partnerships with manufacturers of non-meat sausages, another category which has been seeing tremendous growth. Long-term growth estimates are sensibly lower than for emerging countries, though, with a range of 0-2% annually, and therefore Devro's ability to gain market share will be increasingly dependent on this ability to enter the right categories.
Valuation - Asymmetric opportunity with limited downside, stable dividend yield and free call option on re-rating
A DCF approach with topline growth slightly higher than market average (5% CAGR till 2025 to account for the conversion opportunity), an improvement of 100bps in EBIT margin and a ruthless 10% WACC gives a floor of ~8% downside compared with current prices.
Given the straighforward nature of Devro's activity, you don't have to be very creative to put together a DCF valuation. And you would not want to, as you want to your assumptions to be as realistic as possible!
A base case points towards an undervaluation of c.30%. It was done with an 8% WACC (quite punitive given the stock's 0.6 beta and 5.3% ERP) and the following assumptions:
- A slightly above-market growth rate (5% CAGR to 2025) to account for Devro's ability to enter new verticals and tie together partnerships, as well as its positioning in edible collagen
- Gradually improving EBITDA margin (from 23% in 2020 to 25% in 2025) to account for the cost-savings efforts and efficiency gains already obtained from the 3Cs strategy, while still leaving a big gap with Viscofan (market leader) which has margins above 27%
- D&A driven as % of revenue and standing at 9% of revenue, the average over the 2015-2020 period
- c.5£m of interest expense, not accounting for the savings allowed by the already foreseeable deleveraging (with guidance pointing to a leverage as low as 1.6x at the end of 2021)
- 25% tax rate
- Capex slightly superior to the maintenance figure given by management (£15m) to account for the fact that Devro already has a modern industrial apparel and can unlock further capacity from existing plants
Under these assumptions, even at the current prices (which have rallied since the 2020 trough), you can lock in a c.17% IRR if we model a normalization at the end of 2023
An approach through EV/EBIT multiples is also very encouraging. Devro currently trades at 10.4x EV/EBIT for 2023E, compared to c.17x for Viscofan ($VIS)
Should Devro re-rate at a ~12.5x EV/EBIT multiple compared to ~10.5x today, a scenario that seems very plausible if great results keep coming (especially from Emerging Markets), the implied IRR until 2023E is quite high, at 17% with a 1.5 year investment horizon. And this, while hitting 1.6x Net Debt/EBITDA only at the end of 2023.
If Devro manages to hit the guidance of 1.6x Net Debt/EBITDA at the end of 2021, the leverage could be as low as 1.0x in 2023, further boosting the IRR to c.25%
In a dream case where Devro would mostly close the gap in valuation compared to Viscofan and trade up to 15.4x EV/EBIT, the implied IRR could go as high as 40%.
One of the valuation where Devro is dismissed is the liquidation approach. By applying the following haircuts the the company's net assets:
- Land & Buildings: -30%
- Plant and Machinery, Motor Vehicles: -50%
- Fixtures and Fittings, Computers: -50%
- Assets in construction: -70%
- Inventories: -50%
- Receivables: -50%
... We find that asset coverage is only standing at about 75%, quite disappointing.
Thankfully, the Debt Service Coverage Ratio standing at >7.0x, that we already mentioned, acts as a strong line of defense before we lose our pants during liquidation!
Conclusion:
Overall, I find the valuation to be very compelling, especially given the stable, countercyclical end market, and the track record of dividend distribution that means that you're being paid a 5% cash dividend to wait for your call option on the re-rating to exercize...
Catalysts:
- Re-rating following realization of guidance on net debt (target of 1.6x gearing by 2021E which I am not modelling as achieved until 2023) could boost IRR up to 25% in the base case with a 1.5 year horizon
- Positive initiation of coverage by a major broker (only 5 analysts covering the stock at the moment) would likely reduce the mispricing
- Special dividend if the company continues to deleverage and does not reinvest meaningfully above run-rate maintenance capex (c.£15m per year) given the modern industrial apparel
- Acquisition by Viscofan which would instantly create value through the differential in multiples while allowing Viscofan to acquire a modern asset base - but unlikely given the probability of anti-trust issues
