Zotefoams Share Price Crashes As Second Half Sales Miss Target

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Shares in Croydon-based Zotefoams (LON:ZTF) crumbled by as much as 35% in early trading as the foam specialist put out some bad news. The latest Zotefoams profit warning informs us that sales of its products in the second half of the year would be lower than the first. The share price reaction seems to have settled on -35%:

It should be said that these are turbulent times for markets. Yesterday, there was a mass sell-off as the FTSE crumbled by over 3%. This has followed general weakness all week. There is a sense of nervousness in the air, which is being stirred up by multiple sources. As a result, equities have been badly hit.

Zotefoams are a well-regarded share and popular with private investors. This is the type of business many like. A specialist in producing foams which have a wide range of applications. Products are also trademarked, which may act as a moat. Whilst none are real household names, the products are geared towards quality. This is often more important than cost in industrial applications. The potential addressable market for these is vast. The business also turns a profit, and pays out dividends. On the other hand, it isn’t cheap and the large price to multiple seen before today put many off. In this respect, not too dissimilar to Zytronic.

The Warning

We don’t actually have much to go on today. A ‘Trading Update’ RNS confirms the news as such:

At the time of our interim results in August we stated that we were mindful of a difficult current trading environment in the European polyolefin foams markets and the less stable political and macroeconomic environment. Since that time the market for polyolefin foams in continental Europe has deteriorated significantly while growth in the North American market has slowed and is now expected to be below our previous estimates.

This trading outlook was on 3rd August, and then the company were still hopeful of delivering further growth. It does seem that this is off the table for now:

We anticipate polyolefin foam sales are therefore likely to be around £6 million below current market estimates, resulting in Group sales for the second half of 2019 approximately £2m below the first half of the year. Anticipated profit for this period is impacted by our limited ability to change the operational gearing in the business in this timeframe.

Group revenue was £42.3m, so this implies a second half of £40m or thereabouts. The 2018 total was £81.3m so this might be a close call as to whether there is growth. The previous forecasts we can see from Stockopedia guides us at £85.4m, so is a small miss.

No numbers are given for anticipated profit. It surely would have been helpful to give a guide as all costs are known.

The Business

Prior to the latest Zotefoams profit warning, the business was showing many hallmarks of a good one. Turnover was growing, but more importantly profits were growing at a faster rate. These profitability metrics back this up:

Margins have been broadly increasing over the years which demonstrates a good market for the product that competitors may find difficult to break into. There also could be operational gearing kicking in, as the increased sales means that the high fixed costs of the business can be spread out over more products.

Cash generation is good, although one slight bugbear is the capital expenses. These have outstripped profits and cashflow almost every year. Spends have gotten bigger as time goes on. A potential red flag, as many things can be capitalised.

A quick look at the annual report suggests that this money is being spent on a new manufacturing facility in Kentucky. This makes some sense. Revenues are quite evenly distributed throughout the world with a quarter coming from UK, Europe, North America and Rest of the World.

It does seem that this capex might continue for a couple more years at least. A similar plan is in place to develop a facility in Poland. Upgrades to equipment are also planned for the UK.

The company also pays out a modest dividend. We can see that in effect, they are borrowing in order to sustain this. The company had net cash in 2014, but the increased capex costs has led the position to being a net debt one of £23.4m today, and probably will be more adverse by the end of the year. A share issue of some £20m last year was also needed to shore up the balance sheet.

At the moment funding appears adequate and is comprised of a £25m multi-currency loan, a £25m revolving credit facility, and a £7.5m sterling loan.

The company also has a pension deficit of some £8m. This is a small drag, as the company are committed to spending an extra £500,000 a year roughly to keep it up to date.

Whilst we can see some debts here, the position does not seem too bad. There is still plenty of headroom which does not seem to be in any danger of being breached any time soon and assuming capex does drop off the cash position should start making inroads into the debt.

The balance sheet shows a heavy positive net asset position. There are few intangible assets. One concern may be that trade receivables and inventories have risen past the rate of turnover. This is not a good thing coming into a more difficult period for the company.

Is the Zotefoams profit warning a buying opportunity?

At face value, it seems implausible that a relatively small miss in earnings could wipe out so much value off a company. A £2m loss of turnover may equate to profits falling only slightly – from £10.6m to £10m perhaps. Yet in terms of market capitalisation, over £100m has gone.

The trouble is, there are a few more factors at play. The first being whether this decrease of sales is going to be a one-off thing, or the start of a steady decline. The trading statement makes reference to two different sectors in one section of the business to be slowing. Both Europe and North America have suffered. Whether this may have a contagion effect and spread to other regions or even divisions of their business is not yet clear. What is clear is that markets are heavily punishing any uncertainty.

Another factor is that Zotefoams were an extremely expensive share to buy. Prior to this it was trading at something in excess of 25 times earnings. Much of that premium was due to the anticipation of further growth. If it looks as it that growth may not materialise at the rates expected, we could expect the share to significantly de-rate. With big capital expenses committed for the next few years, it is imperative that trading remains strong.

Technological advances also pose some risk to Zotefoams. Their margins seem to indicate they are enjoying some competitive advantages for now. Whether a competitor could produce a product which exceeds the specifications is unknown.

In my view Zotefoams seems like a good company, but even at the current price does not seem to much of a bargain and I would prefer to wait for updated broker guidance and a lower entry point before taking the plunge. Perhaps another Zotefoams profit warning in future may provide this opportunity.  3/5.

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