Zotefoams – What The Foam? #ZTF

Zotefoams – What The Foam? #ZTF

InIntroduction

Zotefoams manufacture and sell foam.

The two key segments representing 98% of turnover are the Polyolefin and High Performance Products.

The company has been around for a long time, coming into existence as a result of a management buyout from one of BP’s chemical divisions.

They also have a licensing business but that is immaterial to the two main segments.

Now I have no expertise in the foam market, but suffice it to say, foam is used all over the place – think about the cushions in your sofas, aeroplane and car seats, the soles of your trainers and if you ever lived without a dishwasher, then you have probably purchased a fair amount of foam yourself!

Also, producing foams is not easy – think precision manufacturing facilities where the raw materials (chemicals, elements and polymers) are treated (with other chemicals, elements and polymers) to produce the right density / performance product depending on end use.

But foam wasn’t able to soften the landing for Zotefoams, a highly rated stock that was recently brought back down to earth with a 36% drop in a single day.

Should I be foaming at the mouth or licking my lips???

The Cause

You guessed it, it was a profit (and revenue) warning in the trading update issued 3rd October.

“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.

Our High-Performance Products (“HPP”) business unit is performing as expected with strong growth in T-FIT® insulation products and ZOTEK® technical foams mainly in aviation and footwear.”

They hadn’t previously warned, but the interim results announcement did say that they were mindful of trading conditions.

Warning or not, those of us with a heartbeat and who watch these things could expect that suppliers to the industrials / manufacturing sector might be having a tough time at the moment, especially if their customers are in the aviation and autos sector.

Revenue expectations for full year 2019 are reduced from £90.5m to £87.1m, while 2020 is reduced from  £102.1m to £97.5m.

This compares with £81m delivered in the full year to December 2018

Profit expectations for 2019 and 2020 are each reduced by just over 10%, to £8.8m and £11.1m, respectively.

This compares with £8.33m in the full year to December 2019.

So far, so bad

Having previously traded at 25x, for a capital intensive chemicals business – is the drop overdone or was it the initial valuation that was overdone? Why did it command such a high valuation in the first place – see pre-warning multiples below.

(Insert rant here re: negative interest rates, mis-allocation of risk and mis-pricing growth and then carry on reading!)

Current Market Cap: 162.8m

I have used Market Cap / Net Profit to get to the below multiples.

Stockopedia has it at 16x rolling 12 month, so I agree with my figures!

                                                                2019       2020

Pre Warning P/E:                                    25.6        21.3

Post Warning P/E:                                  18.5        14.7

The real reason for the high rating was the very strong performance in the High Performance Products (HPP) business, growing 67% two years ago and approximately 40% in current year.

It represented 19% of sales in 2017, to 27% in 2018 and 30% at half year 2019.

I expect it could be as high as 44% in the H2 of FY 2019 and 37% of the full-year revenues. It also happens to be the higher margin business – operating margins at 20-25% versus 12 – 17% in the core business.

It would appear that on a quarter on quarter basis, given a 2m reduction in revenue vs 6m in Polyolefin, that HPP has delivered 40% growth vs half year to June 2018 and 36% growth vs half year to December 18.

HPP is approaching 50% of turnover, higher margin than the core offering and delivering > 30% growth.

The growth has been driven by the footwear industry, but as the recent trading update makes clear, the product is gaining traction in aviation and I expect it will extend to other industries – much like elite athletes want comfortable shoes, I expect elite travellers to want comfort for their posteriors and elite drivers, DITTO.

Considering where we are in the cycle and the fact that the business delivers revenue and earning growth even when the (historical) core business suggests a near 25% drop in revenue, gets me thinking about Peter Lynch.

One of the 5 classifications for Peter Lynch was the fast growers, and he specifically called out when a small division is delivering high growth such that it becomes a meaningful part of the total business.

If HPP growth is sustainable, this has the hallmarks of a Peter Lynch fast grower that is not always identified – specifically, one where a non-core business is growing rapidly and becoming a meaningful portion of revenues.

Zotefoams appears to have reached that stage (although, ideally it would do this without obliterating revenues from the core business).

The capacity enhancements made by the company would support the view that this growth is sustainable in the short to medium term, with improving margins and cash flow as the recent uplift in CAPEX won’t be repeated.

Clearly it wasn’t under the radar, given the pre-profit warning valuation, but a jittery market seems to have forgotten why it was rated so highly, incorrectly perhaps!

In a cyclical upturn, the core would return to growth, while they have a business growing > 20% with a >20% operating margin. Given recent CAPEX, growth should not come at the expense of free cash.

Is Polyolefin going to make a comeback and is the HPP growth sustainable – perhaps those with expertise in foam (use or production) can answer, but the numbers suggest to me that what we have in front of us, is growth at a reasonable price.

 

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COMMENTS

Wordpress (3)
  • comment-avatar

    Interesting peice Vivek.

    Zotefoams is something of a “specialist subject” for me so there are a few things I can add.

    (I do not currently hold the shares, although unfortunately I still held some immediately before the profit warning. A clear case of not following my own advice!)

    It can be quite difficult to understand the full scope of Zotefoams many end markets, but I’m pretty sure they don’t actually go into cushions – Worth ignoring that for the punderful opportunities though.

    More materially, you mention that the two main operating divisions represent 98% of turnover. They also represent 120% of the profits. The company contonues to believe that the opportunities for the other divisional (essentially technology licensing) are worth persisting with. I remain sceptical, but one way or another there is a 20%+ profit uplift avaiable at some point in the future.

    I tend to agree with you that this looks like a GARP opportunity, but I am personally steering clear for the moment.

    I have no reason to believe that the Polyolefin downturn is permenant, certainly the management don’t given the recent level of Capex for capicity expansion. However, it seems likely the downturn will extend well into next year and perhaps beyond. For that period the company is going to have substantial excess capacity and I cannot see that exciting the markets any time soon.

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  • comment-avatar

    Hi Tony,

    Many thanks for adding to the article. Wife buys the cushions, but I expect foam ones don’t make it into the house – you say punderful, I say artistic licence!

    Part of the reason, I can write this with a snug face is I sold near 600 – not that smug since I bought at 590!

    Re Mucell / licensing, I am of the view that the business can be shut down. There will be exit costs – exit will increase profit, but that is not sustainable so less relevant to future value.
    Given revenue profile I share your reticence, but I would treat this as an option which costs 1m per year in option premium.

    Timing wise I agree – not yet given cyclical considerations – I have no position – but I am monitoring (, cycle and valuation)

    Thanks again,
    Vivek

  • comment-avatar

    Good note. If you go back to the results statement March 2009 for 2008 volume foam fell 21% and the following year grew 25% automotive and construction did the damage then and seem to be the culprits this time but in 2020 HPP profits will exceed bulk and the gap widens so the growth story remains intact. The future is uncertain and bulk may not bounce back as quickly as it did back then but it will return at some point and that will not be in current downgraded numbers

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