Tuesday 09 June 2015 by William Arnold Company updates

McPherson’s Ltd releases FY15 profit downgrade

McPherson’s (MCP) has released a trading update to the ASX revising down its FY15 forecast.  Underlying pre-tax profit was forecast to be around $21.7m-$22.8m for the full year to 30 June, however this figure has now been revised down to ~$15.5m-$16.6m

Whilst disappointing, the ~$6m reduction in pre-tax profit is manageable and importantly the majority of the issues that caused the profit downgrade appear to have been resolved, although we will seek to probe in greater detail the management and system issues that led to many of these negative adjustments. Table 1 details the actual and forecast underlying pre-tax profit.

MCP underlying pretax profit
Source: FIIG Securities, Company reports

As demonstrated by the timeline below, this is the first update to the market since the bond issue in March 2015 and according to management the need to downgrade guidance relates to unexpected market and management developments that have occurred in the last few months.

Timeline

24 Feb 2015:  MCP announced 1H15 results to the market and gave guidance that underlying pre-tax profit for FY15 would be 5-10% above underlying pre-tax profit for FY14 of $20.7m (i.e. $21.7-$22.8m)

20 March 2015:  MCP announces the $60m FIIG-led bond issues and in the webinar presentation the CEO confirmed FY15 guidance of 5-10% above FY14

4 June 2015: MCP announces to market that FY15 pre-tax profit would be 20-25% below FY14, meaning a revised underlying FY15 profit before tax of $15.5-$16.6m

A conference call with the CEO and CFO was held last Friday (5 June 2015) in relation to the update.  Ultimately the ~$6m reduction in profit was caused by a combination of market conditions and internal failings/over optimistic management.

The following points are taken from the ASX release as factors affecting the second half results.  We have commented below each. 

  1. “A significant delay in the acceptance of price increases by some customers; however, new pricing arrangements are now largely in place, which will improve future profitability.”

    Negotiations on contracts and prices continued longer than expected in the Household Consumables and Health and Beauty divisions.  The company expected to capture revised profitable pricing for at least a couple of months in this financial year.  This did not eventuate however contracts are now in place reflecting increased pricing from 1 July 2015.

  2. “Protracted negotiations with customers to remedy the adverse effect of commodity pricing and the AUD/USD exchange rate on the viability of private label contracts. Margins on private label contracts have now been improved, while some other contracts have been exited.”

    MCP has been in long running negotiations since last calendar year with clients in the low margin grocery sector where buyers have significant market power.  Again these negotiations took longer than expected however increased pricing has now been agreed upon commencing in May.  Additionally unprofitable contracts have not been renewed.

    Together, the two above points contributed an estimated $1.7m to the revision.

  3. “Increased promotional expenditure in key accounts in the last quarter to support the establishment and growth of newly acquired brands in a challenging trading environment, which will benefit these brands going forward.”

    Market conditions drove the decision to spend an additional ~$800k on promotional activities with the benefit of this expense expected to be seen in FY16.

  4. “A delay in re-establishing the Australian distribution of some key fine fragrance brands; however, the success of recent product launches indicates a return to growth and a significantly improved outlook for these products.”

    While agreements are in place to supply in this sector, it was found that previous supplier stock has taken longer than expected to run out of the system.  I.e. older non-MCP stock took longer to clear therefore longer than expected for new orders to come through.  This segment was also impacted by issues a key buyer was experiencing with its ordering and stock management systems.  Overall, this has led to circa $1m in reduced underlying profit.

  5. “The performance by the Home Appliances division being below expectations. The recent appointment of a new chief executive, significant restructuring and various initiatives with customers and suppliers have materially improved this division’s outlook for FY2016.”

    Disappointing sales to a key prospective client caused $0.5m less profit than expected as that client struggled to gain market share.  The company is confident of driving sales with this client however we continue to be hesitant on the prospects for this new entrant and its ability to ramp up sales.

  6. “Increased costs re-shaping the New Zealand operation. The appointment of a new divisional manager, the recent outsourcing of the logistics function to a third party provider and the transition to McPherson’s primary ERP system, will provide a solid base for improvement in FY2016.”

    The group experienced poor management of its NZ operation including discovery of and the need to subsequently sell obsolete stock. This has negatively impacted profit by approximately $1m. As mentioned in the ASX release, previous management and systems have been upgraded, although the fact this occurred is of concern and does not reflect well on management. As mentioned above, we will seek to understand in greater detail how and why this occurred and assess whether the measures already taken are sufficient. 

  7. “While the company is in the process of defining the extent of further structural reform, these initiatives will lead to net non-recurring expenses that will impact the company’s statutory FY2015 result.”

    “In light of historically low interest rates, the company has established a new five year fixed interest rate swap agreement. This will reduce interest expense in FY2016 and FY2017, but will result in a one-off non-cash cost of approximately $1.6 million impacting the statutory result in FY2015.”

The company has also highlighted additional one-off costs.  There will be non-recurring expenses relating to restructuring estimated to be less than $2m (however the figures have not been finalised) and there also will be a non-cash component of $1.6m relating to interest rate hedging.

The company has advised they remain within their banking covenants.

Conclusion

Whilst disappointing, the ~$6m reduction in pre-tax profit is manageable and importantly the majority of the issues that caused the profit downgrade appear to have been resolved.  Most notably price increase negotiations are complete and will be realised going forward. Further, a number of the expense and restructuring decisions made in 2H15 are expected to see improvements in FY16.

While management are not providing guidance for FY16 at this stage (this is expected to be released to the market at the Annual General Meeting on 18 November 2015), on the information at hand we are reasonably comfortable that this does not represent a significant downturn in the underlying business of MCP but rather is a function of a number of one-off items, many of which have been resolved. Having said that, there are clearly headwinds in certain sections of their business, with the ability to pass on price increases continuing to be a key variable as the Australian dollar weakens and the domestic retail economy continues to exhibit sluggish growth and high levels of competition. 

There have also been some management issues and potentially optimistic forecasts that have led to some of the downward adjustments which are of some concern. We note that changes have been made in a number of senior management positions. 

Of most importance is the full FY15 results release and guidance and whether earnings will see MCP returning to previous forecasts for FY16 (EBITDA $30m+) which would provide additional comfort that this downgrade relates to non-recurring items as opposed to a more significant deterioration in some areas of the business.

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