Description

Devro plc is a high quality, niche food products manufacturer with attractive secular tailwinds selling at a significant discount to intrinsic value based on normalized earnings. The company, which manufacturers edible collagen casings used in the production of sausage and other meat products, occupies a strong position in its consolidated market which helps drive respectable ROIC (normalized in the teens; depressed by recent capital investment program). Due to the impact from a significant, multi-year investment program that is nearly complete, the company’s current reported earnings obscure the true underlying earnings power.

Devro is currently trading at a very attractive valuation: under 12x normalized earnings (estimated around 22p in 2018) with a 3.4% dividend yield. I think the stock is worth around £3.30-3.50 per share, which is equivalent to 15-16x normalized EPS, 13x EBIT and 10x EBITDA. This valuation is based on the company’s strong, sustainable barriers to entry and long-term secular growth opportunities.

There are no ideal comps but there are a few points worth noting:

• Spanish-listed Viscofan (VIS SM) trades around 18x EPS and 10x EBITDA

• Icahn Enterprises, LP (IEP) values its illiquid stake in Viskase (VKSC), a producer of non-edible casings, at 9x EBITDA in its NAV calculation

• Many branded packaged food companies trade around 20 EPS and 12x EBITDA

• Hormel (HRL) acquired Applegate Farms, a natural/organic prepared meats brand, in 2015 for an estimated mid-teens multiple of EBITDA

Devro manufacturers edible collagen casings used in the production of sausage and other meat products at 5 sites (USA, UK, Czech Republic, China, Australia) and sells to 1500+ customers in  100+ countries.  Devro’s manufacturing process consists of several key steps: collagen is extracted from animal hides, then processed into gel and finally extruded for use by its end customers. Emerging markets represent about â…“ of company sales. It is important to note that China, where the company is opening a new plant, represents around 40% of global collagen casing demand.

Artificial casing is an attractive market

Casings are used in the production of sausage and other meat products and represent about 10% of the meat processor’s cost. Publicly-traded Viscofan estimates the overall casings market is around €4.4bn split roughly 50/50 between animal gut and artificial casings. The artificial market segment includes cellulose/skinless, fibrous, and collagen casings, which are made from natural sources, and plastic casings.  

Spain-based competitor, Viscofan, manufactures all types of artificial casings and is the leader in artificial casings. Devro, which only makes collagen casings, is the #2 in artificial casings and leader in the consolidated collagen casing market (only 5 major producers) with around a third of the estimated collagen casing market. Historically, the artificial casings market has grown around 5% annually and is expected to grow roughly 3-5% going forward due to combination of population growth, urbanization, product improvement and increased meat consumption as well as a continued secular shift to artificial casings.  Artificial casings, and collagen in particular, have gained significant market share from animal gut over the past few decades due to several important drivers, including automation, cost, hygiene and traceability.

The larger industry participants appear to benefit from meaningful barriers to entry from production-related economies of scale. Furthermore, complicated regulatory requirements related to manufacturing and selling animal derived products into over 100 countries enhances the moat.

The attractive nature of industry is demonstrated by the financials: Devro and Viscofan, the two largest competitors, have respectable ROICs (teens and above).

Publicly-traded Viscofan has market information available on their website (http://www.viscofan.com/EN/inversores/Pages/default.aspx).

Devro is under-earning and investing for growth

The company is currently completing a three-year investment cycle to improve and expand the manufacturing footprint, which has significantly depressed operating earnings and inflated CapEx. The two main projects are located in the US and China.

Plant replacement in Americas

The company is replacing its “inefficient,” “unreliable,” and costly 37+ year-old plant in South Carolina, which serves North and South America, with a new facility. The transition to the new facility should be relatively low risk because the new plant employs the latest technology already used in its European facilities. The company expects the £50mm capital project to drive cost savings of around £8mm per year. Over time, the company should be able to drive increased share from the modern facility.

Despite having significant market share estimated around 35%, the Americas division’s financial performance has been extremely disappointing in the last few years. Adjusted EBIT margins were in the 3-5% area, which is well below the 12-20%+ the company earned in other regions and below peers (Viscofan had high 20% EBITDA margins and more commoditized Viskase had 17% EBITDA margins during this period).

New plant in China
The company recently completed a new facility, which will supply the premium segment in the domestic market. The company expects the £60mm capital project to drive around £6-7mm of profit per year.

Risks

• Industry excess capacity: the industry is working through excess capacity but management noted they are not aware of any new incremental capacity coming online (Goldman Sachs conference, May 2016)

• Processed meat demand could be challenged by health concerns:

• The World Health Organization (WHO) notes processed meat is carcinogenic to humans. The following Harvard School of Public Health page provides some good information on the WHO report: http://www.hsph.harvard.edu/nutritionsource/2015/11/03/report-says-eating-processed-meat-is-carcinogenic-understanding-the-findings/

• The FDA has proposed guidelines to reduce salt content in processed foods.

• Food safety/contamination/disease issues related to collagen supply chain and manufacturing process

Model

Below is a summary of my financial model:

Catalyst

The decline in operating and capital investments and a return on these investments should drive reported an normalized earnings higher over the next 4-8+ quarters.