(Debtwire) Iceland stable 4Q and working-capital gain set to slow rising leverage but minimum wage threatens further earnings erosion

06 March 2020 | 10:35 GMT

Iceland earnings have steadily fallen in recent years, partly driven by continuous National Living Wage pressures, causing net leverage to creep up, while a lack of disclosure on like-for-likes clouds underlying performance. But the UK frozen food retailer is guiding towards a 4Q working capital boost and flat YoY quarterly earnings while a reduction in capex next year should also help keep metrics in check, leaving its bonds a reasonable hold at an enticing 11% yield, according to two analysts and buysider, with a second buysider cautious.

The company held an earnings call on Wednesday (4 March) to discuss its 3Q19/20 results for quarter-end 3 January. EBITDA was down 7% YoY at GBP 36.8m, with LTM 3Q19/20 EBITDA of GBP 133m pushing net leverage up to 5.5x from 5.4x last quarter. Management noted that earnings in 3Q19/20 were hit by increased deep-discount voucher promotions.

Iceland’s earnings have been in long-term decline. Its 3Q19/20 LTM adjusted EBITDA of GBP 133m is down from GBP 140m at FY18/19, GBP 157m at FY17/18, GBP 160m at FY16/17 and a whopping GBP 202m at FY13/14. Adjusted EBITDA margins over the same period have reduced to just 4.2% from 7.5% back at FY13/14.

The group has been grappling with cost pressures from the rising National Living Wage in recent years with FY18/19 wage and salary costs for Iceland reaching GBP 316m. From April, the National Living Wage for ages 25 and above will increase 6.2% to GBP 8.72, leaving further cost pressure headwinds going forward.

“LTM 3Q19/20 Adjusted EBITDA margins are 4.2% so the National Living Wage rise can be a large part of EBITDA, it is going to happen and will be a headwind. FY13/14 adjusted EBITDA margins were 7.5% so recent National Living Wage increases have eaten into EBITDA margins each year and why would it stop impacting EBITDA all of a sudden if there is the same cost pressure,” one of the buysiders said “They can improve efficiency to some extent and capex being lower is nothing new while they will generate cash in FY20/21, but the problem is the cost headwind, which is impacting underlying EBITDA each year.”

“The results were spot-on. EBITDA was in-line with expectations and the company is proving pretty resilient and even winning a little market share. They are slowing expansion which should lead to better margins and operationally it is quite a stable story, tracking our expectations. So we are fine. The National Living Wage is a concern, as it is for the whole industry,”a person from independent deep-dive research firm Sarria countered. “They pay above minimum wage, because it is difficult to get part-time staff and as the minimum wage steps up, their costs should step-up too. Our concern is the heavy voucher use that occurred in direct response to other retailers doing the same, as well as Iceland trying to shift stock. This has hit margins.”

Ready for business

One positive tailwind that could offset any sustained rise in the National Living Wage could be a reduction in business rates by the UK government. Chancellor Rishi Sunak has received a written letter from business leaders calling for a number of reforms to business rates ahead of the upcoming budget, according to a press report. Management noted on the earnings call, in response to an analyst question, that there would be a GBP 20m positive operational impact if UK business rates were cut by half.

Management also stated that while Iceland won’t recover the GBP 7m year-to-date YoY decline in earnings for 9M19/20 in the fourth quarter, adjusted EBITDA should be broadly flat YoY in the fourth quarter, which is generally the largest one seasonally. 4Q18/19 adjusted EBITDA was up at GBP 52.5m.

Though earnings have been flagging, the group continues to trade reasonably when considering the tough market conditions. Management noted that Nielsen reported that sales growth over the 12 weeks to 28 December 2019 was the weakest since 2014 while Kantar data for the twelve-week period ending 29 December showed the total grocery market grew by just 0.2%.

One headwind could be its planned reduction in new store openings next year. The group opened 46 new stores in 9M19/20. Iceland no longer discloses like-for-like sales indicators on its existing store portfolio.

“I’m looking for an entry point and the concern is whether they can keep earnings stable. If  they do then great, but I’m a little concerned about the medium-term trajectory, which is not so great. The UK grocery market is not so easy and is low margin with other discounters being aggressive. So while they could get a short-term boost from the coronavirus with more people shopping, leverage is high,” the second buysider said. “A reduction in business rates could also be a source of earnings upside.”

“[UK restaurant chain] Pizza Express was a great business with a value proposition too, the problem is the National Living Wage. They can increase prices but retail is such a complicated business and there is no price inflation so it is difficult to pass on cost increases to the customer. They will generate cash, but net leverage is 5.5x and the National Living Wage will hinder EBITDA,” the first buysider countered. “It is not just Aldi and Lidl who are cheap too, I go to Aldi, but it doesn’t strike me as much cheaper. These bonds will range trade and 4Q EBITDA will be flat, which is not disastrous, and they are good operators. The only hope is that business rates reduce – however, I do not see local authorities bailing them out.”

Metric freeze

Despite the reduced earnings, management reaffirmed its guidance of net debt being flat YoY for FY19/20 despite some upcoming challenges such as a Swindon depot spend, meaning stock levels could be slightly higher resulting in GBP 4m additional fixed costs in FY20/21 and an impact of GBP 6m extra inventory.

Iceland expects a working capital release in 4Q19/20 even if the overall working capital move for FY19/20 will still have been a cash outflow. Iceland had a GBP 33m working capital outflow for the 9M19/20 period.

Positively, the group guided that capex for FY20/21 will be less than GBP 50m, versus the GBP 60m guidance for FY19/20, helping to boost the cash generation potential. Iceland still will be a cash-generative business based on GBP 133m 3Q19/20 LTM EBITDA, given it faces GBP 50m capex, GBP 41m interest and GBP 10m cash taxes, which suggests it could throw off around GBP 32m of free cashflow, ie 0.25x deleveraging per year if earnings stay steady.

Liquidity is steady with GBP 85m cash on balance sheet and access to its undrawn GBP 30m committed revolving credit facility maturing in 2021, while Iceland also has GBP 20m of additional uncommitted financing, according to a Debtwire analyst report. The group still targets paying down its GBP 40m outstanding E+ 425bps senior secured 2020 FRNs with internally generated cash, though management noted that if working-capital swings were volatile, they have a lot of options.

“We remain confident and expect Iceland to deliver around GBP 130m adjusted EBITDA for FY19/20. 4Q19/20 will likely be flat YoY and while leverage is up on the new warehouse, they generate predictable cash. There is no chance of business rates decreasing, so I’m not overly optimistic they’ll get any benefit,” Sarria said. “But the reduction in new store spend should impact sales growth as like-for-likes seem to be negative on the existing stores. Can they grow organically without store expansion? Perhaps not the top line, but we see room for better margins on product mix and store maturity."

“The problem is not management, who are doing a great job, but the cash generation is less than it used to be given the reduced earnings, and the cash generation used to be the reassurance,” the second buysider said.

Taking stock

Management noted that as a result of the coronavirus, the online business has performed well in the past four to five days and it cannot see any obvious impact from a stock point of view, though it may order more stock soon from places such as Italy given the current situation.

It remained tight lipped on possible plans by its South African majority shareholder Brait, which is undergoing a debt restructuring, to sell the business. “We are running the business for the long-term and we have met new investors with Brait, but it is business as usual,” management noted on the earnings call.

Concerns over a 10 December charge by HSBC taken on around GBP 20m of cash deposits were downplayed. Management noted the cash had been held with the bank for a long period of time and now a charge was being put on it.

Iceland’s GBP 200m 6.75% senior secured 2024s lost four and a half points to 83.5-mid yielding 11.7% and the GBP 550m 4.625% senior secured 2025s are four points lower at 76-mid yielding 10.9%, according to Markit. The group bought back GBP 5m of its 2020 FRNs on 18 November and aims to repay the outstanding GBP 40m with internally generated cash before their maturity date.

“This is a very well-run business with cashflow well defined, but the key problem is the National Living Wage. Kantar data is weak, but the value proposition is well defined. I go to Iceland almost every weekend and it is cheap and good. Categories there are doing well and frozen is doing okay – the problem is not that the business is becoming irrelevant,” the first buysider said. “Last year, wage and salary costs of GBP 316m were large and it was mainly people on the National Living Wage. If the National Living wage increases over the next few years at a few percent a year then there will be a large impact over the next five years.”

“Net leverage is high, and the enterprise value is also not so high,” the second buysider said. “The sponsor has been supportive and bought out minorities previously, but the same multiple may not apply now, and they had previously changed the strategy with more premium products, but they have not been so nimble. I want to buy this name, but earnings could easily be lower.”

“It could have been worse,” the second analyst countered.

Iceland declined to comment.

by Adam Samoon