Iceland - More than just energy
All,
Please find our updated model here.
Iceland remains one of the most popular names for you to converse on, with several differing views held even between you. The name remains divisive as we try to overlay Iceland’s unique position in the market as both a discounter and specialist frozen food retailer with headwinds from energy prices and general food inflation. Modelling and reasoning through these aspects, ensuing competitive dynamics and other issues some of you have brought up, we are coming to a view.
Recent results:
- We have previously published a short note on the back of the Q1 numbers released in early September but in summary Iceland divulged that there was a £19m impact from energy prices in Q1 (April-June) and this was likely to be replicated in Q2 (ending 9th September). Extrapolating these numbers and adjusting for further price increases, the energy headwind for FY23 is likely to be £100m.
- However, juxtaposed to the energy headwind, Iceland actually reported an improving Gross Profit margin up 130bps to 5.4%, pre energy impact, versus prior years. This has given the market some comfort and provided the basis for the recent rally in Iceland bonds.
- Additionally, the Company shared Nielson and Kantar data showing overall growth returning to the market due to inflation and softer comparisons. More importantly both sets of data show Iceland’s growth outstripping that of the market.
- Finally, although small, the Company disclosed one of the main shareholders, CEO Tarzem Dhaliwal, purchased £1.5m of the 2028 bonds.
Energy Headwind:
- Energy is the hot topic for all analysts and although the Company disclosed the impact for Q1 and Q2 (c.£20m per quarter) they didn’t offer any guidance for the remainder of FY23. We have estimated the energy usage per store, enabling us to estimate the full year impact is likely to be c.£100m.
- We do not envisage Iceland are going to be in a position to pass through all of these price increases in higher “selling margin” and have settled on c.50% pass-through. The remainder, c.£50m is the net impact to EBITDA for Iceland.
- Iceland are more exposed to energy bills with their over-weight frozen food focus. However, demand for frozen food improves in economic downturns, which may in turn improve the conditions for higher pass-through. This will depend on Iceland’s competitors and their willingness to increase frozen food offering.
- To put into context, we estimate it would require a 300bps improvement in selling margin in Q3 and Q4 to fully compensate Iceland for the impact of energy prices.
- We note however that the Company has very limited hedges beyond the end of September. The energy market in the UK has entered a period of illiquidity, as participants await further details of the government’s energy plan.
- Notwithstanding, we have used 4x increase in energy costs from FY20 to FY23. This is at the top end of recent market movements but we acknowledge the complete lack of liquidity in the market.
Pass-Through of COGS inflation:
- Away from energy, all retailers are experiencing significant increases in their cost of goods as suppliers seek to pass-through their increased costs from energy, reduction in yields and impact of the Ukraine conflict.
- As we highlighted in the brief summary of Q1 results above, Iceland actually reported an improved “selling margin” as they managed to pass through 100% of their suppliers' costs. This will be down to a couple of issues including reduction in promotional activity across the food retail sector.
- This is probably the most important assumption in our model and the level of pass-through willl determine Iceland’s ability to partially absorb the energy headwind.
- We are taking comfort that it appears from CPI inflation data and from comments from other food retailers, that none of the food retailers are entering into a price-war and are, in general, passing on the price increases to consumers.
Cashflow:
- Inevitably, with the energy headwind, Iceland’s FY23 operating cashflow will be lower.
- Still, the business could end FY23 cashflow neutral depending on their Working Capital movements and specifically their stock levels. Iceland guided to reduction in their stock levels over the coming quarters, albeit any reduction would take some time. Based on a c.£100m EBITDA figure, we forecast cashflow to be £17m negative, after a £33m outflow in working capital. In a rising price environment, all else being equal, working capital movement would be an inflow. We estimate an outflow due to impact of energy prices and stock levels remaining static.
- Additionally, this outflow is after £40m of CAPEX. Iceland does have the ability to reduce this and alluded to reduction in CAPEX spend in Q4. We have maintained the previous guidance in our model.
Other issues:
- Iceland have received significant press coverage from their partnership with the charity and ethical lender Fair for You. Iceland are not taking any credit risk in these loans but will be covering the cost of the interest that the Charity charges the borrowers. Iceland benefits as the borrower receives a credit note that can only be used in Iceland’s stores.
- There is no doubt this can and will benefit those deemed eligible but the overall impact on Iceland is limited. It does however cement Iceland’s market position and enables management to maintain a media presence.
Positioning:
- We bought 5% of Iceland 2025 at 92%, yield of 7.7%, as part of our rotation of risk in February. Hindsight is a wonderful thing but we have maintained our position over the summer as we viewed the sell-off was too extreme.
- We maintain our position at current yields and would expect the bonds to trade to 10-12% range (2025's having 6pts of upside). We do acknowledge there are significant headwinds to the business, and a return to recent lows can't be ruled out. However, with their strong cash position and favourable market position (discounter and frozen) top line sales should remain robust. The lack of a trigger in the medium term will always attract buyers at lower levels.
- We do envisage leverage continuing to increase for FY23 (7.5x) and FY24 (8.0x), due to the reducing EBITDA, potentially offset by +0.2x if Iceland can control inventory levels next year to remain NCF neutral (we project a £17m outflow, majority in Q4).
- Downside in the bonds is likely to limited with no upcoming maturities and limited debt ahead of the bonds. The bonds touched low 70’s in the sell off in August prior to the Q1 numbers.
- At 80% on the 2025’s the EV of the Company is £550m or 5.7x FY23 EBITDA, and we are comfortable at these valuation multiples.
- Refinancing is unlikely if leverage stays at 8.0x in FY25. Iceland will have to sell down its Restaurant Group (purchased for c.£40m in 2020). Overall, we would expect margins to normalise over time, which will reduce leverage beyond our forecast period.
- The Company are due to report their Q2 numbers (to 12 weeks ending 9th September) in early November. We remain conscious of the market’s perception of cost inflation and will be focusing on the trajectory of Selling margin, as defined by Sarria (excluding wages, energy and leases), and its ability to compensate for the expected increase in wage and energy costs.
Happy to discuss.
Tomás
E: tmannion@sarria.co.uk
T: +44 20 3744 7009
www.sarria.co.uk