Stockwatch: De La Rue up 350%, what now?

This is a relatively simple story, explains our analyst, who gives his opinion on the banknote printer.

Yesterday saw the biggest one one-day rise in percentage terms and price, in the last three years, for currency printer and security group De La Rue (LSE:DLAR) – with nearly 13% of its shares traded. 

A jump from a little over 40p at one point to about 145p looked a classic “gap-up” to the level which precisely matched the pre-Corona level in January/February, as if reaching this immediate target then triggered profit-taking to 120p.

But you could also see the chart now as a bullish “cup and handle” chart pattern; there has just been a positive trading update, and a capable new ‘turnaround CEO’ bought £51,589 worth of shares at 137p last November. In early dealings today, De La Rue advanced to 180p, and currently sits at around 160p. But what action should investors take, if any?

Source: TradingView. Past performance is not a guide to future performance.

A couple of market technical factors may be behind this rise. Monetary stimulus has helped fuel a speculative “risk-on” mood in the stock market, which De La Rue perfectly meets.

A squeeze on short-sellers is also possible – or perhaps buyers just sense this – given the stock had drifted down from around 60p during April and May rather than join the wider market’s rebound. Only one hedge fund has a disclosed short position over 0.5% of the issued share capital, at 1.1%. 

I drew attention to De La Rue as a “buy” last October at just under 200p, down from 670p three years ago, given a capable CEO taking charge of a business with globally leading positions, although I noted that timing entry was tricky. 

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Interim results to 30 September 2019, declared on 26 November last year, were weak as expected. Then, in February, the turnaround plan was declared together with guidance for adjusted operating profit in respect of the full year to end-March 2020, predicting a £20-£25 million range.

There was reassurance on headroom under banking covenants, albeit with a caution that this did not include the pension deficit liability. Full-year profit expectations were affirmed at end-March, for a strong turnaround after just £2.2 million operating profit in the first half-year.  

Strong start to the new financial year from 1 April

There has been a series of significant contract wins for both the Authentication and Currency divisions which affirms a sense of status-change – by way of modest re-positioning on these two, also their performance.

On 25 February, the company said that having divested the International Identity Solutions business last October for £42 million, Currency and Authentication would provide “two strong divisions with leading market positions and attractive opportunities for revenue and margin growth.” 

It further declared that in Currency, De La Rue enjoys a leading global position in polymer banknotes, selected by 83% of authorities using polymer, although this represented just 3% of the world’s banknotes by volume, so this could be a substantial opportunity.

De La Rue has also built a portfolio of industry-leading paper security features for paper note printing. Long-term followers will be aware, however, that the narrative has often been bullish along such a theme, only for disruptions to happen.

More is needed by way of consistency

In Authentication, significant growth in the latest year should continue for several more as countries adopt tobacco tax stamp schemes to comply with the World Health Organisation, while agreements for drinks tax applications are also targeted.

We are now told of a five-year agreement to supply polycarbonate date pages for a new Australian passport, and that De La Rue’s brand protection has been selected by an international customer to protect its Covid-19 testing kits.

In April and May alone, this division has won contracts with a total lifetime value over £100 million versus management’s target of £100 million revenue by the next financial year. “Strong operating margins” are anticipated. Looking back to 2019 revenues of £39 million this implies circa 40% compound over three years. 

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Strong demand has continued through the pandemic, with currency contracts awarded that represent some 80% of full-year printing capacity. Both product offerings and the cost base have improved, such that a mid-teens adjusted operating margin is expected in the current financial year.

Stock is de-risked if progress can be sustained

Bear in mind, the loss of the UK passport production contract in the last financial year was “a material contributor to profitability,” although it sounds like is being substituted.

Crucially, if stronger, more consistent trading is maintained, then it de-risks a stock with a notorious reputation for upsets that it could not afford given a balance sheet of accumulated liabilities.

This is the chief reason behind the stock’s rebound (monetary stimulus and belief in chart witchcraft accentuate it, perhaps). If necessary, then a re-financing, whether by debt or equity, can plug remaining issues that cash flow can’t.  

A cynic inside me says it’s not unhelpful to be putting out a bullish message ahead of a likely messy set of full-year results on 17 June, certainly if the classic share issue aspect of a turnaround plan is being pursued.

Before this latest update, the City consensus had looked for £18.8 million of net profit in the current financial year, with normalised earnings per share (EPS) of 17.4p, which might even get upgraded in due course.

We’re told the business is not materially affected by coronavirus and prospects for the current year look to be improving. So, at around 160p, the stock could be on a price/earnings (PE) ration lower than 9x, albeit there is no dividend. EPS recovery is helped by a moderate 104 million shares issued, so no major hurdle of dilution for retail investors.

A window of opportunity for a takeover bid looks to be opening, where success would likely require an exit PE plenty higher, although a bidder’s identity could create issues. For example, even as the pandemic appears to abate in developed countries, how many such clients would trust a Chinese owner of banknotes and security matters? Takeover speculation is likely though, given De La Rue’s strong market positions.

Cost reductions are also fuelling turnaround

A round of cost-cutting is expected to significantly complete by this August – with annualised savings of around £35 million to kick in during the second half of this financial year (exceeding and accelerating prior cost reduction commitments of £20 million by the 2021/22 financial year).

Mind that the cash cost of all this will be around £17 million, to be taken in the current financial year – this explains a big disparity between reported and normalised profit, even come the June 2021 prelim results.

The stock had also fallen since last autumn due to interim results cautioning of “a material uncertainty casting doubt on the group’s ability to continue as a going concern, should the net debt to EBITDA ratio fall below 3.0” – hence dividends were suspended. But the CEO then bought 37,500 shares at 137.6p, and the company secretary 44,120 at 139p, promising business would become leaner and more efficient, its revenue decline reversed.

Balance sheet will have benefited from £42 million cash

De La Rue’s end-September position had shown a broadly similar net assets deficit of £24.3 million, albeit with material changes within the profile of short-term liabilities: borrowings up 76% to £180.9 million, while trade payables fell 20% to £154.5 million.

Total current liabilities of £379.4 million compared with £227.7 million current assets, hence a current ratio slightly deteriorated to 0.6 from 0.7. However, October’s receipt of £42 million cash would have mitigated strain. 

There is no capitalised goodwill, and intangibles were a modest £31.9 million, which pushed net tangible assets further into the red at £56.2 million, or minus 54p.

An end-March trading update then cited net debt at around £105 million, including full payment of a pension contribution, enabling “a good level of liquidity headroom under a £275 million revolving credit facility which expires in 2021.

Risks of a hard Brexit also a SFO investigation

Management has made clear that a large proportion of its supplier base is in the EU, as regards changes in customs and VAT, hence there are likely to be concerns as both the EU and UK dig their heels in during Brexit negotiations.

A Serious Fraud Office (SFO) investigation into suspected corruption in conduct of business in South Sudan, was declared last July, the example of Petrofac (LSE:PFC) showing how they can drag on for years.

After such a rebound, it is likely the stock consolidates as traders take profits and investors seek more evidence.

But, as the pandemic is said to be having only a limited impact on operations, with currency printing is at 80% of capacity, De La Rue does look relatively attractive compared to plenty of other stocks that are either affected, or over-priced.

This is a relatively simple story to grasp, of a business with strong market positions that does finally appear to have a capable boss exacting a turnaround. So, I’d retain a ‘buy’ stance and take advantage of whatever dips occur.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.