A weak pound and trouble at the toy factory has seen the tiny trainmaker's profits plunge…
Hornby (LSE: HRN) reported its final results this morning, and they don't make great reading.
Management seem to agree -- they've skipped the final dividend payment to bolster the balance sheet against further trouble ahead.
The share price is unmoved at 100p as I write; investors presumably anticipated the dividend cut after March's warning that interminable problems with Hornby's Far Eastern supplier and the weak pound meant profits would slide by £2 million.
The warning proved accurate, and at least there were no new skeletons in Hornby's cupboard. Instead it's stuffed full of the usual trains, Scalextric and Corgi cars, and Airfix and Humbrol model kits.
Indeed, older investors needn't visit a car boot sale to reconnect with their youth -- they can just read Hornby's reports. But is that reason enough to own the shares?
Sounding the horn
Hornby has followed a simple and successful strategy in recent years. Starting with its trains, it has outsourced the manufacturing of well-loved toy brands to China, then traded on a nostalgia premium for British and more recently European playthings. An awkward balancing act, but one that has proved profitable:
| | 2004 | 2005 | 2006 | 2007 | 2008 |
|---|
| Turnover (£million) | 39.0 | 45.0 | 44.1 | 46.9 | 55.7 |
| Operating profit (adjusted) (p) | 6.4 | 7.7 | 8.0 | 7.9 | 9.4 |
| Earnings per share (p) | 11.7 | 14.3 | 15.1 | 14.2 | 15.6 |
| Dividend per share (p) | 6.0 | 6.4 | 7.3 | 7.9 | 8.3 |
Like a little train puffing up a Welsh mountain, turnover, profits and dividends all rose steadily.
It would be opportunistic to call the last 12 months a train wreck by comparison, but you could certainly say profits have been derailed:
| | 2009 | Change |
|---|
| Turnover (£m) | 61.6 | +10.6% |
| Operating profit (adjusted) (p) | 6.9 | -26.6% |
| Earnings per share (p) | 11.0 | -29.5% |
| Dividend per share (p) | 2.7 | -67.5% |
That 27% decline in profits has wiped off several years of growth. Not good, as CEO Frank Martin admits:
"This has been a challenging year for Hornby. As a result of the weak pound and continuing supply chain issues, our profits and margins have come under pressure. […] Our supply chain issues are a source of frustration but we remain committed to and are making progress towards the implementation of a satisfactory solution."
We can excuse Hornby the extraordinary weakness of the pound -- although it's worth watching. Was outsourcing unsustainably effective in earlier years due to sterling's strength? Watch this space. For now Hornby is increasing prices to bolster its margins.
Those supply issues are more fundamental. The woes stem from its largest vendor running into difficulties after being leveraged-up by a private equity acquirer in 2004. Hornby flagged up the problem 18 months ago, and it even looked into acquiring the supplier in 2008 -- not exactly in the outsourcing business plan.
An established toy company based in Hong Kong bought the supplier in January, and more recent difficulties have arisen from the disruption to the supply chain caused by this new owner integrating its purchase. Hornby says has established a good working relationship with the new owner, but also that it has found other companies to diversify its supply chain.
That's good news, but I'd have liked to have seen contingency plans in operation a year ago. Also, using more suppliers will surely increase Hornby's overheads and reduce its margins, though it looks a price worth paying.
Tracking increasing debt
The other problem flagged up by the results -- though barely alluded to in the commentary -- is debt.
Actually, I say the directors gloss over it, but suspending the final dividend is a signal they know Hornby's debt burden is vulnerability, even if they blame the cut on the volatility of the pound against the Hong Kong dollar.
Hornby ran with little debt for most of its growth years, but this happy state ended in 2008 with its purchase of Corgi for £7.5 million cash. Borrowings have leapt to £7.2 million, with interest payments amounting to over £800,000 over the year.
It's far from a fatal situation -- the interest bill is covered by profits over eight times, and 23% gearing is not excessive. Hornby says it has "improved the security" of its banking facilities, and there are no immediate concerns from the debt. But I'd rather it wasn't there.
All aboard? Not yet
The good news is sales are still growing, lending credibility to management's claims that Hornby is a fairly recession proof company.
Profit of £6.9 million and a £60 million turnover is not to be sniffed at from a company valued at £36.9 million. The P/E ratio is 9.
Hornby enables investors to buy into a specialist consumer company with iconic brands -- a rarity on the British stock market. And those following earlier chapters of the outsourcing story did very well -- shares increased tenfold between 2001 and 2004, from 27p to over 270p.
With the shares now at 100p, can Hornby take off again?
It's certainly possible. Hornby says the U.S. opportunity for Corgi is bigger than expected. The huge American market will always get investors salivating. There are also more licensing deals spicing things up -- a new Scalextric tie-up with Brawn GP could prove lucrative before the F1 season is out.
But I'd want to see those supply issues put to bed before I'd consider buying the shares.
If Hornby can't return to consistently meeting customer demand while turning a growing profit, I'd wonder whether the earlier outsourcing transformation was a fluke, or perhaps too complicated to replicate across Hornby's widening range.
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