Bakkavor - investing in its UK desserts business.

Bakkavor - investing in its UK desserts business.

The publication of UK private-label supplier Bakkavor's first set of annual results since it floated on the London Stock Exchange late last year revealed higher revenues and profits. But what about the company's future prospects? Andy Coyne reports.

2017 significant year for Bakkavor

Or an "historic year" as Bakkavor CEO Agust Gudmundsson put it in a statement accompanying the publication of the UK-based private-label group's 2017 results on Wednesday (28 February).

"We have transformed the group, fully refinancing our lending facilities and listing on the London Stock Exchange, positioning us well for future growth," he said.

"Our strong trading performance, in a highly inflationary environment, reflects both our market-leading expertise in great tasting food and the strong strategic partnerships with our customers."

Generally, the figures explained his buoyant mood. Revenue was up 5.4% to GBPGBP1.8bn (US$2.5bn) on a year-on year basis while adjusted EBITDA  was up 4.2% to GBP152.6m and adjusted profit before tax up 13.2% to GBP84.8m. 

"Good numbers, particularly as we are in a tricky market," is the way recently-installed chairman Simon Burke put it.

Chief financial officer Peter Gates told analysts and investors in a post-results call 2017 "was a year of strong underlying revenue growth and profitability has moved on again".

The company's net debt level was also reduced - from GBP366.9m in 2016 to GBP266.6m - which resulted in lower interest payments, while money has been spent on infrastructure projects in its three markets, the UK, the US and China.

Bakkavor listed last autumn, the latest chapter of a very eventful period for the business. 

Lýdur and Ágúst Gudmundsson, the brothers that founded Bakkavor back in 1986, were also the co-founders of Exista, the biggest investor in the Icelandic lender Kaupthing that collapsed during the country's economic crisis of 2008.

During the height of the crisis, the Gudmundssons bought shares Exista held in Bakkavor, a deal that sparked allegations from some of Exista's creditors the price they paid for the stake was too low.

In the spring of 2009, Bakkavor, saddled with debt, issued a warning about the future of the business as a going concern if discussions with its own lenders fell through.

Bakkavor spent much of the next few years restructuring its manufacturing network in the UK and offloading assets overseas. In early 2016 US hedge fund Baupost Group became a "significant" shareholder - although the Gudmundsson brothers remained controlling investors.

A refinancing of Bakkavor's lending facilities took place last year and then, after a false start, the IPO took place in November.

CEO Gudmundsson said going through the IPO process led Bakkavor to look again at its strategy, which amounts to "developing the business in the UK, US and China and operational efficiencies". He added: "The focus is on strengthening our partnerships with key customers."

Following this week's results, the reaction of analysts seemed to suggest they are reasonably happy with what has been achieved thus far. 

Charles Hall at Peel Hunt said: "The full-year results were in line with expectations, with EBITDA +4.2% to GBP152.6m versus our forecast of GBP151.8m. 

However, he added: "The rate of volume growth year to date is slightly slower than hoped as inflationary costs have been passed on." 

While Karel Zoete, an analyst at Kepler Cheuvreux, said: "The 2017 results met our expectations and guidance from the company at the time of the IPO. As expected, profit growth slowed in H2, based on a more difficult comparison base and the impact of cost inflation. As a result, Bakkavor raised prices but volume growth came down and the margin was stable year-on-year in H2 2017." 

Home provides comfort (and headwinds)

In the UK, by far Bakkavor's largest market by sales, the company supplies products in four categories - salads, ready meals, pizza and bread and desserts - on a private-label basis to retailers such as Tesco, Sainsbury's and Marks and Spencer.

The UK generated GBP1.63bn of Bakkavor's full-year revenue in 2017, up 4.6 % on the previous year.

However, the company faced issues in 2017 relating to inflation and labour costs and those headwinds are likely to remain for at least the first part of this year.

Gudmundsson said: "The second half of 2017 saw volume growth impacted as UK consumers reacted to significant inflationary pressure."

He added in the presentation to analysts that inflation was especially linked to the dairy market, which affected Bakkavor's desserts business.

"Inflation has had an impact on our desserts as dairy prices have rocketed," he said. "Cream prices have doubled."

Gudmundsson said Bakkavor has "worked with customers to minimise the impact". CFO Gates was candid. "It has not been easy. There were difficult conversations to be had."

Bakkavor will hope the pressure on its dairy commodities bill improves in 2018 as towards the end of last year work started on a GBP35m expansion of its desserts facility in Newark, Nottinghamshire. It is due to be completed this year.

In the post-results presentation, meanwhile, Gates said in the UK "labour costs continued to rise because of the increase in the National Minimum Wage".

Gudmundsson called the impact "significant".

Overseas growth is going to be crucial

Bakakvor's two international markets, the US and China, account for only 10% of the group's business but it is investing in new facilities both countries, which should allow it to increase capacity to provide more product to its existing clients.

The company supplies the retail and foodservice markets in both countries.

In the US, a new GBP31m meals facility is being built in San Antonio, Texas on the back of supporting a new "key customer". It is scheduled to start production later this year. 

And work on a new bakery facility in Charlotte, North Carolina, has already started and it too will be operational later this year.

In China, meanwhile, Bakkavor is spending GBP20m on a new factory in Haimen, in the east of the country, while it has also committed GBP3m of investment in a new bread facility near Shanghai that has recently started production.

The two markets generated GBP178.5m in revenue in 2017, up 2.8% on the prior year. Bakkavor touted the potential it sees in the two countries.

CEO Gudmundsson said: "The demand for fresh, chilled food is growing quickly in the US and China. In the US customers are increasingly switching away from frozen to chilled."

Responding to an analyst, Gudmundsson said it is easier to pass on increased raw material and freight costs to customers in the US than the UK because the business there is still quite niche, catering for a more upmarket demographic.

"In the UK it is more mainstream but in the US we are still very much in stores which cater for people on higher incomes so it is easier for us to pass on our costs," he said.

Turning to China, Gudmundsson said: "The biggest obstacle to growth for our customers there is supply - which strengthens our relationships. The new facility there will increase our capacity tenfold, which is absolutely necessary."

2018 likely to be a year of two halves

It was clear from their presentations to analysts that Gudmundsson and Gates see the same headwinds that affected the business in 2017 to continue for the first six months of this year with things picking up in the second half.

"Later in the year, we expect our volume growth to benefit from improved market conditions and new business," said Gudmundsson, "We expect to see dairy prices coming down in the spring."

Gates added "it will be a tale of two halves again like last year".

But adding an additional optimistic note, the CEO said: "Despite these industry-wide challenges, we are confident that our scale, track record of innovation and focus on operational efficiencies ensures we are well placed to deliver ongoing profitable growth, both from existing business and our long-term investment strategy."

Slightly longer-term concerns may relate to the behaviour of the group's key clients, particularly in the UK, as they adapt to changing consumer habits and the increasing threat from discounters and online retailers.

Gudmundsson said: "We need to keep a close eye on market dynamics and consumer behaviour. The focus on health and wellness continues to evolve. We have responded with new ranges of plant-based meals, salads and wraps," he said.

Asked about Bakakvor's relationship with its key customers, Gudmundsson said: "The trend in recent years is to work closer together. The main driver [for them] is to find savings and drive value in the categories.

"It's about saving money in the supply chain. It could be as simple as how many cases we put on a pallet.

"They are facing an uphill struggle with their models because of the discounters etc. They need to cut costs and do things more efficiently."

A lack capacity to expand Bakkavor's customer base may also be a concern to those watching the company closely.

Questioned by Barclays about whether Bakkavor has the ability to pick up contracts from rivals, who may be reconfiguring their businesses, Gudmundsson said: "There's a lot going on in the industry but we don't have a big chunk of capacity at the moment to take on new customers.

"We would have to invest if there is a big shift but there is nothing big on the horizon. There is no low hanging fruit available to us."

The company is also unlikely to see the benefits of its investment in infrastructure - at home and abroad - in 2018.

Gates said the big projects will not deliver "massive numbers" until the second half of 2019. 

"These are long-term investments," he said.

Analysts seem relatively sanguine about the company's prospects for 2018 and beyond.

Zoete at Kepler Cheuvreux is still concerned, though, about the effect of inflation. He said: "Bakkavor provides a somewhat cautious guidance for 2018, as the business is dealing with a high level of cost inflation.

"In H1 2018, cost inflation may hamper volume growth as cost increases are passed on; in H2 2018, Bakkavor sees improving volume growth."

While Hall at Peel Hunt said: "Volumes should accelerate through the year as input cost inflation eases and the company will also benefit from new business wins. 

"The company has passed through the higher input costs as expected, however volumes are currently slower than hoped in the UK as retailers focus on margin improvement rather than promotional activity. 

"A number of commodity prices have now eased (eg dairy), albeit this is yet to be passed on to consumers."

Nevertheless, looking further ahead, Hall suggests the prospects for Bakkavor in the US and China could be rosy.

"[There are] huge opportunities in China and US, which could expand significantly over the next few years on the back of new plants due to open in the current year."