Iceland - Energy payout - Positioning
All,
Please find our updated pdf analysis here. Due to a technical problem, we can only upload our updated Excel from next week. We will send a note advising when available.
We will extend our model to FY25 and FY26 in the coming weeks but have shared our updated model plus a change in our positioning. Previous discussions with clients have centred on the ability to refinance the bonds in 2025 as part of a full refinancing. With recent numbers and strong justified guidance for FY24, refinancing risk is dissipating. In light of our increased confidence, we are rotating our long position in Iceland from an original 5% NAV in Iceland 2025 (bought at 72% in March 2020, exiting at 97%) to a long 5% position in the 2028 at 81%, taking some money off the table. Refinancing is still a risk, but with Company guiding a strong rebound in EBITDA a refinancing in 2024 is highly likely.
Investment Rationale:
- We are rotating our 5% long position in Iceland 2025's into the 2028's at 16pts differential (exiting 25's at 97%, buying the 28's at 81%. This is a result of limited upside in the shorter-dated bonds. We continue to see good momentum in the name over the coming quarters. We would expect 5pts of upside plus coupon, c.11% IRR to March 2024.
- We expect the Company will buy back bonds between now and December 23. There is no reason for holding such high cash balances and we expect buybacks to occur as long as there is some stability in UK energy prices. Iceland are 95% heldged for energy in FY24, but energy remains a significant indicator of confidence in the UK market. We expect further positive Kantar numbers over the next couple of months which will aid the name.
- Concerns relating to Iceland's liquidity are overdone, and we don't envisage Iceland drawing on its RCF at all over the next 18 months. In addition, Iceland are stating "We are confident that our EBITDA in FY24 will be above that achieved in FY22". We don't share that optimism but do see EBITDA improvement throughout FY24, albeit slightly missing this target. This is due to give up of "selling margin" in FY24 as energy prices reduce.
- Downside: We have some outstanding questions in relation to their trade financing/reverse factoring facility. The Company acknowledge its existence, and quote usage at c.£100m of the £120m facility size, with average usage c.£50m throughout the year. Majority of its usage is by trade/food suppliers and we have included £50m as equivalent of super senior debt. However, Iceland has sufficient liquidity to deal with any sudden withdrawal of the facility and we have tweaked their working capital over FY24 showing the Company has sufficient liquidity.
- We remain vigilant on a reduction in selling margin for Iceland in the coming quarters. We expect the reduction in energy prices will result in lower selling margin, as Iceland are forced to pass on some of the savings
Refinancing:
- The FY23 plus flash numbers for Q1 (to June) will remove some of the questions over Iceland’s ability to refinance. We had expected the business to be 4-4.5x leveraged in March 2024, but with energy prices and UK consumers trading down, leverage will be below 4.0x (3.3x on our model) with strong cash balance of £260m. In reality, Iceland will have reduced their Gross Debt if performance turns out at this rate via bond buybacks if a full refinancing doesn't happen soon.
- Based on FY24 EBITDA and Free Cashflow, prevailing interest rates and required interest cover, debt capacity is c. £700-800m, sufficient to refinance the bonds.
- We acknowledge our FY23 and FY24 are under the Company's guidance and to give credit to the management they usually meet or outperform their guidance. However, although we think there is a reversal of the energy price surge to be expected in FY24, our base case is that this will have to be used, partially, in selling margin. Our model assumes selling margin reduces c.100bps in FY24 over FY23.
- An alternative to buybacks in the medium term, the alternative refinancing mechanism available to Iceland is a partial paydown and extension in maturity to March 2027 with a higher coupon. This will enable the Company to benefit from the favourable 2028 coupons instead of doing a full refinancing in FY24. This is unlikely in the current environment given the earnings outlook.
Model:
- The Company are confident that margins won’t suffer with the reversal of energy prices in FY24. We are not as confident and have reduced their “selling margin” by 1-2% over the coming quarters as we expect competition to drive down prices over the coming quarters. This is the main reason we are struggling to meet the Q1 flash figures of £34m, with our EBITDA assumption for Q1 equating to £29m. We could simply adjust our modelling technique but we will maintain the mechanics until later in the year.
- On Capex, we have assumed £50m which is the high end of the Company guidance. This is primarily driven by maintenance and warehouse expansion as we only envisage 3 net new stores for FY24.
- We got working capital wrong for Q4 and with the unusual quarter ends, working capital is difficult to judge. We model an outflow for FY24 as we see the use of reverse factoring/trade financing reducing as cost of this product increases. The Company are more sanguine on trade financing costs.
Other Housekeeping:
- The Company are in the process of transitioning the accounting standards to IFRS from FRS 102 (welcome lease accounting!). The new accounting methods will be applied for FY23 accounts by end of September, with the Company already having received waivers for the delay in filing full accounts.
- The use of Letter of Credits is smaller than we had expected. The Company clarified that they are currently using c. £8-10m in LOC to back-stop energy price movements in relation to their long-term energy hedging contracts.
Happy to discuss.
Tomás
E: tmannion@sarria.co.uk
T: +44 20 3744 7009
www.sarria.co.uk