Iceland - tweaking our model for energy inflation
All,
Please find our updated model on Iceland here. We have made some adjustments to our previous model, mainly on energy costs and price inflation.
Energy costs, food inflation, and return to workplace post-Covid all weigh on Iceland’s recent bond movements. In our analysis, we focus on calculating the impact of all the moving forces on Iceland’s underlying performance. Iceland is not immune from these cost pressures and, due to the nature of its high frozen content, Iceland has a higher exposure to energy costs than a “normal” food retailer.
However, the market is too negative when it comes to Iceland and the inflationary pressure it is under. Even allowing for £50m increase in Energy costs for FY23 over FY21, our model shows Iceland can maintain positive free cashflow. Ultimately, it is the cash generative nature of Iceland that allows us to maintain our long position in Iceland, despite the inflationary pressures.
Inflationary Pressures:
- It comes as no surprise to investors that Iceland is expecting to come under more inflationary pressures during the calendar year 2022.
- Energy costs are the number one pressure. Iceland, given its frozen nature, has a higher energy consumption than its competitors. Iceland is normally 50% hedged for their energy consumption, but for FY23 (from March 22) they have no hedges in place. Richard Walker has mentioned in the press a £20m hit, we expect the hit could be in the £30-40m range.
- Supplier led inflation: Given Iceland’s small market share and lack of own-label ambient product, Iceland has limited pricing power against branded suppliers and acknowledge they will have to absorb the cost inflation pushed through.
- The third inflationary pressure Iceland have is wages. We are seeking clarity from the Company, but the level of FTE employees in FY21 was high, especially against prior years. This may be Covid related, and any modest reduction in this metric will mitigate the wage inflationary pressures substantially.
Outlook:
- The Company have a good track record of meeting their quarterly guidance, and at the Q3 call management guided to a reduction in Net Debt levels and an improvement in EBITDA, year on year.
- The bigger question is for FY23, where we do expect continued inflationary pressures, and despite only modest decrease in top-line sales, we expect EBITDA could drop to c. £118m. Again, there are several upsides to this scenario, including absolute wage levels reducing due to a lower staff per store ratio in line with FY18-20 levels, a reduction in energy assumptions, and higher pass-through of inflationary costs to the end consumer.
Upside:
- Our model shows £50m increase in energy costs in FY23 over FY21, a 2yr period. This is based on current energy prices which are as recent highs. Hopefully, peace can be brokered soon, but any de-escalation in the Ukraine war is likely to herald energy prices lower than current levels. We do not envisage government support in the form of energy subsidies, but opening up alternative sources of energy, including from Iran is a more likely scenario.
- The level of FTE employees for FY21 appears excessive and likely to be due to Covid planning. The ratio of staff: store was averaging c.15 for FY18-FY20 period, but shot up in FY21 to 18.7. We have modelled a modest decrease in this ratio to 18.5, but Iceland are likely to seek reductions to previous levels. Any reduction will fall lead to improvement in EBITDA levels.
- The reduction in online spending across the industry (online grocery shopping accounts for 13.3% currently, down 2.1 percentage points year on year) will also help improve margins. Iceland do not disclose profitability online versus store but the shift back to the store will no doubt have a positive impact on margins.
Positioning:
- We bought 5% of Iceland 2025 at 92%, yield of 7.7%, as part of our rotation of risk in late February. In hindsight, we should have waited but despite the 3 pts mark to market loss we are happy to maintain our long position. Even at the base £105m EBITDA (our model expects trough LTM EBITDA of £118m), Iceland achieves positive cashflow after interest and CAPEX. The business has excellent cash generation, and with a flexible CAPEX requirement, Iceland will trade through any downturn in EBITDA.
- Our model shows a low of £118m EBITDA, and at this level, the overall leverage increases modestly to 5.6x.
- The Company are not due to report their FY22 numbers (to March 22) in June. We remain conscious of the market’s perception of cost inflation and will be focusing on the trajectory of Gross Profit 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
M:+44 7786 705 806
www.sarria.co.uk