The knock-on impact of the stratospheric rise in wholesale gas prices was that US based firm CF Industries decided to cease fertiliser production at its two UK sites. CO2 is a byproduct of the fertiliser production process, with the two CF Industries plants accounting for ~60% of the UK’s commercial supply of the gas. Itis used to stun birds and pigs for slaughter in the UK, but is also a key ingredient in controlled atmosphere packaging and refrigeration.

The damaging impact (~30% drop in capacity) this could have had on Boparan has been partially averted with the UK government striking a short-term deal with CF Industries to restart production at one of its two sites, however the risk has not completely vanished.

Firstly, of the ~520kt combined capacity of the two plants, only the Billingham plant (400kt capacity) is coming back online (as far as we know), meaning close to 25% of the cumulative supply from CF Industries will remain offline indefinitely. Whether this will fulfill demand requirements is unclear, and it could lead to more costly CO2 being sourced from elsewhere.

Secondly, the deal struck with government is for the coverage of operating costs for three weeks, essentially a window for a more “sustainable” solution to be found. It’s certainly not beyond possibility that this so-called “solution” involves the likes of Boparan and other CO2 users in the food supply chain and elsewhere paying up for the higher input costs at producers, at least until energy prices (and particularly gas prices) start to ease downwards.

The timing of such an event is difficult to predict, however there is likely to be an impact on margins at least in 1Q 22 (i.e. August to October 2021) and potentially beyond. Boparan’s £475m 7.625% 25s opened this week down over two points on a cash price basis from the previous close after the CF Industries news broke on Saturday 18th. Over half those losses have been handed back now on the back of the deal struck by government.

As a takeaway, we expect there to be some mild margin pressure in Boparan’s fiscal 1Q 22 (i.e. August-October 2021) from higher CO2 costs, with the exact impact and duration of such pressure difficult to pin down given lack of granularity on cost inputs. Management may shed some light on this issue in 4Q 21 earnings due on 28-Oct.

Although the worst of the crisis has at least been temporarily averted, it has brought to light the vulnerability of the CO2 supply chain in the UK food industry to such a concentrated supply pool (for those interested, there is a little more on that here). It’s a potential risk that bears consideration, in our view, for prospective and incumbent creditors.

Cost inflation

i) Feed costs: in UK Poultry were 19% higher YoY during 3Q 21. This brings about short-term margin pressure as cost pass-throughs to customers are on a lag of at least three months but vary depending on the individual contracts. Some contracts are based on pricing ratchets while others are not, relying instead on commercial negotiations. For non-ratchet contracts, management mentioned on the 3Q 21 earnings call that the company tends to buy feed-stock 12 months out. Despite this, there was a £5.5m EBITDA impact from higher feed prices in UK Poultry during 3Q 21, £3m of which was a timing thing on price-ratchet contracts, the other £2.5m was on non-ratchet contracts.

For 4Q 21, the company expects another 5%-7% increase in feed costs, however there is an expectation that pricing will move more quickly than the price increases, effectively closing the gap witnessed in 3Q 21. Further out, high energy prices and distribution costs are likely to continue to upwardly pressure feed costs for the group, we suggest.

ii) Distribution costs: appreciating distribution costs are a headwind certainly not unique to Boparan as there is a well-known shortage of HGV drivers across the UK. Somewhat more idiosyncratically, there are stories in the press of supermarkets hirings drivers from their own supply chains, offering sign-on bonuses and better wages as an incentive. On top of this, it appears some retailers are charging penalties to suppliers for failure to deliver goods on time. Some of this pressure may gradually ease, aided by news today that Boris Johnson has agreed to relax visa rules for overseas HGV drivers. There are, however, shortages of HGV drivers in other countries also, so the pace at which drivers can be recruited and the pressure eased is uncertain.

iii) Packaging costs: management mentioned packaging costs inflation as a headwind on the 3Q 21 earnings call but hasn’t quantified any effect of this on EBITDA or cash flows. In the packaging market, plastic packaging costs have been increasing this year as a result of supply-chain disruptions and higher demand, with feed-stock and logistical costs compounding the issue. Without greater disclosure from the company, it is difficult to gauge the potential impact of this lingering headwind but it certainly adds to the weight of margin pressure from cumulative headwinds.

Labour challenges bourne out of shortages: labour cost inflation and the company’s ability to pass it on to customers is not a new part of the credit story at Boparan. That being said, the company is a prime candidate for the fallout from Brexit with such a heavy UK footprint and high proportion of overseas workers historically. Labour makes up around 18% of total costs.

Causality is not exclusive to Brexit however, with a shift in consumer spending habits altering the UK labour market landscape. It’s no secret that the UK meat processing industry has struggled with labour shortages this year as warehouse and production vacancies at higher-margin businesses offer more competitive salaries.

In their 3Q 21 earnings call, management said that the impacts from Brexit and Covid-19 came much sooner and more severe than expected. Since Easter, Boparan saw a significant drop in labour availability for production staff and drivers. Some of these drivers are clearly structural and therefore Boparan would need to find structural solutions, they said.

Brexit has led to a reduction in migrant workers. Under new immigration laws the majority of their workforce would be considered unskilled and prohibited from entering the UK. It is also unclear how many workers with EU settled status will return to the UK post the ending of covid restrictions, noted management who said many potential EU workers are spending the summer outside the UK.

But as Boparan admitted on its Q3 21 call, its operations are much more labour intensive than their competitors, most notably in butchery. This reduces waste, which they claim overall is a wash on economics, but in an environment of rising labour costs it said it was trying to increase the level of automation. The payback time is around two years, and it will take at least six-months to automate end of line packaging.

The impact thus far on earnings has been somewhat limited, although it is expected to increase as of 4Q 21 with the challenge becoming more acute. This will not be a short-term obstacle, in our view, as the company will almost certainly need to increase its wage bill to find requisite production capacity. On the flip side, retail demand for chicken may ease a little following 4Q 21 after the typical summer barbeque season peak and as occupancy at restaurants and bars improves. Another consequence of labour shortages aside from wage inflation is the drop in factory productivity, especially in the value-add end of production which is butchery and packaging as a result of fewer birds being available.

Agricultural inefficiencies and demand/supply imbalance: lower birth rates and average bird weights at farms impacted farm productivity and factory yield in 3Q 21. Apart from an inference that feed quality was partly to blame, management did not elaborate much further on the reason for this deterioration.

The lower factory yields and worker shortage meant that in-house supply fell below demand, leading to the need to source externally (and more expensively) to fulfill orders. This diluted margins as Boparan essentially became a distributor on externally sourced product. Strong retail demand on its own is a positive tailwind, however without significant pricing power there is little Boparan can do to benefit from the development without finding more capacity and plugging its labour shortage.

Our take: these headwinds are not going to abate. The British Chambers of Commerce (BCC) recently suggested that staff shortages and supply disruption will continue to hamper growth in the coming months. Echoing this sentiment, BoE governor Andrew Bailey recently noted that he had “a bit more concern about persistence in the labour market story”, while he suggested that commodity price inflation and supply chain bottlenecks looked likely to fade.

Government intervention to relax visa requirements could prove a partial mitigant to the labour market headwinds, as seen with the decision to allow more HGV drivers to enter the country, however the issue remains politically sensitive with ministers seemingly wary of under-cutting UK workers, messaging that these effects are temporary phenomena.

From a macro perspective, UK GDP growth is expected to slow in the second half of 2021, while the BCC warned of a “real danger” that the imminent increase in national insurance rates could stifle the UK’s bounceback. This will likely prove another headache for Boparan, as an already increasing wage bill will get further hit by the NI increase in 2022.

From our perspective, there is a distinction between Boparan passing-through feed cost inflation to customers and having the same success with its burgeoning wage bill. Feed prices are an entirely external variable that from a commercial point of view are a palatable pass-through cost. On the other hand, there may be an argument that the wage bill and rising labour costs is partly a function of market competition and broader structural change.

As previously mentioned, cost inflation has been part of the credit story at Boparan for many years and we certainly err on the side of caution when it comes to the prospect of the company passing through all of this pressure to supermarket customers who themselves are already facing a mountain of challenges and competitive pressures.

One might expect Boparan and its competitors to hold some pricing power with customers given the tight supply and growing retail demand, however the retail market for British meat producers is notoriously challenging with supermarkets exerting their size and dominating the market. This is notwithstanding limited opportunity for supermarkets to source their chicken meat elsewhere with overall market supply proving tight at present. This is partly a function of supermarkets themselves being involved in something of a price war with one another, with price-matching initiatives fuelling a race to the bottom on many items.

Bond price triggers

We don’t see any particular triggers on the horizon that would be likely to cause a big swing in the price of Boparan’s £475m 7.625% 2025 SSNs. The 4Q 21 earnings on 28 October are coming into view, however, which could cause more price volatility.

Our expectation is that there is a distinctly slim chance of any positive developments for management to disclose that would exert upward pressure on bond prices. There are new headwinds to address and although a crisis in CO2 supply may have been averted, we will be paying close attention to management’s take on the potential for the cost of sourcing the gas to increase. An update on the quantitative impact of the labour crisis is also due, with some of this likely to reflect in 4Q 21 earnings. Another development that we will be looking out for is the success in passing through cost inflations and comments management may make on passing through costs outside of feed prices.

Without any prior guidance from the company for 4Q 21 earnings aside from some markers on feed price expectations, European Poultry performance - which happens to be reported as part of overall Poultry, helpfully - due PAYE and some qualitative expectations, there’s less of a focus on “hitting” or “missing” guidance. Overall, bond prices are more likely to move on the cumulative impact of individual factors on the broader credit story rather than individual earnings targets.

To our minds, Boparan is a difficult credit to form a 12-month view on, particularly at present with so much uncertainty in the UK labour market, cost inflation pressures, lingering COVID-related factors and a general minimal disclosure approach from management. That being said, and as previously mentioned, we see very little chance of positive developments from a bond price perspective on the horizon. The company has doubled-down its focus on its poultry business with the recent disposal of Fox’s Biscuits leaving little in the way of meaningful earnings potential in Meals & Bakery.

Looking at specific positive and negative potential triggers, liquidity is not of immediate concern given £107m of headroom as of 3Q 21. This includes £27m of cash and £80m or full availability on the company’s RCF. Additionally, availability on the RCF can be increased to £90m at the company’s option, however this is on an uncommitted basis. For that reason, we exclude it from our interpretation of liquidity for now. By year-end, we expect liquidity headroom to drop to just under £100m, based on our FCF before working capital movements forecast for 4Q 21. By end-FY 22, this headroom could drop to around £70m, again based on our FCF before working capital movements projection for FY 22.

A partial draw down on the RCF in either 4Q 21 or 1H 22 to mitigate cash burn would push leverage higher, which by our definition stood at between 5.4x-6.4x as of 3Q 21, depending on whether operating leases and pension liabilities are included. This could move to 6.5x-7.3x by year-end as the strong 4Q 20 EBITDA rolls off and net debt ticks up. We see this level stabilising and potentially reducing by FY 22, with our base-case forecast pegging reported net debt/9fin-adjusted cash EBITDA at just over 5.5x.

On the positive side of potential triggers, we don’t see much other than the potential for more disposals in Meals & Bakery. Incidentally, a third site producing own-brand biscuits was retained when Fox’s Biscuits was sold and the asset now sits outside of the restricted group.

We don’t have visibility on earnings at this asset so adjudging its value is virtually a non-starter. Taking a step back, the company has wrung out the majority of its non-core asset value over the past 3-4 years so any further disposal activity would be comparatively small (more below).

Can the company grow into its cap structure?

Boparan has relied on asset disposals over the past 3-4 years to manage its balance sheet and offset against heavily negative FCF, amassing over £600m in disposal proceeds between FY 18 and 3Q 21 (note: Fox’s Biscuits disposal proceeds before Northern Foods pension contribution included).

Even though the capital structure has now been refinanced - a transaction that appeared in the balance during parts of 2020 - and the maturity wall pushed out to late 2025, we find ourselves questioning whether the company can sustain the current level of debt which itself is likely to rise in the near-term.

The refinancing was done on an PF run-rate adjusted FY 20 EBITDA of £134.9m, a distant shout from even the LTM 3Q21 reported EBITDA of £99.7m which itself is a generous reflection on earnings. Structuring EBITDA was adjusted from a LfL EBITDA (i.e. after taking out earnings from recent disposals) of £106.5m, meaning net proforma and initiative adjustments (some small negative adjustments in there) amounted to £28.4m or around 27% of unadjusted EBITDA. This meant structuring leverage was 3.3x, with proforma net borrowings of £447.2m. By our definition of a more realistic cash EBITDA, allowing for some initiative adjustments, net leverage on the deal was between 4.0x and 4.5x. This was following a very strong YoY rebound in EBITDA in FY 20 and a particularly good 4Q 20. As of 3Q 21, net leverage before operating leases (LfL comparison with marketed definition of leverage) is at 5.4x, per our definition.

The question is whether the company can organically de-leverage from this clearly very unsustainable level of above 6-times. Admittedly, it won’t face its current headwinds indefinitely and it will be able to pass on certain cost pressures to its customers, however we don’t see it being a sure thing that all cost input pressures are easily passed through.

Similarly, the Poultry business has never been a high margin business and this is now more pertinent given the lack of earnings elsewhere. There were once aspirations for the Poultry division to reach an EBITDA margin of 4%. Even if this ambitious target can be met, leverage of anything above 4.0x times looks unsustainable to us, especially considering the seasonality of the business. This conjecture considers the earnings contribution of what’s left in Meals & Bakery.

On a straightforward level, the company needs to generate EBITDA above £105m to cover annual capex (£40m-£50m), cash interest (~£40m) and pension contributions (~£20m). The company won’t reach that mark in FY 21 and the chances of doing so in FY 22 are looking slim given current circumstances and headwinds; bear in mind that FY 22 for Boparan started in August. That leaves three fiscal years in which to push FCF back into the green without help from working capital before the notes come due in November 2025, although realistically any refinancing would need to be done some time during FY 25.

The disposal of non-core assets has been a key element of the business strategy in the past four years (first Green Isle in 2 parts; followed by Fox’s biscuits - the two most notable businesses). This has raised plenty of cash and prevented a more challenging proposition for creditors and the company, but has left little asset value behind and concentrated earnings risk by some margin in the process.

Quantitatively, we estimate there could be £300m-£400m of asset value left in the Meals & Bakery segment, applying implied metrics from the recent(ish) disposal of Matthew Walker (Christmas pudding business) and Fox’s Biscuits. We estimate that the EBITDA multiple achieved on these disposals could have been anywhere between 8.0x-10.x. This is based on reported sale prices (minus a post-close pension contribution to Northern Foods Group scheme) and deduced EBITDA from that extracted from the marketed FY 20 figure.

What’s left in the segment in terms of asset value is debatable of course, with brands like Fox’s Biscuits certainly worth more on a comparative basis than the remaining biscuit site which produces own-label product for supermarkets. If we apply a more conservative (or realistic, depending on your perspective) EBITDA multiple range achievable on the remaining assets of say 5.0x-6.0x, asset value drops to between £200m-£250m. That leaves the LTV ratio or asset coverage looking a little weak with the Poultry business unlikely to be valued at similar multiples given the lower margins of the business.

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