Operational review
In this section:
Summary Financial performance and dividend
To reflect our prudent approach in this challenging and uncertain economic environment, the Board proposes to maintain the total dividend payable in respect of 2008/09 at 4.50p per share (2007/08: 4.50p). This represents adjusted EPS cover of 1.7 times (2007/08: 1.8 times) and is consistent with our policy of ensuring that our dividend is well covered by free cash flows.
Subject to shareholder approval, a final dividend of 2.95 pence per share (2007/08: 2.95p) will be payable on 28 August 2009 to shareholders on the register at 31 July 2009.
Key performance indicators
Alongside absolute profit and debt measures, the Group uses the following key performance indicators (KPIs) to measure progress, as shown in the KPI table.
Each KPI is defined and assessed within this review. Non-financial KPIs are featured in the Northern Way (our Corporate social responsibility review).
KPI |
2008/09 |
2007/08 |
|---|---|---|
Revenue growth (underlying)7 |
5.0% |
3.3% |
Operating margin* |
5.4% |
5.2% |
Return on net assets (RONA)* |
14.7% |
13.7% |
Pre-restructuring free cash flow8 |
£35.4m |
£48.3m |
Debt ratio (pre-restructuring) |
2.1 times |
2.0 times |
Return on invested capital (ROIC)* |
11.7% |
11.0% |
Revenue
The Group seeks to deliver selective, profitable increases in revenue by focusing on attractive market segments with strong growth potential in areas where margin is enhanced. We continue to exit low margin and low volume products through selective range rationalisation. This, in turn, reduces complexity and drives efficiency improvements in our facilities.
Revenue was up 4.6% at £975.2m (2007/08: £931.9m). Underlying revenue growth7, a key measure for the Group, was up 5.0%. Prices increased by 4.2%, reflecting the commodity price recovery effect, whilst volumes were up 0.8%. Northern Foods continues to demonstrate it is a better balanced business through capitalising on the growth of discount retailers, alongside its traditional premium heartland. Sales to the Group’s top five customers by value (M&S, Tesco, Sainsbury, Asda, Morrisons) remain at 77% and sales of our value ranges to target cash conscious consumers now represent around a fifth of our business.
Operating margin
Profit from operations* rose 8.9% to £52.7m (2007/08: £48.4m) and operating margin* improved 20 basis points to 5.4% (2007/08: 5.2%). A strong performance in our Chilled and Bakery divisions was offset by lower profits in our Frozen division. Commodity inflation was in double digits during the year and, working with our customers, we successfully recovered this in full through a mix of selling price increases and other initiatives. We expect commodity inflation to continue through 2009/10, albeit at lower levels, and we plan to recover inflation fully and drive margin improvement through investment in the business and efficiency initiatives.
RONA
Each business is focused on driving stronger returns from the assets utilised in that business. Better management of capital investment, together with careful use of working capital, leads to improved asset utilisation. The combination of margin and asset utilisation is measured through return on net assets (RONA), which is defined as profit from operations* divided by average operating assets invested in the business.
During the year RONA improved from 13.7% to 14.7%, reflecting improvements in both operating margin and asset utilisation. We target 15% as a minimum medium term RONA for each business and in 2008/09 the Bakery division continued to achieve a return well above 15% and the Chilled division made further progress towards this target. The impact of the stronger Euro on the Frozen division, together with a competitive pizza market, resulted in a decline in RONA.
Profit before taxation
Profit before taxation* reduced by 5.2% to £47.5m (2007/08: £50.1m). Profit for the period1 was £2.5m (2007/08: £34.5m). The charge for restructuring items before taxation was £35.4m (2007/08: £4.7m), relating primarily to the mothballing of the Fenland facility and other cost reduction projects. The charge for restructuring items comprised £11.8m in cash and £23.6m in non-cash items.
Net financing costs decreased to £13.7m (2007/08: £14.0m), reflecting lower floating rates in the second half year as LIBOR declined. The net pensions financing credit reduced to £8.5m (2007/08: £15.7m) due to lower asset returns. As a result the net finance charge was £5.2m compared to a credit in the prior year of £1.7m.
In accordance with accounting standards, the Company records its expected return on defined benefit pension assets within the financial statements each financial year. It has been our practice to show this as a separate line within the finance and expense section of the income statement. Whilst the assets are held as long term investments to meet the long term pension scheme obligations, the nature of the assets means that there can be significant annual movements in asset values and hence returns. This has been very pronounced in the last twelve months. We believe that this masks the true underlying performance of the business and we have therefore introduced an underlying PBT4 and underlying EPS2 calculation in this report, eliminating the distorting impact of net pension financing.
Free cash flow and capital management
A continued focus on cash management was supported by our drive to achieve more profitable utilisation of existing manufacturing capacity. Using RONA as a KPI to embed this discipline across the Group, each business assesses its capital requirements, utilising robust project evaluation techniques which evaluate economic and cash criteria.
Gross capital expenditure (the purchase of property, plant and equipment) in the year was £31.0m (2007/08: £21.5m), compared with depreciation and amortisation of £39.3m (2007/08: £41.7m). This represents 80% of depreciation (2007/08: 52%) with a key project being the investment in increased automation within our biscuits manufacturing. We expect capital expenditure, excluding the new proposed biscuit investment which is currently being evaluated, to continue at broadly similar levels in 2009/10.
Despite continued double digit inflationary increases, working capital remained tightly managed, increasing by only £10.0m during the year. At the balance sheet date, net working capital9 remained favourably negative at £(14.3m) (2007/08: £(25.9m)).
The Group has successfully maintained its discipline over cash management and generated further free cash flow of £24.2m (2007/08: £39.0m) including restructuring cash items of £11.2m (2007/08: £9.3m).
Free cash flow measures the cash generated by the Group from its normal trading activities and represents the cash available (after paying tax and interest costs) to finance dividends, investments or acquisition activity. It is analysed in the table below.
2008/09 |
2007/08 |
|
|---|---|---|
Operating cash flow (before working capital & special pension contributions) |
80.7 |
84.0 |
Movement in working capital |
(10.0) |
(11.6) |
Net interest paid |
(15.2) |
(13.6) |
Net taxation paid |
(1.0) |
(3.0) |
Capital expenditure |
(31.0) |
(21.5) |
Asset sales |
– |
4.4 |
Grants received |
0.7 |
0.3 |
Free cash flow |
24.2 |
39.0 |
Restructuring items |
11.2 |
9.3 |
Pre-restructuring free cash flow |
35.4 |
48.3 |
Debt
A key measure of our financial flexibility is our debt ratio. This is the ratio of net debt to EBITDA10 (calculated under ‘frozen UK GAAP’ (the accounting basis used when the Group’s current financing facilities were established)). This is targeted to be below 3.5 times, the limit imposed by our financing agreements. For 2008/09, the debt ratio was 2.1 times (2007/08: 2.0 times).
Using its free cash flow, the Group invested £11.0m in returning cash to shareholders through a share buy-back. A total of 17,500,000 shares were repurchased during this financial year under the buy-back programme at an average share price of 63p, enhancing earnings per share. The Group incurred £11.2m in cash restructuring costs relating to the Fenland mothballing and cost reduction programmes.
After dividend payments of £20.7m (2007/08: £21.0m); a share buy-back of £11.0m; and cash restructuring costs of £11.2m, the year end net debt3 was £206.7m (2007/08: £200.2m). This level of debt, the majority of which is at fixed rates, continues to position the Group favourably in current volatile credit markets. The Group’s fixed rate funding is through US private placement notes of £143m, which mature between 2012 and 2017. In March 2009, we completed a new £250m Forward Start banking facility through to July 2012, which replaces the existing £460m facility in July 2010. Effective April 2009, the current £460m facility was reduced to £305m. This reduction in facilities is more cost effective by avoiding commitment fees on unused facilities whilst remaining sufficient to support the Group’s future investment plans. Reflecting the prevailing financial market conditions, this will incur higher interest costs next year.
ROIC
Group total equity reduced to £54.1m (2007/08: £165.4m) primarily reflecting the change in the retirement benefit obligation. The Group’s ROIC5, measuring the pre-tax return on shareholders’ invested capital, increased during the year to 11.7% (2007/08: 11.0%), as we continued to improve the efficiency of the business.
Pensions
Under International Accounting Standard (IAS) 19, there is a £71.5m deficit in the pension fund, compared with a surplus of £61.6m at the end of our 2007/08 financial year. This primarily reflects the impact of economic conditions on asset values during the year.
Northern Foods’ long history of providing defined benefit pensions to its employees has resulted in a large pension fund which we need to manage prudently. The principal UK Defined benefit scheme is now closed to new members and work is well advanced to reduce, but not eliminate, the potential for future funding volatility which will be achieved through a liability driven investment programme. We need to ensure that the future service accrual remains affordable to both the Company and scheme members.
Our triennial actuarial pension funding review for the period to 31 March 2008 was completed, resulting in a funding deficit of £75m (Trustee basis) and required no additional cash contributions from the Company, relying instead on fund out-performance over an eight year period to meet the deficit. To maintain the financial stability and competitiveness of the business, it has been necessary to make changes to the Defined benefit scheme. After a period of consultation, member contributions have been increased and the leadership population has been transferred to a Defined contribution scheme. We continue to keep all pension arrangements under review.
Whilst the principal UK Defined benefit scheme has been closed to new entrants since 2005, there remain some 2,207 active members of the scheme. Our aim is to continue to provide competitive pension benefits to our employees at a cost that is affordable to the Company and enables us to compete effectively in the marketplace.
Risks and uncertainties
The operation of a public company involves a series of risks and uncertainties across a range of strategic, commercial, operational and financial areas. Northern Foods has a robust internal control and risk management process, as outlined in the Corporate governance review, which is designed to provide assurance but which cannot avoid all risks. Outlined below are potential risks that could impact the Company’s performance, causing actual results to vary from those experienced previously or described in forward looking statements within this document. These risks are monitored on an ongoing basis through the Company’s risk management processes. Additional risks and uncertainties not identified may also have an adverse material effect on the Company.
- Economic uncertainty – the Company is responding to the current economic conditions by balancing its product portfolio in those markets where this is considered to be appropriate. A number of discount products have been introduced in different markets to compete with the current trend of consumers turning towards value products, whilst maintaining acceptable margins. Given the uncertain consumer outlook, the Company continues to manage cost and cash closely. Sales weighting to the second half year, in particular, assumes sales will be in line with historical sales patterns over the seasonal trading period;
- Customer relationships – the Company seeks to manage the risks presented by its consolidated customer base, and the highly competitive environment that characterises the industry (which generally operates without long term contracts), through its high service, high quality, low cost model targeted across a portfolio of markets where it has strong positions. This is supported by product development programmes and by maintaining and developing strong robust relationships with customers. The Company also monitors customer credit risk to manage exposure in the current challenging environment;
- Consumer trends – exposure to changing consumer trends can impact profitability. The Company seeks to manage these through portfolio changes, with greater weight towards growth trends (which include health, convenience and indulgence) – for example, by managing new product innovation to expand sales in these areas, while managing the exposure to declining market sectors – and to providing profitable value sector products during times of economic slowdown;
- Operational disruption – the short lead times involved in servicing our customers can lead to an adverse impact from disruption to our manufacturing and distribution facilities (for example, by fire, health and safety failure, problems of supply, information systems failure, workforce action or environmental incident). This is managed through a process including systems of standard operating procedure, regulatory compliance, dedicated steering groups, monitoring, audit, consultation and multiple sourcing. Insurance cover is maintained where appropriate but may not cover all risks and losses;
- Business continuity – the Group is at risk to disruption at key sites from incidents such as a major fire which could result in significant operational issues. Our businesses have incident management processes and continuity plans in place to manage the impact of such an event as well as insurance to mitigate the financial impact. A major update of these plans is currently nearing completion;
- Legislation, regulation and litigation – Northern Foods manages a range of regulatory requirements regarding the production, sale, safety, labelling, composition/ingredients and disposal of its products. Compliance monitoring and proactive initiatives seek to manage this risk. The Group has policies and ongoing monitoring in place to ensure that employees are aware of their regulatory responsibilities. Litigation claims and proceedings can have an adverse effect on the Company’s results;
- Change management, recruitment and retention – ongoing change requires close management attention and the Company has experience of managing such risks and has action plans to mitigate them, including Board oversight and project management processes. Failure to implement and complete change can impact financial results, employee recruitment and retention, with the latter also subject to the availability of a suitable pool of domestic and overseas staff. Proactive initiatives for this are included in the Northern Way contained later in this report;
- Managing procurement costs – exposure to price (including foreign exchange impact) and supply fluctuations for raw materials and services is managed by a central procurement function, to better negotiate with relationship based suppliers, agreeing forward prices where appropriate and available. The Company seeks to pass on cost increases, where possible, to its customers through price rises but constraints in achieving this can affect the Company’s results. In addition, the Company manages exposure to key suppliers through dual supplier sourcing where feasible;
- Food safety – appropriate product manufacturing, storage and avoidance of contamination are critical. Standard manufacturing and distribution protocols are in place, together with proven product recall processes for product recovery. Widespread food scares can impact directly through the sale of a contaminated product or indirectly through lack of supply or reduced consumer demand;
- Environment – the Company maintains environmental policies and relationships with relevant regulators to manage the impact its activities have on the environment. In addition, the Company has an active programme (described in the Northern Way) to reduce this impact over time. Nevertheless, changes in environmental legislation or unplanned incidents could impact the Company’s operations adversely;
- Financial risks – the Company has committed financing in place, which can only be withdrawn in the event of a breach of financing agreement, such as covenants, when the Company might be restricted in its ability to operate normally and could be required to dispose of assets to pay down debt and incur additional costs. The principal banking facility is now in place until July 2012 and funding availability for that renewal may be more constrained in light of recent credit market conditions. Board policy is to operate with fixed rate borrowings within a range of 20% to 50% of net borrowings over the medium term, to manage interest rate risk (although the Group may operate outside this range from time to time). Pension schemes could require increases in future Company funding and pension regulation could restrict the freedom of the Company to undertake certain corporate activities (including disposals and return of capital to shareholders). The Company has certain tax exposures in addition to current trading tax balances. These exposures total £23.8m which are provided for but which, in the event of an adverse finding by taxation authorities, could result in a substantial payment of cash. The Irish business is exposed to foreign exchange risk and transaction exposure is hedged on a rolling 12 month basis.
Basis of preparation
This financial information has been prepared in accordance with International Financial Reporting Standards (IFRS).
Forward looking statements
Forward looking statements are made throughout this review. These forward looking statements are based on a number of assumptions concerning future events and information currently available. The user of this Performance review should not rely unduly on these forward looking statements, which are not a guarantee of performance and which are subject to a number of uncertainties and other facts, many of which are outside of the Company’s control and could cause actual events to differ materially from those in these statements.
Although Northern Foods believes that the expectations reflected in those forward looking statements are reasonable, it cannot assure users that those expectations will prove to be fulfilled. In addition to those factors described under ‘Risks and Uncertainties’, other factors could cause actual results to differ materially from our expectation, including economic and political conditions, changes in laws, regulation and accounting standards, customer relationships and actions, effectiveness of spending and marketing programmes and unusual weather patterns. No guarantee can be given of future results, levels of activity, performance or achievements.
Comparative statements
In this report, Northern Foods makes certain statements with respect to its market position or its products’ or its brands’ market positions by comparisons with third parties or their products or brands. These statements are based on both internal sources and independent sources and are accurate to the best of the knowledge and belief of Northern Foods.
Going concern
In determining whether the Group’s annual consolidated financial statements can be prepared on a going concern basis, the directors considered the Group’s business activities, together with the factors likely to affect its future development, performance and position. The review also includes the financial position of the Group, its cash flows, liquidity position and borrowing facilities. The key factors considered by the directors were as follows:
- the implications of the challenging economic environment and future uncertainties on the Group’s revenues and profits. The Group undertakes forecasts and projections of trading and cash flows on a regular basis. This allows the Group to target performance and identify areas of focus for management;
- the impact of the competitive environment within which the Group’s businesses operate;
- the potential actions which could be taken in the event that revenues are worse than expected, to ensure that operating profit and cash flows are protected;
- the Group has access to overdraft facilities and a committed bank facility to meet day-to-day working capital requirements. Following the refinancing of the bank facility in March 2009, the Group has committed bank facilities to July 2012. In April 2009 the existing facility was reduced from £460m at March 2009 to £305m. The facility will reduce to £250m in July 2010.
As at the date of this report, the directors have a reasonable expectation that the Company and Group have adequate resources to continue in business for the foreseeable future. Accordingly, the Annual report and financial statements for the 52 weeks ended 28 March 2009 have been prepared on the going concern basis.
- 9
- Net working capital is defined as inventories plus trade and other receivables less trade and other payables
- 10
- EBITDA is earnings before interest, tax, depreciation and amortisation. It is calculated as profit from operations plus depreciation and amortisation, all measured before restructuring items
