Končar Group – the risks of high growth

Preliminary FY2022 accounts of the Končar Group (hereinafter: “Končar” or „the Group”) show a significant sales growth of 51,6% (+17% in 2021), driven by: (i) organic growth across all business segments, (ii) acquisition growth due to the completed takeover of Dalekovod, and (iii) inflationary environment. The growth would have been even higher, however Dalekovod’s results had been consolidated only as of April.

The Group’s CAeu-adjusted EBITDA (only partially adjusted due to limited information available) followed the sales trend and ended at around HRK 525m, with the margin of approx. 10%. However, if Dalekovod had been consolidated from the beginning of the year, both the absolute EBITDA and the EBITDA margin would have been lower due to Dalekovod’s negative EBITDA in the first quarter of 2022.

While the developments within the income statement have been positive, the Group’s cash flow, on the other hand, shows significantly different pattern.

High cash burn to support growth

The Group’s 2-year (2021-2022) cumulative FCF stood at HRK -729m, meaning that almost twice the amount of total FFO of HRK 746m achieved during the same period has been utilized to support growth. The largest outflow was recorded within working capital, in which investments amounted to HRK 1,16bn. The investments of that magnitude lead to negative operating cash flow and were largely driven by increase in activity (62% came from volume, price, mix and the acquisition of Dalekovod, while 16% came from changes in the working capital cycle). Končar’s operating cycle has always been long (on average 150 days), now further extended due to the integration of Dalekovod, which has historically had financial and operational issues leading to a pre-bankruptcy proceedings. CAeu estimates that the integration will take some time to show positive results, both in margins and working capital movements.

Capex and dividends rebounded in 2022, leading to a record negative FCF. Negative cash flow has been further exacerbated by the outflows for the acquisition of Dalekovod and a couple of bolt-on acquisitions in total amount of HRK 386m.

In order to finance the cash flow gap described above, the Group used mainly two sources. The largest source was new debt in an amount of HRK 637m, followed by internal cash reserves of HRK 575m (deposits and cash accounts are included in this figure).

As shown above, the Group’s cash flow over the last two years follows completely different pattern compared to the key figures in the income statement. This underpins the importance of analysing cash flow, as in the Končar case it had a significant effect on its leverage and liquidity levels. Furthermore, high growth over the last two years masked one fundamental issue in Končar’s business – below-average profitability.

Weak profitability has been Končar’s underlying issue for years

Končar had a negative FCF in five out of last six years. While the negative 2021-2022 FCF was largely driven by high growth, FCF over the 2017-2020 period was also cumulatively negative at HRK -8m. Although the deficit was relatively low, it shows there were some fundamental issues in the cash flow generation. Given that the 2017-2020 period was not a period of high investments, whether working capital or Capex (Capex-to-Depreciation and Amortization ratio stood at 1,07x only), it is clear that one of the main Končar’s weaknesses was low profitability compared to industry standards and its large global peers. The manufacturers’ average EBITDA margin is normally between 11% and 18%, while Končar has historically delivered the margin of 7-8%. The new management has managed to improve the EBITDA margin bringing it to the 9-9,5% level largely on the back of increased scale, and despite the negative influence of the margin-dilutive acquisition of Dalekovod and the inflationary environment which had a negative effect on raw material prices.

CAeu estimates that there is still a long way to go for Končar to sustainably bring the EBITDA margin up above 10%, more closely to the industry average and large global peers. For example, Siemens and ABB regularly post EBITDA margin in the 13-15% range, which is only one but important reason why Končar’s valuation hovers around 5,0-5,5x EBITDA, while Siemens and ABB are valued at 13-20x EBITDA.

Can Končar sustain additional growth amid increasing leverage and deteriorating liquidity?

Končar’s orderbook has been solid with a backlog of projects worth HRK 7,3bn and a Book-to-Bill ratio of 1,2x. Operationally, there is certainly space for growth also taking into account Končar’s relatively small size in the global market. Financially, the manoeuvre space is more limited, however still large enough, though not without risks.

The Group’s leverage measured by Net Debt / FFO stood at 0,7x at the 2022YE, however based on the pro-forma consolidation with the Dalekovod’s Q1 2022 figures, CAeu estimates the Net Debt / FFO ratio at 0,9x. In order to maintain solid credit profile, Končar could further lever its business up to Net Debt / FFO of 3,0-3,3x, which would allow them to take HRK 1,0-1,1bn more debt. Important prerequisite would however be the gradual stabilization of working capital and maintenance of the FFO margin at the level of 9-10%. Margin improvement could open more space for new debt, as 1 p.p. more on the FFO margin level opens up space for additional HRK 160-170m od debt at this level of activity (HRK 5,3bn). On the other hand, obtaining new secured debt in the amounts quoted above could prove to be challenging despite relatively low LTV ratio of 48% at 2022YE, as additional debt of HRK 1,0-1,1bn would likely require tangible collateral taking into account Končar’s current financing structure. The banks’ risk appetite for unsecured lending amid increasing interest rates and rising uncertainties might be limited in this case.

CAeu estimates that the Group will increase its leverage going forward taking into account the management’s growth strategy but will remain below Net Debt / FFO of 3,0x in the base case scenario.

Another relevant aspect to watch over the coming years is Končar’s liquidity. Historically, Končar had been lead quite conservatively, and had maintained net cash position and high liquidity reserves. With the changes in the ownership and management structure, the Group has taken more proactive approach towards growth, both operationally and financially. Liquidity metrics have been deteriorating over the last couple of years but are still at an adequate level. Available cash (cash on accounts, short-term deposits, and available credit lines) comfortably covers short-term debt maturities, however high growth could deplete at least a portion of reserves, leading to a higher liquidity risk.

What has growth brought to Končar’s investors and creditors so far? What are the key risks going forward?

Končar’s growth has been strong over the last two years, but it came at a cost. Firstly, cash flow metrics have been highly negative due to rising raw material prices and effects of acquisition of Dalekovod. Secondly, the leverage has gone up from traditional net cash position to a still modest level yet increasing. The management has not yet deviated from its moderate dividend policy (payout ratio of approx. 25%) which is a positive sign for creditors. Finally, liquidity has been on a downward trend as cash reserves are gradually disappearing but are still at a comfortable level.

Creditors are facing higher risk going forward because the change in the Group’s financial strategy will have impact on all relevant metrics. Končar’s credit rating will feel a downward pressure which will impact pricing. This, together with an increase in base rates could impede Končar’s growth.

CAeu expects that Končar’s credit profile will remain solid, absent any major negative events.

Investors have seen an increase in share price over the last two years, from around EUR 100 per share to around EUR 130 per share. However, given the rather low share turnover due to specifics of the Croatian capital market and the Group’s ownership structure, the increase in share price might not truly reflect all benefits and risks associated with the high growth. Dividends remained flat, with a question mark on the dividend policy going forward.

Here are the key risks to watch going forward:

• Full integration of Dalekovod into the corporate structure
• Inflation and the ability to pass-through cost increases
• Sustainability of the new financial strategy within the context of rising interest rates and debt growth
• Working capital needs in relation to the available liquidity
• Potential new acquisitions taking into account the current debt potential

To conclude, Končar’s financials remain strong despite rising risks. However, the Group will have to sustain the higher level of sales in order to start benefitting from larger scale, which could be challenging amid increasing uncertainties in the global markets and credit conditions. The currently low debt level and still adequate liquidity provide (some) comfort in the short- to medium-term*.

It is much easier to handle high growth and highly negative FCF if your company is large, full of cash, has low debt level to start with, and has good access to capital. All companies relying almost fully on debt financing, especially in volatile industries, will certainly face higher probability of bankruptcy over the coming years.

Understanding your company’s, or your customers’, suppliers’, and competitors’ risks is the key to successful management. CreditAnalyst.eu helps CFOs, CEOs and CROs make informed strategic and financial decisions through advanced financial statements analyses. For more information, please send an email to mario@creditanalyst.eu or call +385 98 920 17 13.

* This analysis does not provide either credit advice or investment advice. Do your own research before granting any kind of credit or before investing in Končar’s shares. CreditAnalyst.eu is not responsible and cannot be held liable in case you make any kind of decisions based on this analysis.