Heidelberger Druckmaschinen : Improved earnings and FCF, strategic transformation continues; but we change our recommendation to Reduce (vs Buy) on tight valuation

Heidelberger Druckmaschinen AG’s (HDD) full-year results for its fiscal year 2016-17 (ending 31 March 2017) showed flat sales, but material improvement in earnings and free cash flow on the back of lower restructuring costs and payouts and further improved working capital efficiency. - The EBITDA margin, at 7.1% (2015-16: 7.5%), came in at the lower end of HDD’s target corridor (7-10%), despite drupa print fair costs of € 10m. Our Oddo adj. EBITDA, which excludes certain (non-operating) items, improved to € 163.6m in 2016-17 (2015-16: € 161.7m) yoy. - We believe that HDD’s capital structure and Oddo adj. net leverage (2x excluding and 5.6x including pensions and operating leases) is acceptable, and its liquidity resources are sufficient. We take comfort from the fact that HDD’s pension liabilities are long-dated and that it faces manageable annual pension payments of € 8-10m currently (rising to max c.€ 15m p.a in later years). - Although its new equipment business is clearly cyclical, HDD’s general ability to generate material free cash flows in normal business years is noteworthy, although its ongoing transformation and investments will not allow the company to realise its full FCF potential in the short- to medium-term. - Strategically, HDD is moving ahead with its digital focus and further cost impacts in this transition phase will weigh on earnings in coming years through restructuring, optimisation and integration costs related to its bolt-on M&A strategy. Nevertheless, we believe HDD’s strategy is the right way to strengthen its “razor-blade” business (aftermarket. services, consumables), transform its “razor” business (equipment) towards digital and to expand in growing segments such as packaging and in geographic growth markets such as Asia, although the latter is currently difficult. - HDD’s 2021-22 sales and EBITDA targets of € 3bn and € 250-300m respectively are ambitious, but not out of reach – if it can execute on its M&A strategy and acquire higher-margin businesses in the less capital-intensive services/consumables space. - Credit Opinion: We maintain our ‘B’/Stable credit opinion as we see no rating upgrade pressure, following S&P’s methodology. However, we deem that HDD’s corporate rating suffers too much from its long-dated pensions, which entail manageable pension payouts in the coming years, as well as the stigma that the rating agencies attach to the global printing industry. While the latter is indeed true, we would note that HDD has very limited exposure to difficult webfed offset printing. - Recommendation: Downgrade to Reduce, driven by the further bond price surge (the bond trades now at 109.1%), which leaves a YTC of 1.8%. A call in May 2018 is certain in our view, as this would enable HDD to lower its interest coupon of 8% to a maximum of 5-6% (our estimate) if it issues e.g. a new 5-year bond. - - >