Why has Hornby come off the rails?

Trains and Planes and Automobiles
and Paint, and Kits, and Glue
put together the way Hornby thought
was That the Thing to Do ?

A modern day nursery rhyme or a business school case study in the making?

Hornby (AIM: HRN), with a market cap of £20m now (versus a peak of £100m) and annual sales of £62m in the UK and Europe, has been throwing everything into its toy-box. Over the last twelve years it has been bringing together a disparate collection of businesses, all of which are only loosely connected with toys (models Hornby would say) and have very different types of end market.

It has model and hobby brands that all boys and some girls will recognise – Airfix, Scalextric, Humbrol, Corgi, Pocher – and of course the grand-daddy of them all, Hornby Trains. Even that is now a disparate collection including Rivarossi, Lima, Arnold, Joueff, Electrotren – all Hornby’s counterparts in Italy, Germany, France, and Spain

And through enormous vicissitudes partly, but not entirely, due to those of the toy industry in general and possibly the model trains industry in particular, it has been trying to weld them all into a modern-day  international marketing distribution and manufacturing group, although it hasn’t quite got there yet.

In a more than 100 year history, the original pre-war Hornby trains went through various incarnations in the ’60s and ’70s, including being owned by Triang; and, when the latter went bust, buying itself out and listing on the USM in 1986; and then, in 2001 on the main market, from whence last year it went back down onto AIM again.

On the way it bought its various other businesses – some, especially the model trains, after their respective owners got into their own difficulties. The last in 2004 was the up-market Italian Rivarossi, which itself had acquired its Italian mid-market counterpart Lima, and before that the mid-market Arnold in Germany, and the down-market French Joueff. Today Trains still delivers some 45% (about £30m) of group sales with, in normal times, the highest margin. Scalextric and Airfix/Humbrol bring in another 45%.

Perhaps such a list itself spells trouble. These brands were not the only ones struggling to find the right quality and price points in what some might have thought was a declining market (although not everyone would agree that is the case today). In Germany and Austria famous brands like Marklin, Fleishmann and Trix have all gone bust and been rescued or merged. For a time Marklin was owned by private equity group Kingsbridge Capital, who paid over $100m for its equity and debt before Marklin itself went bust in 2009.

But like all those famous brand names, Marklin was rescued again and still survives. Maybe that teaches us something. That all these brands encompassing many levels of price and quality are kept going shows that each has value – but obviously only within its particular, relatively small, market niche.

The same must go for Hornby’s other brands. Consultants McKinsey would probably charge tens of millions to thoroughly research all the market niches, manufacturing facilities (most are now concentrated in a few Far East OEMs) and distribution channels that would enable Hornby to most efficiently weld itself together. Failing that, Hornby has been trying on its own – and incurring severe losses and disruptions along the way. But the brands themselves – 32% of the latest balance sheet and valued at 24p/share – seem to have solid value.

The recent collapse in the shares has followed four years of steadily declining profits (which had reached nearly £9m in 2007-8 enabling an 8.5p per share dividend) and then severe losses caused by, according to Hornby, a succession of external problems.

First, from 2012 onwards has been ‘Trouble out East’ in the form of disruptions and production delays, while Hornby Trains’ key Chinese supplier since 1997 Sanda Kan (supplier to many other brands also) nearly went bust under the ownership of JP Morgan private equity, and was rescued by competitor Hong Kong Kader Industries. Those disruptions have cost Hornby substantial lost sales and profit in what is usually its largest and highest margin business and, while slowly receding as Hornby has diversified away from one sole supplier, were still costing 15% of budgeted train sales in the year to March 2015, after a horrendous 41% in 2014 when the group plunged to a £4.5m loss.

It also suffered a self-inflicted loss in 2012-13 after it badly overestimated demand for special products for the London Olympics.

To counter all this, Hornby has been diversifying away, at some further cost, from Kader, and also completely reorganising by outsourcing distribution, moving its head office, and starting to install a company-wide ERP system. To implement this Hornby took on board as CEO Richard Ames in April 2014, who in mid 2015 helped the chairman promise that “the future of the business is brighter than it has been for some time”. This was after the company had approached breakeven in the year to March 2015, and was provided shareholders stumped up £15m in a near 1 for 2 fundraise at 95p that would pay for the reorganisation and enable it to secure renewed banking facilities.

Unfortunately the wheels started to come off only two months later in September with a profit warning, followed in November by a further warning of a £2m group loss for the year as implementation of the ERP system, which had been successfully completed in the UK, was causing disruption with its extension to the European businesses. All this impacted the half-year results with the usual seasonal first-half break-even turning into a £4m loss, while a couple of weeks ago an even bleaker picture for the full year emerged:

“The Group is expecting a substantially wider trading loss than previously forecast while a full stock take and a balance sheet review following the reorganisation of the European subsidiaries will result in a £1.0m write off. In total the Group is now expecting to report an underlying loss before tax in the range of £5.5m – £6.0m – a substantial setback in our recovery plan for the business. As a result the Directors consider there to be a risk that the Group will breach a covenant of their banking facility in March 2016.”

No wonder Mr Ames had to go. But does it mean Hornby plc really is now worth only £20m (with the shares at 37p) compared with net balance sheet assets (after the £6m loss) of £36m and some £60m annual sales?

Observers seem to be unanimously pessimistic, especially about the banking covenant. And a few discretionary funds have sold – though not completely out – while another has added to its position. Despite the supply problems in the Trains business, there is no suggestion the company has no future: in fact customer feedback at recent toy fairs has been good, and a glance at eBay shows that Hornby’s train products are highly sought after, even for used items at prices above retail, while its habit of manufacturing in batches leaves pent up demand for many items.

As mentioned, the brands alone are valued in the balance sheet (mandated, these days, to fairly represent them) at 24p per share. And, traditionally, at the March year end the balance sheet shows inventories and trade debtors well exceeding what is owed to suppliers. Last March after the Christmas boost the former totalled £24m against £9m in trade creditors, while at the latest September 2015 balance sheet when stocks build before Christmas, stocks and debtors had ballooned to nearly £31m, with creditors level. That is probably the effect of the European distribution hiccup and explains the borrowing problem despite the receipt of the £15m funding in August.

Despite the hiatus, and the resulting loss of sales that the company reported after Christmas, the balance sheet should return to normal at some point, especially as the company still says its ERP implementation is on-going.

And behind the scenes, if all goes really pear-shaped and the bank turns nasty, lurks Bachmann, probably now the world’s largest model train company, albeit with only about half of Hornby Trains’ turnover in Europe where it competes head to head. Until recently its owner and in-house manufacturer, Kader, also manufactured for Hornby (we don’t know by how much it has now diversified away) while Bachmann, who is strong in America, has a reputation for mopping up competitors to bring their manufacturing operations into its owner’s Chinese plants. Bachmann UK, like Hornby, has also suffered supply disruptions, erratic sales, and thin margins, but seems to have backlogs for its models, so that putting the two together shouldn’t damage the sales of either.

All in all, this appears to be an interesting situation that might be worth a punt – although the shares are currently very volatile. Phoenix Asset Management, who has 29.6% following last year’s funding, must have thought Hornby a ‘goer’ then, while two other institutions hold another 37%, so they will decide whatever happens now.

And it must be said also that there has been disquiet on trade boards about changes to terms that Hornby has been imposing in the last few years, including selling direct, bypassing some long-standing distributors, and attempting to stop on-line sales that may themselves be contributing to Hornby’s erratic orders. If so, its business might be in more trouble than it appears.