HKFoods: When can the hybrid loan be redeemed?

Translation: Original comment published in Finnish on 09/10/2024 at 7:14 am EEST

HKFoods arranged its financial situation in terms of liquidity in June 2024. From an equity investor's viewpoint, the key question in the company is still related to the conditions and timing of redeeming the hybrid loan. In our forecasts, the hybrid will be redeemed in 2026, but this is uncertain and requires good operational performance and stable cash flows from the company. We consider redeeming the hybrid and strengthening other equity to be key steps toward sustainable dividend payments.

Liquidity should be secured for the next couple of years

In June 2024, HKFoods refinanced its 90 MEUR bond and signed a new credit line of 20 MEUR. Both will mature only in 2027, which means that the company’s financial position is secured for the next few years. In addition to the above-mentioned liabilities, the company has approximately 40 MEUR of debts maturing in 2025 (mainly bank loans), but most of these can be paid off with the price of the Danish divestment carried out in 2024 (35 MEUR cash consideration). At the end of June, HKFoods had interest-bearing net debt of 215.6 MEUR, of which the share of IFRS 16 lease liabilities was 91.2 MEUR.

In addition to the above-mentioned interest-bearing net debt, the company has a hybrid loan of 25.9 MEUR classified as equity in the balance sheet, whose annual interest increased to 16% as of September 2023. The high cost of the hybrid loan devours a significant portion of the company’s cash flow, which partly slows down the strengthening of other equity and reduces distributable funds.

Covenants prevent the hybrid from being redeemed for the time being

In September each year, HKFoods has the opportunity to redeem, i.e. pay off the above-mentioned hybrid loan. Earlier this year, the company announced that it will try to redeem the loan in September 2024, but in connection with Q2, the company said that the hybrid cannot be redeemed due to the covenants of the new loan agreements. The covenants are intended to limit the risk related to HKFoods’ creditworthiness from the debt financiers' perspective. The graphs below describe the covenants of HKFoods bank loans and our forecasts of the development of the company’s indebtedness. The covenants of bank loans are slightly stricter than bond covenants. The covenants tighten over time. In the graphs, we describe the development of the terms based on the situation at the end of the year, which is a slightly simplified approach, as changes also occur during the year.

Source: Inderes’ estimate

The graphs show that at the end of June HKFoods’ indebtedness would have been too high relative to covenant levels if the hybrid had been redeemed. However, by the end of 2024, the indebtedness in the balance sheet decreases significantly in our forecasts, which is affected, e.g. by the likely divestment of the Danish businesses, the 5 MEUR payment in August from the Baltic divestment (completed in 2023) and the seasonally improved cash flow during the rest of the year. In our forecasts, HKFoods’ indebtedness continues to decrease during 2025-26, which is affected, e.g., by the expected strengthening of the cash flow from operating activities and the remaining payments from the Baltic divestment (fixed purchase price of 10 MEUR in August 2025 and additional purchase prices in 2025-27, the value of which was 10.5 MEUR in HKFoods’ balance sheet at the end of June). The decline in indebtedness is slowed down especially by HKFoods’ high financial costs, which we estimate will be 16.5 MEUR in 2024 and 13.2 MEUR in 2025, in addition to which approximately 4 MEUR/y is paid in interest on the hybrid. In the presented projections, the hybrid interest rate is assumed to run until September 2026.

Although the estimated key figures of HKFood's balance sheet presented in the above graphs, in theory, decrease in 2025-26 to low enough levels to redeem the hybrid, the safety margin is rather thin to the covenants. In meat processing, cash flows from operating activities are typically weak at the beginning of the year and strong at the end of the year, so meeting the covenants throughout the year requires a safety margin compared to the balance sheet figures at the end of the year. We also believe the company must prepare for fluctuating earnings levels, which could temporarily weaken its solvency.

In a positive scenario, the hybrid is redeemed in 2026

In order to be able to redeem the hybrid in 2026, the company would probably first need (e.g. in summer 2026) to refinance the 90 MEUR bond maturing during 2027 to ensure its long-term financial position. In addition, the redemption of the hybrid requires sufficient cash assets as the redemption may not be possible with a credit line. We believe that the company can successfully accumulate cash flow if the result improves according to our forecasts. However, a key challenge in this situation is whether the company can over two years build a sufficient safety margin for the covenants required by debt financiers. If there is not enough safety margin, the redemption of the hybrid could be postponed again or, on the other hand, the company could resort to share-driven solutions to strengthen the balance sheet.

Earnings improvement is the biggest source of uncertainty

Our current forecasts expect a significant improvement in the company’s EBIT level (adj. EBIT 2023: 11.6 MEUR vs. 2025e: MEUR 24.7). The earnings level has developed positively over the past 18 months, and the company has implemented efficiency-enhancing investments during 2024, the benefits of which will be visible from H2 onwards. On the other hand, the company’s profitability has historically been at a weak level for a long time and has also fluctuated between the years, considering which, we feel there is uncertainty about the expected earnings turn.

Source: Inderes’ estimate

Figures for continuing operations have not been reported as fully comparable for previous years, but the adjusted EBIT for Finnish operations has fluctuated between -37 MEUR and 18 MEUR (median 8 MEUR) in 2010-22. The Group’s administrative expenses should also be considered, which we estimate will be approximately 7-8 MEUR/year after the divestments. Both the actual earnings level for 2023 and the estimated earnings levels for 2024-26 are significantly higher relative to the company’s typical earnings level in history.

Redeeming the hybrid would be a step toward sustainable dividend payments

In a positive scenario, we believe HKFoods could develop into a stable dividend payer in the long term reminiscent of its peer Atria. We feel that the company’s prerequisites for dividend payments would improve significantly with the possible redemption of the hybrid. Of course, the company would still need to accumulate equity in the balance sheet even after redeeming the hybrid to get the balance sheet indebtedness permanently under control. In our opinion, distributing dividends before redeeming the hybrid would be poor capital allocation, considering the high interest rate of the hybrid loan. In the short term, strengthening the balance sheet should be a priority to reduce the high financing costs and promote the long-term investment story.

Source: Inderes’ estimate. 2019-2023 include the result of discontinued operations. 2024-27 only include the result of continuing operations.