Each month Richard Beddard trawls through annual corporate results for his Watchlist and the Share Sleuth portfolio of companies that satisfy key valuation metrics such as earnings yield and return on capital – and profiles the most interesting candidates.
Colefax (CFX): Declining demand
Buoyed by the weak pound, Colefax increased revenue by 5 per cent in the year to April 2017, but that wasn’t enough to make good a marked decline in demand in the company’s main export markets, the US and the EU.
On a constant currency basis, revenue fell 5 per cent. In terms of profit, the company received no benefit from its more valuable dollar earnings, due to hedges that essentially fixed the pound to-dollar exchange rate at $1.50, a level decided before the UK voted to leave the EU. The hedges lost Colefax £2 million in 2016, leading to a near 30 per cent decline in adjusted profit.
Colefax designs luxury fabric and wallpaper, and sells it to interior designers and wallpaper and fabric retailers. The ultimate customers are the rich, who reduced their spending in the run-up to the US election in November 2016 because, the company believes, of political uncertainty.
Colefax is also susceptible to the state of the market for plush residences. In the UK, where revenue fell by 1 per cent, the high-end housing market has been dampened, the company says, by very high levels of stamp duty.
Sales are recovering in the US, and tentatively in the UK and Europe, where revenue declined by 6 per cent inconstant currency terms in 2017. In the current year, the negative impact of hedging should be lower too and, provided the pound remains weak, profit should benefit.
Taking a longer-term view, Colefax owns famous and distinct brands, such as the eponymous Colefax & Fowler brand, that have earned reasonable returns even in bad years. Judging by return on capital, 2017 was a bad year: the company returned 7 per cent, which was on a par with 2009 and 2012, the least profitable years of the past 10. Cash flow is strong, though, and management conservative. The firm consistently returned cash to shareholders by buying back shares.
A share price of 520p values the enterprise at just under £90 million, or 23 times adjusted profit. The earnings yield is 4 per cent. Although the valuation looks expensive, profitability should rebound. Colefax shares are probably fairly valued rather than overvalued. A bad Brexit could increase costs, however, because Colefax imports most of its fabrics from manufacturers in the EU.
Goodwin (GDWN): Less profit in the pipeline
Mini-conglomerate Goodwin is just about performing adequately as it reduces its dependence on the oil industry. In the year to April 2017, profit fell for the third consecutive year, to levels last witnessed during the financial crisis of 2008.
Profitability declined because Goodwin is getting lower prices for its products. Its most significant market is the oil and gas industry, which it supplies with pipeline valves. Oil companies and miners, which Goodwin also supplies, have been hit by dramatic reductions in the prices of the commodities they produce. Because their revenues are falling, they’ve cut investment in order to shore up profits, which means fewer pipeline projects.
In response, Goodwin is seeking business in other markets that have hitherto been less significant – US military programmes, for example. It’s also relying more heavily on a second group of refractory engineering subsidiaries that supply the jewellery casting industry with casting powders, waxes, rubber and 3D printers. This is big business in China and India. Goodwin’s refractory engineering division has generally been less profitable than its mechanical engineering division, but in 2017 the former produced almost half of Goodwin’s overall profit.
It earned operating profit of £6 million on revenue of £40 million, while Goodwin’s diminished mechanical engineering division earned a slightly higher profit of £7 million, but this was on much higher revenue of £91 million. While refractory engineering made marginally less profit, its profit margin of 15 per cent was almost twice that of mechanical engineering. Sadly, this reversal has less to do with improvement in the refractory engineering division (although there has been some) than it does with the collapse in mechanical engineering margins.
Overall, Goodwin’s return on capital is just about acceptable, at 8 per cent, but that’s much lower than it was during the oil boom. A share price of £15.50 values the enterprise at about 15 times adjusted profit. The earnings yield is 7 per cent.
While that’s not a high valuation for a company with such a profitable history, Goodwin may not be able to perform as well in future. It must compete in industries where it has less expertise and is less well established. Meanwhile, the company is funding the investment required to serve new markets by borrowing. Goodwin still has reasonably strong finances, but they are being eroded.
Renishaw (RSW): Fair price for the future
In the year to June 2017, export titan Renishaw increased revenue across the board by 23 per cent (or 14 per cent at constant exchange rates) to £537 million.
Renishaw makes machine tools that help manufacturers operate equipment more efficiently. Its probes, gauges and sensors reduce the time it takes to inspect components and automate machines, increasing the speed and reliability of traditional subtractive manufacturing (where products are shaped by removing material). It also manufactures additive manufacturing systems, also known as 3D printers.
Losses in Renishaw’s much smaller healthcare division, which manufactures surgical robots, spectroscopes and medical implants, increased to £6.5 million. This division presents a conundrum when it comes to valuing Renishaw. The company is making long-term investments in new markets that might not reach their potential for many years, although it is focused on making the division as a whole profitable.
If you ignore the potential of the healthcare division and the probability that demand for machine tools will keep growing as factories become more automated, Renishaw shares are frighteningly expensive. The share price of £46.30 values the enterprise at nearly £3.5 billion, about 39 times adjusted profit. The earnings yield is just 3 per cent.
But there’s much hidden value in Renishaw’s know-how. Massive investment over the years has produced more than1,600 patents(which prevent rivals from copying Renishaw’s innovations),and a highly skilled workforce. According to Renshaw’s statistics, employee turnover is well below national averages for manufacturing businesses, which is an important source of advantage because it means skills are retained.
As a designer, manufacturer and distributor, Renishaw is vertically integrated, which Enables it to ensure quality and be somewhat self-reliant. It uses its own machine tools in its manufacturing processes, which gives it insights into how they can be improved. By expanding an already extensive network of sales and support offices, Renishaw is ensuring it can supply and work with manufacturers wherever they are.
The share price of £46.30 may be fair for a slice of the future. But don’t expect the future to unfold smoothly. The industrial markets for Renishaw machine tools – planes, trains, automotive and smartphones, for example – can be capricious, and while the healthcare division promises much, it has yet to deliver.
Dart (DTG): Back down to earth
Rising costs and more competition brought airline and haulage company Dart back down to earth in the year to March 2017. Certainly, 2016 was a hard year to follow: Jet2, Dart’s airline, was able to increase prices, while the cost of jet fuel fell sharply. Dart earned a return on capital of about 26 per cent.
In response to UK tourists’ apparently insatiable appetite for European holidays, Jet2 is expanding. Itis taking delivery of 34 new planes, and it has just opened two new bases at Stansted and Birmingham. However, Jet2 found it harder to fill the seats of its burgeoning fleet in its most recent financial year.
Financing the purchase of the planes and the elevated cost of operating from new bases while they’re still being established also contributed to a reduction in return on capital by almost a half, to 14 per cent.
While Dart is changing, so may the regulatory landscape it must navigate. The future for UK airlines flying to Europe is complicated by uncertainty about the terms on which UK operators will be allowed to fly to EU destinations once the UK leaves the EU. Jet2 is hopeful that the EU will recognise the value of UK tourists to its economies, and that the UK will defend the interests of a valuable industry by ensuring that operators are able to fly pretty much as they are able to now, but nothing is certain.
Mounting financial obligations and increasing uncertainty are a worrying combination, but there’s good reason to keep faith in Dart. Over little more than a decade the company’s entrepreneurial managers have firmly established Jet2holidays, to the point where the package tour company now fills almost half of Jet2 airline seats. Dart has developed a highly profitable niche–family-friendly holidays– and it believes its packages will remain popular in recessions, not just because an annual holiday is almost obligatory for many families, but also because all-inclusive holidays and low initial deposits make budgeting easier.
A share price of 520p values the enterprise at nearly £1.3 billion, or about 13 times adjusted profit. The earnings yield is 8 per cent. The lowly valuation probably prices in a period of turbulence while Dart digests its larger fleet and the UK leaves the EU. The shares may well be good value.
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