A share ready to smoke

Specialist engineer Molins (MLIN: 125p) may be well below the radar of most investors, but the Milton Keynes based company has an interesting story to tell and one that is yet to be priced into its share price.

Currently, around 60 per cent of sales come from the tobacco industry where Molins specialises in improving the effectiveness of existing customer plant, monitoring and testing product quality and conducting the analysis of cigarette smoke. This is the high-end part of the business and accounts for a quarter of revenues. The core business, specialising in manufacturing and servicing tobacco processing machinery, accounts for a further 35 per cent of turnover with balance coming from supplying packaging machinery to the pharmaceutical and fast-moving consumer goods (FMCG) markets with the aim of improving operational efficiency of plant.

By its nature the business carries a variety of risks, no more so than macro risk as it is highly exposed to a changing economic climate which impacts order visibility and can lead to cancellations. Molins also carries currency risk since only 13 per cent of sales are originated in the UK and manufacturing facilities are located in a number of countries overseas. There is competition in the after-market from third-party suppliers, too.

Compelling valuation

These risks partly explain why the company is being valued at only £24.7m, almost 20 per cent below net asset value of £30.6m, even though there are no financial concerns. In fact, Molins has net funds of £5.7m and that was after making £1.9m of capital and product development spend in the first half. Or put it another way, deduct net cash from the market cap and a business that generated cash profit of £7.5m in 2011, is being valued at only £19m. Now that ludicrously low multiple of profits would be justified if sales were sharply going backwards. But this is not the case as at the half-year stage order intake was running 14 per cent ahead of the same period in 2011 and, in a trading update last week, chief executive Dick Hunter revealed that sales in the third quarter were at similar levels to the first half and order intake was ahead of last year. Importantly, each of Molins's three businesses has a strong order book for delivery in the fourth quarter which offers reassurance that the company will meet broker forecasts for the full-year.

Analysts at Canaccord Genuity are currently predicting a 16 per cent rise in the company's full-year cash profits to £8.7m, based on a £1m increase in revenues to £90.9m and reflecting a 120 basis point rise in cash profit margins from 7.5 to 8.7 per cent. Underlying pre-tax profits will be flat, though, at around £4.5m, after deducting non-cash depreciation and amortisation charges of £4m, up from a £3m charge in 2011. However, it's worth pointing out that a large proportion of the £1.5m spent on capital expenditure in the first half was directed towards tobacco testing business Arista Laboratories, in order to take advantage of the extra demand for its services resulting from tighter US regulations being implemented by the Food and Drug Administration (FDA).

Demand driven by new regulation

Currently, the US regulator is hearing representations from cigarette manufacturers in advance of issuing guidance on 2013 testing requirements in the coming months in order to tighten up the testing regime for harmful compounds found in tobacco smoke. The new regulations are expected to be published in April. True, the exact timescale and nature of the FDA new testing regime is uncertain, but what is not in doubt is that Molins is ideally placed to capitalise on the opportunities in the years ahead.

Moreover, by having an onshore US testing facility, Molins has a significant logistical advantage and a marketing one, too, to attract business for its testing services. That could be really important because the new FDA consultation list has over 90 harmful compounds on it that could be tested, compared with only 20 that are subject to testing at the moment. As a result, industry analysts believe that several of the major tobacco manufacturers, who currently do the testing of these compounds in house, will outsource much of it in future. In turn, this could offer a real opportunity for Molins to grow its testing business, something that I firmly believe has not been factored into the company's valuation. In fact, once the FDA makes its announcement, I think the penny will drop among other investors.

Strong dividend support

It's worth pointing out that the investment in the testing business is not being made at the expense of shareholders as the board raised the dividend by 5 per cent last year to 5.25p a share, so even a maintained payout would imply an attractive yield of 4.2 per cent. There is no doubt at all that the payout will be at least held because, even after factoring in further investment in Arista Laboratories, Molins' year-end net cash pile is still expected to be around £5.7m, equating to 30p a share. Moreover, underlying pre-tax profits of £4.5m will produce EPS of 17.7p so that payout, which accounts for a modest £1m of £8.7m of cash profits, is comfortably covered.

So, with the FDA set to announce a new tobacco testing regime in the coming months, Molins' shares, at 125p, look set for a re-rating priced on seven times earnings and a hefty 20 per cent below book value. I have a target price of 150p and rate the shares a trading buy.