As a value investor, I also try and search out companies with substantial asset backing and a strong balance sheet so that the management team have the time to turn around the business. In the optimum scenario, an improvement in the cash profitability of the business will enable the management to recycle cash into new products or marketing and sales efforts to drive revenues which will in turn have an accentuated impact on profits given the operational gearing effect. That's because with a much reduced fixed cost base, and lower variable costs, a greater proportion of revenues falls through to the bottom line.
Over the years, I have managed to identify a number of such recovery plays and many in my annual Bargain share portfolios. For instance, Trifast (TRI:85p), a leading global manufacturer and distributor of industrial fastenings, was a classic recovery play in last year’s portfolio and one I am still very positive on as the share price makes headway towards my 100p fair value target price ('Time to make a bolt-on purchase', 18 March 2014). I have also spotted another in the same sector, 600 Group (SIXH: 19p), a small cap engineer with a market capitalisation of £17m.
Platform in place for earnings recovery
The company consists of two divisions: machine tools and precision engineered components, and laser marking. The tools business is by far the larger operation and accounted for 90 per cent of 600 Group's profits last year by designing and developing metal cutting machine tools under the brand names Colchester and Harrison, and manufacturing precision engineering components under the brand names Pratt Burnerd and Gamet. These are sold globally through direct sales in North America (Clausing) with region accounting for 50 per cent of 600 Group's revenues, Europe (17 per cent), UK (15 per cent) and Australia (10 per cent). The balance of sales are made in Africa, central America, The Middle East and The Far East.
The much smaller division is laser marking which trades under the Electrox brand. This operation designs, develops and manufactures equipment for the permanent marking of a wide variety of materials using lasers from its operations at Letchworth Garden City. These can be sold as a custom product for integration into automated production lines, or fitted into a range of standard and custom workstations built at 600 Group's facility. The equipment is then sold by direct sales operations in the UK and North America, and through an established network of distributor partners throughout Europe and beyond. The laser unit generated revenues of £6.9m in the financial year to end March 2013 at a margin of 3.1 per cent, whereas the tooling division reported revenues of almost £35m and enjoyed a much healthier margin of 6.1 per cent.
And as I alluded to at the start of this article, 600 Group is showing all the traits I look for in a recovery play. Firstly, the company refinanced its credit lines in September 2012 and also had an equity raise. Combined with a restructuring of the business, the sale of surplus freehold property and the sale and partial leaseback of its main facility in Heckmondwike in West Yorkshire in December 2012, this resulted in net debt being slashed from £8m in March 2012 to £5.6m by last September. That's the equivalent of 25 per cent of shareholders funds so net borrowings are now relatively modest. Apart from reducing the cost base which led to some hefty one-off charges in the last financial year, 600 Group's management team also strengthened the financial and operational control environment by introducing a dashboard of key performance indicators (KPIs) for each business unit. Customer service was targeted as an area of need of improvement.
Moreover, with the benefit of a much stronger balance sheet, the board had the finances at its disposal to invest in new product development, production equipment and facilities, and return inventory holdings back to normal levels in order to support sales activity in the UK businesses. As a consequence, customer backlogs, which had become unacceptably high in Europe, are now back to acceptable levels by industry standards, although further improvements are being targeted. That's an important point to note because customer loyalty had been severely tested, but is now proving robust a fter the company re-established lead times and quality standards that meet or exceed the requirements of its clients. Management has also been able to move the main focus of its relationships with supply chain partners from financial issues towards design-led cost reduction activity and product development.
Market back drop
It also pays to research the industry back drop in order to ascertain whether or not the environment is favourable for revenue growth, so the business can benefit from the operational gearing effect of rising sales. On this score, machine tool consumption in North America, which had been broadly stable since 2010, has been declining second the second half of the 2012/13 fiscal year. Despite this 600 Group's North American business, trading under the Clausing brand, has delivered healthy growth by focusing on market share gains through customer service. Almost half of revenues are derived from the sale of work-holding, accessories, spares and service, and these activities tend to be less reliant on the manufacturing investment cycle than the sale of machine tools.
Importantly, there is now a real prospect of revenue growth in the region. According to research from Oxford Economics and the latest Global Machine Tool Survey, the North American market is expected to report double digit growth this year. The European market, where 600 Group's sales were up 35 per cent in the first half of the financial year to March 2014, is also expected to lead the growth, buoyed by the resurgent UK economy.
This explains why in the six months to end September 2013, the tool division reported a near seven per cent rise in revenues to £17.7m and a near trebling of operating profits to £1.2m. Operating margins surged from 2.8 per cent to 6.9 per cent as the benefits of improved operating efficiency, higher throughput at the Heckmondwike site, a more favourable sales mix of component and aftermarket sales improved profitability. There should be scope for further growth, too, especially since 600 Group has regained exclusive rights to the distribution of Colchester branded products in Germany, the largest market in Europe. This important development should provide opportunities to increase market share in the territory, a point I will be paying close attention to when 600 Group reports its full year results in June.
I will be also paying attention to the performance of Electrox. The division reported flat revenues of £3.5m in the first half as the main focus in the period was launching a new range of laser marking equipment. These products have been well received by the market and I understand the order intake has been strong in the second half to end March. This augurs well for the full-year outcome. In the first half, Electrox still managed to grow operating profits by 30 per cent to £144,000 on a 4.1 per cent margin, so I will be looking for more margin upside at the full-year stage. That seems feasible considering the global market for laser marking is estimated at more than £200m, of which Electrox has a 3.5 per cent market share, so there is scope for market share gains to boost sales.
Earnings recovery set to take hold
The improving market back drop in both Europe and North America, combined with the upside from new product launches, is set to propel 600 Group's profits northwards. For the financial year to end March 2014, analyst David Buxton at brokerage finnCap anticipates 600 Group will grow revenues by four per cent to £43.5m and, with the benefit of a lower cost base, this will drive pre-tax profits up almost fivefold to £1.9m. On this basis, expect underlying EPS of 1.8p, up from 1.1p in the year to March 2013. The respective figures for the current financial year to March 2015 are revenues of £47m, profits of £2.1m and EPS of 2p.
The surge in 600 Group's pre-tax profits can be easily explained by the increased cash profitability of the business. That's because cash profits are forecast to rise from £1.7m in the financial year to March 2013 to £3.2m in the current year, so the £1.5m difference accounts for 90 per cent of the rise in pre-tax profits over the two financial years. It also illustrates how the cost reduction programme and efficiency savings are feeding down to the bottom line.
But even if 600 Group only meets expectations for the current fiscal year then it's shares are very modestly rated on a prospective PE ratio of 10. In fact, they are the cheapest engineer in the universe I cover on any measure. For instance, assuming 600 Group reports cash profits of £2.8m for the year just ended then its enterprise value (market capitalisation plus net borrowings) of £22.6m is only eight times those cash profits. To put this into some perspective, in the small-cap engineering sector, the shares are rated on a 33 per cent discount to the likes of Carclo (12 times cash profits to enterprise value); and 20 per cent below the rating of Ricardo (RCDO), Renold (RNO) and Gooch & Housego (around 10 times). Even if 600 Group was only rated at the sector average rating of 9.4 times cash profits, this would imply a share price of 25p.
However, there is a case to be made that the shares should enjoy a higher rating given the strength of the earnings recovery and the fact that the company could prove to be an interesting takeover target. In fact, 600 Group's board received a bid approach from Qingdao D&D Investment Group last September. These discussions were terminated by 600 Group's board in February as they didn't believe an offer would be forthcoming following protracted negotiations. However, if the profit recovery gathers further momentum it is unlikely to be the last predator sniffing around especially since 600 Group has the benefit of valuable trading and capital losses in the UK from previous years. Interestingly, the top seven shareholders control 57 per cent of the 84.5m shares in issue, so if the price was acceptable it would be relatively easy for a bidder to gain control of the company.
600 Group is also a rare example of a company with a fully funded pension scheme so there are no hidden nasty liabilities to deter potential investors. And the great thing is that there is no bid premium at all in 600 Group's share price given its sub-sector rating.
Target price
True there is some overhead resistance to the share price at November's high of 22p, which was hit following the bid approach last autumn. But beyond that there is only minor resistance at 23.5p, dating back to the high in May 2012, and after that the share price should have a free run up to the May 2011 high of 38.75p. Clearly, a strong earnings recovery and one greater than finnCap's current forecast will be needed to drive 600 Group's shares back to that level. But it's not impossible if the recovery in the North American market and the ongoing strength in mainland Europe for the group's tool and precision equipment prove even stronger than analysts currently predict.
Clearly, director Derek Zissman is confident of prospects as he recently doubled his holding by buying 150,000 shares at 17.5p. In my view, its well worth following his lead. Ahead of full-year results in June, and the next trading update, I rate the shares a medium-term buy on a bid-offer spread of 18.5p to 19p. My year-end target price is 30p.
Please note that I am working my way through a long list of companies on my watchlist that have reported results or made announcements recently including: IQE (IQE), Pure Wafer (PUR), LMS Capital (LMS), Communisis (CMS), Eros (EROS), Inland (INL), Netplay TV (NPT), API (API) H&T (HAT), Air Partner (AIP) and Record (REC).
