Moreover, I attempt to find companies where there is a realistic chance of a multi-month rally in the share price as other investors cotton onto the investment opportunity. This is especially the case for recovery plays that have already undergone a restructuring. That's because any improvement in the cash profitability of the business will enable management to recycle cash into new products or marketing and sales efforts to drive revenues ahead. In turn, this can have an accentuated impact on profits because with a slimmed down fixed cost base after the restructuring, and lower variable costs, a greater proportion of revenues fall through to the bottom line.
A prime example of this is Trifast (TRI: 108p), a leading global manufacturer and distributor of industrial fastenings. The company was a classic recovery play in last year’s Bargain Shares Portfolio and one I am still very positive on as the share price makes headway towards my recently upgraded 125p target price (‘Fasten on for a profitable ride’, 7 May 2014).
And investors are now warming to another classic recovery play I spotted in the same sector, 600 Group (SIXH: 21.5p), a small-cap engineer with a market capitalisation of £18m. Shares in the group have moved up around 13 per cent since I initiated coverage last month (‘Tooled up for a strong recovery’, 14 Apr 2014), but still offer substantial upside to my year-end target price of 30p. I would definitely be buying ahead of the group’s full-year results due out next month.
Improving backdrop not priced in
For starters, 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 the end of March 2014, analyst David Buxton at broker finnCap anticipates 600 Group will grow revenues by 4 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. That will make for some eye-catching numbers on the results statement.
On that basis, expect underlying EPS of 1.8p, up from 1.1p in the year to March 2013. In other words, with 600 Group’s shares trading on a bid-offer spread of 20.5p to 21.5p, then they are priced on less than 12 times last year’s likely post-tax earnings. The respective forecasts for the current financial year to March 2015 are revenues of £47m, pre-tax profits of £2.1m and EPS of 2p. This means the current year PE ratio drops to less than 11.
On any measure the group is the lowest-rated engineer on the market. For the purpose of making viable comparisons, assuming 600 Group reports cash profits of £2.8m for the year just ended, then its enterprise value (market capitalisation plus net borrowings) is only 8.4 times cash profits. To put that into perspective, in the small-cap engineering sector, the shares are rated on a 16 per cent discount to the likes of Ricardo (RCDO) and Renold (RNO), both of which are rated on 10 times cash profits. Even if 600 Group was valued at the sector average rating of 9.4 times cash profits, this would imply a share price of 25p, or 17 per cent above the current price.
But 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 group could prove to be a takeover target. Indeed, 600 Group's board received a bid approach from Qingdao D&D Investment Group last autumn and, although the discussions were terminated as 600 Group's management didn't believe an offer would be forthcoming. If the profit recovery gathers further momentum Qingdao is unlikely to be the last predator sniffing around. At the current share price, we are getting takeover prospects in the price for free.
600 Group is also a rare example of a group with a fully funded pension scheme, so there are no potentially nasty hidden liabilities to deter investors who want to buy into this recovery story. The group’s balance sheet is robust, too, as net borrowings of £5.6m account for only 25 per cent of shareholders' funds, so there is no debt overhang to concern investors with.
Positive outlook underpins earnings recovery
To recap, 600 Group consists of two divisions: machine tools and precision engineered components, and laser marking. The tools business accounts for 90 per cent of 600 Group's profits and activities include designing and developing metal-cutting machine tools and manufacturing precision engineering components. These are sold globally through direct sales in North America (accounting for half of 600 Group's revenues), Europe (17 per cent), UK (15 per cent) and Australia (10 per cent).
Importantly, prospects are looking pretty good. 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 grow strongly, buoyed by the resurgent UK economy.
600 Group's much smaller Electrox laser marking business designs, develops and makes equipment for the permanent marking of a wide variety of materials. These are sold by direct sales operations in the UK and North America, and through an established network of distributor partners throughout Europe. 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 as new products boost sales.
Trading strategy
It's my considered view that the combination of a bumper set of full-year results, a positive outlook statement and one that will fully support what could prove to be conservative analysts' estimates for the current financial year to March 2015, are likely to drive up shares in 600 Group after the results beyond the 12-month high of 24p. Director Derek Zissman is clearly confident of prospects as he doubled his holding last month by buying 150,000 shares at 17.5p. In my opinion, it’s still worth following his lead. Offering 40 per cent share price upside to my year-end 30p target price, I rate 600 Group's shares a recovery buy.
■ Due to a technical glitch, the complimentary postage offer for IC readers purchasing my book Stock Picking for Profit ended prematurely last week. Subject to availability, the offer has been extended to 26 May for all internet orders placed at www.ypdbooks.com. Please use offer code ICOFFER when ordering online. The book is priced at £14.99, plus £2.75 postage and packaging. Telephone orders placed with YPDBooks (01904 431 213) will continue to incur the £2.75 fee. I have also published an article outlining the book's content: 'Secrets to successful stock-picking'
