It’s just ‘Weird’

Thus attention has turned to Weir Group (WEIR), the Glasgow-based group that supplies equipment to the mining, oil & gas and power industries. Weir's size - market value £5.1bn with its share price at £26.20 - makes it big enough to acquire substantial companies, but not so big that it is free from predators. US giants such as Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL) and Weatherford International (NYSE:WFT), which stray into Weir's space, are all much bigger.

Weir's problem is that it tried to engineer an all-share merger with a Finnish rock-crushing equipment maker Metso (HLSE:MEO1V). This would have created a company with a market value of £9bn or so. But Weir was rebuffed so it walked away, harrumphing that its strict financial discipline meant it could not possibly raise its intended offer further. Fine. Still, I'm left thinking that Weir needed Metso more than Metso needed Weir. Worse, without a substantial acquisition to occupy the City, attention might turn to the shortcomings of Weir's record and its prospects.

Let's put this another way - following the collapse of talks between Weir and Metso, analysts speculated that Weir itself might become a takeover target. True, that is consistent with conventional wisdom. But the more pertinent question for investors is this: what on earth can justify Weir's share price given that the group can muster so little internally-generated growth and relies so heavily on acquisitions to power itself?

The table 'Acquisition-driven & how' gives a clue to what's happening. It shows some very unusual figures. In the six years from 2008 to 2013, Weir's cumulative spending on acquisitions was more than twice what it spent on its own capital account to renew and add to its fixed assets. Not just that, but capital spending was minimal - barely more than what it charged against accounting profits to allow for depreciation of its assets. In other words, virtually all of the group's capital spending seemed to be aimed at maintaining what it had rather than expanding capacity.

This implies two things. First- as just mentioned - that Weir depended heavily on acquisitions for growth; second, that there was a dearth of investment opportunities. True, the past six years were an exceptionally good period. Profits and earnings were given a mighty boost by a once-in-a-generation demand for hard commodities - much of it propelled by China's dash to modernity - and by the shale gas bonanza in the US. So it may not have mattered much if investment opportunities were few; or maybe management did not even need to pursue too many.

But the big one-off boosts have run their course. For Weir - as for many other capital equipment suppliers - it's back to the humdrum reality of grabbing growth in a harsher world. In which case, the lack of capital spending and the over-reliance on acquisitions don't bode well; nor do they square with Weir's share rating.

Even assuming that 2013's operating profits of £467m are typical - a brave assumption for a cyclical business - then the resulting value falls way short of the share price. Capitalising those operating profits at an 8.5 per cent interest rate, giving the group the small benefit of the tax shelter from its limited debt and adding back surplus cash still only yields a value of £20 per share.

Nor is there much to be garnered by contriving a value for Weir's 'development cap-ex' (the capital spending in excess of depreciation) because there is so little of it. On average in the five years from 2009-13, Weir spent just 7p per share on development cap-ex - next to nothing against its £26 share price. True, if we were to treat Weir's acquisition spending - 100p per year on average in 2009-13 - as quasi development cap-ex that would transform the value being generated. But it would also be wishful thinking.

The blunt truth is that capitalise average operating profits and it is tough to see value much in the excess of £15 per share; capitalise average free cash flow and it is hard to find value much above £10 per share. The disparity between these two values is also a comment on Weir's limited ability - despite its minimal capital spending - to turn accounting profits into cash; and that goes hand in hand with its diminishing ability to turn capital into revenues (see 'Slowing down' table).

It's not that Weir is a poor company - on the contrary. What's amazing is that the share price is as high as it is and that - even from this level - analysts are prepared to speculate that a predator might bid for the company.