To recap, the company offers a range of original equipment manufacturer (OEM) and own-brand products to around 3,000 distributors and resellers. Flowtech's catalogue contains no fewer than 47,000 individual product lines and is distributed to over 90,000 industrial maintenance, repair and overhaul end users from facilities in the UK and Benelux. Over 80 per cent of products are stocked and can be delivered next day by national courier service FedEx, providing a 'best in industry' service offering. The domestic market accounts for 88 per cent of sales.
Post flotation, Flowtech had pro-forma shareholders' funds of £49.4m and net borrowings of £7.1m to give a modest net debt-to-equity ratio of 14 per cent. Current assets of close to £20m, half of which is stock and £7.6m are trade receivables, are largely funded by gross borrowings of £9.4m and trade payables of £4.5m, so the working capital position is pretty comfortable with currents assets exceeding current liabilities by almost £12m. This means that the company has the firepower to make selective bolt-on acquisitions, something the company put into practise this week with the purchase of Knowsley-based Primary Fluid Holdings for a total consideration of £9.8m.
Primary Fluid specialises in designing and making hydraulic systems and purifiers, which accounts for about two thirds of its turnover, and also distributes hydraulic components which represents 30 per cent of revenue. It also has a small service and repair business too. For the financial year to 31 December 2013, the business reported revenue of £11.2m and profit before tax of £1.1m. Net assets at the same date were £5.2m. Following completion of the acquisition the business will continue to operate from its existing facilities and the current management team will remain with the business.
Earnings enhancing acquisition
Importantly, the acquisition is likely to boost Flowtech’s earnings per share in the first year of ownership given the structure of the deal. That’s because the company is paying £4.65m in cash on completion; a further £1.6m on the first anniversary of completion; and the balance of £3.5m by allotting 2.8m new ordinary shares in Flowtech at 124p each. The acquisition includes property which is owned by Primary Fluid and valued at £1.1m and, at completion, Primary Fluid will have a net cash position of £1.7m. In other words, Flowtech is in effect only paying £2.95m in cash up front, all of which can be funded from bank facilities or internal cashflow. The 2.8m new shares issued to the vendors, representing 7 per cent of Flowtech’s existing issued share capital of 40m shares, are subject to a lock-in period of 12 months from completion before they can be disposed of.
It looks a decent fit too. As Sean Fennon, chief executive of Flowtech rightly points out: "We have known this business for some time and the culture is similar to ours; we believe that this is a great opportunity to build on the strong foundation we have created to date and increase our product portfolio, principally by strengthening the Flowtech offering in Hydraulics, a market predicted to continue its exceptional growth momentum."
Other deals are possible too now that Flowtech has been removed from the shackles of its former private equity owners. Indeed, it could easily use its paper to acquire existing distributors to accelerate the move into new markets. As long as the company pays a sensible price, as it has done with Primary Fluid, then it makes sense too and a strategy that investors are likely to continue to warm too given the company’s modest share price rating and robust earnings growth expectations.
Strong financials
In fact, factoring in a small contribution from the Primary Fluid acquisition to earnings this year post completion of the deal, analysts at Edison Research now expect Flowtech’s underlying pre-tax profits will rise by a third from £4.5m in 2013 to £6m driven by a 13 per cent rise in revenues and margin gains. On this basis, expect EPS to increase from 8.2p to 11.5p, implying a forward PE ratio of 11. But it's in 2015 when the benefits of the acquisition start to come through. The respective estimates for 2015 are pre-tax profits of £7.3m and EPS of 13.4p, based on a 32 per cent increase in turnover to £45.4m. Prior to the acquisition, Edison was predicting profits of £6.3m and EPS of 12.5p.
On this basis, Flowtech shares are now trading on well under 10 times next year’s earnings estimates. To put that rating into some perspective, the average PE ratio for Flowtech’s peer group is 15.9 for fiscal 2014 and 14.2 for 2015. For the current financial year, the forward earnings multiples for industrial distributors are 15 for HellermannTyton (HTY: 320p) and 16 for Brammer (BRAM: 437p). This means that Flowtech shares are already priced 20 per cent below the lowest rated company in its universe even though it has a robust earnings growth profile for the next couple of years at least. The valuation anomaly becomes even more pronounced next year as on my calculation the share price discount is in excess of 30 per cent.
If that’s not reason enough to invest, the board has stated it plans to pay a dividend of around 5p a share for fiscal 2014, so the prospective yield is 4 per cent with the shares trading on a bid-offer spread of 125p to 127p. Covered more than two times by post-tax profits, the dividend is not only secure, but the board have scope to adopt a progressive policy in the future.
In my view, the combination of a surge in profits this year and next, margin improvement, and a maiden dividend, all make for a compelling investment case and one that on a 12-month basis a wider investor audience will undoubtedly be attracted to given Flowtech’s lowly share price rating. I also feel that the shares should be trading nearer to the sector average earnings multiples, implying a target price of at least 165p, or a third per cent higher than the current price. Needless to say, I continue to rate Flowtech's shares a buy at 127p ahead of the company’s interim results on Tuesday, 16 September.
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
