To recap, the company offers an unrivalled range of original equipment manufacturer (OEM) and own-brand products to over 3,600 distributors and resellers. It's a sizeable operation as Flowtech's catalogue contains 52,000 individual product lines and is distributed to 85,000 industrial maintenance, repair and overhaul end users from facilities in the UK and Benelux. Recognised as the definitive source for fluid power products, over 80 per cent of products are stocked and can be delivered next day by national courier service, providing a 'best in industry' service offering. This core distribution business accounts for two thirds of the company’s revenues and is very profitable too, generating margins of 20 per cent before central overheads. So why the steep de-rating?
Unwarranted de-rating
Ordinarily, shares only de-rate severely if a company issues a profit warning, or the rating is too rich to start with. On both counts this is clearly not the case with Flowtech. Indeed, having edged up pre-tax profits to £3.3m on revenues up by 24 per cent to £21.4m in the first six months of last year, the company recently announced in a pre-close trading update that full-year revenues rose by 18 per cent to £44.7m, implying second half revenue growth of 13 per cent.
True, the contribution from those two aforementioned summer acquisitions – Northern Ireland-based Nelson Hydraulics, a distributor of hydraulic equipment, components and hose assemblies, and North Wales-based Albroco, a distributor of hydraulic and electro-mechanical components to the mobile, on- and off-highway and construction markets – have helped drive top-line growth. Prior to coming under Flowtech’s ownership, they generated combined annual operating profits of £900,000 on revenues north of £8m.
The bottom line is that the company is set to increase its 2015 pre-tax profits from £6m to £6.7m, implying EPS have risen from 11.4p to 12.3p. On this basis, the shares are rated on only 9 times last year’s likely earnings. The board have also committed to raising the dividend by 5 per cent to 5.25p a share, so there is an attractive 5 per cent dividend yield on offer too. They can certainly afford to do so because year-end net borrowings were £500,000 lower than previous guidance at £8.9m, representing balance sheet gearing of 15 per cent and a very comfortable 1.2 times cash profits earned in 2015.
Clearly, the fall off in demand from end markets in the oil and gas industry has caused concern amongst some investors given this impacts the maintenance, repair and overhaul (MRO) market that Flowtech Fluidpower services. However, growth from other sectors has clearly compensated for that shortfall. I also feel that investors have yet to factor in the sharp falls in sterling against the euro in recent months. That’s because sterling’s strength in the first half of last year masked a strong operational performance in the Benelux region, so a previous strong headwind has in effect turned into a benign tailwind. It’s only fair to say that the £700,000 growth in pre-tax profits last year was a little less than I had anticipated when I last reviewed the investment case in September. But it’s still growth and makes Flowtech a stand out performer in the UK industrial markets. It certainly doesn’t warrant a 28 per cent decline in the share price since September, a drop that’s almost 10 percentage points more than the decline seen in the FTSE engineering and machinery index.
Moreover, the lowly rating implies that profits will grind to a halt this year even though the company is set to benefit from a full 12 month’s contribution from acquisitions, and there is a strong possibility of further bolt-on purchases being made. Indeed, I understand that Flowtech's board plan to utilise the company’s lowly geared balance sheet and are actively pursuing several potential acquisitions at the moment.
Forecasts for the year ahead
Even without factoring in a contribution from any more acquisitions, Flowtech Fluidpower’s bottom line should still get a £450,000 additional uplift from the operating profit earned from the Nelson Hydraulics and Albroco acquisitions over a full 12 months trading period, rather than only six months in last year’s results.
Frankly even if analyst Andy Hanson at house broker Zeus Capital proves too optimistic in his assumption that the company can deliver current year revenues of £52.9m to drive up pre-tax profits to £8.1m and deliver EPS of 14.9p, the fact that Flowtech’s niche business is posting growth is definitely not reflected in the current rating. And with balance sheet gearing so low, there are good prospects for a further 5 per cent uplift in the payout to 5.5p a share as Mr Hanson predicts. In fact, the £2.37m cash cost of that prospective dividend is covered 3.3 times by the cash profits Flowtech made last year, and is almost four times covered based on estimates for 2016.
Priced on a 16 per cent discount to book value, rated on a 30 per cent plus discount to the distribution sector average earnings multiple, in my view Flowtech Fluidpower’s shares rate a buy on a bid-offer spread of 107p to 109p. Buy.
Please note that I have published two columns today and have analysed the investment cases of 10 companies so far this week. My 2016 Bargain shares portfolio, and updates on all 10 constituents of my 2015 portfolio, will be published on our website and on the IC app after the market closes on Thursday 4 Febraury.
MORE FROM SIMON THOMPSON...
I have written articles on the following 41 companies this year:
■ Grainger: Buy at 243.5p, target 280p; Dart: Take profits at 580p; Crystal Amber: Hold at 159p; Redde: Take profits at 203p; Burford Capital: Run profits at 196.5p; Renew: Run profits at 404p; Plethora Solutions: Speculative buy at 4.5p ('Stock check', 5 Jan 2016)
■ Elegant Hotels: Buy at 118p, target price 130p to 135p ('Check in for a profitable stay', 6 Jan 2016)
■ Safestyle: Run profits at 272p ahead of pre-close statement on 25 Jan 2016 ('Clear cut gains', 6 Jan 2016)
■ Epwin: Run profits at 143p, new target 170p ('Epwin on the acquisition trail', 6 Jan 2016)
■ GLI Finance: Recovery buy at 37.5p ('GLI shelves fundraise and its chief executive', 6 Jan 2016)
■ LXB Retail Properties: Buy at 97.5p, new six-month target 120p; Urban&Civic: Buy at 286.5p, target 325p; Conygar: Buy at 172p, target 200p ('Hot property, 7 Jan 2015)
■ Somero Enterprises: Buy at 139p, target 185p; 1pm: Buy at 70p, target 82p; First Property: Run profits at 53p; Avation: Buy at 145p, target 200p ('Small-cap value plays', 11 Jan 2016)
■ 32Red: Run profits at 147p; Netplay TV: Buy at 7p ('Chipping in', 12 Jan 2016)
■ Cambria Automobiles: Buy at 87p, new target 95p; Vertu Motors: Buy at 76p, target range 85p to 90p ('Motoring ahead', 12 Jan 2016)
■ Global Energy Development: Hold at 24p ('Cash rich, but unloved', 12 Jan 2016)
■ KBC Advanced Technologies: Bank profits and sell in the market at 183p ('Tech watch, 13 January 2015)
■ Sanderson: Buy at 75p, target range 85p to 90p ('Tech watch, 13 January 2015)
■ Trakm8: Buy at 300p, new target 400p ('Tech watch, 13 January 2015)
■ Amino Technologies: Buy at 120p, new target range 155p to 160p ('Amino has the ammunition', 14 January 2015)
■ easyHotels: Buy at 89p, initial target 100p ('easyHotels ramps up expansion', 14 January 2015)
■ Stanley Gibbons: Hold at 58p ('Stanley Gibbons fundraise', 14 January 2015)
■ Miton Group: Buy at 28p, target 35p; Moss Bros: Buy at 97p, target 120p to 130p; Bioquell: Buy at 140p, minimum target 170p; UTV Media: Trading buy at 184p ('An awesome foursome', 18 January 2015)
■ Equity market strategy ('Bear Market signals', 25 January 2015)
■ STM: Buy at 47p, target 80p; Stadium: Trading buy at 103p; Fairpoint: Run profits at 150p, target range 200p to 220p ('Exploiting market anomalies', 1 February 2015)
■ Character Group: Buy at 505p, target 600p; 1pm: Buy at 67p, target 82p; and Entu: Hold at 68p ('A trio of small cap plays', 2 February 2016)
■ Inland: Buy at 83p; Henry Boot: Buy at 220p, target 260p; FTSE 350 housebuilding sector: Trading buy ('Playing the housing market', 3 February 2016)
■ Flowtech Fluidpower: Buy at 109p ('Undervalued and ripe for a re-rating', 4 February 2016)
■ Safestyle: Run profits at 253p ('Awaiting news on a cash return', 4 February 2016)
■ Simon Thompson's 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 £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking
