The company offers a huge 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 more than 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 UK distribution business accounted for two thirds of the company’s revenues of £44.8m in 2015 and is profitable too, generating margins north of 20 per cent before central overheads. So why is the company being so lowly rated?
Major profit warnings failed to materialise
Firstly, the sharp share price derating since early June largely reflects investors’ expectations that Flowtech’s financial performance would mirror the 6 per cent revenue decline across the industry in the first five months of this year based on industry data from The British Fluid Power Distributors Association. In other words, investors were expecting a major profit warning. In the event, Flowtech’s underlying revenues were actually flat in the six month period if you strip out the impact of earnings accretive acquisitions which lifted revenues by 28 per cent to £27.4m. That’s not to say that the business has been entirely insulated from the softer general market backdrop. It clearly hasn’t and increasing market weakness in the last few weeks has led Flowtech’s board to guide analysts down in their profit forecast, but only modestly so.
In fact, Andy Hanson at brokerage Zeus Capital trimmed his full-year revenue forecast by only £800,000 to £53.9m, implying that Flowtech will still post top-line growth in the order of 20 per cent in 2016. Admittedly, a 0.6 percentage point reduction in trading margins to 14.9 per cent means that pre-tax profits estimates have been reduced from £8.1m to £7.6m, but that still represents 13 per cent year-on-year growth and that’s enough to drive EPS up by around almost 15 per cent to 14.2p. It also supports a 5 per cent hike in the dividend per share to 5.5p as analysts predict. On this basis, Flowtech’s shares are being rated on 7.2 times earnings estimates and offer a prospective dividend yield of 5.3 per cent. Zeus Capital is the house broker, but its EPS and dividend estimates also mirror those of analyst David Buxton at broking house finnCap.
Another issue that is likely to have concerned investors is the sharp fall in sterling post the EU Referendum. That’s because between 30 to 40 per cent of Flowtech’s UK purchasing is denominated in foreign currency, so the 15 per cent plus decline in sterling against the euro and US dollar in the past 12 month is expected to have an impact. Bearing this in mind, I understand that Flowtech’s board took the shrewd decision to make significant inventory purchases in China ahead of the EU Referendum, thus gaining better pricing from Chinese suppliers before sterling started to weaken. This pre-emptive move has insulated the business from margin pressure near term.
I would also flag up that in previous periods of sterling weakness, most notably in 2009 to 2010, Flowtech was able to maintain margins by passing on price increases to customers, reflecting the strength of its business model. For instance, a plumber who needs a part urgently to complete a job is unlikely to baulk at paying a few extra pounds for it if delivery is guaranteed the next day as the extra cost is relatively insignificant to the daily labour cost being billed to the client. I strongly feel that investors have overreacted to the impact of sterling’s weakness on Flowtech’s business, and underestimated the ability of management to pass on higher wholesale costs to end users.
Earnings accretive acquisitions de-risk earnings estimates
I also feel that investors are overlooking the fact that Flowtech has been recycling its bumper cashflow into acquisitions that are very supportive of earnings forecasts. The company made two important earnings accretive acquisitions last year, both of which underpin earnings estimates: 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.
Since the start of this year the board have made two more acquisitions, in February and March, for a combined cash consideration of £3m. The first involved the purchase of assets of the UK division of Indequip which added complementary product range to its existing pneumatics ranges and new customers too. The integration process is going well and substantial savings are likely to be made from the integration of the employees and operations into the Skelmersdale site. Flowtech also acquired Hydravalve (UK), a specialist distributor of valves and associated equipment to the process industry based in Willenhall in the West Midlands. This business adds to its procurement position in valves.
The profit streams from these acquisitions not only de-risk the above profit forecasts, but with the benefit of a lowly geared balance sheet the company continues to strengthen its product offering in the hydraulics sector. In fact, it has just made the small bolt-on acquisition of Yorkshire-based, Triple Six, a specialist designer and distributor of several ranges of hydraulic cylinders and semi rotary actuators looks a smart deal too. The business services the civil engineering, railways, marine and nuclear industries. It was keenly priced too as for a net initial consideration of £450,000 Flowtech has acquired an operation that made operating profit of £150,000 on revenue of £1.2m in 2015. There is a £300,000 earn-out subject to financial performance over the next two years, implying a likely exit multiple of five times operating profit, or around seven times net profit.
This latest addition to Flowtech’s growing portfolio of distribution businesses means that from a standing start at the time of the IPO two years ago, its Power Control and Motion division is now generating annual revenues of £17m and is expected to account for £1.8m, or 18 per cent of the company’s operating profit of £10m this year before accounting for central overheads of £2m.
Peer group comparison
Importantly, not only has Flowtech performed far better than the 28 per cent slump in its share price since the start of June would suggest, but it is performing better than most of its rivals too. That makes a near 50 per cent earnings multiple discount to its peer group anomalous to say the least.
For instance, general distributors Diploma (DPLM:820p) and Premier Farnell (PFL:192p) are both priced on around 19 to 20 times this year’s earnings estimates, and a favourite of mine Trifast (TRI:135p) is rated on 13 times likely earnings. I covered that company in a column earlier this week (‘Brexit winners’, 1 Aug 2016). I would point out that Flowtech offers a much higher dividend yield than any of its peers, so there is strong yield support, and a price-to-book value ratio of around 0.75 is hardly punchy either.
Of course, more investors may wish to maintain their cautious stance and await the next trading update at the time of the half year results on Tuesday, 13 September. However, I feel that given the obvious value on offer here that those results are likely to prompt a share price re-rating when investors cotton onto the profit growth Flowtech is generating even in a tougher trading environment.
In the circumstances, having advised buying the shares at 118p at the time of the Aim-listing ('A fluid performance', 2 Jun 2014), and reiterated that advice at 137p in the spring (‘Profits flow at Flowtech’, 13 Apr 2016), I continue to rate them a buy on a bid-offer spread of 100p to 103p. My target price of 157p equates to a modest 11 times this year’s likely earnings and, if achieved, would still mean that the equity is priced on a 25 per cent earnings multiple discount to peers. That’s seems a realistic target to me, so ahead of the next trading update in six weeks time, I rate Flowtech’s shares a trading buy.
