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Manufacturing currency gains

Manufacturing currency gains
October 5, 2016
Manufacturing currency gains

It's no surprise either that the slump in sterling is having a major positive impact on the pricing power of some of the exporters I follow and no more so than Aim-traded AB Dynamics (ABDP:470p), a UK designer, manufacturer and supplier of advanced testing systems and measurement products to the global automotive industry. I included the shares in my 2015 Bargain Shares Portfolio at 173p and last recommended buying at 425p, suggesting a new target of 500p ('Business as usual', 13 Jul 2016).

I had good reason to remain positive because guidance from the board highlighted "excellent visibility on revenues well into the next financial year". It's not difficult to understand why this is the case as around 96 per cent of the company's sales are derived from overseas customers, so the precipitous fall in sterling in the past 12 months - the currency is down by around 17 to 18 per cent against both the US dollar and euro - is giving the business a major pricing advantage, not that it really needed one as demand for its products is such that analysts have upgraded their earnings estimates no fewer than three times in the past year or so.

 

Strong end markets

This earnings upgrade cycle reflects increased investment by the car industry in new car models with a focus on advanced safety systems, and strong sales of both track and lab testing products. This is clearly benefiting AB Dynamics as revenues from track testing systems (robots and soft crash vehicles) are expected to rise by a third to £15.2m to account for three-quarters of likely turnover of £20.2m in the 12 months to the end of August 2016, according to analysts at broker Cantor Fitzgerald. They also believe that this segment will be able to post double-digit growth in the next two financial years.

I would also flag up that the company's laboratory testing business is stepping up a gear or two, driven by the strategic partnership with Williams Advanced Engineering, the technology and engineering services business of the Williams Group, to bring novel virtual vehicle dynamic simulators to the global automotive sector. This collaboration combines Williams' expertise in F1 simulators and high-speed dynamic motion platforms, with AB Dynamics' industry knowledge, manufacturing capabilities and sales channels.

Using F1 vehicle modelling and simulation, the technology will enable engineers to test-drive conceptual vehicle designs through virtual environments, well in advance of the launch of physical prototypes. Upside here is likely to drive AB Dynamics' laboratory testing revenues up by almost half to £7.1m in the 12 months to August 2017, ramping up to £9.6m the year after, according to analysts' estimates. In other words, AB Dynamics' revenues from all its activities could rise from around £20m in the financial year to the end of August 2016 to almost £30m within the next couple of years.

In turn, this stellar top-line growth is driving profits. In a pre-close trading update yesterday ahead of full-year results on Wednesday, 16 November 2016, AB Dynamics' board confirmed that its results are bang in line with the hefty upgrades earlier this year, which imply the company will increase full-year pre-tax profit from £3.8m to £4.7m (August 2016 year-end) and deliver EPS of 21.6p.

Given the strong dynamics propelling revenues upwards, I feel comfortable with predictions that pre-tax profits can rise by just shy of 13 per cent to £5.3m in the 12 months to August 2017, rising to £7m the year after. On this basis, expect EPS of 24.6p and 32p, respectively. Of course, AB Dynamics needs to have ample facilities up and running to cater for the anticipated higher demand, so is constructing a new facility to be funded entirely through internal resources, and which is due to complete in the third quarter next year. It can certainly afford to do so because it has a cash-rich balance sheet and boasted net funds of 56p a share at the half-year stage this year.

And the board have hit the right balance between investing in the business and rewarding shareholders as analysts' expect mid-teens hikes in the dividend per share to 3.11p, 3.57p and 4.11p, respectively, in the financial years ending August 2016, 2107 and 2018. The board declared a 2.75p a share dividend last year, so this implies a compound average growth rate in the forecast dividend of around 14 per cent over a three-year period.

The point being that with currency tailwinds strengthening in recent weeks, and sterling hitting a 33-year low against the US dollar, the full benefit of sterling's recent devaluation further underpins those profit estimates. In fact, if the cross rate remains at this level I believe there is scope for further currency-led earnings upgrades. And that possibility is not being fully factored into the share price as net of cash on the balance sheet AB Dynamics' shares are rated on 17 times current year earnings estimates, falling to 13 times August 2018 forecasts.

 

Target price

My advice here is simple: if you followed my recommendation to buy AB Dynamics' shares in February 2015 at 173p, since when you will have banked dividends of 3.96p with a likely final dividend of 1.9p a share to be declared at the time of the full-year results on Wednesday, 16 November 2016, or for that matter purchased at any point since then, I would run your bumper 174 per cent profits as the investment risk remains skewed to the upside.

Trading on a bid-offer spread of 465p to 470p, valuing the company's equity at £84m, I expect the shares to hit my target price of 500p and note this could yet prove conservative given the favourable foreign exchange and trading back drop. Run profits.

 

Trifast for superlative gains

AB Dynamics is not the only company on my watchlist that has been benefiting from a currency tailwind from its significant overseas exposure. The same is true of Trifast (TRI:170p), a small-cap manufacturer and distributor of industrial fastenings. The company has operations in 17 countries across Europe, Asia and North America and generates around 70 per cent of its operating profit outside the UK. It has a relatively complicated currency matrix as a manufacturer and exporter from Asian and UK manufacturing operations to a global market. This means the relationships of the US dollar to Singapore and Taiwanese currencies, and the euro-US dollar cross rate are important variables.

Bearing this in mind, the collapse in sterling this year has created a positive tailwind and one that led analysts to upgrade their full-year pre-tax profit estimates by £500,000 to £17.7m following Trifast's trading update yesterday ahead of the company's half-year results on Tuesday, 8 November. On this basis, they now anticipate 10 per cent growth in pre-tax profits in the 12 months to the end of March 2017 and a similar percentage increase in EPS to 10.8p. Furthermore, with the benefit of a relatively ungeared balance sheet - net debt is expected to fall from £16m to £12.4m in the 12 months to the end of March 2017, significantly less than Trifast's forecast operating profit of £18.7m - the board are on the look-out for bolt-on earnings-accretive acquisitions.

They have a decent track record to date as both of the company's recent acquisitions are performing well. The 2014 acquisition of VIC, an Italian maker and distributor of fastening systems predominantly for the white goods industry, has proved a shrewd purchase and one that has trebled Trifast's exposure to domestic appliances, a segment that accounts for almost a quarter of its sales. This business enhanced the manufacturing content within Trifast's earnings stream and is a key factor behind the company's improved financial returns. Manufacturing now accounts for 35 per cent of its total revenues, but is higher margin than distribution which is another reason why Trifast is expected to increase its operating profit margin from 10.4 per cent to 10.8 per cent in the current year.

The acquisition of Kuhlmann, a distributor of predominantly customised industrial fasteners focused mainly on the domestic German market continues to perform well, so much so that Trifast has just paid out the €1.7m (£1.5m) of consideration which was deferred for one year after that deal completed. Strategically, Kuhlmann also provides Trifast the lever to gain entry into the domestic German automotive sector.

Another key take for me in the company's trading update was the ongoing growth in multinational OEM (original equipment manufacturer) customers, of which 50 account for 60 per cent of Trifast's sales, and signs of an improvement in domestic activity in the UK industrial market in recent months. Indeed, the fall in sterling is good news for exports from UK automotive OEMs, Trifast's largest sector domestically. I anticipate further inroads into the global OEM market given the potential to increase market penetration in this area.

I would also flag up that the company is seeing strong trading in its operations in Sweden and Holland which cater for the automotive industry, a sector that accounts for 30 per cent of Trifast's revenue, or double the level of seven years ago. There has been a pick-up in trading activity in the Hungarian operations, too, which supply the electronics sector. This highlights the benefit of having a broad-based geographic spread of operations, and targeting the right industries in the first place.

 

Target prices hit

Of course, if you have been following my columns you will know that I have been banging the drum on the investment case for Trifast all this year, having picked it out as one of the five obvious winners from the slide in sterling earlier this summer ('Brexit winners', 1 Aug 2016). The company's share price has since risen by 20 per cent since that article two months ago to an all-time high of 170p post yesterday's earnings upgrades. That's rather good news if you followed my original advice to buy the shares at 53p in my 2013 Bargain Shares Portfolio.

The 220 per cent share price gain aside, the company is highly cash generative and this has enabled the board to adopt a progressive dividend policy. In fact, with net debt of £16m representing only 19 per cent of shareholders' funds at the March 2016 year-end, and analysts predicting borrowings will fall to around £12.4m by March 2017, then there is not only scope for additional bolt-on earnings-enhancing acquisitions, but further hikes in the payout. The well covered dividend was raised by a third to 2.8p a share last year, ahead of expectations, and analyst Ben Thefaut at broker Arden Partners is pencilling in a 10 per cent hike to 3.08p in the current financial year.

On this basis, Trifast's shares are rated on 15.7 times forward earnings, and offer a 1.8 per cent prospective dividend yield, a reasonable rating in my view for a company with a strong order book, solid prospects and one benefiting from a major foreign currency tailwind. So, although the shares have hit analysts' upgraded target prices in the range between 165p and 175p, I feel that it's worth running your bumper profits ahead of what will undoubtedly be another positive set of results in a month's time. I also believe there is a decent chance of the board pulling off another earnings-enhancing acquisition which could be the catalyst for further EPS and target price upgrades. Run profits.