The reaction to the company’s half-year results was severe to say the least, with shares in the company marked down from 159p to 137p, taking them below the 153p price level when I last updated the investment case (‘An unloved engineer’, 28 Apr 2014), albeit they are still well ahead of my 107p buy-in price in my 2012 Bargain Shares Portfolio. If you followed that recommendation you would have banked five dividends totalling 13.75p a share, too, and are in line for a maintained 2.5p a share half-year dividend, highlighting the importance of the 5.5p a share annual payout in the total investment return. Still, that does not detract from the fact that the shares are now almost 10 per cent adrift of my last recommended buying price of 153p, although the price did rise to a high of 182p following that article in April.
As I have noted many times this year, this is not a market for companies to disappoint and those that do are being severely punished. In the case of Molins, the combination of the appreciation of sterling and reduced equipment and aftermarket sales in the company’s tobacco machinery division, reflecting the unstable geopolitical backdrop in eastern Europe and the Middle East, resulted in first-half pre-tax profits falling from £1.5m to £600,000 on revenues down sharply from £47.8m to £40m. Indeed, the revenue shortfall was entirely down to weakness in the tobacco business and was further compounded by two large emerging markets orders being pushed back into the second half.
Investor overreaction
That said, I feel investors have overreacted. Firstly, they have ignored the progress being made in Molins’ scientific services business which increased first-half revenues by 4 per cent on a like-for-like basis and improved operating profit sevenfold to £700,000. The unit develops, supplies and supports process and quality control instruments and machinery for the tobacco industry (where it is the market leader) and other industrial sectors. In addition, it provides analytical services, which test for the constituents of tobacco and smoke. These services are used for regulatory, research and product development purposes.
As well as supplying standardised instruments, the scientific services division's expertise in technical innovation enables Molins to engineer specialised equipment to meet specific customer requirements. The business is continuing to benefit from this type of product. For example, the launch of a new instrument for the testing of e-cigarettes, extending the product range for a variety of industrial applications, and launching newer products for carton testing and air sampling all contributed to the robust showing from the scientific services business in the first half this year.
Molins’ packaging machinery business is making decent progress, too. In the UK, the unit is delivering on a strategy to increase its customer base, especially in the pharmaceutical sector and in healthcare. Overall sales here rose 9 per cent in local currencies, but edged down slightly to £18.3m as the contribution from non-UK operations was impacted by the strength of sterling. Still, underlying sales are growing nonetheless, and by introducing a more standardised range of products the company continues to win new orders.
So factoring in the ongoing strength of both the scientific and packaging machinery divisions, and scope for the deferred orders in the tobacco machinery division to come through in the second half, analysts Paul Hill and Gilbert Ellacombe at research firm Equity Development now expect Molins to grow second-half revenues from £57.3m last year to £60m this time around.
On that basis, they expect second-half pre-tax profit to grow 20 per cent to £4.7m to deliver adjusted EPS of 17.5p in the six-month period. True, full-year pre-tax profit will still be £100,000 adrift of the £5.4m reported last year, and well shy of the £5.8m analysts expected six months ago, but that’s still far better than the savage share price reaction would lead you to believe. To put the current valuation into perspective, and assuming of course Molins makes up the first-half shortfall in the second half, then expect 2014 adjusted EPS of 19.6p and a maintained dividend of 5.5p a share.
On that basis, the shares are trading on a modest seven times earnings estimates and offer a historic yield of 4 per cent. That’s hardly an exacting valuation once you consider that the sector average is around 15 times earnings estimates for fiscal 2014. To put the valuation into perspective, in the small-cap engineering universe Molins is being rated on almost half the rating of both Renold (RNO: 58.5p) and Hill & Smith (HILS: 566p), and a third less than Avingtrans (AVG: 142p). The shares are also lowly rated on a price-to-book value basis, trading on a 24 per cent discount to end June 2014 net asset value of 181p a share. That seems overly harsh in my view considering the company is still expected to post decent growth in both sales and profits in the second half to make good most of the first-half shortfall.
Risks fully factored in
True, there is execution risk here given the heavy second-half weighting to those profit estimates and the potential for more orders to be deferred if the geopolitical environment does not improve. I am also fully aware that capital equipment spend is exposed to the cyclical global economy.
Furthermore, there is always a risk that currency headwinds could impact the numbers again given that around 90 per cent of Molins' sales originate from outside the UK. However, I feel investors have now more than factored this risk into the valuation. In fact, it is worth pointing out that sterling has actually being losing ground against the US dollar since the half-year end, reversing some of the appreciation that led to the revenue and profit shortfall on translation of that foreign income.
In part this reversal in sterling is mainly down to worries on the forthcoming independence vote in Scotland, but nonetheless the 6 per cent depreciation of sterling against the greenback in the past couple of months can only be helpful when overseas sales are converted back into Molins reporting currency.
I also feel that investors have not fully recognised the potential for a hefty working capital inflow in the second half as the inventory build in the first six months of this year unwinds. Stocks increased by £4.4m to £22.9m in the period, but with sales predicted to ramp up the second half, and profits forecast to increase by 20 per cent, then analysts forecast a year-end net funds position of £1.9m, reversing the net debt position of £900,000 at the end of June.
Bearing this in mind, I would not be surprised at all to see the company make some debt-funded bolt-on acquisitions, in particular for the scientific services division. A £13m borrowing facility with Lloyds Banking (LLOY: 72p) offers significant headroom to facilitate any such deal.
Target price
In the circumstances, I still feel that my fair value target price of 220p is not unreasonable, albeit the share price will have to overcome the 182p high from the end of May first. That is going to clearly take time and Molins will have to deliver on a much improved second-half performance for investors confidence to be restored.
But with Molins' shares heavily oversold – the 14-day relative strength indicator (RSI) is showing a reading of only 20 – and the earnings multiple very modest, I feel that locking into a 4 per cent dividend yield is well worth doing given the potential for an earnings recovery next year when analysts still predict a 9 per cent rise in pre-tax profit to £5.8m.
Trading on a bid-offer spread of 136p to 138p, and offering almost 60 per cent upside to my fair value target price, Molins' unloved shares rate a medium-term recovery value buy.
■ 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'
