Spirax-Sarco – an outstanding British company

It also has a superb dividend track record, having grown its annual dividend per share every year for more than 50 years. There are not many companies that can lay claim to that achievement. 

This week, I am going to take a closer look at this excellent business. 

What does it do? 

This engineering company has two core businesses. Both fulfil a role of problem solvers that help customers to run their businesses more efficiently. 

Spirax-Sarco (77 per cent of revenues, 70 per cent of trading profits) specialises in industrial and commercial steam systems and the use of electrical heating applications. Steam is used extensively in many processes because of its many useful properties such as its high temperature, it’s easy to control and cleans and sterilises things in an environmentally friendly way. 

The company makes many different products that use steam technologies such as steam traps, automatic control valves and heat transfer systems. They are used across a broad range of industries and commercial applications with the aim of helping the customer achieve a variety of goals such as: 

• Saving energy 
• Improving productivity
• Saving water
• Reducing waste and emissions

Watson Marlow (23 per cent of revenues, 30 per cent of trading profits) makes specialist peristaltic pumps (a mechanical pump in which pressure is provided by the movement of a constriction along a tube). These pumps are used in niche applications that need accurate metering, hygiene and low running costs.  

They are used extensively in sectors such as biotechnology, pharmaceuticals, food and beverages, chemical processing and mining. As with the company’s steam products, the products are designed to boost a customer’s productivity and cut waste so that they can try and become more profitable. 

The company has 114 business units in 47 countries, makes over 1,500 different products and has over 100,000 direct customers. 

What makes Spirax-Sarco a very good business? 

The main reason is that it is making products that solve problems for its customers. Many of its products are for niche applications that do not have lots of competition.  

One of the key reasons for the company’s success is its direct selling strategy. Over 70 per cent of its annual revenues come from direct sales to customers. This is not only more profitable than selling through wholesale distributors, but it also allows the company to get close to its customers and build up long-term relationships with them.  

This has a number of benefits; mainly the ability to win more profitable business from existing customers. It also tends to make customers more loyal and create a significant barrier to competition. 

The company also has a significant number of defensive characteristics, which means that its revenues and profits tend to be more stable and reliable than many other manufacturing companies – something that can attract a high valuation for a business. 50 per cent of its sales come from relatively non-cyclical sectors such as food, pharmaceuticals, biotechnology and healthcare. 

What makes the company’s revenues very predictable is that half of them come from regular repair and maintenance sales. These are part of a customer’s day-to-day operating budget and don’t tend to be cancelled as easily as big projects for new machinery. This source of revenue is made up of lots of orders with an average invoice value of around £1,000. 

Small projects to improve existing customer assets account for around 35 per cent of sales and again form part of a company’s operating budget. Typical invoices are between £10,000 and £50,000. Only 15 per cent of sales are made up from the big new projects that come from a company’s capital budget that are often cancelled or deferred in a recession. 

These desirable characteristics have allowed both the company’s core business to deliver a steady and highly profitable financial performance in recent years. You can see that both the Spirax-Sarco steam business and Watson Marlow have had consistently high profit margins over the last decade. I’ll have more to say on the financial performance of the business shortly. 

High profit margins tend to attract competition. The fact that both these businesses have been able to not only maintain, but grow their profit margins over the last decade is a sign that competitors have yet to eat their lunch. This is a sign that they possess a highly sought-after economic moat. 

Where's the growth going to come from? 

Good businesses with high profit margins are all very well but unless revenues and profits can keep on growing, Spirax-Sarco's shares are unlikely to continue being an attractive investment. 

In fact, you can see from the table above that growth has actually been quite subdued for a period between 2011 and 2015. From 2016, acquisitions have seen a significant uplift in profitability for both businesses but this is not the kind of growth that the stock market tends to put a high price tag on. The most valuable businesses keep on adding value by growing with what they already have – known as organic growth. 

Source: Spirax-Sarco H1 Results Presentation 

Thankfully, the company has a strategy to grow organically, and if the results in the first half of 2018 are anything to go by it is doing reasonably well. 

Growth is coming from a variety of sources. New products in new and existing sectors are a source as is adding new offices and sales resources in new parts of the world. But one of the best sources of growth is getting more business from its existing customers as their businesses change and develop. This is one of the big benefits of having a direct sales force that gets to know its customers and their business. It allows them to understand what they need and generate incremental sales. 

Growth at the moment seems to be underpinned by favourable demographics such as a rising population that in turn is pushing demand for more healthcare and food and beverages. New battery technologies such as those used in electric vehicles is driving demand for steam and pump products. 

Generally speaking, the overall demand for Spirax-Sarco’s products and services is driven by global trends in industrial production, which are currently positive. They can and will turn down in the future which means that revenues and profits are not completely recession proof. They are, however, protected to an extent by a high proportion of repairs and maintenance sales. 

According to the current consensus estimates by City analysts, underlying earnings per share (EPS) growth is expected to be in the 6-7 per cent range in 2019 and 2020 – after acquisitions give higher growth in 2018. 

Strong and sustainable financial performance 

As well as having the capability to keep on growing, I am looking for four key characteristics in order to identify a high-quality company: 

• High and stable profit margins – ideally higher than 10 per cent. 
• High and stable returns on capital employed – ideally higher than 15 per cent.
• A high level of profits converted into operating and free cash flows.
• Low levels of debts and pension fund deficits. 

Spirax-Sarco scores well on all these criteria. 

Profit margins (as measured by earnings before interest and tax or Ebit) have been remarkably steady as mentioned earlier, which is a good hallmark of quality. When looking at any company, I always look at how it has fared in a recession. I am wary if I see a sharp decline in profitability and profit margins as this is a sign that unless the business has changed since then it is vulnerable in the next downturn. 

Spirax-Sarco's margins did dip slightly in 2009 but not by enough to suggest that this business is highly cyclical and risky. We already know that a large chunk of its sales and profits come from repairs and maintenance, which would explain most of the stability in margins. According to current City analyst forecasts, the company’s profit margins are expected to increase over the next three years. 

The trend in ROCE is very similar to profit margins. ROCE shows trading profits as a percentage of the money invested in the business. In many ways, it is similar to the interest rate on a savings account. Imagine having a savings account paying more than 20 per cent interest every year. That’s what shareholders in Spirax-Sarco have effectively been owning a slice of. ROCE fell in 2017 due to money invested in acquisitions. This should start increasing again if profit margins rise as is currently expected. 

Good businesses convert their profits into cash flow. Bad ones don’t. The first test of cash conversion is comparing operating profits with operating cash flow. Sometimes operating cash flow can be less than operating profit due to one-off factors. If this happens year after year then you might want to start questioning whether a company’s profits might not be as high as they seem. Spirax-Sarco passes this test. 

Heavy investment in new assets (capex) in excess of replacing existing ones (depreciation is a rough proxy for replacement capex) tends to reduce a company's free cash flow (and free cash flow per share (FCFps)) relative to its profits (or EPS). Working capital outflows (usually increases in stocks and trade debtors from growing revenues) can also do the same thing.  

You don’t want to punish a company for investing – especially if that investment is earning a high return – but generally speaking don’t want to see too big a gap between a company’s EPS and free cash flow per share. Spirax-Sarco's free cash flow has lagged its profits quite frequently and is expected to do so for the next three years. I don’t think the gap is big enough to question the quality of the company’s profits. 

Debt and debt-like liabilities such as pension fund deficits can create problems for shareholders if they become too big. Spirax-Sarco has a reasonably small pension fund deficit, but debt has increased significantly due to acquisitions made in 2017.  

That said, net debt to Ebitda – a popular measure of company indebtedness – is not excessive (unless the company concerned is in the financial, property or utility sector a number over three times is starting to get uncomfortable and a sign of increased risk) and is expected to fall rapidly. 

A great business but are its shares too expensive? 

High-quality businesses and their shares are very popular with investors right now and have delivered very decent returns over the last few years. Their scarcity value has also arguably pushed up their valuations. Spirax-Sarco is a very good case of this with its share price increasing by 28 per cent so far this year at the time of writing. 

The company’s high levels of profitability and predictability rightly attract a high valuation for its shares. However, given underlying profits growth is only expected to be modest, it does beg the question as to whether the current valuation has got ahead of itself. 

On any widely used measure of valuation, there is no way that Spirax-Sarco's shares could be considered to be attractive. In fact, the shares – and similar high-quality businesses such as Rotork and Halma – are valued so highly that they may have made even the most long-term oriented quality investors feel uncomfortable in buying them at the current share price. 

My guess is that the share price may pause for breath for a while unless there are material upgrades to analysts’ profit forecasts. That said, I expect the shares to retain a fanbase among those who invest in outstanding businesses and it would not surprise me one bit to see Fundsmith’s new Smithson investment trust invest in the shares.