Annual results from Aim-traded Skelmersdale-based Flowtech Fluidpower (FLO:118.5p), the UK's leading specialist supplier of technical fluid power products, made for a very interesting read.
Flowtech’s main distribution business offers more than 100,000 individual product lines to more than 80,000 industrial maintenance, repair and overhaul end-users in the UK and Benelux through a network of around 5,000 distributors and resellers. It also has a power motions controls (PMC) division that designs, assembles and supplies engineering components and hydraulic systems.
Having made a series of acquisitions since IPO in 2014, new chief executive Bryce Brooks, who took the reins last autumn, has bolstered the board and set out a statement of intent to extract “the considerable synergy potential [from acquisitions] by focusing on cross-selling opportunities, improved procurement terms from major suppliers, optimising Flowtech’s operating cost base, and making efficient use of the working capital base". A group credit manager was appointed in the fourth quarter of 2018 with the intention of improving cash collection rates, reducing the amount of capital tied up in working capital, improving stock turn and the return on invested capital in the business.
Mr Brooks’ replacement as finance director is Russell Cash, a former Baker Tilly partner, who held the same position at Manchester-based FRP Advisory LLP. The board has been strengthened further with the appointment of Bill Wilson, a highly experienced international non-executive director in the industrial distribution sector, and the promotion of Nick Fossey, who joined the business in March 2016 from Flowtech’s largest supplier, Eaton Corporation, to the position of chief operating officer.
Not that the acquisitions made by the previous management team haven’t delivered. Flowtech raised £11m at 170p a share in a placing 12 months ago to fund the purchase of Beaumanor Engineering, a Leicester-based fluid power equipment distributor and a competitor to the Flowtech's Flowtechnology business; and Derek Lane, a specialist fluid power engineering business that has crossover with Flowtech’s PMC division. In the nine-month period under its ownership, these two businesses contributed £1.1m of operating profit in 2018, or just under half the £2.3m rise in Flowtech’s 2018 adjusted operating profit, which increased by 25 per cent to £11.4m on revenues up 42 per cent to £111m.
It’s more a case that mergers and acquisitions activity will now be supported from free cash flow to create a "compounding effect on investor returns". Rolling out a profit-sharing scheme for all of Flowtech’s individual profit centres is part of the process to enhance investment returns by rewarding business units that achieve a return on average working capital of more than 20 per cent, thus creating a culture at the local level to focus on ‘return on capital’. This approach supports entrepreneurial flair across the business, safeguards internal growth and is attractive to business vendors and management teams alike, reflecting the agility of the small- or medium-sized business, but with the support of a much larger umbrella organisation.
Free cash flow key to dividend growth and debt reduction
Furthermore, with gross margins rising by one percentage point last year to just shy of 35 per cent, by extracting operational cost savings and improving return on working capital, Flowtech should be able to maintain profit momentum solely through organic sales growth (underlying sales increased by 5.7 per cent in 2018, and were 4 per cent ahead in the first quarter of 2019). If the directors can achieve this then it’s realistic to expect underlying operating profit to kick on again this year towards and perhaps even beyond the £12.4m estimate of house broker Zeus Capital, which is based on a modest rise in revenues.
On this basis, estimated free cash flow of £7.1m in 2019 should be ample to cover the £3.9m cost of lifting the dividend per share to 6.4p, and also pay down Flowtech’s 2018 closing net debt of £19.9m. Analysts at broker finnCap are even more aggressive in their 2019 cash-flow assumptions, predicting operating cash flow of £14.1m generated from cash profits of £13.8m to produce annual free cash flow of £10.4m. On this basis, finnCap expects a 23 per cent reduction in Flowtech’s net debt to £15.4m by the year-end. Debt reduction is important as cutting last year’s net interest bill of £755,000 frees up cash flow to either recycle back into the business, or return to shareholders through a higher payout.
A strategy to drive a rerating
It seems an eminently sensible strategy to me and one that should appeal to other investors, too, and drive a rerating of the shares, which are still only priced on a forward price/earnings (PE) ratio of 7.5 and supported by a prospective dividend yield of 5.3 per cent. That modest rating suggests the company has gone ex-growth, which it hasn’t, and points towards a dramatic drop-off in trading activity this year. Or, to put it another way, the extreme equity risk premium embedded in the current share price is based on an Armageddon economic scenario that is simply not playing out, otherwise Flowtech wouldn’t have posted 4 per cent like-for-like sales growth in the first quarter. It also factors in a sizeable Brexit discount that is way in excess of that embedded in the ratings of other distributors. On a standard PE ratio, Flowtech is trading on less than half the multiple of rivals.
To take into account the impact of debt levels, a fairer way of comparing ratings is to use an enterprise value (market capitalisation plus net borrowings) to cash profit multiple. On this basis, Flowtech’s enterprise value equates to just under seven times 2019 forecast cash profits, a 30 per cent plus discount to the rating of larger players in the sector including old favourite Trifast (TRI), a small-cap manufacturer and distributor of industrial fastenings, with operations across 31 locations across the UK, Europe, Asia and North America. Trifast’s share price has more than quadrupled since I included the company in my 2013 Bargain Shares Portfolio, driven in no small part by a step-change in the company’s profitability under the watchful eye of chairman Malcolm Diamond. He holds the same position on the board of Flowtech, a major bull point in my eyes.
I first advised buying Flowtech’s shares at 118p ('A fluid performance', 2 Jun 2014), since when the board has paid out total dividends per share of 23.5p excluding the 4.04p final dividend declared for the 2018 financial year. The share price subsequently peaked last summer at 195p, just shy of my 205p target price, so had been performing well until the company issued what was a modest profit warning when it released its half-year results last autumn ('Investors overreact to Flowtech’s warning', 19 Sep 2018). The main reason for the downgrade was due to higher operating costs from acquisitions made last year, and costs incurred to streamline the cost base. I believe that investors massively overreacted to the warning, and maintain that view. Buy.
Finally, I am now on holiday and my next column will appear on our website at 12pm on Tuesday, 7 May 2019.
■ Simon Thompson's new book Successful Stock Picking Strategies and his second book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £2.95, or £3.75 if you purchase both books. Details of the content of both books can be viewed on www.ypdbooks.com.