Renishaw: An excellent business that's hard to weigh up

The business

Engineering businesses can be very difficult for investors to understand. In trying to learn what they do, they are often faced with lots of technical jargon, which can be quite offputting. It can seem that you need to be constantly referring to a dictionary or an internet search engine to try to make sense of the business.

You have to accept that you are probably not going to fully understand the technology behind every product, but the good news is that you don’t need to. An understanding of what the products are designed to do and the markets they are used in is often good enough to make a reasoned judgement on a business and its future prospects.

Renishaw is a UK-based engineering business, but It could also reasonably be seen as a technology company that provides patented problem-solving products and software. Ninety-four per cent of its revenues came from outside the UK in 2019. It operates from 81 locations in 36 countries. Two of its founders, David McMurty and John Deer, own 53 per cent of its shares.

Sources: Renishaw and Investors Chronicle

The most significant countries in terms of revenue generation are the US, China, Japan and Germany, which between them accounted for 61 per cent of revenue in the year to December 2019.

Sources: Renishaw and Investors Chronicle

Its business is dominated by its Metrology division, which accounted for 93 per cent of its revenues and 97 per cent of its operating profits in the year to December 2019. It also has a small healthcare division.

Metrology

This business designs, manufactures and sells a large number of products that are based on measuring parts of its customers’ production process. Their aim is to help customers to maximise their production output, improve the quality of their products, and make the process more efficient. In short, to help them do more with less and do it better.

The best way to see this business is as a problem solver and improver. Renishaw works very closely with its customers and in doing so develops a deep understanding of their businesses and their needs. It then aims to meet these needs with innovative, high-quality patented products, combined with local support. This creates high levels of customer loyalty and a strong barrier to competition.

This business is based around a portfolio of key products that offer significant benefits to its customers:

• Machine tool probe systems. These are sensors and related software that are used in applications such as metal cutting machines. They allow the settings and the measurements of the machine to be controlled automatically. The result is a machine that is more productive, more accurate and produces less waste.
• Co-ordinate measuring machine (CMM) products. These are sensors, software and control systems for 3D CMM, which allow the highly accurate measurement of components and finished products.
• Styli for probes. These are attached to probe sensors at the point of use to get more accurate measurement data.
• Performance testing products. These are calibration and testing products that are used to determine the positioning and accuracy of industrial and scientific machinery.
• Gauging. Renishaw’s EQUATOR gauges improve the process control of a shop floor. It allows engineers to program parts in minutes and talk to many different machines at once.
• Spatial measurement. These are high-speed laser measuring and surveying systems that are used in extreme environments such as mines and quarries.
• Position encoders. These enable accurate motion control in applications and come in magnetic, optical and laser forms. They give real time feedback on a machine’s performance.
• Additive manufacturing (AM). The manufacturing of 3D printed components used in industrial products, consumer products and mould tooling.

These products can be used in every sector of the industrial and manufacturing economy. Renishaw’s key metrology markets are in aerospace, automotive, electronics, energy, mining and precision manufacturing.

The source of demand for Renishaw’s products come from the ongoing and developing trends in these key markets. They range from shorter product cycles in consumer electronics, which require flexible measuring systems; increasing automation due to a shortage of skilled labour; more complicated technology; and lighter and more fuel-efficient aircraft and car engines.

The benefits for customers can be significant. On a shop floor found in a typical manufacturing or engineering business its products can make a big difference to the efficiency and productivity of it. They can speed up the setting up of parts, check the measurements of finished parts and check for errors very quickly and accurately. They are backed up with software that is quick and easy to use.

At the heart of all this, Renishaw is selling products and processes that help its customers’ profits and competitive position. By doing this well, it hopes to improve its own.

Healthcare

The purpose of this business is aimed at improving medical research and the time it takes to complete medical procedures. The main products are:

• Dental scanners used for digital dental preparations for dentists and the measurement of dental implant locations.
• Computer-aided design (CAD) software used to design things such as dental crowns and bridges. Renishaw also provides the capability to make crowns and bridges.
• 3D titanium implants. These are used in surgery to reconstruct faces, heads and jaws after cancer surgery or a serious accident.
• Neurosurgical robots. These are used in precision surgery in areas such as the brain and are also used for biopsies and the delivery of drugs.
• Surgical planning software.
• RAMAN microscopes and spectroscopy used in the chemical analysis and imaging of materials in areas such as nanotechnology, biology and pharmaceutical. These are used to diagnose and track the progress of diseases and have recently been used to analyse products for plastics contamination and identify fraudulent food products.

This business is well supported by the fundamentals of its end markets. Increasing life expectancy and ageing populations have driven up the demand for healthcare, as well as its cost. Renishaw’s products help to improve the speed of medical procedures and cut waiting times, as well as helping to reduce their cost and improve their safety.

The RAMAN products are proving to be increasingly attractive in medical research and are becoming more widely used in industrial applications.

A key attraction of the products in this business is that barriers to entry are high due to high regulatory standards. This limits competition and hopefully allows products to earn decent profits over a number of years.

Business performance

Renishaw’s Metrology business is capable of being very profitable and earning high margins. However, its revenues can be very volatile and subject to large swings, depending on demand patterns in end markets.

One of the key risks that investors face if they own shares in Renishaw is that there is very limited revenue visibility. The company’s outstanding order book is typically only around one month’s revenue, which means that it’s difficult for management and investors to predict how much money a company will make in any given year. This takes on even more significance in the current horrible economic climate.

Renishaw: divisional revenues and profits

Sources: Renishaw and Investors Chronicle

The Metrology business is currently going through a very rough patch, which is likely to get worse as the shutdown of economies caused by the coronavirus takes hold. Profits have fallen sharply from £147.8m in the year to June 2018 to £61.5m in the year to December 2019.

The 3D printing business and EQUATOR gauging system had been doing well, but weak smartphone demand in Asia has seen sales into the consumer electronics markets fall. The business had also not been helped by ongoing trade tensions between China and the US.

Healthcare has only been making a small contribution to overall profits, but had until recently been building up its revenues. This business has also been hit by weaker end markets and lost money in the six months to December 2019 despite good demand for its neurological robots.

Renishaw: key performance indicators

Sources: SharePad and Investors Chronicle

Renishaw’s operating margin and return on capital employed (ROCE) show that a lot of the time it has had the hallmarks of a very profitable and high-quality business, but the trends are currently heading downwards. The conversion of profits into free cash flow is not great as the company invests to grow the business in the future.

Its financial position is strong, with minimal borrowings and a solid cash balance. It does have a final-salary pension fund deficit, but this looks to be manageable.

History suggests that Renishaw’s profits are not very recession resilient. They collapsed very quickly in 2008-09, which led to significant cost-cutting and the scrapping of the dividend. They did, however, bounce back very quickly, and by 2011 the business was very profitable again.

The company’s commitment to research and development (R&D) is impressive – nearly 15 per cent of revenues in 2019 – and underpins its ability to serve its customers well. This is shown by a portfolio of nearly 2,000 patented products.

Sources: Renishaw and Investors Chronicle

Most of the R&D spending is expensed against revenues, but some of it is capitalised (put on the balance sheet) with its cost spread over its useful life. The high level of expensing is a sign of prudent accounting, but as with any research-intensive company you should always check to see if there is a big difference between the amount of cash spent and the amount expensed (this includes amortisation of capitalised costs) to see if profits might be flattered by it. The good news for investors in Renishaw is that it is not, as the gap between the two has been consistently small.

Renishaw: R&D cash spent and expensed

Source:Renishaw/Investors Chronicle

The company also has a very significant investment in working capital relative to revenues. Stock levels are high to make products and serve customers, while there are significant sales on credit, which are not offset by squeezing the payment terms to suppliers.

Sources: Renishaw and Investors Chronicle

This means that there can be significant working capital cash outflows when revenues are growing, but these reverse to inflows when business turns down, as we have seen recently.

The future

Predicting this company’s future profits is not easy at the best of times and is nigh on impossible at the moment given large sections of the world’s economy have been shut down. The company’s guidance of adjusted pre-tax profit of £50m-£70m back in January can safely be ignored as no-one really knows what’s going to happen over the next few months.

If 2009 is any guide, profits could collapse very quickly. Based on my view that the current situation is worse than 2009 then seeing Renishaw become lossmaking is not out of the question.

With even very strong businesses now raising equity, is it possible that Renishaw, with a net cash balance sheet position, might do the same? It did not in 2009 and the position of the two founding shareholders suggests that it is unlikely, but cannot entirely be ruled out. The half-year dividend has been scrapped and I expect further cost-cutting measures to the ones announced in January.

That said, this is a business that I like a lot. The long-term demand drivers for it exist and I like its products’ problem-solving characteristics, which are a source of competitive strength. Its close relationship with customers is very similar to the approach that has served Spirax-Sarco so well over the years. 

The dominant shareholding of its two founders mean that it can be run like a private company and not be pressured into sacrificing the long term for short-term profits. This is a good thing but it means that other shareholders will have to accept that profits will not always be maximised every year.

It’s a business that many investors have been happy to own a slice of over the past decade. The key problem I see is how do investors value it given its volatile revenues and limited short-term revenue visibility. I think it’s a very difficult task. The share price has almost halved since peaking just below £58 at the beginning of 2018 and have been very volatile as profits have fallen.

This subject of valuing a cyclical business is worthy of a whole article in itself, but you need to take into account the ups and downs of a business cycle somehow. Over the past 20 years, Renishaw’s operating margins have ranged from as low as 3.5 per cent in 2009 to nearly 30 per cent in 2015. The average is around 20 per cent. Applying this to current trailing 12-month revenues gives an operating profit of £107m. 

This is very helpfully not far away from last year’s profit when earnings per share (EPS) was 126.7p, which we could use as an estimate of through-the-cycle earnings (but admittedly a crude one at that). The current share price of 2,997p gives a price/earnings (PE) ratio of 23.6 times. Not so long ago, investors would be happy to pay this kind of valuation for a very good business. I think today’s investors might be better holding off for now.