One stock picking technique I deploy is to target well-funded companies priced below the intrinsic value of their assets and offering realistic catalysts to narrow the share price discount. An improvement in trading conditions is the most likely one.
Hargreaves Services (HSP:480p), a diversified industrial services group and brownfield land developer, is a good example. The group released an unscheduled trading update a week before today’s annual results which prompted joint house broker Investec to upgrade its pre-tax profit estimate by 17 per cent. It was the fourth upgrade since April when analysts had expected pre-tax profit to rise from £4.9m to £7m in the 12 months to 31 May 2021. Hargreaves has reported underlying pre-tax profit of £21.2m and more than trebled adjusted earnings per share (EPS) to 70.7p.
The group has also turned a net debt position of £28m into net cash of £16.5m (51p a share) in the past 12 months to de-risk the investment case, and enable the board to quadruple the annual dividend to 19.2p a share. For good measure, the directors are now considering realising value from the group’s German metals trading subsidiary, HRMS. The business could sell for a material premium to book value. The re-rating is far from over.
Hargreaves’ eye-catching performance highlights hidden value
- Four profit upgrades since April.
- Annual dividend quadruples to 19.2p a share.
- Potential sale of HRMS could realise windfall gains.
The key driver behind Hargreaves Services’ earnings upgrade cycle has been the outperformance of HRMS, the group’s German metals trading subsidiary, buoyed by favourable commodity market conditions and improved efficiency at its carbon pulverisation plant. HRMS is a key supplier of specialist raw materials to major European customers in the steel, foundry, smelting, ferroalloy, sugar, limestone, insulation, refractory and ceramic industries. Hargreaves booked £13.6m of net profit from its 86 per cent economic interest in HRMS, up from £2.1m in the 2019/20 financial year, after HRMS’s pre-tax profit surged from €4.5m to €25m on 88 per cent higher revenue of €388m.
Hargreaves’ directors are now considering all options to release shareholder value, noting that HRMS would be better placed as part a larger business. The business is certainly an attractive investment proposition to potential acquirers, having generated profits between €3m and €11m over the previous five years and is now benefiting from a potential commodity super cycle. The highly profitable operation is clearly worth significantly more than its €40m net asset value, one reason why Hargreaves should be rated on a premium to book value of £144m (448p a share).
Importantly, HRMS doesn’t take open trading positions, and hedges all liabilities, so with the benefit of low fixed overheads profits are operationally geared to any increase in market activity. Although it’s difficult to forecast beyond the short-term, HRMS has already secured forward trading positions to benefit from the current favourable market conditions for the next six months at least, prompting analysts at Investec to raise their current year group pre-tax profit estimate by 59 per cent to £14.6m. I can see scope for further upgrades, too, and not just from HRMS.
On solid foundations
In the group’s land division, the buoyant housing market in Scotland has materially de-risked Hargreaves’ development of Blindwells, a 1,600-unit residential development site located 15 miles to the east of Edinburgh. Persimmon (PSN) is due to complete the purchase of 12.9 acres (197 plots) for £9.4m in the second half of the financial year to 31 May 2022, and the group is in advanced negotiations for the sale of a further 77 plots worth more than £3m. Hargreaves’ Unity joint venture, which has planning consent for 3,100 homes and 2m sq ft of commercial space at the former Hatfield Colliery site near Doncaster, has 34 acres of land worth £14m under conditional contract to national housebuilders, too. The joint venture contributed £4.1m of pre-tax profit in the 2020/21 financial year largely due to the £25m sale of 79 acres of land to a national retailer to house an 800,000 square feet (sq ft) distribution centre.
Interestingly, the directors highlight the potential to expand developable acreage at both Blindwells and Unity to provide a further 1,500 residential plots and up to 1m sq ft of commercial space. They are also reaping gains from further land assets. For instance, Hargreaves is set to book £1.3m profit when the forward sold 44,000 sq ft Bridlington retail park (which has been pre-let to budget retailers B&M and Lidl) completes in the final quarter.
Prospects for the group’s industrial services and earthworks divisions have been improving, too. The former increased its pre-tax profit contribution by 14 per cent to £4.2m on better margins, and has already booked 70 per cent of budgeted revenue for the new financial year. In the UK, management are focused on growing mechanical and electrical engineering services to complement its materials handling operations. In Asia, the division has signed a £5m per annum three-year contract extension with CLP Power Services.
Hargreaves' specialist earthworks subsidiary is a strategic partner to the consortium (Kier/Eiffage/BAM/Forrovial) constructing the Chiltern Tunnels to Brackley section of the new HS2 railway. Work on the £120m four-year contract will ramp up in the second half of the current financial year and hit full run rate in 2022/23. Chief executive Gordon Banham says that the division has tenders out for work on the Lower Thames Crossing and Sizewell nuclear power plant, amongst others, so there is scope for other major contract wins.
Hargreaves share price has risen 133 per cent since I initiated coverage 16 months ago (Alpha Report: ‘A high yielder offering significant hidden value’, 19 March 2020), and is up 30 per cent since I my last update (‘Targeting companies on the upgrade’, 3 June 2021). However, the shares are still only priced on 11 times conservative looking EPS estimates of 43.6p even though there is scope for more earnings upgrades as the year progresses. Shareholders can also look forward to a 16.5p a share pay-out in October (ex-dividend: 16 September), and a five per cent forecast hike in the total dividend to 20.2p a share in the 2021/22 financial year to underpin a prospective dividend yield of 4.1 per cent.
In the circumstances, I am raising my target price from 450p to 575p, and see scope for a re-rating well beyond 600p a share in the event of a disposal of HRMS at a material premium to book value. Buy.
Finally, I have published an additional article ('Set fair for a profitable voyage').
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