Luceco keeps the light on

These products aren’t flashy but they are essential for both residential and commercial properties. The active housing market and persistent growth in the electronics market has driven demand. Luceco has been capitalising on this thanks to: its ownership of leading brands; loyal customers in the professional and retail market; and strong demand for the new products and innovations it has an ability to roll out at an impressive pace. Last year around half of sales were of products that were under three years old.

The group has seen margins expand rapidly since an annus horriblis in 2018 since profitabity has surged to industry-leading levels. But the share price tells a different story. Investors' worries, while understandable, may look graver than the problems the company has recently encountered.

China crisis

Demand for Luceco's products is currently in good health. In the first half, its high-margin wiring accessories business, which accounts for half revenues and 80 per cent of profit, grew sales by 72 per cent to £54m. Its smaller LED and portable power businesses, which both account for about a quarter of group revenue, both saw sales up by about a third. This puts all Luceco's divisions ahead of pre-Covid trading levels.

The problem is, Luceco is facing severe supply issues. The company manufacturers about half of its products in its factory in China and purchases most of the rest from original equipment manufacturers (OEMs) in China (see pie chart below). Customers also collect 42 per cent of products directly from China. Its wiring products are also mostly made from plastic and copper. In the first half of 2021 shipping costs increased by 500 per cent and the average cost of copper and plastic was 37 per cent and 71 per cent higher respectively than 2020.

In its half-year results, Luceco estimated total annual cost of inflation to be £20m, which is equivalent to a 15 per cent increase in cost of goods sold. It expects £13m of this increase to hit in 2021. Unsurprisingly, management is of the view that “gross margins would inevitably see some temporary compression during this phase”. It believes that it will be able to partially offset the costs through price rises and kept its full-year operating profit guidance unchanged.

However, the market seems unconvinced by Luceco’s reassurances and the shares are down by over a fifth. Events over the past week have added to the angst. Reports have emerged of an energy shortage in China, adding to the downward pressure on Luceco’s share price. The combination of rising coal prices and pressure from the Chinese government to cut emissions has driven provinces to curb construction activity. Luceco’s factory is in the Zhejiang Province and, according to reporting from Nikkei Asia, “Zhejiang was among several provinces receiving a ‘second-level warning’, meaning they face severe challenges to meet the energy targets”.

However, Luceco says the energy issues have not impacted its operations because “their power requirements are modest relative to their size, helped in part by their own on-site renewable energy generation in China, whereas the Chinese authorities are currently focusing their attention on rationing electricity use by more power-intensive industries”.

An added dimension to the supply chain problems is visible on Luceco's balance sheet in the form of ballooning working capital requirements. Luceco inventories have increased because its products now take double the amount of time in transit and it has had to increase stocks to “ensure customer service continuity in an unsettled supply chain”. At the same time, receivables have increased as many invoices do not get paid until port clearance is confirmed. This contributed to a £9.8m increase in working capital requirements in the first half and a £14.5m outflow over the past 12 months. Meanwhile, the cash squeeze has caused its adjusted free cash flow margin to drop to 4.6 per cent from 14.2 per cent in the first half of last year.

Deja Vu

These events are all the less welcome as they bring back some unpleasant and not-too-distant memories for shareholders. In late 2017 the company revealed it had overstated the value of inventory, leading to a large hit that was followed by a period of torrid trading exacerbated by rising commodity prices and unfavourable currency movements. While trading is strong, once again the company appears to be facing a cost headwind at a time when key working capital items look worryingly high. There are clear risks.

But there are other reasons to feel more positive, which the share price may be ignoring. Its 2021 first-half revenue of £108m is a record for the company and is 31 per cent more than in the first half of 2019. As well as boosting sales, the company has also experienced a “step change” in profitability in the past two years. Despite the supply chain issues it has encountered this year, its half-year adjusted operating margin was still 17.7 per cent compared with 8.7 per cent in the first half of 2019.

Part of this boost to profitability has come through operational efficiency improvements at its China factory. Indeed, raising gross margins has been a key focus since 2018 (see chart). It brought in a new management team and in 2020 automated socket assembly, injection moulding, metal stamping and raw material central feeding. This project has delivered 9 per cent of cost savings over the past three years. It has also increased focus on the wiring accessories business and higher-margin products since its calamitous 2018 financial year.

Luceco’s jump in profitability has enabled it to boost its return on capital employed (ROCE) to 42.5 per cent during the first half of the year –this ROCE number is derived differently to the standardised number in the accompanying table. ROCE represents the profit generated from every pound that has been invested in a company's operations. This is an 18 percentage point improvement on 2020 and 24.2 percentage points better than 2019. According to broker Liberum leading sector peers have a ROCE of around 30 per cent while Luceco’s would have been “closer to 47 per cent excluding the Covid related inventory increases”.  

Sustainability

A strong part of the business's investment case is that it is positioning itself as an enabler for the green transition. Part of this is due to its LED lights, which convert 95 per cent of their energy into light – making them much more environmentally friendly than traditional lightbulbs. But while the UK market for LED lighting is sizable at about £800m, margins are not high. Despite almost doubling profitability in the first half, operating margins still stood at 8.6 per cent compared with the 28.3 per cent reported by the wiring accessories business.

But there are likely to be plenty more 'green' opportunities. One is a soon-to-be-launched EV charging range. These chargers will be installed at homes and offices and will enable the company to benefit from an EV market that is expected to grow at 20 per cent a year over the next nine years. By 2024, Luceco is expecting more than 1m charger installs per year.

The company is positioning itself to sell into growing markets and its strong return on capital bodes well. It has also promised to return at least 40 per cent of its earnings as dividends. The recent worries with its supply chains are offputting and, as with any macro issues, it is difficult to forecast what will happen. It also helps explain the rise in inventory levels and receivables, something that would normally be considered a classic red flag.

Brokers aren’t concerned about this in the medium term. FactSet's consensus EPS forecast has stayed at 21.6p for 2023. Coupled with Luceco’s recent share price drop, this means the ratio of price/next-twelve-month earnings (NTM PE) has fallen from 22 to 16 in the past month and the price/earnings growth (PEG) ratio sits below one. True, a warning cannot be ruled out given the backdrop, but for a company this profitable it looks good value, although there is no denying it is a stock that requires nerve to buy.