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Warning signs at Aggreko

The equipment hire company has seen margins fall as receivables rise
January 31, 2019

For several years, power-generation equipment rental group Aggreko (AGK) has been attempting to limit the damage from tough trading at its power solutions business. Souring economic sentiment and rising competition from generalist equipment rental companies is only likely to make management's job harder. We feel the negative trends experienced by the business over the last five years may prove more deeply entrenched than suggested by the shares' current rating.  

IC TIP: Sell at 717p
Tip style
Sell
Risk rating
High
Timescale
Short Term
Bull points

Self help
2020 Olympic work

Bear points

Margin declines
Forecast downgrades
Rising debtors-to-sales
Deteriorating economic sentiment

Aggreko rents out equipment for power generation, heating and cooling around the world. Its business is divided into rental solutions, which serves developed markets and accounts for 52 per cent of revenues, and power solutions, which is split into an industrial division (27 per cent of revenue) and a troubled utilities division (21 per cent). The group is well positioned to benefit from long-term trends towards increased demand for power and decentralised generation of energy. However, its operations are also very cyclical with much demand pinned to the health of the global economy and conditions in the oil and gas industry. Meanwhile, a large fixed cost base and high capital requirements make returns very sensitive to changes in demand and supply – so-called operational gearing.

This operational gearing has been evident during the last five years when the company has faced problems with contracts, particularly in Argentina. The pre-exceptional operating margin has steadily fallen from 23 per cent to 13 per cent between 2013 and 2017, and at the half-year stage was 9 per cent compared with 10 per cent in the first half of 2017. The worsening outlook, meanwhile, has been reflected in steep downward revision to earnings forecasts over the last two years, although, this has levelled off more recently (see chart).

The fall in profitability has been the chief reason for the underlying return on capital employed (ROCE) nearly halving in the five years to the end of 2017, from 21 per cent to 11 per cent. Net debt over the same period has risen from £363m to £652m, while cash profits (Ebitda) have dropped from £636m to £529m. Despite management's efforts to cut costs and improve fleet efficiency we think the company faces an uphill struggle with a goal to return ROCE to mid-teens by 2020.

A particular issue is the increasingly gloomy sentiment about global economic prospects based on the data coming from both the US and China, as well as the trade war between the two economic superpowers. The volatility of the oil price is also unlikely to help spending decisions of many of Aggreko's clients, and rising competition from generalist hire companies could put pressure on rental prices and fleet utilisation. On the plus side, the 2020 Olympics are bringing in work and the rental solutions business enjoyed strong demand in the first nine months of 2018, with sales up 26 per cent, buoyed by North American oil and gas customers.

An issue the group faces in convincing investors that things can improve is a decline in the perceived quality of its earnings based on the rising percentage of its reported sales represented by debtors (see graph). Debtors, also known as receivables, represent the amount of income earned by a company on which payment is outstanding. Furthermore, at the end of 2017, the amount of debtors that were classed as trade receivables (work that has been invoiced for) had fallen to less two-thirds of the total. That said, there was some encouragement to be taken from improved collections at the half-year stage.

 

AGGREKO (AGK)   
ORD PRICE:717pMARKET VALUE:£1.84bn
TOUCH:716.6-716.8p12-MONTH HIGH:891pLOW: 637p
FORWARD DIVIDEND YIELD:3.9%FORWARD PE RATIO:14
NET ASSET VALUE:507pNET DEBT:57%
Year to 31 DecTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20151.5625271.727.1
20161.5222161.927.1
20171.7319553.927.1
2018**1.7818048.727.5
2019**1.8319749.528.0
% change+2+9+2+2
Normal market size:2,000   
Matched bargain trading    
Beta:0.81   
*Peel Hunt forecasts, adjusted profit and EPS figures