A rare UK innovator available at a good price

The company celebrates its 50th birthday this year, and executive chairman Sir David McMurtry reminisced in his results commentary about how he and co-founder John Deer started out in the latter’s house, using underlay from McMurtry’s carpets as dust seals.

It has come a long way since then. Renishaw now employs more than 5,000 staff – 3,000 of whom work in the UK doing the type of high-value manufacturing that’s lauded by politicians. Its encoders, gauges and other specialist devices are used for precise measurement and testing across a range of advanced manufacturing processes, serving industries such as aerospace, automotive, consumer electronics, healthcare and semiconductors.

Innovation “has always been central to what we do”, McMurtry said.

Renishaw has typically been profitable, too, with a pre-tax profit margin running at above 20 per cent for most of the past decade. However, a combination of a downturn in the semiconductor industry and higher costs meant sales for the 12 months to June were flat and adjusted pre-tax profit slipped by 14 per cent to £141mn. Renishaw’s return on sales fell back to 20 per cent, compared with 24 per cent a year earlier.

The culture that the co-founders have fostered in the business doesn’t come cheap, either. Renishaw typically spends between 13 per cent and 18 per cent of its revenue on R&D and engineering costs.

A fair day’s pay

Labour is the company’s largest cost and grew by 13 per cent last year to £268mn, or nearly 40 per cent of sales. This was partly due to an increase in headcount but also a global salary benchmarking exercise, which led to a 10 per cent increase in workers’ basic pay. This was “to ensure that we are competitive in what has been a tight employment in many countries”, chief executive Will Lee said. Voluntary employee turnover fell to 6.8 per cent, from 10.7 per cent in the previous year, as a result.

On top of this, the company has embarked on its biggest ever capital investment – a £50mn-plus expansion of its manufacturing site at Miskin in south Wales. It is building two new halls, which will increase its manufacturing floorspace by 50 per cent.

Last year’s capex more than doubled as a result, to just shy of £74mn, and management is guiding for a similar level of spending in its current financial year, as the group begins to kit out the first of these halls with the necessary machinery.

Renishaw announced the plan to increase manufacturing capacity in June 2022, when demand for semiconductors was peaking. Over the next year, global semiconductor sales dropped by 17 per cent, according to World Semiconductor Trade Statistics (WSTS), an industry data provider. Renishaw’s sales to the industry fell to 16 per cent of total revenue last year, from a fifth a year earlier. As a result, the second of the two halls will be built but then mothballed “until absolutely required”, finance director Allen Roberts told analysts.

The combination of flat sales and higher costs has turned investors more negative, and the company’s share price has halved since its most recent peak of over £70 in March 2021. They are now priced at 20 times consensus forecast earnings – a discount of a third on their five-year average.

The annual return on common equity, which shows how efficient the company has been in turning its capital into profit, averaged 25 per cent in the five years to June 2018 but dropped to 12.7 per cent in the five years since. Even if the dismal figure for 2020 is stripped out, ROCE only edges up to 15.9 per cent.

Passing the baton

Then there’s the uncertainty around succession. Some 50 years on from cutting up underlay, McMurtry and non-executive vice-chairman Deer both still play a major role in the business and together own a majority of the shares. Unsurprisingly, given their advancing years (Deer is 85, while Sir David is a relatively sprightly 83) they have an eye on an exit. However, a formal sale process held two years ago to find “a buyer who will respect the unique heritage and culture of the business” was halted after three months, with none of the approaches deemed suitable.

The pair’s continued hold over the business can be viewed in a couple of ways. Proxy advisers have repeatedly recommended voting against their re-election to the company’s board, citing corporate governance concerns. Almost 30 per cent of shareholders voted against Sir David’s re-election at this year’s annual meeting and nearly 26 per cent voted against Deer’s return to the board. Institutional investors representing more than half of all independent shareholders voted against their re-election. Minority shareholders seemingly lack a voice, although the board says it “continues to make itself available” to shareholders and has pledged to increase investor engagement.

The counter-argument is that despite their advancing years, the pair are still committed to doing what they feel is best for the business. If they were less bothered, they could have sold to the highest bidder or halted an expensive growth strategy that is a drag on short-term profits and the valuation.

The expansion is deemed important because “a lot of the growth we have in our plans is from physically larger products”, Lee said. These include additive manufacturing machines that produce lighter parts with much less waste, as well as a range of more efficient enclosed encoders.

Lee also highlighted growth opportunities in automation, via a new product line that supports the set-up, calibration and control of robotic systems.

And although the semiconductor market remains a short-term headwind, the most recent WSTS data showed a second month-on-month improvement in July, indicating that the market may have bottomed out. A rebound from next year is also forecast.

The key risk for investors to weigh up is whether the lower returns experienced in recent years are a longer-term trend or if McMurtry and Deer’s eventual departure could cause the company to lose its way.

New(ish) broom

Though possible, neither risk seems likely. And while McMurtry still holds the title of executive chairman, there is a highly experienced team below him. Lee, who has been chief executive for more than five years, joined the company as a graduate trainee 17 years ago, while Roberts was appointed back in 1980.

And it’s no surprise that the combination of a pandemic, inflationary pressures and upended supply chains led to a couple of leaner years, particularly as the group preserved investments in R&D and doubled down on expansion. Having ended its last financial year with net cash above £190mn, Renishaw can lean on its balance sheet to cope with any new setbacks.

On balance, while the shares’ current discount to their long-run valuation is understandable, this looks like a good entry point for a long-term investor. Not only should the bulk of the remaining capital investment complete this year, but last year’s hike in labour costs is not expected to repeat. Even if end markets remain depressed for another 12 months, its earnings potential should improve next year, as reflected in a 7 per cent forecast rise this year, and 16 per cent in FY2025.

Then there’s the possibility of a bidder returning with an offer that the co-founders can accept, even if the expectation of a buyout is rarely a good reason to own a stock in and of itself. This caveat may be truer in Renishaw’s case, as the last sale process took place when the shares were much more highly rated.

Shares appeal to investors for all kinds of reasons, though – and so long as they offer the prospect of a good return, the thought of buying into a UK-based business that holds innovation in such high regard seems as good a reason as any.