Is Fenner plc Now A Clear Buy?

An open-cast coal mineThe downturns in coal, iron ore and oil have not done many favours for Fenner plc (LON:FENR), which specialises in reinforced polymer technology, and makes products such as the large, heavy duty conveyor belts used in coal mines.

Fenner also makes a range of other polymer products, including hoses, belts, rollers, seals and medical device components. I’ve watched the firm’s share price fall by more than 50% over the last year and have become interested, because as far as I can see, all of Fenner’s products are consumables.

This is significant because while growth might be slowing among some of Fenner’s key customers, they aren’t shutting up shop: the kind of components made by Fenner need regular replacement in order for expensive plant to remain operational.

What’s more, as Fenner is keen to point out, its products are relatively low value, when compared to the kinds of operational and capital expenditure faced by large industrial and commodity firms. This should give Fenner two key advantages, in my view:

  • Customers will remain loyal as long as Fenner products maintain their market-leading qualities
  • Customers will not be especially price sensitive (within reason)

What about the numbers?

I’ve explained above why I believe Fenner could be an attractive business in which to own shares — the question now is whether the price is right.

Valuation

Let’s take a look at Fenner’s valuation:

  • PE10: 10
  • 2014 P/E: 9
  • 2015/16 forecast P/E: 10
  • 2015/16 forecast yield: 5.85%
  • Price/book ratio: 1.2

I’m a big fan of the PE10 (current price/10-year average earnings per share) as a tool for identifying stocks that are cheap based on historic average earnings, but that may currently be experiencing short-term problems.

In Fenner’s case, all three P/E measures are broadly equal, highlight the firm’s current out-of-favour status — but also its stability, in my view.

Quality and profitability

I’m satisfied that Fenner looks fairly cheap — the question now is whether it is cheap for a reason. The most likely reasons for this are a lack of growth prospects, and/or poor profit margins.

Growth is likely to be cyclical and also dependent on the firm continuing to innovate and offer products its customers need. That seems a reasonable assumption to me, given the firm’s 153-year track record, so what about profitability?

  • 5-year average operating margin: 10.0%
  • 2014 operating margin: 6.1%
  • 5-year average return on capital employed (ROCE): 12.7%
  • 2014 ROCE: 7.7%

It’s clear that Fenner’s profitability varies through the economic cycle. Fenner’s operating margin rose from a low of 3.4% in 2009 to a peak of 13% in 2012. In today’s market, I can live with the current 6.1% margin, given the potential for improvement as the effects of Fenner’s planned cost cutting take effect and/or the firm’s markets become more buoyant.

There’s also the question of debt. Fenner’s closing net debt last year was £117.3m, slightly lower than in 2013. That equates to net gearing of about 35%.

Interest payments were £14m last year, giving interest cover of 4.9 times net cash from operating activities, or more conventionally, 3.2 times operating profit. Both measures seem comfortable enough to me, especially as Fenner expects its cost-cutting  measures to reduce cash overheads by an annualised £9m over the next two years.

Fenner’s dividend may come under pressure, but earnings cover should be around 1.6 times this year, and a reduction in capex should mean that last year’s free cash flow cover can be maintained, protecting shareholders from a cut.

What’s the outlook?

I think Fenner’s performance over the next year or two is likely to be pretty subdued, but as I explained earlier, I don’t expect a wholesale collapse in sales or profits, due to the consumable and essential nature of the firm’s profits, and their wide and diverse installed base.

I’ve recently added some shares in Fenner to my portfolio, as over the next 3-5 years, I expect Fenner to deliver gradual earnings growth and benefit from a re-rating towards a P/E of around 12-13. Combined, these give me a tentative target price of between 250p and 300p.

In the meantime, I’m happy to collect the Fenner’s 5.8% dividend yield and await further developments.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author owns shares in Fenner. Do your own research or seek qualified professional advice before making any investment decisions.

£28 might be a fair price for ASOS plc shares, but there’s no point paying this much

Clothes rail in shopInvestors tend to associate Ben Graham with value investing, but the master investor had an opinion on growth stocks too.

Usefully for us, Mr Graham developed a very effective simplified alternative to discounted cash flow valuations.

The Graham Formula, as it became known, provides an estimate of the intrinsic value of a growth stock over a 7-10 year period.

Here’s the formula. Note that it can easily be rearranged to calculate the growth rate, g, using the current share price:

Intrinsic value of stock = EPS * (8.5 + 2g) * 4.4 / Y

(EPS = last reported adjusted earnings per share, g = long-term forecast earnings growth rate, Y = yield on 20-year AAA-rated corporate bonds — see here)

How is this relevant to ASOS?

With this in mind, I was interested to come across an old article by Stockopedia founder Ed Croft which used the Graham Formula to value ASOS plc (LON:ASC), back in February 2012. At the time, the online clothing retailer’s shares were trading at around £18, which seemed expensive enough and implied a 7-10 year annualised eps growth rate of 27%. ASOS shares did of course quadruple in value from this point to last year’s £70 high, before crashing back down to trade at their current price of around £28.

Given the strong performance of ASOS stock, you might think that ASOS has been outperforming its implied 27% annual eps growth rate since 2012. Yet it hasn’t. After Ed’s article was published in February 2012, ASOS went on to report a 67% fall in earnings per share for 2012, before recovering somewhat in 2013 and 2014.

Over the three years from 2011 to 2014, ASOS delivered annualised earnings per share growth of just 5% per year! Of course, three years is much less than the 7-10 year timescale specified by Ben Graham, but a 27% annualised growth rate still seems a bit ambitious.

Whare are growth expectations today?

Given this, what does today’s ASOS share price imply about future growth, using the Ben Graham Formula?

I’ve crunched the numbers, and the current ASOS share price of 2,850p implies an annualised growth rate of 19% per year for the next 7-10 years. Is that reasonable? It’s certainly not impossible, if ASOS achieves its goal of becoming the Amazon of online fashion retail, but it’s a demanding goal.

ASOS’s recent results suggest that selling online is not more profitable than selling on the high street — ASOS’s operating margin of around 5% looks pretty dismal alongside the 20% margin generated by Next – and I think it’s fast becoming obvious that there is no secret sauce that makes online retailers better businesses than those who trade on the high street as well.

More to the point, today’s valuation of ASOS leaves no room for disappointment, and little room for ASOS to exceed expectations. Given that growth stocks typically only outperform the market when they exceed expectations (or when a bull market gets out of control), I don’t see any reason to buy ASOS at today’s price.

Mind you, that’s what Ed said back in 2012 — since when ASOS shares have gained another 60% or so… It just goes to show that while statistics and modelling can be a useful guide to market-wide returns, almost anything can happen to individual stocks — although personally, I am still pretty sure ASOS is overvalued.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author has no interest in any company mentioned. Do your own research or seek qualified professional advice before making any investment decisions.

How much is BHP Billiton spin-off South32 worth to shareholders?

An open-cast coal mineIn August last year, BHP Billiton plc (LON:BLT) announced that it would spin-off a selection of its non-core assets into a new company, the shares in which would be distributed to BHP shareholders.

Investors had been hoping for a cash return or share buyback, and were not overwhelmed by this idea: BHP shares fell by nearly 8% in the 10 days that followed.

The assets to be disposed of — described by the firm as “a selection of its high-quality aluminium, coal, manganese, nickel and silver assets” were essentially Billiton assets which BHP acquired when it merged with Billiton.

It’s certainly true that these assets aren’t especially profitable, at the moment, but they do have reasonable scale, and I think the market may have underestimated the medium-term value in these assets.

What are they worth?

Disclaimer: There are lots of approximations involved here. This is just for fun — don’t take it too seriously or use it as the basis for any investment decisions.

The demerger is expected to take place in the first half of 2015, and the new firm has now been given a (predictably naff) name — South32 — which appears to refer to the fact that all of the firm’s assets are in the southern hemisphere: South Africa, Latin America and Australia.

As I’m a BHP shareholder, I decided to make an attempt at estimating the likely value of the demerged assets, and hence the value of the shareholder return I will receive.

I’ve taken the list of assets BHP has provided for South32, and used the firm’s final results from last year to generate the following numbers:

Asset Revenue ($m) Underlying EBIT ($m) Net operating assets ($m)
Aluminium & alumina 3,287 48 6,244
Cannington silver 1,079 412 234
Energy Coal South Africa 1,279 (170) 989
Illawarra metalurgical coal 886 (39) 1,384
Cerro Matoso nickel 595 10 860
Manganese business 2,096 476 1,613
Total 9,222 737 11,324

Source: BHP Billiton results y/e 30 June 2014

Here are the highlights:

  • Revenue: $9.2bn
  • Adjusted operating profit/EBIT: $737m
  • Adjusted operating margin: 8.0%
  • Net operating assets: $11.3bn

The question now is how to value such a business. Clearly caution is required, despite the new entity’s 8% operating margin and meaningful revenues.

I’m going to suggest three possible valuations:

  1. Price to sales ratio of 1: to put this in context, Anglo American currently has a P/E of 0.8, but Rio and BHP have a P/S of around 1.6. South32 should have “minimal net debt” according to BHP, so it should be in a slightly stronger position than Anglo — a P/S of 1 seems reasonable.If South32 had a P/S ratio of 1, this would equate to $1.73 (approx 115p) per BHP share.
  2. BHP has promised that South32 will have a strong balance sheet, so perhaps the market will be more generous and value it at its net asset value of approximately $11.3bn. Again, this is a little more than Anglo American, but significantly less than Rio and BHP.If South32 had a price to book ratio of 1, this would equate to $2.12 (approx 140p) per BHP share.
  3. Finally, I had a stab at valuing South32 on a P/E basis. This required me to estimate how South32’s operating profit might translate into post-tax earnings. Last year, BHP’s profits after tax were 65% of its operating profits, so I used this as a basis for the calculation.Crunching the numbers gives earnings per BHP share for South32 of 9 cents (approx 6p). BHP, Rio and Anglo are all valued on around 10 times forecast earnings at the moment, so using a P/E of 10 as a guide, South32 could be worth 60p per BHP share.

I’ve calculated the value of South32 per BHP share because the shares in South32 will be distributed pro-rata to BHP shareholders, so it’s logical to look at this like a special dividend.

Although methods 1. and 2. (P/S of 1 and P/B of 1) gave similar results, averaging 128p per BHP share, valuing South32 on a P/E of 10 gave a dramatically lower value of just 60p per share.

If you think abou it, this is logical, — the reason BHP is hiving off these assets is that they are underperforming. The question is whether they can be turned around, and how long this might take.

South32 listing price

In my view, South32 shares are likely to be cautiously received by the market.

There may be some forced selling by institutional investors whose remit doesn’t allow them to hold the shares, so I wouldn’t be surprised if they dropped to around 50p when they are listed.

Selling the shares at 50p would equate to a 3.6% special dividend — not to shabby, assuming the market doesn’t write down BHP shares following the demerger.

However, I suspect that patient investors may snap up South32 shares and enjoy a considerably larger reward, over a 2/3 year timescale, perhaps. As things stand at the moment, that’s certainly my plan — I don’t intend to sell straight away and will see how the new company performs, first.

Commodity outlook

Finally, just a note to emphasise that it’s worth looking at South32 in the context of commodity prices.

Aluminium and silver are very cheap at the moment, but this situation won’t last forever. Manganese appears to be very profitable, and the price of nickel rose strongly last year, so this business could also do better in 2014/15 than it did last year.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author owns shares in BHP Billiton and Rio Tinto. Do your own research or seek qualified professional advice before making any investment decisions.

Fenner plc, Lamprell Plc and The Weir Group PLC: falling knives or bargain buys?

Should you catch a falling knife?The falling price of oil is starting to throw up potential bargains in the engineering and oil services industries. Three examples from the engineering sector are Fenner plc (LON:FENR)Lamprell Plc (LON:LAM) and The Weir Group PLC (LON:WEIR).

However, there’s a clear risk that all three of these could prove to be falling knives.

Of the three, I suspect that Fenner is closest to bottoming out: as I explain in a new Motley Fool article this morning, it doesn’t seem likely to me that Weir and Lamprell’s current valuations reflect the full consequences of oil’s recent collapse.

In contrast, Fenner’s business is more diverse and benefits from the fact that many of its products are consumables, that need to be replaced regardless of market conditions in order to keep essential plant in working order.

I’m believe that all three of these companies will become attractive recovery plays when the time is right, and I will be watching them closely over the coming months to learn more and see what happens.

You can read the full article here.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author has no position in any company mentioned. Do your own research or seek qualified professional advice before making any investment decisions.

AO World PLC Flashes Sell As Early Backer Cuts Stake (updated 12/01/15)

A share tip circled in a newspaper share listingI have to admit that Norman Stoller isn’t a name that was familiar to me until today, when I saw that he had sold £10m worth of shares in online appliance retailer AO World PLC (LON:AO), back in December.

A quick Google made things clear: millionaire businessman Mr Stoller was one of three men who helped fund AO when it was originally founded, more than a decade ago.

Of course, after such a long time, it’s only natural that Mr Stoller might want to lock in some gains, but I’ve had AO on my list of shorting candidates for some time and have previously highlighted its crazy valuation.

Founder selling, in my view, is the final piece of the jigsaw needed to justify a short sale.

Let’s take a quick look at AO World’s financials:

  • 2014/15 forecast P/E: 216
  • 2015/16 forecast P/E: 69
  • Operating margin (TTM): 2.5% (adjusted) / 0.4% (reported)

Hardly a value buy — even if earnings per share double again in 2016/17, AO would still be trading on a P/E of around 35 at today’s 260p share price. Given that so much growth is already baked into AO’s share price, even the tiniest slip-up could result in a major fall, as we saw when Boohoo.com shares fell by 40% earlier this week, after Boohoo reported sales growth of 25%.

What concerns me most, however, is AO’s wafer-thin operating margin. This company clearly makes almost no profit on the goods it sells, and I don’t see any potential for this to improve — it doesn’t really have any way of differentiating itself from its competitors, except by competing on price.

There’s little doubt this is a viable business with reasonable scale, but the valuation makes no sense to me.

AO is due to publish a third-quarter interim statement on 22 January, so we shouldn’t have too long to wait to find out how the company fared in the Black Friday sales — and whether there will be any changes to full-year guidance.

Update 12 January 2015: AO has brought forward its planned update to big up its Christmas sales figures. Website sales rose by 38% during the final quarter of last year, while total revenue rose by 25%.

Interestingly, these are exactly the same as the equivalent figures in the firm’s interims, which cover the previous two quarters. AO has confirmed that it expects full-year results to be in-line with current expectations, which are:

  • Revenue: £500.7m
  • Post-tax profit: £5.5m
  • Earnings per share: 1.2p
  • (Taken from latest Stockopedia consensus figures 12 Jan ’15)

However, there’s no mention of profitability in today’s update, and in my view the valuation risks I highlighted in my original article above remain valid.

It’s worth noting that today’s gains have only pushed AO’s share price back to the level it was at before Mr Stoller’s £10m share sale was disclosed.

I remain short.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author has a short position in AO World. Do your own research or seek qualified professional advice before making any investment decisions.