Tuesday, 17 April 2012

Investment spotlight: Can Weir Group continue to pump up profits?

Weir Group @ 1652.95p,-10.05p (-0.72%)

I've been taking a keen interest in Weir Group, the pump specialist, who's share price has come back from a high of 2236p to the current 1652.95p.
The company has a global presence and occupies a niche position supplying the Oil & Gas; Minerals; and Power and Industrial sectors through 3 division bearing the same name.
Major customers include BHP Billiton, Shell, Rio Tinto, Vedant, Anglo American, Xstrata, and BP.

Sales consist of new equipment and a growing aftermarket business along with exposure to the latest, if highly controversial, shale oil extraction methods.
Oil and Gas occupies around 30% of the company's forecast revenues and it appears that concerns around the viability of this latest trend has resulted in the current pull back of the share price.
The Power and Industrial division has also been subdued following the tsunami/Fukushima nuclear disaster of last year.

Over the last 5 years:-
- Revenues have doubled (£1009m to £2292m) and profit before tax has more than trebled (£109m to £391m)
- Operating margins have steadily increased over the last 5 years from 10.97% in 2006 to 17.62% in 2010
- Return on Capital Employed has also increased over the same period from 33.23% to 58.98%.
- Although not a headline grabber, the dividend yield has actually doubled in the last 5 years from 16.5p per share to 33p paid out last year.
- Over the same period, dividend cover has improved from 2.41 times to 4.05.

- Cash has swung around from £54.2m in 2007 to £114m in 2011 and it looks like there was a major acquisition in 2007 with the decrease in cash and increase in borrowings from 2006.
- Gross borrowings are now £695m (payable inside 5 years) and swallow up 62% (gross gearing), of shareholders funds (net assets) which themselves total £1118m. 
62% is a big jump on 2010's 39.9% gross gearing figure and is probably due to acquisitions. I note that the Preliminary accounts also refer to a post balance sheet acquisition of around £114m.

- Utilising the available cash would result in net borrowings of £582m and gearing of 57.9%.
- Interest cover, based upon payments of £19.4m and adjusted profit before tax of £410.9, is a healthy 21.18 times so should be manageable (see later for cash flow v earnings v borrowings though).
- Net assets (Shareholders funds) have more than doubled from £545m to the already stated £1118m.
But, there is a size able intangibles figure (goodwill) of £1332m, which if excluded takes the net asset figures negative by £214m. 
Serves to illustrate that there have been significant acquisitions over the last 5 years which requires healthy future cash flows to justify.

- Cash flow per share is 94.02p per share but it is a concern that this is significantly below the 133.6p earnings per share figure.
- Headcount has increased by 2,000
- Current liabilities were recorded at £796m, up from £534m.
- Consensus growth is forecast at 18% (2012) and 10% (2013) bringing the forecast P/E down to 10.8 (2012), then 9.6 (2013).

Earnings forecasts do seem to be going up despite general market concerns around Chinese growth and the demand for commodities: oil, gas, and minerals.
But it might be that investor's expectations for the company had got ahead of analysts forecasts and have now reverted to the average which has pulled the share price back.
I am concerned at the proportion of intangibles which potentially negates all shareholders interest as it outweighs the remaining assets.
This also points towards what might have been a highly acquisitive few years for the company and I note that they continue to look at acquisitions so, it seems that shareholders have already put a lot of faith in the company's management.
But it remains to be seen if this continues to be borne out particularly when cash flow has started to fall short of earnings per share. 

Generally this shortfall can be put down to lead time differences between monies going out on working capital etc and monies coming in. 
In most cases the effect is only minor but to illustrate the point it can create a mini credit crunch at which point liquidity in the form of short term credit may be required, the result being that a company might possibly "waste" money on finance charges just to bridge the shortfall between cash coming in and cash going out. 
I note that in these most recent results Weir's short term borrowngs jumped from £6.3m to £92m, which is part of a bigger jump, from £534 to £796m, in the overall current liabilities (payable within 12 months).
However, as mentioned, the company also makes reference to a post balance sheet purchase of Novatech at £114m along with the repayment of bridging finance used to purchase Seeboard so, I would assume, that these numbers now look more favourable.

On the positive side, the numbers do illustrate success in the company's strategy and I particularly like the strategy:
- to build on technical expertise with new equipment
- target high growth, long cycle industries
- establish long term relationships with aftermarket support
- sharing of technology and expertise across sectors

It actually sounds a lot like my view of the Aerospace market but it remains to be seen if this is the case although I can certainly see that potential with the company's subdued Power division when you consider the life cycle of a nuclear plant.
And looking forward, the company's management are forecasting decent growth in 2 of its 3 divisions. 
But they also continue to look at strategic acquisitions as a driver for growth, the rate of which, is a concern.

Positives and negatives then but there is a track record so, on that basis, with just a little bit of positive economic news and/or upside surprise, I can probably see Weir returning to its 52 week high of 2236p and probably pushing beyond this to 2368p.
2368p would give a very handsome 43% gain in addition to the yield of 2.2%.

However, it is very much dependent upon your forward view on the state of the global economy and whether or not there is a bubble in commodity prices to correct.  Any hiccough in demand needs to be watched for as this would bring cash flow and borrowing concerns into focus.

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