Finding industrial companies with real mettle

Scouring the ravaged SA industrial landscape for bargain-priced investments is a dangerous business these days.

There is a paucity of good news to spark sentiment for a revival in industrial company fortunes, while the possibility of corporate implosions remains large with a slew of risks and challenges that cannot always be managed by even the most experienced executives.

In the past 18 months, investors would have witnessed the steady demolition of the local construction sector — starting with a breakdown of more marginal players (Esor, WG Wearne and Distribution & Warehousing Network) then hitting more established players (Aveng, Group Five and Stefanutti Stocks).

At the time of writing, ArcelorMittal SA warned that up to 2,000 jobs were at risk after it plunged deep into the red in the six months to end-June on the back of lower selling prices and rising costs.

The steel giant’s woes are really a template for the challenges most local industries are facing — rising input costs (most notably markedly higher electricity charges) coupled with soft demand and pricing pressures due to the slackening in local economic activity and low business confidence.

Making matters worse for companies clinging to a vestige of viability are stretched payment terms from cash-conserving clients, the stalling of large project work, labour inflexibility and stricter loan arrangements from banks, as well as increased regulation (including the carbon tax). For those involved in importing either equipment brands or raw materials, there has been a volatile exchange rate to deal with as well.

A source who is involved in supplying equipment to the mining sector articulated the struggle to maintain operational cash flows: "In terms of holding back payment, mining companies have become the new retailers. They are pushing out payment days as they focus on their working capital. Suppliers are being seriously squeezed."

In this profit-eroding trading environment it is not surprising that a good number of well-established industrial counters are trading on trailing earnings multiples of as low as five times, with a decent dividend yield in tow.

But Charles Pettit, CEO of investment firm Apex Partners, reckons equity valuations for industrial counters on the JSE are not as cheap as they seem.

Apex recently acquired a number of businesses from Torre Industries, the company that Pettit built up by acquisition from the listing of the old SA French group in 2013.

Pettit says Apex is on the lookout for opportunities in the industrial space.

"Valuations might look cheap on the JSE, but you need to look at the trading environment and figure out what earnings will be in the years ahead. Historic multiples are no longer relevant."

Pettit says it is important for investors perusing the industrial segments of the JSE to look at opportunities than can offer a huge margin of safety.

"For us there is a price for everything. Perhaps a two to three times multiple does represent good value, because ratings have compressed dramatically over the past few years to cater for a very limited appetite for risk."

Neil Brown, co-head of Electus Fund Managers, believes local industrial companies will need to change the way they operate in the prevailing tough economy.

Previously, industrial companies could trade out of a downturn and recover strongly — sometimes enhancing growth with acquisitions, he says. "But we are seeing a prolonged downturn that is severely testing industrial companies, especially those that have geared up to make costly acquisitions. When operating leverage and financial leverage collide it can be terminal, and can mean companies have to pursue fresh capital via rights issues."

Brown believes industrial company directors might have to be more proactive in addressing operating challenges. "What tends to happen is that boards often don’t make critical changes to operating structures and strategy until it’s too late. Then these directors resign … but the damage has been done."

Admittedly IM is not painting a picture that would appeal to most ordinary investors. But wizened investors know that often the best time for a bargain — a long-term bargain, that is — is when the wreck is still smouldering and most of the market is too appalled to sift through the debris for value.

While the JSE’s industrial sector spans many subcategories, IM has chosen to look at the merits of a handful of diversified industrial players that these days might be regarded as small caps.

HUDACO

Market cap: R4bn

Earnings multiple: 9x

This diversified industrial consumables conglomerate is probably the best known of the "second-line" industrial shares on the JSE.

Hudaco has an enviable long-term track record and its highly regarded management has a reputation for eking out returns for its shareholders through thick and thin.

In its latest interim report to end-May, Hudaco reported turnover up 7.5% to R3.2bn with some margin squeeze evident in the 2.5% gain in operating profit to R297m. Most reassuring, though, was that cash generated from operations was up 200% to R300m, which, along with reasonable gearing of under 45%, more than justified Hudaco pegging its interim payout at 190c a share.

IM takes considerable reassurance from Hudaco’s incredible operational diversity, which spans consumer-related products such as auto spares, power tools, spanners, batteries and security equipment, and engineering consumables involved in power transmission, diesel engines, hydraulics, pneumatics, thermoplastic pipes, bearings and steel.

Hudaco probably won’t produce a stellar performance in the second half (traditionally the stronger trading period), with the economy still plodding on unconvincingly. The larger consumer-related businesses will take some strain, but there might be a better performance from the engineering consumables segment. But overall cash generation should remain strong.

What investors can bank on is that Hudaco’s management will probably extract more synergies and efficiencies — which could be serious margin enhancers when the economy does finally turn for the better.

IM reckons Hudaco is a solid longer-term bet that has the ability to endure further setbacks in the economy. A recent investment note by Absa Stockbrokers — researched by our good friends at Intellidex — estimates a fair value of R151 a share for Hudaco.

INVICTA HOLDINGS

Market cap: R2.9bn

Earnings multiple: 24x

Invicta, which owns the reliable Bearing Man business along with a wide-ranging portfolio of industrial products, was once the go-to industrial counter, even shading the more established Hudaco.

But things have changed in recent years. Corporate controversy around executive share dealings has dogged sentiment and — to be perfectly honest — so has the link to controlling shareholder Christo Wiese, the retail tycoon embroiled in the Steinhoff debacle.

But a more tangible weight has been the sizeable settlement with the SA Revenue Service involving a full and final settlement stemming from arrangements around an empowerment scheme that tops R750m.

The settlement is payable over four years — and R300m was paid in October last year with three R100m payments staggered in October this year, 2020 and 2021. A final payment of R150m will be made in October 2022.

This is a sizeable settlement, and the issue puts additional strain on Invicta’s balance sheet and cash flows at a time when the going is incredibly tough for industrial equipment providers. Invicta has already signalled its intention to conserve cash, passing the final dividend in the 2019 financial year and indicating that normal dividend policy will only resume when cash flow allows.

Unfortunately for Invicta, long-serving executive Arnold Goldstone retires as CEO at this critical time. A new CEO is still to be appointed, and there are already deep ponderings around whether new leadership could see a dramatic restructuring to focus on the biggest and best assets.

Another key question is whether the much-mooted offshore thrust — which started unconvincingly with the acquisition of Singapore-based engineering consumables business Kian Ann — will be revisited, or whether new leadership might prefer to concentrate on shaping up the core local operations.

There’s no doubt Invicta has some top-quality assets that would fire earnings in more vibrant economic conditions, and there is certainly value on offer considering a tangible NAV of more than R34 a share. But the dour economy won’t offer much momentum, so unless the new CEO hits the ground running, Invicta’s shares are likely to drift uncertainly.

ENX GROUP

Market cap: R2.1bn

Earnings multiple: 8x

ENX, which was built on the foundations of the old Austro listing, seems intriguingly poised. The company, which acquired the old Eqstra group some years ago, has decent profit cogs that generate reassuring cash flows.

Operations span industrial equipment supply and services (most notably forklifts) as well as fleet management. There are also smaller operations involved in petroleum and products.

But the company is lumbered with significant debt that was brought onboard with the Eqstra transaction. The group’s net interest-bearing debt increased to almost R4.7bn at the end of February. Interest paid was about R196m — a figure which needs to be seen against the backdrop of ENX’s cash generated by operations of R720m (which is equivalent to about 400c a share).

The market has largely remained unimpressed with ENX’s solid operating performance. The share price is down more than 40% over the past three years, and slightly down over the past 12 months. The market also seemed determined to discount the potential for a value unlock based on an ongoing cautionary notice around options for ENX’s interest in its fleet management business, Eqstra Fleet Management and Logistics (EFML). Shareholders were told that this could see EFML sold in "whole or in part".

At the time of writing, ENX disclosed EFML has been sold to conglomerate Bidvest for an enterprise value of R3.1bn and an equity value of R1.3bn (in other words, after the debt has been stripped out). For the record, ENX’s fleet business recorded interim revenues of R1bn and adjusted profit before tax of R93m in the half-year to end-February.

Directors pointed out that the fleet leasing book has shown positive growth of R147m since August 2018, which they reckon should "manifest in increased turnover going forward". Bidvest seems to have clinched a good deal.

But ENX — which carried EFML at just R630m — has unlocked substantial value for shareholders. The net sale price is equivalent to 720c a share, which suggests the market’s habit of trading ENX shares at or near its tangible NAV estimate of about R12 a share.

It will be fascinating to see how the Bidvest proceeds are mobilised — other than to cull debt at the centre. It would probably make sense to buy back shares at current levels, though further offshore forays in the equipment division perhaps should not be ruled out.

Interestingly, recent cautionary notices have also referred to ENX "reviewing other strategic opportunities to maximise stakeholder value". Perhaps the value unlock has just begun.

ARGENT INDUSTRIAL

Market cap: R469m

Earnings multiple 5.5x

Argent has bucked the grinding down share price trends in the industrial sector, appreciating some 60% over the past nine months.

The change of sentiment at Argent — hardly a counter the mainstream market dabbles in too frequently — was the introduction of an influence shareholder (the Milkwood Trust), which seems to have spurred efforts to unlock the enormous value that has been so long been trapped in Argent.

While the share price has shifted, the share still offers a nearly 50% discount on an estimated tangible NAV of about R10.50 a share.

The NAV is worth bearing in mind as Argent is in the throes of disinvesting out of its SA companies, reckoning the proceeds would be better invested offshore and — sensibly — for share buybacks. Properties are being actively sold off, and the group confirms talks with "various parties" around the disposal of certain SA subsidiaries.

At this juncture, most of Argent’s revenue and profit are still derived from SA, but CEO Treve Hendry has forecast that profits from its foreign operations should exceed the local contribution by September 2020.

To give some perspective to the span of the diverse local operations, SA-derived revenue topped R1.4bn and operating profits of R67m. There’s no indication of how much of its SA segment Argent intends to sell, but the enthusiasm for offshore expansion is palpable. Recently the offshore operations were bolstered by the acquisition of highly specialised industrial businesses Fuel Proof and Roll-tec Safety for £4.8m (up to £6.4m based on performance targets).

But here is the kicker: Argent’s specialised offshore operations managed an operating profit of R48m off turnover of just R308m. That’s a seriously reinforced operating margin, and if Argent can avoid buying dud businesses then the offshore hub looks awfully compelling. The mix of value unlocking and growth potential makes Argent appear a fairly compelling prospect for the medium term.

DENEB INVESTMENTS

Readers might argue against Deneb’s inclusion, since the market appears to view the company as a proxy on its property portfolio.

IM would tend to agree were it not for the strenuous efforts by management — led by the stoic Stuart Queen — to make a real go of its portfolio of diversified industrial interests.

Older readers will remember that Deneb’s operating base is largely the old Seardel clothing and textile manufacturing operations that were rescued from the brink of insolvency by Hosken Consolidated Investments (HCI) about 10 years ago. As a standalone entity — still controlled by HCI — there has been a dramatic honing of operations, the key development being the exiting of the unprofitable clothing manufacturing operations.

In its most recent financial report, Deneb indicated that it had started a process to divest from certain businesses — Winelands Textiles, Frame Knitting Manufacturers, Brand ID and First Factory Shops.

The group noted: "The businesses have been put on the market for sale and we will update shareholders of the progress."

Perhaps it’s not the price these businesses will fetch that is important, but rather the stemming of ongoing losses. At last count these businesses lost a hefty R78m, and R108m the previous financial year.

Ultimately Deneb, which turns over nearly R3bn from continuing operations, should hold a cluster of specialist industrial businesses in specialist textiles, steel products, chemicals, toys and stationery. These operations should have enough margin space to trade profitably through thick and thin.

Obviously one cannot ignore the value proposition in Deneb’s properties, which carry a value of R1.4bn and generated R130m in profits in the year to end March. With such a solid (and perhaps conservative) underpin to Deneb’s tangible NAV of 329c, the share price can really not have too much downside.