The industrial sector remains a difficult place to be in South Africa, despite improved market sentiment driven largely by sectors such as mining.
Concerns about deindustrialisation are valid, as local companies continue to struggle in an environment of endless regulations and cheap imports from China and other trading partners.
Even the successful, diversified players trade on only mid-single-digit earnings multiples. This equates to double-digit earnings yields (the inverse of an earnings multiple). The market is sceptical of their ability to grow.
The dividend story is no guarantee either, as these are capex-hungry businesses that can experience major swings in working capital (cash tied up in stock and debtors). The good ol’ “factory that produces widgets” — a favourite of accounting lecturers since forever — is not an easy way for investors to make money.
When times are tough, only the strong survive. In this sector, “strong” means diversified groups with solid balance sheets. When the pressure is relieved slightly, those balance sheets can be used to execute acquisitions.
This has led to roll-up strategies and the creation of industrial conglomerates of various sizes. There are only a handful of focused industrial companies in the local market, with investors largely avoiding them.
Hudaco is a perfect example of a conglomerate. The latest results were decent overall, with continuing operations generating turnover growth of 9.5% and operating profit growth of 11.2%. The interim dividend came in 10% higher, so this is a solid growth rate in the context of the modest valuation (a p:e of 8).
But in the discontinued operations, we find two highly problematic business units that have been taken behind the shed. They won’t be coming back.
The alternative energy business is now plagued by oversupply as demand for power backup solutions washed away
The first is the alternative energy business, where the party stopped when load-shedding went away. That sector is now plagued by oversupply as demand for power backup solutions washed away, teaching a hard lesson about the risks of making money from a temporary issue. Of course, only hindsight has taught us that load-shedding was temporary.
The second is a business that supplies battery products for forklifts, demonstrating just how specialised these underlying industrial endeavours can be. Hudaco is shutting this operation down after the entry of a competitor (linked to ex-staff) made this business unattractive. That kind of vulnerability is a concern, as markets operate in a constant state of flux in which new competitors are always a risk.
These issues show that diversification in the industrial sector is probably a good thing, as many of the businesses depend on one or two key factors for survival (be it a specific product, supplier or customer). But this also makes it difficult to forecast overall performance.
Argent Industrial’s results for the year ended March also came out this week, reflecting revenue growth of 7.7% and dividend growth of 11%. This is another example of double-digit growth in a sector that tends to expect only single-digit increases in earnings.
Notably, Argent has built a primarily offshore group, with South African operations contributing only 27% of profit before tax. Investors looking to participate in this broader sector, but perhaps nervous of the deindustrialisation issue in South Africa, could look at Argent in more detail.
Another name with a significant offshore business is Invicta, though its split is nowhere close to Argent’s. In Invicta’s numbers for the year ended March, it even highlights deindustrialisation as its No 1 key risk. With R260m in profit for the year from South Africa vs a group total of R503m, it is still generating more than half its earnings here at home.
Despite the difficult local conditions, Invicta grew the dividend per share 9%. It didn’t quite achieve the double-digit dividend growth seen at the other two players, but that’s still a solid outcome.
It’s tough, but these three names all rewarded investors with a dividend growth rate in excess of their earnings multiples. It’s a crude rule of thumb, but it suggests that there is value here. Argent shareholders had a great year, with a total return of 46% (much higher than Invicta’s 16% and Hudaco’s 1.3%).
It’s dangerous to distil just one conclusion from this, but investors do seem to be rewarding Argent’s offshore exposure (even if the overall multiple remains low) and balance sheet strength. The lights might be on in South Africa, but the local industrials sector isn’t glowing.
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