Share Sleuth: seven good long-term investments

slot-machine-hitting-jackpot-with-all-sevens

Clues in Dewhurst and ITE's annual reports reveal why one might make a good long-term investment, and the other might not.

My New Year's resolution requires me to upgrade the Decision Engine, which means overhauling 60 spreadsheets and, sometimes, the conclusions I've reached about the companies they model.

So far I have upgraded 10 sheets. The score column next to each company name in the table is a mark out of 10, depending on how closely the shares meet my criteria. To score 10, the company has to be, in my estimation and according to the data, a good, well-managed business at an attractive valuation.

Experience tells me shares scoring seven or more are probably good long-term investments. Shares scoring five or less are questionable.

DECISION ENGINE SCORES

Dewhurst

Score: 9

Manufactures components for lifts, keypads and railway rolling-stock, particularly pushbuttons.

Science

Score: 8

Does scientific research and product development for customers in medical, industrial, consumer and energy industries. Provides strategic advice.

XP Power

Score: 8

Designs, manufactures and distributes power adapters for industrial and healthcare equipment.

Next

Score: 8

Retails clothes and homeware.

Solid State

Score: 8

Manufactures and distributes specialist electronic components and computer systems, used in harsh environments where enhanced durability is a requirement.

Victrex

Score: 8

Manufactures and develops applications for PEEK, a polymer often used in place of metal where durability and lightness are paramount.

Treatt

Score: 7

Sources and processes essential oils, which are ingredients used in flavours, fragrances and cosmetics. Develops flavours.

Tristel

Score: 6

Manufactures disinfectant systems for simple instruments and surfaces in hospitals, veterinary surgeries, and laboratories.

Howden Joinery

Score: 6

Manufactures kitchen cabinets and supplies complete kitchens to small builders.

ITE

Score: 4

Organises tradeshows, mostly in Russia, Eastern Europe and Asia

NAGGING DOUBTS ABOUT DEWHURST

A highly respected professor of accounting recently described the section in a company's annual report that discloses the risks it faces as a 'completely useless section', written by lawyers to protect the company from being sued.

I agree with his general point, company reports are full of useless information, but the principal risks sections is one of the first I look at.

I chuckle when I read the bit about the desperate need to retain key staff, and while the rest of the section may not be as self-serving, it is often pretty generic. But if a company deems it necessary to include an item that is not merely boilerplate, it's probably significant.

This is part of Dewhurst's disclosure from its annual report, published last month. It describes a technological threat to the business:

graph 1

A large part of Dewhurst's business is manufacturing pushbuttons for lifts (and trains) and keypads for ATMs, it has many decades of expertise in the design of attractive, durable, and vandal proof pushbuttons, which is valuable because a little more spent on a pushbutton can reduce repair and maintenance bill substantially.

But the number of pushbuttons used on a typical lift control panel or ATM is falling in many instances.

Destination dispatch systems send you to a lift going to the floor you have requested, they don't always need an extensive control panel in the lift car. Touchscreens are replacing keypads on some ATMs and lift control panels.

The effect of technological change on the results of a company like Dewhurst is gradual, so when it explains its performance over the year just concluded, it will focus, as Dewhurst did in 2016, on the factors that impacted revenue and profit over the short term.

Economic uncertainty had a negative impact, the cheap pound a positive one.

To the long-term investor the risk of obsolescence could be much more important; indeed, it could be the only thing that matters, but you won't read about it anywhere else in the annual report.

As I've said before, I think by broadening its product range Dewhurst is adjusting. It will probably remain highly profitable, but perhaps not as profitable as it was before. The presence of technological change in the principal risks section is a reminder to keep this decision under review.

There is something else nagging away at me about Dewhurst, and it relates to another section buried so deep it is often ignored.

Like the principal risks section, I read the segmental report before I read what the chairman, chief executive and finance director have to say, so I know what I want them to explain to me.

Dewhurst's segmental report shows a really dramatic reduction in profit in the UK, where in the previous year the company made the most profit.

graph 2

Operating profit in the UK declined by nearly 60 per cent although revenue increased. The result wasn't a catastrophe for Dewhurst because operating profit in Europe, the Americas and Asia and Australia all grew, but the executives provide no explanation.

I don't like loose ends, and the UK performance might reveal a weakness in the business, so I've asked Dewhurst to comment.

BIG CHANGES AT ITE

Right at the bottom of the companies re-ranked the Decision Engine is ITE, which published its annual report earlier this month. A score of only 4 out of 10 reflects big changes at the company in terms of where it operates, its financial strength, and its management.

Exhibition organiser ITE's reliance on oil-dependent Russia and neighbouring states has been exposed after the oil price crashed two years ago, like it was during the financial crisis of 2008.

This time around, low oil prices are more persistent and Russia's economy has also been weakened by economic sanctions, which has encouraged ITE to press ahead with a policy it was already pursuing, to mostly acquire but also develop trade shows in other emerging markets. The most promising are China and India.

In fact, as ITE's segmental report shows, its Russian business, responsible for 38 per cent of revenue in 2016, is still fantastically profitable, and its neighbouring Central Asian businesses (responsible for another 16 per cent), are too.

In Russia, it earned pre-tax profit margins of 40 per cent in the year ending in September 2016. The problem isn't so much profitability (return on assets in Russia was 44 per cent in 2016), it's the absolute level of profit, which has fallen because ITE is contracting.

Customers pay for exhibition space in advance, which gives ITE time to reduce the space it rents, and the staff it employs, to match demand, not perfectly, but well enough to ensure it remains profitable.

While the reduction in the absolute level of profit might have dismayed investors, presumably if the company had done nothing it would have stayed in business.

It has done something though. Since the financial crisis of 2008 it's acquired dozens of rival exhibitions and companies, which has helped increase net financial obligations (borrowings and roughly capitalised lease obligations) from below zero in 2013 to over 70 per cent of operating capital.

In other words, the company is mostly funded by debt, of one kind or another.

The problem is the covenants (agreements) ITE has with its banks probably require it to maintain profit above a certain level in relation to borrowings, so its financial position could put it in jeopardy even though return on capital is still high (China, India etc. are profitable too, just not as profitable yet).

graph 4Andrew Beach, ITE's new finance director, says that should profit fall substantially the covenants could be breached:

He admits the company may have to shore up its finances. Elsewhere in the annual report ITE says its prospects in Russia are improving, but Turkey's tourism-dependent economy is troubled by political unrest internally and poor relations with its big neighbour Russia. ITE earned 14 per cent of revenue in Turkey and Ukraine in 2016.

If business conditions improve, ITE will probably recover strongly, but the Decision Engine isn't designed to weigh up the probabilities of recovery, it's designed to discriminate between companies where things have to go right for them to succeed and companies that should be resilient come what May.

In previous evaluations of ITE I underestimated how unstable profits could be, and prior management (the chief executive is new, too) has exacerbated the potential for instability by allowing debt to approach dangerous levels. The board is also an unknown quantity. Those three factors explain ITE's lowly score.

interactive-investor-logo-small-sizeThis article was originally published on our sister website Interactive Investor.


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