2024-01-18 04:24:30 ET
Summary
- Spirax-Sarco, a U.K.-based engineer, has a strong business model but is facing challenges in a weak economy.
- The company's revenue growth was 13% YoY, but pre-tax profit fell 18%.
- The company's dividend growth remains likely, but the current yield of 1.6% is not exciting.
U.K.-based specialist engineer Spirax-Sarco ( SPXSF ) has a superb business. But it faces challenges in a weak economy.
I last covered the name in my 2021 “sell” piece Spirax-Sarco: Priced For Perfection , since when the shares have retreated 31%.
At that point, my thesis was that the business has an attractive moat and solid model but the shares were overpriced. While the track record of dividend increases was strong, the yield was low. Even after the share price fall, I continue to see these shares as overpriced.
The Business Model Continues to Perform Well
The pros and cons here continue to be largely as I outlined before. Indeed, predictability is one of the attractions of Spirax-Sarco in general.
I continue to think the business model, that has been well proven over time, is highly attractive.
The client base is industrial, with ongoing requirements that in many ways are shielded from the economic cycle due to their critical important to the businesses. Spirax-Sarco offers some proprietary products. Overall it works to develop at least partially bespoke solutions which, combined with service, can help build enduring client relationships and give it some pricing power.
All of that shows through in the most recent results, the interims . Revenue growth was 13% year-on-year, the operating profit margin was 15.5% and pre-tax profit fell 18% but still came in at £114m.
The company’s mixed set of product offerings can also help even out some shifts in demand. In the first half, for example, strong growth in steam and electric thermal was offset by lower biopharma sales in the Watson-Marlow division.
One concern about the business model I have is the debt involved in growth through acquisition. At the year end point, net debt was around £750m. That may sound modest, but it was a big jump from the c. £200m position a year prior. In July, Spirax-Sarco completed the acquisition of a 15% stake in Kyoto Group
Some Challenges for the Business Lie Ahead
However, despite an attractive business model, the company is affected by the wider market environment. In the first half, for example, it pointed to weak or non-existent demand growth in many regions.
While some of its product sales are requirements from the customer’s perspective, some could be delayed during periods of tightened budgets. I see that as a risk for the next several years.
The weaker profits in the first half partly reflected product mix, with the company pointing to a sales slowdown in its highest margin businesses, Biopharm and Semicon WFE. This remains an ongoing concern. As the company said in its results,
The Biopharm and Semicon WFE sectors are likely to remain challenging across the remainder of the current year. Demand from Biopharm customers is now likely to normalise in 2024 as they continue to work through COVID-19-driven excess inventories. In both the Biopharm and Semicon WFE sectors, based upon the latest customer feedback, we expect demand to improve in the latter part of 2023 but remain cautious as to the extent of the recovery in this year.
This year could, if this is right, see some sort of return to stronger sales again in these areas. For now, though, that feels rather conjectural to me.
It added that, despite,
the short-term challenges of predicting the precise timing and scale of the return to growth in the Biopharm and Semicon WFE sectors, we remain confident in the strong underlying medium and long-term growth drivers for both sectors.
Dividend Growth Remains Highly Likely
As I outlined in my previous article, one attraction of the shares is the superb record of annual dividend growth across over half a century. After the most recent full-year rise of 12%, the interim results for the current financial year saw an 8% increase in the interim payout.
That was covered over 2x by earnings in the period. It was not covered by adjusted cash flow in the period. The company prizes its dividend track record and I expect it to keep raising the payout annually. Although it was not covered by adjusted cash flow in the first half and high capex in recent years has eaten into cash flows, over the long run the company’s cash flows have not raised concern about coverage: last year the full-year dividend was fully covered by free cash flows.
The record of increases is impressive, but the current yield of 1.6% does not excite me much.
Valuing Spirax-Sarco Shares
Still, that uneven road demonstrates that the company’s portfolio of products does not mean it can achieve smooth profit growth. That rather hurts the investment case at the sort of premium prices seen previously for the shares.
Indeed, in November the company issued a trading statement saying that it expected a 1-2% year-on-year fall in pro forma sales. It also said it expected an adjusted operating profit margin at the lower end of market expectations.
What does the valuation look like now given that?
The company has rallied around 22% from a recent low point in November. But it continues to trade on a P/E ratio of 34. I think that continues to look high. Like-for-like sales are declining, first half profits were down and I see reasons for ongoing concerns over the next several years about customer demand. Sales growth could still come through acquisitions, but that has a price and could add more debt to the balance sheet.
I think a P/E ratio closer to 20 would be more reasonable and below that could be a bargain. For now, then, I continue to rate the shares as a “sell”.
For further details see:
Spirax-Sarco: Still Expensive Even After A Large Fall