Share Sleuth's April watchlist

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Share Sleuth's April watchlist
Each month Richard Beddard trawls through annual corporate results for his Watchlist and the Share Sleuth portfolio of companies that satisfy key valuation metrics such as earnings yield and return on capital - and profiles the most interesting candidates.

This month, ARM (ARM), a company that dominates on smartphones, is profiled. The firm designs the microprocessors in 95% of smartphones and has enabled the market to grow faster and made itself indispensible. However, in order to justify an expensive valuation, it may just have a quadruple its profits to well over £1 billion.

Meanwhile, Brammer (BRAM) gets the thumbs down from our Share Sleuth due to adjusted profit rising just 3%. The market leader in the relatively small bearings parket has acquired 15 small distributors recently, but it finances those deals with money from investors and banks through placings and debt.

Watch - ARM 

In the year to December 2014, ARM lifted revenue 11% and adjusted profit 19%. Net cash (including short-term deposits) increased 28%, as the business continued to earn cash flows in excess of reported profit and salt them away. Return on capital was about 24%.

ARM designs the microprocessors in 95% of smartphones, and increasingly in connected devices building the "Internet of Things" and internet servers. All of these devices must deliver a lot of processing power from minimal electrical power.

While traders salivate over royalties from sales of the popular iPhone 6 smartphone, long-term investors need only appreciate the business model.

ARM makes money principally from licence fees that give a chip manufacturer access to particular designs or architectures, and from royalties on each chip the manufacturers ship.

The cost of developing more efficient chips is high, but by outsourcing design to ARM it's spread across the industry. The quid pro quo is that ARM allows partners to develop applications for its designs. By getting the balance right, ARM has enabled the smartphone industry to grow faster and made itself indispensable. It may do the same for other devices.

A share price of 1,165p values the enterprise at just over £16 billion, or 63 times adjusted profit in 2014. The earnings yield is just 2%. To justify that price, ARM's profits might have to quadruple to well over £1 billion; it's a lot to expect.

Reject - Brammer 

Given the news from Europe, it may be no surprise that the leading pan-European supplier of maintenance, repair, and overhaul (MRO) products for industrial machinery raised adjusted profit only 3% despite acquiring 15 small distributors. Overall revenue increased 11%.

The surprise is that Europe did well; it was the UK that contracted. Six major UK customers spent over 20% less with Brammer than the previous year, and operating profit in the UK fell 26%.

Brammer supplies components for production-line equipment and tools to large manufacturers and food producers such as Siemens, Unilever (ULVR), Tata Steel, Rolls-Royce (RR.), the Ministry of Defence and Danone. It aims to save customers money by allowing them to deal with fewer suppliers and by providing stock control and technical support, as well as component vending machines.

Brammer is a market leader in the relatively small bearings market, and it's growing by acquiring distributors of other products, sometimes in new territories. It hopes to ape the North American market, where consolidation has given the five largest MRO distributors 25% of the market.

The problem is that Brammer finances acquisitions with money from investors and banks through placings and debt. A share price of 360p values the enterprise at £675 million, about 19 times adjusted 2014 profit. The earnings yield is 5%.

Watch - Bunzl 

Distributor Bunzl's (BNZL) results in the full year to December 2014 seem unimpressive. Revenue grew 1% and adjusted profit grew 4%, although at constant exchange rates the company says the figures were 7% and 10%, closer to what shareholders expect.

Bunzl was, as usual, highly profitable, earning a return on capital of 23%. It earned in cash what the accounts identified as profit, and borrowed more than it had the previous year. It is entirely funded by debt or lease obligations, although that may not be a concern.

There are two rationales for the debt. Profitability is very stable, because Bunzl mostly supplies defensive industries with their everyday needs and demand is pretty constant, irrespective of economic conditions.

And Bunzl achieves its high level of profitability through scale. It can make more acquisitions and grow faster if it borrows. Scale gives Bunzl more buying power, and allows it to serve customers - wherever their operations are - with a wide range of products that reduces the administrative burden of managing many suppliers.

In 2014 Bunzl made 17 acquisitions, adding to well over a hundred in the last decade, but the risk is limited by their small size. Bunzl itself is worth 38 times more than the combined total of all 17.

A 20-year price chart that heads almost directly from bottom left to top right probably explains why investors have such faith. A share price of 1,900p values the enterprise at £8 billion or 24 times adjusted profit. The earnings yield is 4%.

Watch - Idox

The Scottish referendum last year helped Idox (IDOX) earn 6% more revenue and 3% more profit in the year to October 2014 than the year before. Its finances also improved somewhat.

Idox's roots are in document management software, which it sells to 90% of UK local authorities. In addition to providing election services, from voter registration to counting, Idox has document management solutions for many local authority functions, including education, planning, social services and estate management.

In 2010 Idox acquired document management software firm McLaren, extending its reach to private sector oil and gas, mining, utility and pharmaceutical companies. McLaren contributed nearly a third of revenue and just over a quarter of profit in 2014, but its subsequent acquisitions have indebted Idox.

Judging Idox's prospects is tricky. Its strong position in the UK public sector should allow it to profit fairly consistently despite pressure on local authority spending, but the private sector is more competitive, explaining McLaren's lower profit margins.

Idox forecasts flat IT spending in the public sector in 2015, and describes its private sector markets as "challenging". Around 10% of revenue comes from the oil and gas industry, which is cutting investment due to falls in the oil price.

A share price of 40p values the enterprise at about £170 million, about 15 times adjusted earnings. The earnings yield is 7%.

Add - Roll-Royce

Rolls-Royce's results for the full year to 31 December 2014 were disappointing. Mostly because of low levels of defence spending, the giant engine manufacturer recorded a 6% decline in revenue and 13% fall in adjusted profit. Cash flow was also down sharply.

Rolls-Royce supplies engines, parts and machinery for rigs and service vessels. Although the defence order book improved for the first time since 2010, Rolls-Royce's marine and offshore division is likely to experience a fall in revenue in 2015 as oil producers cut investment.

The company expects 2015 revenue to be between 4% below the levels it achieved in 2014 and 4% higher. Profit, it says, may fall between 4 and 13%.

Its long-term strategy is focused on four Cs: customer, concentration, costs and cash, and is unchanged. As long as globalisation promotes world trade and air travel, and environmental regulation and energy prices require more efficiency of engines, Rolls-Royce should prosper.

A share price of 950p values the enterprise at nearly £19 billion, or 12 times adjusted profit in 2014. The earnings yield is 8%. The shares may not look cheap, but they should prove so for investors who can ride out the next few years.

Watch - XP Power

In full-year results to December 2014, XP Power (XPP) posted flat revenue and a 5% improvement in profit. But for the strong pound, revenue would have grown 5%. XP is largely unencumbered by debt. North America, XP's largest and most promising market, and Asia did well, but revenue contracted in Europe. The UK, where the company is dominant, disappointed most.

XP Power makes power adapters that convert high voltage alternating current to low-voltage direct current required by electronic equipment. The converters are often built into industrial and healthcare devices such as CT scanners and semiconductor manufacturing equipment.

Typically, it takes years for manufacturers to design them into their products, but XP then has a secure stream of revenue, often for the life of the product. The contraction in the UK was due to products that had reached the end of their lives.

Profitability has been high and relatively stable since 2010, though, when the lower profit margins at XP's original but now much less significant distribution business were eclipsed by those on the products it designs and manufactures. Management expects a similar underlying rise in revenue in 2015 to the 5% rise seen in 2014, which probably means more profit too.

A share price of 1,550p values XP at about £300 million or 15 times adjusted 2014 earnings. The earnings yield is 7%, which is probably fair. Although it's growing profitably, XP Power's end markets, for example semiconductor equipment manufacturers, are cyclical.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.