Stockwatch: Potential 7% yield should drive a re-rating

Has Molins been punished too harshly? Over 2014 the AIM-listed shares in this diversified industrial engineering group plunged from 194p to 80p. Then, after a brief rally to 91p in early 2015, have dropped again to 76p. At this level they trade on a forward price/earnings multiple of 6, reducing to 5, and the prospective yield is a whopping 7.2% - assuming the company achieves the consensus forecast (see table).

That Molins has tested such low levels over four months implies the market is sceptical of the 5.5p dividend, although forecasts imply earnings cover of 2.2 to 2.8 times - scope, therefore, for earnings downgrades and the payout still to happen.

The history has involved a strategic shift from tobacco machinery to packaging machinery, also scientific testing for the cigarette industry - i.e. aspects of related diversification. Despite Molins enjoying a strong position in machinery, tobacco was seen as a mature if not declining industry apart from China and some other developing countries.

Tobacco and scientific services are challenged

While the changes have made sense in principle - needed to avoid Molins' earnings and rating languishing - in practice the tobacco industry has seen difficult conditions such that the 2014 results showed tobacco machinery sales down from £34.4 million to £26.4 million and this division's £2.9 million operating profit becoming a £0.2 million loss.  "As well as a widespread slowdown in activity, which affected all geographic regions, sales were impacted more specifically by geopolitical concerns in the Middle East and Eastern Europe."

Deflation appears to have prompted manufacturers to cut prices to stay competitive, and aftermarket product sales have also slowed. More positively, product development is going well e.g. a 10,000 per minute cigarette-making machine and (reflecting synergies) a new packing machine in collaboration with the group’s packaging side. But the tobacco side’s order book is lower than last year and no market improvement is expected in the short term.

Progress is more mixed in scientific services. 2014 sales slipped from £26.5 million to £24.8 million, although normalised operating profit rose from £1.1 million to £1.8 million. Sales of quality control instruments and analytics machinery have been strong, especially to China and smoke capture in the US. A test-machine for e-cigarettes is also doing well.

However, the order book is said slightly lower, which together with competitive pressures means a challenging year ahead. No new testing for US regulatory requirements has impacted sales by the analytical services laboratories, although there is development progress in Canada. The scientific services side is undergoing a strategic review which implies uncertainty as to appropriate direction/positioning.

So with these two divisions representing 55% of 2014 revenue and tobacco machinery trading around break-even, it currently puts a lot of emphasis on packaging machinery.

Improved performance expected from packaging machinery

While 2014 saw a 9% reduction in sales to £40.4 million, it largely reflected sterling’s strength (converting overseas revenues) given this is an international business manufacturing in Canada, the Netherlands and Singapore. Meanwhile operating profit increased from £1.5 million to £1.8 million amid a focus on margin improvements and aftermarket products; and the order book is cited significantly higher, year-on-year.

Such characteristics of group trading were affirmed by a 24 April AGM update which didn't, however, re-iterate the point made at February’s prelims, that performance will likely be second-half-year weighted. A key question, therefore, is whether (security of) the dividend yield is satisfactory compensation for the risks here, and opportunity cost of what you could make investing elsewhere.

On a strictly earnings view it is too early in the year for the board to give realistic guidance on the dividend; an enticing 7%+ yield is down to analysts' forecasts. They have good reason though: Molins' 2014 cash flow statement shows the 5.5p annual dividend paid since 2013 as absorbing £1.1 million in context of end-2014 balance sheet cash of £9.8 million. Technically, earnings could collapse and the board still maintain the payout for a good while. Indeed, company directors tend to reassure shareholders that this is the case if there is spare cash during cyclical downturns.

Certainly, 2014 was a difficult year: after various exceptional charges totalling £2.8 million, 2014 operating profit was whittled down to £0.6 million and the bottom line was slightly loss-making. You would need to take a seriously negative long-term view of the tobacco industry though, to regard Molins as trapped in decline.

Soundly supportive balance sheet

It’s also worth noting net assets of £25.9 million i.e. 128p a share, although this does include £15.7 million of intangibles - otherwise NAV is 50.6p a share. That still becomes relevant for downside limitation with the shares in a 70p range. Obviously assets are only so useful in terms of what they can earn, and questions could be asked over the true value of £18.5 million inventories, but overall Molins has a decent balance sheet. £11.9 million longer-term debt versus £9.8 million cash meant a total net interest charge of £0.3 million versus £3.4 million normalised operating profit.

Speculative, but intriguing risk/reward

It's quite a long shot and certainly involves speculation, but an enterprising investor could see logic to average-in a shareholding and bide time for profits recovery. A 7.2% yield implies the stock must eventually re-rate to price the dividend more competitively, once group risks reduce, and it is not as if there are near-term debt (refinancing) issues.

So yes, the market's pricing is harsh. It likely follows also from low liquidity in a company capitalised at just £15 million, i.e. shares hard to trade and especially to sell if the going gets worse. But there are more speculative AIM stocks with underlying businesses nothing like as proven as Molins', capitalised much higher. If the stockmarket continues to disregard the stock, it is possible the likes of a Chinese tobacco-related company buys it out, or a packaging group takes similar initiative.

For more information see: molins.com.

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