Stockwatch: A tuck-away with takeover potential

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Stockwatch: A tuck-away with takeover potential packaging Brexit uncertainty PE
Can Macfarlane (MACF) defy any economic slowdown? At 58p the FTSE Fledgling shares in this protective packaging group have fallen from a spring-time high of 69p, weighed down by fears the business cycle is maturing and Brexit disruption will fester.

The forward price/earnings (PE) multiple is currently about 10 times, a rating which the stock hasn't seen for four years as it's trended higher. The five-year chart is a similar, if less dramatic, trend to what we've seen with Lavendon (LVD), where a cyclical soared from 2012 before running into consolidation and decline - albeit without the operational gearing of plant hire.

Macfarlane provides bespoke packaging for the electronics, aerospace and medical sectors, and is the UK market leader for distributing consumable products by way of industry logistics, mail order and internet retail.

Mind, the history of UK-listed packaging groups tends to involve proclaiming "specialist" qualities to contend a better PE rating, but they still tend to get hit by recession.

Macfarlane has, however, grown its sales element to internet retailers by three percentage points to 22% in the last year or so, which should mitigate cyclicality as online sales continue to grow.

Increased momentum

In recent weeks the stock has bumped along a 52p support level then blipped up on seemingly bullish interims: "Momentum achieved in the first half of 2016 has strengthened in the second half of the year with improving organic growth and the continuing benefit of acquisitions."

Macfarlane qualifies for a classic growth stock value criterion thanks to consistent earnings growthIt comes across as fresh news, although Arden Partners, the company's broker, had already published ambitious forecasts on 28 July for 25% earnings growth this year. The board has merely reiterated this, rather than raising expectations anew.

Moreover, full-year expectations assume they will benefit from the festive period in the fourth quarter thanks to its e-commerce exposure.

This update doesn't add anything to the bottom line, although it bolsters the story with "strengthening momentum" versus Brexit uncertainties conspiring for modest pricing.

Value, but take care

The table shows Macfarlane qualifying for this classic growth stock value criterion as a virtue of consistent earnings growth. Ideally you are looking for a value below 1.0 for the forward PE multiple divided by the projected earnings growth rate - the PEG ratio.

Macfarlane, therefore, looks attractive, although a contrarian would say it's time to worry when cyclicals become perceived as growth stocks, the UK having enjoyed a record-long upturn since 2009 amid monetary stimulus.

PEG is a snapshot measure, but it can be useful for businesses with strong market positionsSome exception can, however, be made for Macfarlane enhancing its organic growth capably with acquisitions.

Not to pin valuation on the PEG ratio, it mainly underlines how cautious sentiment has reduced the PE just when a boost is expected for earnings per share.

While it's quite a snapshot measure, it can still be useful when the business in question has strong market positions, this being the kind of stock that's more likely to recover or get taken over. Its chief risk is becoming a value-trap if recession follows.

Acquisitions boost

The 2016 interims need some clarification in terms of revenue growth, which seemed quite weak at 3.7% when including acquisitions made during the period: Colton Packaging Teesside and Edward McNeil in Glasgow.

There was a performance split, with packaging distribution sales 5.5% ahead or 0.5% organically, while manufacturing sales were 9.0% lower after a decision not to follow price competition in labels.

It didn't undermine profitability, but is a reminder of challenges in this sector. The interim gross margin slipped 0.1% and reflects competition at 29.2%, while the table shows a medium-term recovery in the operating margin from a 2012 drop.

It's the kind of business that needs to acquire to get investors' attentionA lowly 4.3% operating margin last year also explains the modest long-term PE multiple, reflecting a business with less freedom to price.

Commensurately, though, a £79 million market cap values Macfarlane only at about 0.4 times annual sales.

So it's the kind of business that needs to acquire to get investors' attention, albeit sporting a track record and forecasts that imply this strategy is being executed well.

Interim pre-tax profit advanced 8.1% to £2.0 million and the July acquisition of Nelsons for Packaging is expected to make a "strong contribution" during the second half.

Altogether, these acquisitions help explain the 2016 earnings boost, the broker forecast coming two days after the Nelsons announcement.

Four directors fill their boots

After the end-August interims, the chairman, finance director and two non-executive directors made purchases of 20,000 to 25,000 shares each, totalling £57,249, a marker for belief in value. Despite their cautioning with the results, Brexit uncertainties will persist.

There hasn't been institutional selling apart from a unit fund holder going sub-5% at end-September which could be redemptions-related.

The listed packaging sector's history shows big and small companies taken outOtherwise, institutions such as Hargreave Hale - for discretionary clients - and Miton Group (MGR) added to their holdings after the interims, like the directors.

Miton's 12% stake would be difficult to sell in a downturn unless at a hefty discount, implying Macfarlane's long-term potential is judged as offsetting risks with the UK economy, which represents 97% of revenues.

The specialist character of Macfarlane's markets and its competitive strengths for online retail imply long-term takeover potential. Fund managers like Miton will know the listed packaging sector's history shows big and small companies taken out - for example Field Group and Rexam.

After all, "you have to be in it to win it", especially in a downturn.

Balance sheet issues

As a result of its acquisitions policy, Macfarlane had £38.7 million goodwill/intangibles at end-June, the table showing slightly negative net tangible assets persisting.

Acquisitions have also pushed up debt by £5.0 million to £16.9 million (June to June), if well within its £25.0 million facilities.

A July share placing at 58p raised £5.6 million with 7.9% dilution to help finance the purchase of Nelsons, and debt is expected to reduce by end-2016 amid strong final quarter cash inflows.

Balance sheet issues are insufficient to cause worry, considering robust cash flow Mind the recent increase in borrowings means £55.2 million of current liabilities tipped above £52.1 million current assets at end-June.

Also, the group is running a £12.6 million pension fund deficit amid lower bond yields, making £1.4 million deficit reduction contributions in the first half, although other investments have mitigated the impact from bonds.

So there are a few balance sheet issues arising, albeit not enough to cause worry, considering robust cash flow (see table below).

Who knows to what extent the UK economy may suffer, but Macfarlane offers good credentials as a tuck-away.

For more information see the website.

Macfarlane Group - financial summary Broker estimates
year ended 31 Dec 2011 2012 2013 2014 2015 2016 2017
Turnover (£ million) 145 142 144 154 169    
IFRS3 pre-tax profit (£m) 3.9 5.5 4.7 5.6 6.8    
Normalised pre-tax profit (£m) 3.9 4.7 4.7 5.6 6.8 8.9 10.4
Operating margin (%) 5.3 3.6 3.6 3.9 4.3    
IFRS3 earnings/share (p) 3.0 3.4 3.0 3.8 4.4    
Normalised earnings/share (p) 3.0 2.7 3.0 3.8 4.4 5.5 6.1
Earnings per share growth (%) 80.8 -10.9 12.3 24.8 16.2 24.9 10.6
Price/earnings multiple (x)         13.1 10.5 9.5
Price/earnings-to-growth (x)         0.8 0.4 0.9
Annual average historic P/E (x)   6.5 11.1 13.1 11.2 13.4  
Cash flow/share (p) 2.0 3.0 3.0 2.4 4.3    
Capex/share (p) 1.0 0.7 0.7 0.4 0.4    
Dividends per share (p) 1.6 1.6 1.6 1.6 1.7 2.0 2.1
Yield (%)         2.9 3.4 3.7
Covered by earnings (x) 2.0 1.7 2.0 2.4 2.6 2.8 2.9
Net tangible assets per share (p) -2.0 -1.5 0.9 -3.1 -2.2    
Source: Company REFS

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.