Interactive Investor

Stockwatch: Buy this share on the dips

3rd January 2017 10:20

Edmond Jackson from interactive investor

Last December's £633 million takeover of Fyffes by Japan's Sumitomo Corporation was frustrating in that I had drawn attention to it some years before, arguing that fruit and bananas in particular were a long-term growth market, even if Fyffes' stock performance was quite irregular and off-radar for most investors.

I then let it drop off the map, like most, but value was eventually affirmed by Sumitomo. So I wonder the extent of parallel with AIM-listed Produce Investments, a British potatoes and daffodils supplier, considering how the Jerry Zucker Revocable Trust (named after a late Israeli-American entrepreneur) held 11.8% in Fyffes, and last 7 December raised its stake in Produce Investments from 6.5 million shares to 6.9 million or 25.7% of the equity.

Such extent of ownership of a £47 million company means this trust is locked in, taking a long-term view until a trade buyer makes a move. Either that or the fund manager has special confidence in Produce Investments, currently priced around 175p at the high end of a two-year range of 120p to 190p, albeit down on the 300-320p range the stock reached in 2013 and 2014.

The volatility is explained mainly by variable cropping and a squeeze on supermarket pricing, but management says it has restructured to cope.

I should also clarify, hedge fund Toscafund did reduce its stake from over 10% to 4.1% last October to November, but at the same time asset manager Ruffer went to over 5%. So Toscafund takes a more sceptical view or believes in a better switch.

Double-digit profit surge

Produce Investments is "vertically-integrated", from growing seeds to processing and supplying major retailers and wholesalers. Key brands include England's largest fresh potato packer Greenvale, potato grower the Jersey Royal Company, anti-sprouting storage group Restrain and Cornish daffodil hand-pickers Rowe Farming.

The group hasn't updated on trading since September, when results for the year to 25 June 2016 showed a 4% rise in revenue to £185.1 million and a 14% improvement in operating profit to £9.2 million, helped by more stable retail market conditions. Pre-tax profit dropped 41% to £3.3 million, however, due to the closure of a packaging site in Kent costing £4.6 million and metal contamination causing a product recall.

The matter has been fully resolved and management has now created a supply chain model "more closely aligned" to current market conditions, which can also offset any fluctuations - the closure of a Kent packing facility has removed surplus capacity, for example.

When the chairman of 10 years retired last October, he said: "The business model is more resilient, more diverse and well placed to handle any pressures that it might encounter."

This coincides with supermarkets introducing fresh food price increases as competition eases from the discounters - as if Aldi and Lidl have borrowed from German government subsidies to expand, long enough.

Unjustified valuation

A forward price/earnings (PE) multiple of around 7 times is in line with the stock's annual average historic PE of recent years, although the rating should improve if management de-risks the business with more consistent results. The prospective dividend yield is nothing special at 4.5%, but forecast earnings cover this an ample three times. Yields in the region of 5% or more tend to be covered below two times, so this is yet another sign the stock is being priced cautiously in case of setbacks.

The table also shows a strong cash flow profile, some years in excess of earnings, which bolsters security of the dividend. Capital expenditure is obviously grabbing a share of this and management is on the outlook for further acquisitions, despite a lowly cash position last June. But the overall profile hints more at upside rather than downside, further supported by a strong net tangible assets per share value and operating margin improvement from 3.9% to 6.3% in the last financial year.

So, while Produce Investments isn't exactly an exciting new business and supermarket suppliers are usually a turn-off for investors, key financial metrics hint at a positive risk/reward profile at around 175p.

Flexibility for M&A

My chief concern is that management want to diversify into more food service providers and possibly venture into other markets through acquisitions; but the cash/debt position doesn't imply much flexibility.

At the last balance sheet date of 25 June 2016, cash had run down from £2.8 million to £0.7 million; admittedly after repaying £7.0 million of longer-term debt during the year. Short-term debt rose from £16.5 million to £18.9 million. This leaves net gearing of 35.4% with intangibles representing 31.5% of net assets and net interest charges clipping 11.9% of interim operating profit in the last financial year.

Fair enough, but the board needs to better clarify its funding facilities in annual results like this, especially when it entertains acquisitions as a key plank of development strategy. As things stand it will benefit from a fresh long-term debt facility. Even the 2016 annual report doesn't clarify the group's funding flexibility under present arrangements.

This is a side-step, but I recall Warren Buffett once disclosing how he'd taken out a low-cost debt facility in an annual report, because its terms were attractive and he wanted to demonstrate flexibility for acquisitions even though nothing attractive was in sight.

Weather chief risk

Management says it has upgraded its IT systems partly to cut the risk of failure - migrating to an external cloud-based provider from in-house servers - and doesn't envisage any major impact from Brexit in the short term, although immigrants represent a significant portion of the workforce - a risk if tougher controls ensue.

Weather is the chief factor management can't control, however, and any investor would need to be convinced that climate change won't mean freak weather upsets at key times for the business. But, as the 25.7% shareholder appears to believe, any drop in share price is an opportunity to accumulate for the long-term prize.

For more information, visit the website.

Produce Investments - financial summaryConsensus estimates
year ended 25 June2012201320142015201620172018
Turnover (£ million)154206192178185  
IFRS3 pre-tax profit (£m)67.68.67.33.5  
Normalised pre-tax profit (£m)5.67.710.26.110.88.69.3
Operating margin (%)4.43.75.83.96.3  
IFRS3 earnings/share (p)23.126.931.719.811.6  
Normalised earnings/share (p)20.427.338.115.636.724.326.4
Earnings per share growth (%)-0.233.739.7-59.1135-33.88.8
Price/earnings multiple (x)    4.87.26.6
Annual average historic P/E (x)7.57.47.97.26.8  
Cash flow/share (p)3715.642.434.432.6  
Capex/share (p)12.512.52913.614.3  
Dividend per share (p)5.53.65.96.97.27.68.3
Yield (%)    4.14.44.7
Covered by earnings (x)47.872.35.23.23.2
Net tangible assets per share (p)71.572.7117128129  
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.

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