Stockwatch: An income share on growth multiples

Where does the buck stop for equities valuations, either for dividend yields or earnings/cash flows? AIM-listed Andrews Sykes Group exemplifies how a keen search for yield amid ultra-low low interest rates is skewing some shares on the high side; this happening among small caps being a typical late-cycle feature.

Andrews Sykes is a sound if fairly mature business hiring pumps, heating and air conditioning, thus benefiting ideally from cold winters and hot summers, and generating plenty spare cash for distribution.

Its geographic profile is about 66% UK, 17% Middle East/Africa and 17% rest of Europe, thus geared mainly to the UK economy which continues in good shape. It also provides a hedge against sterling weakness, and the United Arab Emirates offers growth in pumps hire.

Low-risk dividend drives re-rating

After its stock drifted downward over 2014 and 2015, I drew attention at 330p on the basis of a 7% prospective yield, which was uncovered by earnings and cash flow post capital expenditure, albeit underwritten by £19.7 million balance sheet cash.

A 23.8p total dividend (see table) required a cash distribution just over £10 million annually and debt was a modest £6 million; so the shares' risk/reward profile favoured upside despite a fairly flat earnings record.

They proceeded to rally over 2016 such that a current 470p high represents a yield just over 5%, assuming the 23.8p dividend is at least maintained. There aren't any published forecasts, but the 2016 interim statement said: "The board continues to adopt the policy of returning value to shareholders whenever possible."

End-June cash was £20.6 million and, although a 60.9% jump in interim pre-tax profit to £7.5 million benefited from a £1.4 million positive swing in intercompany foreign exchange gains/losses, it's fair to say it would need a business slump to compromise a 5% yield.

Mind also that the dividend payout might grind higher with stronger underlying trading, but is unlikely to take another radical step up like it did in 2013 and 2014.

Sound business enjoying a growth rating

The first half of 2016 showed heating revenue steady despite a mild winter, likewise air conditioning. Benelux operations continued to recover and last September saw above-average temperatures in Europe, helping boost demand for air conditioning. Middle East pump hire also continued to do well, such that as of late September the board was confident of "an improved performance for the full year."

The figures actually came across better than the narrative: interim operating profit up 28.6% to £6.4 million on continuing operations revenue up 7.2% to £30.3 million.

It looks fair to target some £13 million normalised pre-tax profit for 2016 with IFRS3 profit higher, and earnings per share (EPS) outcomes in a 25-30p area implying a price/earnings (PE) multiple of roughly 17 times, at the high end of the annual average range.

Regarding cash flow, the interim statement cited a 55% jump in net cash from operations to £5.8 million, albeit with £2.2 million then going on fleet renewal/expansion, such that after dividend payments and a £1 million loan repayment cash-at-bank slipped by £1.9 million.

So the cash flow profile is good, if not exactly gushing. The long-term context (see table) shows a very strong cash flow profile versus capital expenditure, albeit with multiples reducing from 5.1 in 2011 to 2.7 in 2015 – the interim cash flow statement maintaining the latter. Properly, there would need to be further progress in cash generation to grow dividends, respecting cyclical risks.

This is all fair enough if the UK economy stays robust, with the Bank of England's monetary stimulus continuing to provide support, and assuming no fractures emerge on the Continent, say in the event of a Le Pen French Presidency.

Looking back to the 2009 results, however, Sykes' revenue fell 19.3% and operating profit by 27.8% (hence some operational gearing), so, while that was a particularly acute recession, it shows heating, air conditioning and pumps are not so essential services like supermarkets.

High premium to net asset value

The 470p share price represents a multiple of 4.4 times the net tangible assets of 106.8p per share last September. In fairness, that reflects good management exacting high returns on assets/capital employed, and, unlike many acquisitive support service stocks, the balance sheet isn't inflated with capitalised goodwill/intangibles.

This share has for years traded on at least twice net asset value. My point is more to consider the aspect of downside protection; that if earnings do get compromised anytime in the next two year, then the dividend would become exposed as a key valuation prop.

So Andrews Sykes is notable both for offering a sound 5% yield presently, but also how "search for yield" has boosted a small-cap that would normally rate more cautiously.

It's as if this share re-rated first in 2013 as quantitative easing (QE) boosted cyclicals, its 2016 advance later appearing climactic as investors chase yield.

Alternatively, it was a fair upwards correction after underperformance from mid-2014 to early 2016 when the dividend actually rose; the market being sceptical of dividend growth during this period while earnings were flat-to-falling.

What then, should be the investing stance?

If the next prelims (typically around 10 May) reassert a sound business generating strong cash, the shares look likely to test 500p as hopes for dividend growth revitalise.

Mind, there's unlikely to be any trading update beforehand - Andrews Sykes has never shown inclination to publish such. Also, that while a 5% yield would seem a prop, any softening in trading outlook henceforth is liable to prompt enough shareholders to lock in gains such that a tight market for a circa £200 million share means downside from 470p.

Aside from the results, buying with fresh money requires confidence on a two-year view that Brexit and continental European issues won't jolt business. It all makes Andrews Sykes a vivid example of how yield-chasing has skewed some cyclicals towards "growth" ratings, while genuine growth plays sweat on stratospheric PE's. Is the market increasingly ignoring risk?

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.