Interactive Investor

Two great companies for the Share Sleuth portfolio?

24th February 2017 11:46

Richard Beddard from interactive investor

Friday evening, country pub, four mates. We're talking about sporting injuries, teenage kids, whether we'll ever see our cheekbones again, that kind of thing. There's a farmer at the bar telling his mates how he's getting twenty, thirty pounds more per tonne for his grain. It's a coincidence because days before Ken Greetham, the chief executive of Wynnstay, told me the same thing. Maybe it's a sign...

Though it also runs a pet shop chain, Wynnstay mostly supplies feed, seed, and fertiliser to farmers in Wales and the West and North West of England. If farming is prospering, Wynnstay should be too. In good times, when prices are rising and farmers must increase yields, they buy more agricultural commodities to increase output. When farmgate prices - the prices they get for the produce - fall, farmers skimp.

In recent years, there's been a global glut of milk and grain, which has reduced farmgate prices for both livestock and arable farmers. In 2016, dairy farmers were blending more of their own feeds to save money. Because Wynnstay is selling greater volumes of cheaper "straight feed", unblended ingredients as opposed to blended ones, profitability has suffered a double whammy.

Falling prices have reduced revenue, which means Wynnstay is generating less revenue from its mills and stores. The switch to straight feed, as opposed to blended feed, has reduced profit margins too.

Profit margins at Wynnstay are so thin, you can't really see the thinning on my chart. They fell from 2.1% in 2015 to 1.8% in 2016. Falling capital turnover and falling profit margins have pushed return on capital below 8%, a kind of benchmark for viability in my estimation.

Viable business

That's not to say Wynnstay isn't a viable business. It's beaten the benchmark every other year in the last ten, and averaged 10% return on capital. But if 7% were to become the new normal, I'd be concerned.

There are signs it won't. Greetham tells me farmers can't mix feed as well as Wynnstay can, and as prices recover they should switch back to blended feeds in order to get the best yields.

Towards the end of the year, milk and grain prices improved, partly because of normal self-correcting market mechanisms - if production is uneconomic, farmers feed cattle less for example, which reduces yields and creates scarcity, and partly because the pound crashed and milk and grain are priced in more expensive dollars. Wynnstay is selling into a more buoyant market.

Long-term though, Wynnstay says prosperity depends on two factors: a growing global population and food security. Growing population increases demand for food globally and the strategic necessity of a homegrown food supply should underwrite demand in the UK.

But there's a third factor, the globalisation of the food supply, which has made the UK less self-sufficient. The Department for the Environment, Food & Rural Affairs publishes the ratio of UK food production to the value of raw food for human consumption, commonly called the "self-sufficiency" ratio. Self-sufficiency was above 80% for indigenous foods throughout the 1980's and 1990's, but since the turn of the century it's been lower (76% in 2016).

The government considers the EU a secure source of food so Britain's exit, if it complicates trade, may spur a self-sufficiency drive. But the globalisation trend has not been the farmer's friend, and neither, therefore, has it been Wynnstay's.

As a supplier of commodities in a global market, Wynnstay is a difficult company to love. It doesn't have much pricing power, yet it has wrought stability, mostly by buying up smaller local suppliers and retailers and operating them more efficiently*.

If it returns to former levels of profitability, the shares could be good value, but compared to current profits, they look pricey. My much adjusted figures suggest Wynnstay's trading at 21 times 2016 earnings. Often cyclical shares are at their cheapest when profits are down, but traders are predicting recovery so the share price is, relatively speaking, high.

I'm wondering, though, whether Wynnstay's 10% average return on capital, assuming it is sustained, is good enough. It's not that far above my 8% minimum guideline. There's not much margin of safety.

Porvair: No margin of safety

Talking of margin of safety, I'd love to add Porvair to the Share Sleuth portfolio if only the shares weren't so expensive. All the numbers from its full-year results are impressive.

It's not the smoothest of growth stories. About a third of revenue comes from lower margin filters used in the processing of aluminium and iron, which are cyclical industries. Porvair also has long-term contracts to supply filters to a number of new gasification plants. This provides a surge in revenue and profit while the plants are being constructed, that subsides into a maintenance state thereafter.

High share prices for previously unglamorous British exporters are a concern

Mostly, though, Porvair makes filters that protect often very expensive pieces of machinery. They're critical, for example they prevent contamination in hydraulic, fuel and lubrication systems on aeroplanes.

They're relatively inexpensive compared to the systems they protect. And they're designed in, which means to replace them with filters from a different supplier, a customer would have to go through the expense of sourcing, testing, and accrediting a new component.

Customers are generally more worried about quality than price, and are likely to stick with Porvair, factors which have helped the company lift profitability in recent years.

Since the Brexit vote, Porvair has also been helped by the parlous pound though. Were it not for the crash in the currency, revenues wouldn't have been 14% higher, as reported, they'd have been 8% higher. Porvair earns 85% of revenue abroad, mostly in the USA and Asia.

Its market valuation has risen to exuberant levels. Based on Porvair's performance in 2016, a very good year, the earnings yield is just 4%, equivalent to a price/earnings (PE) ratio of about 28.

I wonder if traders aren't focusing too narrowly on a goldilocks period for British exporters while the pound is low because we're leaving the EU, but before we've actually left it and benefit not just from the single market but all the trade agreements the EU has with the rest of the World.

High share prices for previously unglamorous British exporters is not just a concern because it puts Porvair and other companies on my watch list out of reach, it also makes me wonder about the valuations of shares in the portfolio that supply components or services worldwide. There are quite a few.

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*See a business that's virtually bomb proof.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

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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