A catalyst for 20% upside at this mid-cap

Cyclical swings in demand for oil and gas make it difficult for companies who operate in this volatile industry. A slump in prices from $116 a barrel to a low of less than $29 not only hurt producers, but also suppliers like Rotork who saw demand for their services dwindle. Of course, the tide would always turn, and we're seeing some of that in latest results.

At the forefront of the global flow market, Rotork has always been solid. It makes actuators - a type of motor that controls mechanisms or systems - and flow control systems for the oil & gas, marine, mining, power generation and water treatment markets.

In March 2013, the share price peaked at 310p (about £31 prior to a 10 for 1 share split in 2015) before trouble hit. Excluding 2009 and 2010, organic sales growth had been ticking along at double-digit pace between 2004 and 2012. But when oil weakness hit, organic sales fell 19% from their peak in 2014.

Worse for Rotork, cash profit margin, a crucial measure that had been running at a healthy 25% until 2014, slumped by around 600 basis points.

However, 2017 is tipped to be a turning point, with sales set to grow modestly for the first time since 2014. It's prompted a review from broker UBS, which has run the numbers to see if the firm can return to operating margin of 25% within the next five years.

According to analyst Mark Fielding, "a change of CEO can be a positive catalyst" for Rotork. Former boss Peter France left the group at the end of July, with executive chairman Martin Lamb taking on the mantle until a full-time successor is found, with a view to starting in the first half of 2018.

Fielding reckons Lamb will provide steady leadership in the interim. His previous stint as chief of engineer IMI saw the firm increase operating margin by 900bps between 2001 and 2013. Clearly, Lamb is capable of laying the groundwork to achieve his aim of 25% margin at Rotork.

This target is achievable through initiatives like reducing employee costs to 23.5% of sales and hitting a compound annual growth rate in organic sales of 4%, argues Fielding. He now forecasts margin for 2021 of 25.7%. "This is supported by our analysis of the cost base progression since 2003 which shows significant headroom to drive operating margin upside," he says.

While the possibility of increased research and development investment has been mooted by Lamb and could create uncertainty, Fielding believes the impact will be short-lived. "When asked this question, Lamb suggested it would only be likely to be seen as a one or two quarter type impact."

With a bullish view on future prospects, Fielding upped his 12-month price target for Rotork to 295p and reiterated his 'buy' rating. The update Monday helped Rotork shares advance almost 4% to 251p, implying over 19% upside still to come.

"A 2019E EV/EBIT of 13.2 times compares to the sector on 13 times. At our price target, the sector premium would be 20% - in line with the 10-year average premium," says Fielding.

Rotork trades on a meaty forward price/earnings (PE) ratio of 23.8 times for 2017 on UBS estimates, falling to 21 times in 2018. That said, investors have been happy to pay up for quality in the past. The promise of margins like this suggests they're likely to do so again.

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.