QUALIPORT
Another One For the Watchlist

By Maynard Paton (TMFMayn)
September 17, 2001

Carburton Street, London -- Following the recent Qualiport watch list update, today's article covers the latest addition to possible portfolio members: Renishaw (LSE: RSW).

Renishaw's business is metrology, the science of measurement. The company develops, designs and manufactures specialist measuring equipment known as probes. These devices, together with the associated software, allow manufacturers to automate the precision machining of their components. Systems have also been developed to meet manufacturers' quality control requirements.

According to Renishaw, its market-leading probes are "the industry choice". The group is reported to have an 80% share of the probe market, with over 90% of group sales now being generated overseas.

The group's market standing is not surprising, since the present management team virtually created the industry. Renishaw Chairman and Chief Executive David McMurty built the first probe in the early seventies, and alongside Deputy Chairman John Deer, has run the company ever since. Between them, McMurty and Deer own 50% of the company.

The financials

Here's Renishaw's five-year financial record.

Year to 30th June            1997    1998    1999    2000     2001

Turnover (£m)                81.4    92.3    96.3   105.6    125.3
Operating profit (£m)        14.3    20.7    23.3    25.7     27.9
Pre-tax profit (£m)          16.8    22.3    25.2    28.3     30.8

Earnings per share (p)       17.2    22.0    25.5    28.9     34.0
Dividend per share (p)        8.7    10.0    11.4    13.2     15.1

The table flatters Renishaw a little, given the company suffered a profit setback during 1997 (operating profits in 1996 were £17.6m). The costs associated with a new product that failed to meet the company's expectations caused the blip. Overall though, growth in sales and profits has compounded at around 10-12% per annum since 1991.

There are three significant points to note from the above table. Firstly, there's been no recourse to acquisitions to help boost sales (the last acquisition was in 1988). Secondly, Renishaw can consistently generate juicy 20%-plus operating margins (even in 1997, a relatively bad year for the company, a 17.5% operating margin was achieved). And thirdly, there have been no exceptional charges dogging the accounts in recent years.

Working capital and cash flow

Although Renishaw haven't revealed their depreciation charge, nor the amount of cash absorbed into working capital, within their latest preliminary results, the figures from the previous years don't create too many questions. Cash flow diverted into stock, debtors and creditors has consistently remained a small proportion of operating profits.

Year to 30th June            1997    1998    1999    2000     2001


Operating profit (£m)        14.3    20.7    23.3    25.7     27.9

Change in                    (3.4)   (2.3)   (2.6)   (3.4)     -  
working capital (£m)

Depreciation (£m)             2.9     3.1     3.5     4.0      - 

Capital Expenditure (£m)     (6.6)   (9.2)   (9.6)  (11.6)   (10.5)

On the capital expenditure front, the depreciation charge in the Renishaw profit and loss account does appear to understate what's actually spent on tangible fixed assets. However, over recent years, approximately 50% of all fixed asset expense has been related to land & buildings. It's fair to say that most, if not all, of this spending was discretionary capital expenditure relating to the company's expansion and various office extensions. All in all, the depreciation charge does not vastly understate the amount of maintenance capital expenditure required just to keep the business going.

Cash pile and return on equity

Elsewhere in the accounts, shareholders find a very reassuring entry: a large cash pile. Renishaw had £39m in the bank at the end of June, a figure that represents over 10% of the company's current market value. Indeed, the company has had over £30m stuffed in the bank for at least the last five years. This hoarding suggests i) the company isn't about to suddenly blow it on an acquisition, so often a temptation for managers controlling excess cash mountains, and; ii) Renishaw management are probably very cautious, which is usually a good boardroom characteristic in the long run.

Since 1996, Renishaw have improved annual post-tax profits by £7.8m by adding (through retained profits) another £43.3m of additional capital. Therefore, the incremental return on equity performance is 18%. On a traditional return on equity basis, the company has recorded performances of around the 22% level over the past few years.

Using those figures, and noting that the company has no debt and its (low return) cash pile has traditionally made up about 30-40% of company assets over the years, I've no doubt Renishaw is a company that can generate superior long-term returns on reinvested profits.

Valuation and Summary

In terms of creating a free cash flow valuation, there are one or two small points within Renishaw's latest results that require some subjectivity.

Stripping out an estimated £4.8m depreciation charge from last year's £27.9m operating profit, and replacing it with £7.4m of cash expenditure on non-property assets, gives operating cash flow of £25.4m.

Now, Renishaw's latest tax rate was 20%. That's a low charge, both in general terms and historically for the company (the group's tax rate has steadily declined from 28% in 1998). If we assume a 27% rate, then post-tax operating cash flow comes to £18.5m, or 25.5p per share.

Knowing that the company's full-year dividend stands at 15.15p per share, plus the company has 54p per share cash pile, a share price of 400p would appear attractive. At that price, if you strip out the cash pile, Renishaw shares would offer a historic free cash flow yield of 7.4%.

Overall then, Renishaw is a solid, if unspectacular, business. While the world of metrology may not be the most visible for private investors, the track record of the business and the boardroom is certainly clear. A business with superior financial characteristics, led by the people who created its niche industry, Renishaw is certainly Qualiport material.

More: Renishaw discussion board | Renishaw website