QUALIPORT
Big Rewards From Renishaw's Recovery

By Maynard Paton (TMFMayn)
July 25, 2002

Qualiport watch list member Renishaw (LSE: RSW) published its annual figures today. As had been indicated for some time, the numbers showed a hefty profit shortfall. However, the engineering firm has seen -- and come through -- many downturns before. As and when global economies pick up, Renishaw shareholders will prosper. Indeed, investors have a genuine opportunity to double their money over the next five years.

Key features

The key investment features of Renishaw are:

* Market leader: 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. The market-leading probes are "the industry choice" and Renishaw is reported to have at least an 80% share of the market.

* Experienced management: Renishaw's management team virtually created the industry for measuring 'probes'. Chairman and Chief Executive Sir David McMurtry built his 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.

* Attractive financials: Although the company's performance is sensitive to the global economy, Renishaw does have many inherently attractive financial features. Operating margins above 20% and a large cash pile are typical characteristics of the Renishaw accounts. Since 1990, Renishaw has improved its dividend by an average of 14% a year.

The financials

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

Year to June 30th             1998     1999    2000    2001    2002

Turnover (£m)                 92.3     96.3   105.6   125.3   104.5
Operating Profit (£m)         20.9     23.3    25.7    27.9    13.4
Pre-tax profit (£m)           22.4     25.8    28.3    30.8    16.1

Earnings per share (p)        22.1     26.3    29.1    34.0    20.9
Dividend per share (p)        10.0     11.2    13.2    15.1    15.9

The world economic downturn and consequent "subdued demand" for Renishaw's products hindered the 2002 performance. Revenues slumped 17% to £104.5m while operating profits dived 52% to £13.5m.

The release of prior year tax provisions (leading to a tax charge of just £800,000 on a £16.1m pre-tax profit) cushioned the earnings per share (EPS) fall (down 39% to 20.0p). With the boardroom continuing to have "every confidence" in the company's prospects over the longer term, the full-year dividend was raised 5% to 15.9p.

At the June 30th year-end, Renishaw had net cash of £36.6m (49p per share). Today's preliminary figures also continued the company's pleasant trend of clear accounting statements. There were no exceptional items and, with Renishaw's last acquisition back in the 1980s, no goodwill entries either.

Cash flow and return on equity

Renishaw's preliminary statement failed to give figures for depreciation and the net cash outflow of working capital -- poor form in my view.

Year to June 30th             1998     1999    2000    2001    2002

Operating Profit (£m)         20.9     23.3    25.7    27.9    13.4

Change in
working capital (£m)          (2.3)    (2.6)   (3.3)   (8.3)      -  

Depreciation (£m)              3.1      3.5     4.0     5.1       -
Net capital
expenditure (£m)              (7.6)   (10.0)  (11.6)  (10.5)   (8.5)

The year ending June 2001 saw a large build up of stock. During those twelve months, turnover jumped 19% while the group's end-of-year stock level surged 46%. The question "is the rising stock level a sign of near-term trouble?" asked last year was answered by a subsequent profit warning. One year on from the stock build-up, stock levels remain at the same June 2001 level (£22m).

On the capital expenditure front, the depreciation charge in the Renishaw profit and loss account has appeared to understate what's actually spent on tangible fixed assets.  However, between 1999 and 2001, large amounts were spent on additional land and buildings. The 2002 figure has fallen to a more 'normal' level of capital expenditure.

Things get tricky when turning to Renishaw's incremental return on equity. With 2002's depressed post-tax profit of £15.1m lower than the figure recorded in 1996, prospective Renishaw investors have to look back over the past decade:

Period        Cumulative         Increase in     Incremental return
           retained earnings      earnings          on equity
                  (£k)               (£k)               (%)

1990-2002       91,523              6,012              6.57
1990-2001       87,914             15,543             17.68
1993-2001       73,015             19,700             27.98
1993-2002       76,624             10,169             13.27

Similar to the current environment, the early 1990s downturn also caused Renishaw's profits to fall sharply. Earnings topped £9.1m in 1990 and hit a low of £5.0m in 1993.

The table above shows the differing equity returns from the 1990 peak and 1993 low to 2001 (i.e. the pre-2002 recession peak) and 2002 (the current earnings low). The average of the four performances comes to 16.1% -- not a bad result, given one-third of the company's asset base is usually represented by cash.

Going on the 1993-2001 achievement, Renishaw's high operational gearing should mean very attractive returns as and when a recovery develops.

Valuation

On today's figures, Renishaw shares (at 338.5p) are valued on an earnings yield of 6.2% and dividend yield of 4.7%. However, because Renishaw has a long, fine business record and is run by very experienced management (who have coped with many economic peaks and troughs before), it makes sense to value the shares on a 'recovery basis'

Looking back at the 1990s recession, it took Renishaw five years to exceed its 1990 earnings peak. But even during the relatively bleak years of 1992 and 1993, Renishaw shares traded on a price to earnings (P/E) ratio of 20 (a level similar to the boom years of 1996-2001).

So, assuming 2007 sees...

* Renishaw regaining their 2001 EPS high of 34p;
* The shares trade on a P/E ratio of 17.5.

... then investors could see the shares standing at 595p five years out. Add on an estimated 80p of dividends (five years of 16p annual payouts), and the total investment return by 2007 could be 336.5p (595p - 338.5p + 80p) per share. At today's 338.5p share price, that projection equates to a 14.8% annual compound return. On this basis, the shares look very attractive for a long-term investor.

More: Renishaw For The Watch List | How To Value Companies Set For Recovery