QUALIPORT
Health And Safety For Your Portfolio

By Maynard Paton (TMFMayn)
December 9, 2002

Halma (LSE: HLMA) is back on the Qualiport watch list. No surprise though, as the company's market-leading positions in many areas of health and safety provide some fine investment qualities. Halma also has one of the strongest dividends on the market. Over the past 24 years, the annual payout has improved at an average of 19.6% per annum. The shares are quite cheap at the moment, too.

The business

Although Halma has been reviewed many times on the Fool before (here, here and here), here's another company recap:

* Health and safety: Halma "develops, makes and markets products worldwide that are used to enhance public safety and minimise hazards at work". About 80% of Halma's profits come from subsidiaries "recognised as leaders in their home markets or world markets". Products involve fire and gas detection (31% of group profits), water treatment (16%), lift safety control (12%), industrial resistors (8%), specialist optical instruments (20%) and various other industrial devices (13%).

* Performance before price, repeat purchase: Purchasers of health and safety equipment undoubtedly place product quality above price. As such, the reputation of Halma's brands and the group's technical prowess provide a decent operational 'moat'. Halma also benefits from a notable amount of repeat purchase business. For instance, new buildings account for just 25% of fire detector sales, with the remainder coming from refurbishment, changes of building use and replacement technology. Profits from spares and servicing also help.

* R&D risk: Technological innovation is key to Halma's success, as around 20% of annual sales come from products developed in the past year. Over £8m is spent annually on R&D; if the development process stumbles, profits will suffer.

* Acquisition risk: Unlike many other companies, Halma has a long, successful record of acquisitions. Following £50m-plus spent on acquisitions during the past five years, another £46m was paid to buy Belgian sensor business BEA in October. Importantly, the corporate activity has almost always been funded by internally generated cash flow. Halma last issued shares for an acquisition in 1994.

* Board changes: David Barber, the major force behind Halma's growth record and non-executive Chairman, is to retire next year. Stephen O'Shea, Halma chief executive, has been in charge for seven years.

The financials

The table below highlights Halma's five-year financial performance:

Year to March 31st              1998    1999    2000    2001    2002

Turnover (£m)                  213.8   218.8   233.5   268.3   267.6
Operating Profit* (£m)          41.8    40.8    43.4    49.7    48.0
Exceptional Items (£m)          (5.8)      -    (7.8)      -       -
Pre-tax Profit* (£m)            42.4    41.8    43.8    49.7    48.3

Earnings per share* (p)          8.3     8.0     8.4     9.3     9.1
Dividend per share (p)           2.8     3.3     4.0     4.6     5.3

(*adjusted for goodwill and exceptional items)

Given the aforementioned expenditure on acquisitions, sales growth averaging 6% per annum since 1997 isn't the greatest of achievements. Indeed, generally subdued economic conditions caused a sales decline during fiscal 2002. However, operating margins have commendably remained around the 18% mark. Relating to the closure of certain businesses, exceptional costs totalling £14m have not been excessive. In recent years, the rate of dividend growth has slipped from what was the traditional 20% per annum to 15%. This month's six-month results showed the interim dividend increasing by 10%.

Cash flow and return on equity

Year to March 31st               1998    1999    2000    2001    2002

Operating Profit* (£m)           41.8    40.8    43.4    49.7    48.0

Change in Working
  Capital (£m)                   (7.9)   (2.9)   (1.8)   (1.3)    0.5

Depreciation (£m)                 5.3     5.7     6.3     7.0     7.4
Net Capital Expenditure (£m)     (7.7)   (6.2)   (7.2)   (8.3)   (6.5)

(*adjusted for goodwill and exceptional items)

There's no problem in the working capital department. Over the past five years, net cash absorbed into stocks, debtors and creditors has been just 6% of reported operating profits. The performance has improved in recent years; since 1999, the working capital absorption averaged 3% of operating profits.

Halma's cash generative nature is confirmed by inspecting its expenditure on tangible assets. Since 1998, net capital expenditure has totalled £35.8m. Set against a cumulative depreciation charge of £31.7m, reported earnings are not camouflaging excessive asset expenditure.

Another point worth noting is that during the year ending March 2002, Halma managed to generate a £48.0m operating profit from tangible assets of £44.3m. From the results of this study, it's clear Halma benefits from inherently attractive, difficult-to-replicate, intangible assets.

Halma's return on equity (ROE) performance is a little disappointing, though. In the five years from March 1997, earnings have increased from £25.1m to £33.1m. Over the same time (and adjusting for £84.1m of goodwill written off and £5.8m of goodwill amortised), Halma's equity base has jumped from £165.0m to £247.5m. The resulting incremental return on equity comes to just 9.7% (£8.0m/£82.5m).

Given the tangible asset-light nature of Halma, it's fair to assume the large slug of goodwill has hampered equity returns. Goodwill amounting to £36m was purchased via acquisitions during the relatively buoyant economic years ending March 1999 and March 2000. Those purchases, combined with the subsequent deterioration in global economic conditions (one third of group sales are made in the US), have not done Halma's recent ROE any favours.

For the record, the incremental return on equity for 1995-2000, 1995-2001 and 1995-2002 come to 13.2%, 14.3% and 11.4% respectively. Another factor for the low-ish returns is Halma's considerable cash pile: £37m as at September 2002. (Following the BEA purchase, Halma will operate with net debt).

Valuation and summary

Halma can be described as consistent, robust and unspectacular. Can't-do-without products, industry growth driven by ever-greater legislation, high margins, low fixed assets and shareholder orientated management -- Halma possesses many long-term investment attractions. The only blot, perhaps, is the reliance on acquisitions to keep the momentum going. Although the boardroom has yet to slip up in this respect, the risks remain. That said, BEA, Halma's largest ever purchase, was bought on a reasonable price to earnings (P/E) ratio of 16-17 and offers obvious 'synergy' benefits.

At 120p per share, Halma is valued at around £440m. The shares stand on a forward P/E of 12.8 and offer a prospective dividend of 4.9%. Assuming net capital expenditure runs 13% higher than the depreciation charge (in line with the past five years), then the twelve months ending September 2002 saw 8.6p per share of free cash generated. If the 'earnings enhancing' BEA acquisition offsets any further sales downturn to leave near-term profits flat, a 115p entry price would offer a prospective free cash flow yield of 7.5%.

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