QUALIPORT
Reasons For The Halma Rally

By Maynard Paton (TMFMayn)
June 19, 2003

Halma (LSE: HLMA) shares have rallied 27% since the Qualiport's purchase in March. Tuesday's annual results explained why. Though profits were down, the engineer provided a relatively positive outlook statement and confirmed its largest ever acquisition was performing well.

To recap, Halma develops a wide range of health and safety equipment. Its market-leading businesses involve fire and gas detectors, water treatment and analysis products, lift sensors, industrial safety systems, bursting discs, high power electrical resistors and various ophthalmic instruments.

The health and safety industry has three attractive traits for the long-term investor.

1. Proprietary products: Years of hefty R&D spend and product improvements have provided Halma with a range of patents, plenty of prominent brands and a reputation for reliability -- all of which form good barriers to entry.

2. Quality over price: When purchasing safety equipment, the penalty for product failure is very high relative to cost. Thus Halma customers are often price-insensitive and are prepared to pay a premium for quality and service. 

3. Legislative pressure: Health and safety regulations are tightening up around the world, thus stirring increased demand for Halma-type products. 

Five-year record

Halma's five-year record is shown below:

Year to March 31st              1999    2000    2001    2002    2003

Turnover (£m)                  218.8   233.5   268.3   267.6   267.3
Operating Profit* (£m)          40.8    43.4    49.7    48.0    46.1
Exceptional Items (£m)             -    (7.8)      -       -       -
Pre-tax Profit* (£m)            41.8    43.8    49.7    48.3    46.5

Earnings per share* (p)          8.0     8.4     9.3     9.1     8.6
Dividend per share (p)           3.3     4.0     4.6     5.3     5.8

(*adjusted for goodwill and exceptional items)

The twelve months to March 31st 2003 saw group sales and profits slip for the second consecutive year. The decline was masked by the £46m purchase of BEA (the world leader in automatic door sensors) in October. Excluding the 'excellent' six-month BEA contribution, turnover dropped 6% to £252m and operating profits fell 10% to £43m.

A subdued global economy caused all six of Halma's divisions to record flat-at-best underlying sales. European revenue growth of 10% was offset by difficult trading in the US, which this year became Halma's largest market with 31% of group turnover.

Still, the results reiterated two traditional features of Halma's finances. Firstly, operating margins remained a healthy 17%, a level seen throughout the past decade. Secondly, the dividend improved again, this time by 10%. It's worth remembering Halma has probably the best payout record of any listed share; between the early 1970s and 2000, the dividend was raised by at least 20% per annum; during 2001 and 2002, it improved by 15%.

Cash flow

The latest results reinforced Halma's great cash flow profile:

Year to March 31st              1998    1999    2000    2001    2002

Operating Profit* (£m)          40.8    43.4    49.7    48.0    46.1

Change in Working
  Capital (£m)                  (2.9)   (1.8)   (1.3)    0.5     8.8

Depreciation (£m)                5.7     6.3     7.0     7.4     7.5
Net Capital Expenditure (£m)    (6.2)   (7.2)   (8.3)   (6.5)   (9.4)

(*adjusted for goodwill and exceptional items)

No problems with working capital this year, as Halma generated an inflow of nearly £9m. In addition, spending on tangible assets remains minimal when set against the depreciation charge. Net capital expenditure has exceeded depreciation by 10% over the past five years, which indicates reported earnings are not hiding any excessive asset purchases.

Another point to note is that during the past year, Halma produced a £46.1m operating profit from tangible assets of £46.9m. From the results of this study, it's clear Halma benefits from inherently attractive, difficult-to-replicate, intangible assets.

Though light on assets, Halma's recent return on equity performance is poor. In the five years from March 1998, earnings have increased from £29.7m to £31.2m. Over the same time (and adjusting for £84.1m of goodwill written off and £9.1m of goodwill amortised), Halma's equity base has jumped from £182.0m to £256.5m. The resulting incremental return on equity comes to a paltry 2.0% (£1.5m/£74.5m).

Shareholders can blame acquisitions (goodwill of £77m has been acquired since 1998) and the tricky global economy (earnings have been flat over five years). While there's little doubt Halma can earn a superior return on its existing 'operating' assets, the extensive corporate activity of late would suggest such investment possibilities are very limited.

(For the record, the incremental returns on equity for 1995-2001, 1995-2002 and 1995-2003 -- which encompass the economically buoyant late 1990s -- come to 14.3%, 11.4% and 9.1% respectively.)

Valuation and summary

These results weren't spectacular. Indeed, two straight years of falling profits and lacklustre equity returns aren't the best advert for a Qualiport business. Yet it's the future that counts for shareholders. The primary drivers for success -- the solid (and expanding) product range and a proven, conservative boardroom -- remain in place, ready and waiting for an economic upturn. Reassuringly, the company said sales and profits should improve in the current year, though most of that will surely come from the full-year BEA contribution.

At 140p, Halma shares trade on a price to earnings ratio of 16.4 and offer a dividend yield of 4.2% using Tuesday's figures. Assuming BEA can produce a full-year operating profit of £5m and capex runs 10% higher than depreciation, Halma generated underlying free cash of 8.7p per share in the year to March 2003. A 116p entry price would therefore offer a historic free cash flow yield of 7.5%.

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