QUALIPORT
Renishaw Recovery Means Big Profits

By Maynard Paton (TMFMayn)
July 28, 2003

A year ago, the Qualiport suggested Renishaw (LSE: RSW) could provide big profits to long-term 'recovery' investors. So far at least, that judgement has proved correct. Over the past twelve months, Renishaw's shares have motored nearly 50% higher, while the stock market has risen only 5%. A revival in company sales, emphasised in last week's annual results, has been the catalyst for the share-price performance.

Key features

To recap, the key investment features of Renishaw are:

* Market leadership: Renishaw develops, designs and manufactures specialist measuring equipment, known as probes. These devices, together with their associated software, allow manufacturers to automate the precision machining of components. Renishaw's market-leading probes are 'the industry choice' and the firm is reported to have at least an 80% share of this market.

* Proven management: Renishaw's management team virtually created its industry. 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, McMurtry and Deer own over 50% of the company.

Five-year record

The table below shows Renishaw's five-year financial record:

Year to 30 June               1999    2000    2001    2002    2003

Turnover (£m)                 96.3   105.6   125.3   104.5   110.6
Operating Profit (£m)         23.3    25.7    27.9    13.4    16.6
Pre-tax profit (£m)           25.8    28.3    30.8    16.1    17.8

Earnings per share (p)        26.3    29.1    34.0    20.9    19.7
Dividend per share (p)        11.2    13.2    15.1    15.9    16.7

The twelve months ending 30 June 2003 saw a reversal in Renishaw's fortunes, as sales rebounded 6% to £111m. With trading conditions improving mid-way through the financial year, Renishaw's 'year of two halves' certainly emphasised the company's high operational gearing:

Six months to           31 December 2002      30 June 2003

Sales (£m)                   51.5                 59.2
Operating profit (£m)         5.4                 10.3
Operating margin (%)         10.4                 17.3

A very low tax charge in 2002 distorted the annual earnings comparison, with full-year earnings per share (EPS) falling from 20.9p to 19.7p.

Cash flow

Renishaw's preliminary statement once again failed to give figures for depreciation and the net cash outflow of working capital. Nevertheless, this is how Renishaw's cash profile has shaped up since 1999:

Year to 30 June               1999    2000    2001    2002    2003

Operating Profit (£m)         23.3    25.7    27.9    13.4    16.6

Change in
working capital (£m)          (2.6)   (3.3)   (8.3)   (0.8)      -

Depreciation (£m)              3.5     4.0     5.1     5.8       -

Net capital
expenditure (£m)             (10.0)  (11.6)  (10.5)   (8.5)   (8.0)

On the capital expenditure front, the depreciation charge in Renishaw's profit and loss account vastly understates the cash spent on tangible fixed assets. However, between 1999 and 2001, large amounts were spent on additional land and buildings. The 2002/3 figures appear to reflect 'normal' levels of capital expenditure, albeit they're still about 40% higher than the reported depreciation. But cash flow in general remains in good shape, with the 2003 dividend up 5% to 16.7p per share, and net cash standing at £35m (51p per share).

The analysis gets awkward when considering Renishaw's incremental return on equity. With 2003's depressed post-tax profit of £14.3m lower than the figure recorded in 1996, investors have to go back to over the past decade to evaluate the company's historic profit reinvestment performance.

Just as in the present environment, the early 1990s downturn also caused Renishaw's profits to fall sharply. Earnings topped £9.1m in 1990, then hit a £5m low in 1993:

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

1990-2003       93,712              5,175              5.52
1990-2001       87,914             15,543             17.68
1993-2001       73,015             19,700             26.98
1993-2003       76,624             10,169             12.18

The above table shows the differing equity returns from the 1990 peak and 1993 low to the 2001 peak and 2003 low. The average of the four performances comes to 15.5% -- not a bad result, especially as one-third of the company's asset base is typically made up of cash.

All in all, going on the 1993-2001 achievement, Renishaw's high operational gearing should mean very attractive equity returns, as and when a sustained recovery develops.

Summary and valuation

The faith placed upon Renishaw last year when all seemed gloomy now looks well founded. It wasn't a difficult call: the company and its experienced management have been through economic downturns before -- and prospered thereafter. At no point during the last year or two was there a suggestion that Renishaw's industry-leading position had taken a knock: probably the reverse, if anything. In the current year, trading conditions have 'continued to improve', with new products and markets supporting the optimism.

Sadly, the market is now expecting Renishaw to make a full and speedy recovery. At 499p, the shares trade at 25 times the latest reported earnings and offer a 3.1% dividend yield.

If you assume:

* Earnings are a genuine reflection of free cash;
* Operating profits in 2003 are twice those recorded in the second half 'recovery' of 2002; and
* Corporation tax is 20% (as reported in 2003)

... then the shares offer a forward free cash flow yield of 5% (adjusted for the 51p per share cash pile). Demanding a 7.5% free cash flow yield would require an entry price of 352p.

More: Invest In Experienced Management | Big Renishaw Rewards | Metrology.