QUALIPORT
Rotork Joins The Watch List

By Maynard Paton (TMFMayn)
August 14, 2003

Rotork (LSE: ROR) is to join fellow engineers Halma (LSE: HLMA) and Renishaw (LSE: RSW) on the Qualiport's watch list. Its business may not be the most transparent, but there's plenty of evidence to suggest Rotork is a quality company suitable for a buy and hold portfolio. Thumbs-up to discussion board regular Jagro77 for the suggestion.

Actuators

A FTSE 250 company worth £290m, Rotork designs, manufactures and supports a range of industrial actuators. For non-engineers, an actuator is a mechanism that controls the opening and closing of a valve. An ordinary tap handle is a type of actuator, which when turned opens or closes a valve connected to a water pipe. Rotork's actuators are much more technologically advanced than a household tap, though, and they are used as major control elements in oil and gas refineries and pipelines, water distribution systems, and sewage and effluent treatment plants. (More details can be found in the Rotork annual report.)

The company can trace its origins back to 1945 and produced the first actuator under the Rotork banner in 1952. It's been at the forefront of actuation technology ever since and has carved out a leading global position in this particular engineering field. The company supplies the world's best-selling actuator, the IQ, which was superseded in 2000 by the IQ Mk II. Rotork listed on the London stock market in 1968.

Rotork has encouragingly stuck to its actuator strengths over time and recently disposed of its last (small) non-actuator business. There's been no sign of any aggressive acquisition activity either. Up to £27m has been spent on corporate purchases since 1997 (all of which had a line in actuators), the largest being £8m spent on US firm Jordan Controls in 2002.

Outlined in the company's annual report, Rotork enjoys significant barriers to entry: "Valve actuators are critical components and their long-term reliability and performance is of importance to users. Rotork's reputation for quality, worldwide support and technical innovation is crucial to its leadership in its field."

Purchasers of actuators risk a high penalty for failure -- the cost of a reliable actuator is minimal compared to the problems an unreliable one can cause. Any new entrant has therefore to persuade oil majors and water companies that its product can perform much better than a tried and tested Rotork and at a lower cost -- not an easy task, especially when the buyers expect to operate actuators for decades hence in hazardous, out-of-the-way locations. Continuing research and development, the Rotork brand and the company's reputation also go a long way to prevent newcomers getting a foothold in the market.

Though Rotork supplies actuators to mega-firms like BP (LSE: BP.)(NYSE: BP), it appears the company does not suffer unduly from powerful buyers. No one customer represents more than 5% of group turnover and operating margins have never dipped below 16% in the last ten years. Furthermore, third-party engineers who manufacturer most of Rotork's parts present little in the way of supplier pressure.

Substitutes aren't a problem either. Powered by electrics, fluids or hydraulics, Rotork provides a range of all three actuator types and it's difficult to imagine industrial pipeline valves being controlled by anything else.

The downside of top-notch engineering products is that they hardly ever wear out. Rotork does say, however, that it has a large number of repeat customers, with demand generated by new, expanded and upgraded facilities. Even so, investors should not expect a reliable stream of 'replacement' income.

Five-year record

Rotork has a proven financial record. Over the past ten years, sales have grown by an average of 9% per annum, pre-tax profits by 10% per annum, earnings per share by 11% and the dividend by 14%. The table below summarises Rotork's recent performance:

Year to 31 December       1998     1999     2000     2001     2002

Turnover (£m)            101.4    110.4    107.9    123.7    133.5
Operating profit (£m)     23.9     26.9     20.8     25.3     27.0
Exceptional items (£m)       -        -        -        -        -
Pre-tax profit (£m)       25.8     27.8     21.6     25.9     27.5

Earnings per share (p)    19.3     21.3     16.8     20.2     21.6
Dividend per share (p)    10.9     12.2     12.2     13.0     13.9

(All figures adjusted for goodwill)

The growth rate has slowed in past few years, with profits compounding at only 4% per annum from 1997. Since 1988, there has been only one profit glitch, which occurred in 2000. In that year, Rotork suffered a decline in product demand from the oil and gas sector, though it did manage to maintain its dividend. Operating margins in 2002 were a very healthy 20% and equal to Rotork's ten-year average. Thankfully, there has been no requirement for exceptional items of late.

Though sales have jumped 33% since 1999, earnings have moved broadly sideways. The blame for the standstill performance lies in a reduction in operating margins (they touched 24% in 1999) and the aforementioned acquisitions (which reduced the company's cash pile and the resulting interest received upon it). Recent interim results did not indicate a signifcant profit upturn was imminent.

Cash flow

Rotork has no problems in the cash flow department:

Year to 31 December       1998     1999     2000     2001     2002

Operating profit (£m)     23.9     26.9     20.8     25.3     27.0
Depreciation (£m)          1.5      1.9      2.0      2.0      2.2
Movement in
  working capital (£m)    (3.2)    (2.8)    (6.2)    (1.9)    (2.9)
Net capital            
  expenditure (£m)        (2.3)    (2.5)    (3.1)    (0.6)    (1.9)

On average, working capital absorbs about 15% of any one year's operating profit. Not great, but stock, debtor and creditor days are generally quite steady. However, expenditure on tangible fixed assets -- or lack of it -- is much more attractive. Over the past five years, net capital expenditure (capex) has exceeded the depreciation charge by around 12% on average. With depreciation equating to less than 2% of sales and tangible fixed assets of £14m producing a £27m operating profit in 2002, it's clear Rotork relies heavily on its precious intangible assets.

The company commendably likes to retain a sizeable cash balance on its books. At the last update, shareholders counted a net £20m (or 23p per share), though the bank balance has steadily dwindled from the £34m seen at the end of 1997. Also, Rotork has spent £7m on share buybacks over the past few years, though employee options have meant the number of shares in issue remaining steady around 86m.

The end result of Rotork's progress is a decent incremental return on equity. During the five years to December 2002, an additional £32.7m of shareholders' equity produced an extra £4.3m of earnings. The 13.7% incremental return is all the more worthy when considering Rotork's low-return cash hoard and the £15m of goodwill acquired.

Worth noting too is that, at the end of December 2002, Rotork had a £17m pre-tax pension liability. With the firm generating a similar after-tax figure in earnings for 2002, the deficit looks manageable.

Management

The Rotork boardroom breaches two corporate governance guidelines: executive directors outnumber non-executives (four to three) and certain executives are on two-year contracts. Still, shareholders can be comforted by the management's experience. Chief executive Bill Whitely has been a board member since 1984 and was appointed to the top seat in 1996. In fact, Whitely, the finance director and the engineering director have an aggregate 62 years of employment at the firm. 

Director salaries raise a few eyebrows. Like most chief executives, Whitely has seen his pay jump significantly in the past few years. While profits and staff wages have improved around 4%, his basic salary has increased by 10% per annum (to £205,000) since 1997. What's more, the total boardroom holding in the company is a miserable £540,000.

Summary and valuation

Rotork is certainly an equal to Halma and Renishaw. And similar to its sector counterparts, Rotork also finds organic growth hard to come by. But a robust business offsets the pedestrian prospects. All in all, a leading industry position, critical products, operational focus, high margins, good cash flow and experienced management combine to form a Qualiport share.

Assuming maintenance capex runs 12% higher than the depreciation charge, Rotork generated 20.0p per share of free cash in the twelve months ending June 2003. Adjusting for the 23p per share cash pile, an entry price of 290p is required for a historic free cash flow yield of 7.5%. The current share price is 341.5p.

More: Order Rotork's annual report, for FREE! | Rotork website

The author owns shares in Halma.