QUALIPORT
Three Quality Engineers

By Maynard Paton (TMFMayn)
December 7, 2004

Forget all about those 'metal bashing' jibes -- some engineers are quality long-term investments. Today's article outlines their positive characteristics.

Watch list recap

The Qualiport has three engineers on its watch list: Halma (LSE: HLMA), Renishaw (LSE: RSW) and Rotork (LSE: ROR).

To recap:

* Halma develops and manufacturers a wide range of health and safety equipment, including fire alarms, lift sensors and water filters. Read more.

* Renishaw makes high-precision measuring devices and systems for the electronics and semiconductor industries. Read more.

* Rotork produces industrial actuators typically used to control systems within oil and gas refineries and pipelines. Read more.

All three companies are constituents of the FTSE 250. Here are their main shareholder features:

Reputation, patents and brands: Halma, Renishaw and Rotork have all been around for decades. All are market leaders in their particular niches, with past reputation, patents and brands all helping to form decent barriers to entry and persuade newcomers to stay away. Also, the markets in question are relatively small for some of the world's industrial giants to take too much of an interest in (annual earnings from the three companies total £70m).

Performance before price: The customers of the three companies require reliability, because product failure is often very high relative to cost. Although buyers include large conglomerates with immense purchasing power, they're unlikely to shop around too much if it means risking employee safety, the quality of their own products or operational headaches at out-of-the-way locations.

R&D: Though difficult for the outsider to gauge accurately, existing industry rivalry seems quite tough. All three firms proudly disclose their research and development expenditure and accomplishments within their accounts, which suggests they do not take their technological leadership for granted. Though each may have different ways of totting up the figures, Halma spent £11m (4% of sales), Renishaw spent £22m (17% of sales) and Rotork spent £2m (2% of sales) on R&D during their last full financial years.

Operating margins: Above-average operating margins highlight the competitive strengths of the three firms. The ten-year average for Halma, Renishaw and Rotork is 18%, 19% and 21% respectively. Margins at Halma and Rotork are quite stable, though Renishaw's have ranged from 13% to 24% since 1994.

Dividend history: All three companies have illustrious dividend records, with payout increases stretching over two decades or more. No guarantee for the future of course, but the past suggests reliability, consistency and a working culture that favours patient, long-term investors.

Net cash: All three companies regularly operate with net cash. At their latest year-ends, Halma had £22m, Renishaw had £33m while Rotork had £32m. It's worth noting that net cash on a listed company's balance sheet is quite a rarity in the FTSE 350. Read more.

Shareholder-orientated management: The directors at Halma, Renishaw and Rotork are not fat cats. Boardroom remuneration features a mix of relatively low pay, reasonable salary growth, muted bonus payments and large ordinary shareholdings. Read more.

So are there any other long-term engineering gems? Here is a trio of quality possibles:

First Technology (LSE: FRS)

Worth £267m at 354p a share, First Technology is a leading developer of crash test dummies and gas sensors. Recent results showed a healthy operating margin of 20% and net cash of £3m. The company encountered difficulties and scrapped its dividend in 1992, though the payout has risen steadily ever since. The non-exec chairman was previously the executive chairman from the 1985 flotation up to 2003, but he and his co-directors control less than 1% of the company. Read more.

Castings (LSE: CGS)

Castings is a foundry and machining group that makes various components using, among other materials, spheroidal graphite and austempered ductile iron. At a 172p share price, the company is worth £75m. The latest annual report showed net cash of £24m and operating margins of 13%. The boss has run the firm since the late 1960s and currently owns over 4% of the company. The dividend has been upped every year since at least 1989. This description of a past annual report is also encouraging. Read more.

FW Thorpe (LSE: TFW)

FW Thorpe designs and builds a wide array of commercial lighting systems. With the shares at 338p, it carries a valuation of £40m. The 2004 annual report highlighted operating margins of 13% and net cash of £8m. The company was formed by Fred Thorpe in the 1930s and various descendants have picked up the reins over the following years. The present board and other Thorpe family members hold about 60% of the company. The dividend was reduced in 1991, but has risen steadily thereafter. Read more.

Any for the watch list?

Do First Technology, Castings or FW Thorpe have what it takes to join the watch list? After this admittedly quick review, the answer is no. The watch list already has three solid engineers and none of the three possibles really outshine them on the characteristics mentioned above.

Lack of financial commitment from the management is a drawback at First Technology, which also has a history of operating with net debt. In addition, lower margins at Castings and Thorpe suggest they do not have the pricing power of the watch list favourites. That said, First Technology, Castings and Thorpe are certainly not bad companies, with their dividend records and cash piles suggesting operational consistency for investors looking primarily for 'value' among second-tier engineers.

Halma interim results

Halma published its interim results this morning:

Six months to	02 Oct 2004	04 Oct 2003
Turnover (£m)	144.1	146.9
Operating profit (£m)	24.5	24.4
Pre-tax profit (£m)	24.6	24.4
Earnings per share (p)*	4.59	4.53
Dividend per share (p)	2.58	2.44

The results were not spectacular. Excluding acquisitions (detailed here) and disposals, turnover slipped 3% to £135m while operating profits fell 7% to £22.8m. The decline in performance was mainly attributed to adverse currency movements, though Halma claimed five of its six divisions reported growth in local currency terms.

Operating margins were steady at 17% and, despite spending £23m on new businesses, Halma ended the half-year with net cash of £2m. There was the usual dividend increase as well, the payout rising 6% to 2.58p per share.

In terms of valuation, the shares at 156p trade on a trailing twelve-month price to earnings ratio of 16.4 and yield 4.1%. Assuming operating profits remain at a standstill, free cash of 9.2p per share could be generated in the forthcoming year. Demanding a 7.5% free cash flow yield thus requires a 123p buy price.

Maynard tipped FW Thorpe in the April edition of the Value Investor newsletter. He owns shares in Halma.

Portfolio value

Holding	Number of shares	Closing price 06/12/04 (p)	Value (£)
Associated British Ports	681	469.25	3,195.59
Emap	372	831.5	3,093.18
Halma	1,920	164.5	3,158.40
Johnston Press	1,608	513	8,249.04
London Stock Exchange	2,018	414.75	8,369.66
Cash			87.41
Total			26,153.28