QUALIPORT
When Growth Shares Stop Growing

By Maynard Paton (TMFMayn)
July 5, 2005

These remarks should excite all long-term investors:

"The compound growth rate in earnings per share over the whole thirty years since 1972/73 now averages 19% per annum. Few, if any, UK companies can match this record."

"The Group has a record of unbroken dividend growth since the 1970s. During the whole of the twenty-year period to March 2000, the dividend per share was increased by not less than 20% per annum, possibly the longest such sequence recorded by a UK quoted company."

"£10,000 invested in [the Group's] shares at the average share price during 1974, 1975 or 1976, including gross dividend income, would be worth, at the end of March 2003, over £4.8m."

The firm in question is Halma (LSE: HLMA). The comments were made by David Barber, who retired in 2003 following 30 years as company chairman.

Sadly, Halma is no longer the growth force it once was. Full-year results issued a fortnight ago revealed earnings at a standstill and a dividend increase of just 5%. Indeed, the group's longer-term history provides an instructive lesson on two common mistakes investors make: extrapolating the past well into the future and forgetting that fast-growing companies often 'revert to the mean'.

Slowdown

Here's a summary of Halma's earnings and dividends over the past 20 years:

Year to March 31st	EPS    (p)	EPS growth (%)		DPS   (p)	DPS growth (%)
1986	1.28			0.24
1987	1.52	19		0.29	20
1988	2.00	31		0.34	20
1989	2.57	29		0.45	30
1990	3.08	20		0.58	30
1991	2.87	(7)		0.74	27
1992	3.26	13		0.92	25
1993	4.19	29		1.11	20
1994	4.79	14		1.33	20
1995	5.59	17		1.60	20
1996	6.44	15		1.92	20
1997	7.01	9		2.30	20
1998	8.26	18		2.76	20
1999	7.99	(3)		3.31	20
2000	8.41	5		3.98	20
2001	9.34	11		4.57	15
2002	9.10	(3)		5.26	15
2003	8.55	(6)		5.79	10
2004	9.44	10		6.19	7
2005	9.42	0		6.50	5

Obviously a lower rate of inflation and the benefits of starting from a low base (Halma reported post-tax profits of about £4m in the mid-Eighties; today they stand at £35m) have played their part, but there's no escaping the fact that earnings have stuttered since 2001, which has prompted dividend improvements to tail off as well.

Something really worth noting is that Halma's current 146.5p share price was first breached during April 1996. Back then, investors were prepared to pay a forward price to earnings (P/E) ratio of 23 and collect a dividend yield of 1.3% for the firm's then prospects. Given Halma's preceding track record, paying up for the company's double-digit growth was, presumably, quite understandable at the time. But Halma's expansion rate subsequently slowed to a pedestrian pace, causing its market rating to contract and, well, nine years is a long time to invest without capital growth!

A coincidence perhaps, but the mid-Nineties was the time David Barber split his role of joint chairman and chief executive and saw Stephen O'Shea appointed chief executive. Though O'Shea commendably kept to Barber's strategy (i.e. focusing on leading businesses in specialised markets, cash generation, return on capital, and so on), earnings growth averaged about 4% per annum under his stewardship -- not the greatest of achievements it has to be said.

Perhaps Halma's new bosses can re-invigorate the company. Geoff Unwin replace Barber as chairman in 2003 while Andrew Williams replaced the retiring O'Shea as chief executive earlier this year. Both men were honest about the task ahead within last month's annual statement:

"We must become more active in the way we build the distribution channels of our businesses, particularly in the US and other key markets.  We have sometimes lacked clarity and speed of action in this area in the past and not allocated a significant proportion of our resources to make it happen."

"We are continuing to upgrade the quality of our management right across the Group and particularly at subsidiary board level." 

"All aspects of selling have received particular attention and we are disappointed not to see better progress on the revenue line...  We are having success but it is patchy, we need to do more - faster."

Five-year record

Despite the lacklustre growth of late, Halma remains an attractive business. It is chock-full of market-leading subsidiaries, which develop a wide range of health and safety products such as fire alarms, water analysers, lift sensors, bursting discs and electrical resistors.

Halma's long-term positives revolve around intellectual property and reputable brands (which help form good barriers to entry), price-insensitive customers (because product failure is often very high relative to cost) and worldwide legislative pressure. More on Halma's buy and hold attractions can be found here and here.

This table summarises Halma's progress since 2001:

Year to March 31	2001	2002	2003	2004	2005
Turnover (£m)	268.3	267.6	267.3	292.6	299.1
Operating profit* (£m)	49.7	48.0	46.1	50.0	50.3
Exceptional items (£m)	-	-	-	(9.1)	-
Pre-tax profit* (£m)	49.7	48.3	46.5	41.1	50.4
Earnings per share* (p)	9.3	9.1	8.6	9.4	9.4
Dividend per share (p)	4.6	5.3	5.8	6.2	6.5

(*adjusted for goodwill)

In the most recent financial year (to March 2005), acquisitions and disposals clouded Halma's performance. Adjusting for the comings and goings, underlying turnover was flat and profits fell slightly. This time around, the accounts were hindered by currency movements, steep price increases to certain raw materials and there being no repeat of a substantial contract for water-leak detection equipment. Group operating margins continued their trend downwards during 2004/5, having fallen from nearly 19% in 2000/1 to under 17% in the year just completed.

Cash flow and balance sheet

Notwithstanding the standstill profits, cash flow at Halma remains good:

Year to March 31	2001	2002	2003	2004	2005
Operating profit* (£m)	49.7	48.0	46.1	50.0	50.3
Change in working capital (£m)	(1.3)	0.5	8.8	0.5	2.0
Depreciation (£m)	7.0	7.4	7.6	7.9	7.9
Net capital expenditure (£m)	(8.3)	(6.5)	(9.4)	(8.7)	(9.1)

(*adjusted for goodwill)

There were no problems with working capital in 2004/5, as Halma generated an inflow for the fourth year running. In addition, spending on tangible assets was minimal when set against the depreciation charge (on average, the past five years have witnessed net capital expenditure equivalent to 111% of depreciation).

With £25m absorbed by acquisitions during the year, net cash of £22m declined to £12m (roughly 3p per share). The performance allowed the full-year dividend to be lifted by the aforementioned 5%. There was also a passing reference to the group's pension shortfall, which remained at £41m before related taxation. With annual pre-tax profits of £50m, this is one of the relatively larger deficits on the Qualiport's watch list.

Valuation and summary

Based on the 2004/5 results, today's 146.5p share price offers a P/E of 15.5 and a dividend yield of 4.4%. Factoring in the small discrepancy between depreciation and capital expenditure, Halma produced free cash of 9.2p per share in the twelve months under review. Account for the cash pile, and a 126p buy price is required for a historic 7.5% free cash flow yield.

Interestingly, this comment was made within Halma's results:

"We have continued our progressive dividend policy, dividends having increased every year for more than 25 years... As [this year's] dividend increase is above the earnings increase, dividend cover has reduced a little.  Our task is to deliver the earnings growth in the coming years so that we can raise that cover again."

Great past record or not, dividend growth is ultimately fuelled by earnings growth. Dividend cover (i.e. earnings divided by dividends) in 2004/5 was 1.45 so, unless profits spark back into life, at some point in the not-so-distant future the distinguished record of payout improvements may well end. Suffice to say, there are only so many years shareholders will tolerate currency movements, amongst other reasons, as an explanation for a static financial performance.

Still, Halma should have the wherewithal to step up a gear or two. The firm enjoys some can't-do-without products, industry growth driven by ever-greater legislation and robust financials. These characteristics should help the refreshed board stop Halma from 'reverting to the mean' and instead return the company to growth.

More: Halma Annual Results 2004

Maynard owns shares in Halma.

Portfolio value

Holding	Number of shares	Closing price 04/07/05 (p)	Value (£)
Associated British Ports	681	495	3,370.95
Emap	372	795.5	2,959.26
Halma	1,920	145	2,784.00
Johnston Press	1,608	483.75	7,778.70
London Stock Exchange	2,018	489	9,868.02
Cash			345.54
Total			27,106.47