Interactive Investor

Stockwatch: is this FTSE 100 ethical stock a buy after 30% drop?  

10th October 2022 10:54

Edmond Jackson from interactive investor

They ended 2021 at a record high, but 2022 has not been kind to shares in this blue-chip firm developing life-saving technology. Here’s what analyst Edmond Jackson thinks about prospects for 2023.

How cyclical or defensive is Halma (LSE:HLMA)? Currently at around 2,150p, has this “infrastructure/health technology” stock mean-reverted to a long-term uptrend, or is there further downside risk?  

With a mantra of “making the planet safer, cleaner and healthier” it certainly meets ethical investment criteria. Water leaks are a current topical example in the UK, where Halma is involved in leak detection via sensors that let water companies know of problems – and priority pipes to mend. 

A Belgian subsidiary provides opening/closing doors to shops, car parks and offices; and a Swiss medical unit makes specialist devices to inject new lenses into the eye during cataract surgery. 

A total 43 businesses comprise this international group; its last annual report showing only 18% of group revenue as UK-derived – versus 39% from the US, 20% mainland Europe, 16% Asia Pacific, 4% Africa and Near/Middle East, and 3% rest-of-world. 

A 22 September update asserted “good progress in a challenging environment” with first-half numbers in line with board expectations. 

Like I have just recently explained regarding AstraZeneca (LSE:AZN), a chief reason for stock volatility is shifting expectations for interest rates that affect sentiment towards growth stocks. 

The all-time chart illustrates the context; where a de-rating from over 3,200p early this year to near 2,000p since last June, dropped the shares below the 200-day moving average. This does, however, look rational when you trace back to late 2018 and before.

It’s unclear quite whether Halma’s 2019 to end-2021 rally chiefly reflected ultra-loose monetary policy in response to Covid – when growth stocks were preferred. 

Is this rating justified for a FTSE 100 company? 

The six-year financial summary shows respectable performance with a modest improvement in the earnings per share (EPS) growth rate from 7% to 11% in the March 2020 year, advancing to over 16% in 2022. Yet the raw numbers barely justify price/earnings (PE) multiples as high as Halma has enjoyed. 

The stock currently trades on 30x consensus for EPS of around 72p in the March 2023 year, based on £273 million net profit, easing to 28x assuming EPS of 77p in 2024. It implies Halma’s very respectable operating margins being sustained at over 20%. 

Returns on total capital and equity have trended in high-teen percentages, and earnings are backed by a strong record of free cash flow.  

Halma - financial summary
Year-end 31 Mar201720182019202020212022
Turnover (£ million)9621,0761,2111,3381,3181,525
Operating margin (%)17.416.917.917.719.920.5
Operating profit (£m)167182217236263313
Net profit (£m)130154170184203244
Reported EPS (p)34.236.844.848.653.665.1
Normalised EPS (p)39.345.148.453.851.760.1
Earnings per share growth (%)21.414.87.411.0-3.816
Return on total capital (%)13.414.316.314.516.117.1
Operating cashflow/share (p)45.645.757.867.473.262.6
Capex/share (p)9.38.411.112.911.110.5
Free cashflow/share (p)36.337.346.754.562.152.1
Dividend per share (p)13.714.715.716.517.718.9
Covered by earnings (x)
Cash (£m)66.870.781.2106134157
Net debt (£m)196220182375256275
Net assets (£m)7798289811,1381,1671,403
Net assets/share (p)205218259300308371
Source: historic Company REFS and company accounts

Yet this is an £8 billion company, relatively challenged to sustain high growth rates.  

Perhaps few investors nowadays recall Rentokil’s situation decades ago, before it became Rentokil Initial (LSE:RTO)l, and how its chairman Sir Clive Thompson was known as “Mr 20%” for delivering such earnings growth annually.  

Yet the halo eventually slipped and, although this pest control and hygiene services stock has enjoyed a strong bull run in the latest decade, EPS growth has hardly been linear. From a 617p high nearly a year ago, this £9 billion stock has quite similarly de-rated in 2022 – from a near-30x forward PE to 23x.  

In due respect, Halma has sustained dividend increases of over 5% going back 26 years, even in respect of its March 2020 year when many other boards cut pay-outs amid Covid uncertainty. Yet even assuming consensus for a 20.6p dividend rising to 22.2p for the March 2024 year, the stock’s high price means its yield is barely 1%.  

Not to emphasise net assets, but they constitute just 17% of Halma’s market value.  

2008 crisis and its aftermath offers encouragement 

Halma’s record during the financial crisis in 2008 reinforces its defensive credentials. 

The March 2009 year saw EPS rise around 10% with no big difference between reported and adjusted figures. The dividend rose by 5% and revenue by 15%. Two acquisitions helped but were small not transformative. 

March 2010 then saw adjusted EPS again up 10% while reported earnings rose 14% and the dividend by 7%, despite revenue only 1% ahead. That second-half became testing, with “limited visibility due to different countries, sectors and products being at differing places in the economic cycle”. 

Yet after this modest admission of cyclicality, growth resumed such that March 2011 saw EPS numbers advance around 20% on revenue up 13% and the dividend up 7%.  

The stock has been far less volatile than most during macro stress. 

In mid-2007, it fell from 230p to 175p by March 2009, then rallied to over 350p by mid-2011. The eurozone debt crisis then caused only a modest easing to 335p. 

Mind how in 2009, Halma’s annual revenue was around £450 million compared with over £1.5 billion nowadays, hence it was easier to deliver growth metrics.  

How resistant to a higher interest rate environment? 

While Halma’s net debt reached £375 million in 2020 for gearing of 33%, more recently it has been around 20% - if generating only an £8.4 million net interest charge in the March 2022 year, shaving just 2.6% of operating profit.    

Higher rates should therefore not pose a problem for the company, but if they continue for longer, then growth stocks will find it harder to perform. 

Conversely, if central banks act to lower rates in due course, growth stocks will likely benefit. 

Change in CEO will be more significant at company level 

It is another parallel with AstraZeneca, where a highly-respected CEO is due to retire. Andrew Williams has delivered a fine record from 2005 when Halma made around £50 million profit on £300 million revenue.  

The growth does not simply reflect conglomerate-style acquisitions; collaboration between group companies has been fostered. 

Taking the helm next year will be the current CFO who joined in 2016 as group financial controller. An accounting background is logical to lead a modern industrial holding company with strategic focus. Financial controllers are sometimes criticised, however, for lacking imaginative flair – say if a group needs to adapt more radically than by making acquisitions, to grow. 

Buys US medical consumable devices operation 

Around £138 million equivalent is currently being spent on buying IZI Medical Products, a Maryland-based business which makes items for radiologists and surgeons with a return on sales “substantially” above Halma’s target range of 18-22%. 

Given around £30 million of revenue achieved in its financial year to March 2022, an implied price/sales multiple of 4.6x suggests this target does need to be making at least £10 million equivalent a year. It implies a purchase PE multiple of around 14x, assuming Halma’s definition of “return” is a fully net basis. 

Hopes for synergy are implied by “taking IZI to the next level, adding R&D, commercial and international growth opportunities...” 

Are you a confirmed value investor? 

According to the Occam’s Razor principle – “the simplest solutions are often the best” – you would default to valuation criteria and avoid this stock currently.  

Yes, the business’s history and prospects look sound. But if there is no going back to ultra-low interest rates, the stock remains pricy and its drop below a 200-day moving average is irrelevant. 

Buyers are still likely, however, for a perceived “safe haven industry” stock. Halma may also enjoy support on days when lower interest rates are mooted. 

I suspect it implies a choppy period ahead quite like Rentokil Initial’s chart over the last two years.    

If rated on 15-20x earnings, Halma would trade in a range more like 1,100p to 1,400p, still only offering a maximum 2% yield. 

On a value basis, the best I can say is: Hold. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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