With a UK slowdown looming, our companies analyst assesses the pros and cons of this cheap, well-run company.
The tactical question of whether to buy a ‘value’ style small-cap stock in the face of UK growth slowing is exemplified by Epwin (LSE:EPWN), a £125 million manufacturer of low-maintenance building products.
In line with such stocks derating generally since last September, its price had fallen from near 120p to 85p by 1 April, and despite robust 2021 results last Wednesday it has managed to claw back only to 88p.
This is despite a likely 2022 price/earnings (PE) ratio below10x, the free cash flow multiple possibly as low as 4x, and a 5% yield.
Not helping the macro view was the fact that construction and house-building stocks eased yesterday as investors fear that soaring house prices and rising mortgage rates will temper first-time buyers, who are fundamental to housing market health.
Refurbishments may also suffer from lower consumer discretionary spending, compared with so many home improvements after lockdowns, when people had money to spare from not eating out or travelling.
Strong trading and a highly cash-generative business model
Yet Epwin’s current trading is in line with the board’s expectations, with like-for-like revenue ahead of last year. Strong demand is expected to continue in 2022, albeit at a slower growth rate than last year.
PVC decking products and aluminium window systems continue to see growth ahead of expectations, aided by the delayed launch (due to lockdowns) of the new Stellar window system.
If this rosy outlook succumbs in due course, it would affirm market efficiency: cyclical stocks fall ahead of evidence of slowdown, and also soar at the depths of recession in anticipation of economic recovery.
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Yet Epwin is no regular small cap cyclical. It is distinguished by very strong cash flow: the table shows how free cash flow per share has been around twice earnings per share, and in 2021 was 2.3x.
Last year saw 189% conversion of operating profit to cash, enabling £35 million of operating cash inflow versus £24 million in 2020. The 2021 dividend was covered 4.8x by free cash flow.
Apart from 2020, when lockdowns compromised the building sector, this has enabled a strong record of payouts, such that consensus for 4.3p a share in respect of 2022 implies a yield around 5%.
Potential attractions to private equity
A strong cash flow profile lends scope for management to collaborate with private equity to buy the group if a modest valuation persists. Also in support is Epwin’s circa 20% market share in key products.
There have been steady acquisitions of privately held building materials companies; indeed, Brickability Group (LSE:BRCK) was subject to a 2016 management buyout funded by Promethean Investments, before its mid-2019 flotation.
As we see in the potential bid approaches currently for Ted Baker (LSE:TED) consumer fashion, private equity does not necessarily fret about timing relative to the business cycle. If a company is essentially attractive, then private equity will exploit a modest valuation.
I am not predicting this to happen for Epwin; but if it did in say the next two years, there would be customary grumbling among commentators that the UK stock market fails to rate businesses properly, thereby working to acquirers’ advantage.
In which case, the likes of Epwin could be said to rate a ‘hold’ and potentially a ‘buy’ in the sense of averaging steadily in.
Contrasting stories around construction-related stocks
Bullish: a purchasing managers’ survey two days ago cited orders rising at the fastest pace in seven months, with robust hiring of workers. The UK has a shortage of housing stock; moreover, people are in the habit of refurbishing/developing homes to add value. Epwin also supplies social housing development, which is likely less cyclical.
Bearish: sharp input price rises have led to fears that projects will scale back later this year. The Bank of England has lost control of its 2% inflation target: as the real rate creeps towards a 40-year high of 10%, interest rates will keep rising even if this causes recession. Yet the expectation of a 2% Bank Rate by the end of this year is modest in the long-term context, and existing home-owners are substantially in long-term fixed mortgages.
Looking back on Epwin’s chart, the second half of 2017 saw the stock derated from 125p to about 70p after management cited the negative impact of cost input inflation, and also disruption from two customers jointly accounting for about 10% of revenue. Altogether, this seems quite a modest hit – the table shows only a low single per cent hit to 2018 revenue and operating profit –yet net profit nearly halved. It also took until later 2019 for the stock to break out of this lower trading range.
So, if pain does lie ahead for building activity, the market is justified in exacting a 5% yield by way of current pricing. Among house-building stocks, Taylor Wimpey (LSE:TW.) has been in a steady downtrend for nearly a year, and has now reached net tangible asset value. If you trust forecasts, it yields over 8% on a sub-7x PE. Persimmon trades at twice NTAV but yields a whopping 11% on a sub-9x PE.
That suggests market pricing distrusts forecasts, especially looking further out into 2023.
It would seem a few months are needed to reveal the economic reality behind the fears, in order for sentiment to change.
Epwin Group - financial summary
Year end 31 Dec
|Turnover (£ million)||256||293||293||281.0||282||241||330|
|Operating margin (%)||7.5||8.2||5.2||5.3||6.1||2.6||12.5|
|Operating profit (£m)||19.1||24.0||15.1||14.8||17.2||6.3||17.7|
|Net profit (£m)||15.3||19.6||10.1||5.8||10.7||2.6||5.4|
|Reported earnings/share (p)||11.2||13.8||8.1||7.5||7.5||1.8||8.5|
|Normalised earnings/share (p)||11.6||13.9||12.6||8.9||9.6||4.5||8.6|
|Operating cashflow/share (p)||15.8||19.0||12.1||16.2||22.0||16.0||23.4|
|Capital expenditure/share (p)||6.6||8.9||5.0||8.7||6.0||5.6||3.8|
|Free cashflow/share (p)||9.2||10.0||7.1||7.5||16.0||10.4||19.6|
|Covered by earnings (x)||1.8||2.1||1.2||1.5||4.3||1.8||2.1|
|Return on capital (%)||17.1||21.4||13.8||12.5||9.2||3.4||9.4|
|Net Debt (£m)||14.4||20.6||25.1||24.8||86.1||99.3||86.9|
|Net assets per share (p)||56.6||64.2||65.6||63.0||62.1||61.8||67.8|
Source: historic company REFS and company accounts
Net profit benefits from a low tax charge
Epwin’s 2021 results reflect a well-managed business, which reinforces my sense that someone could take advantage of a low stock price to buy it out, if interest rates remain sufficiently low.
Capacity has been expanded by way of acquiring three regional distributors of plastic building products; and construction is complete on a new distribution and finishing facility at Telford. Thirteen trade counters have been added in northern England, southern Scotland and Norfolk.
In underlying terms, the operating margin has risen from 3.9% to 5.6% ,although it was 7.5% in 2019. At the reported level, this is not quite as good as Brickability’s margin that reached 8-9% in its March 2019/20 financial years, however.
Price increases and surcharges are being implemented to mitigate inflationary pressure on material and labour costs. PVC resin has been especially affected, so there are efforts to increase the use of recycled resin. Some time lag is involved, however, and the full margin impact has not yet been recovered. Wage inflation is not quantified beyond “increasing market pay rates”.
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Recent consensus for Epwin achieving low single-digit earnings per share (EPS) growth this year and next seems a fair compromise, though it is still a guess amid the uncertainties.
Even so, cash generation has enabled net debt to halve to near £9 million, which should benefit profit, given that £4.8 million of finance costs took 27% of last year’s operating profit. There is also over £65 million in headroom on banking facilities – useful for taking advantage of “a healthy pipeline of potential takeovers”.
EPS does benefit from a low tax charge of just £400,000 relative to £12.9 million pre-tax profit, although note six to the accounts justifies this. Applying a regular 19% tax charge means adjusted normalised EPS of 7.7p relative to 8.6p published, which would nonetheless be better than recent consensus for 7.4p. The full-tax 2021 PE multiple is 11.4x.
The precise stance on Epwin therefore depends significantly on your macro view and approach to risk. There is a risk of medium-term downside; however, the stock already merits attention to consider averaging into over the longer run. Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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