This company thrived during bull runs after both the financial crisis and Covid crash. Analyst Edmond Jackson thinks this could be a great time to buy before markets turn higher again.
Is it time to buy good-quality, small cap cyclical stocks hit by recession fears? Such is the question posed by decent results from equipment rental group Vp (LSE:VP.).
It would seem that Vp is the epitome of value investing; buying into a well-established business, strongly positioned, when market sentiment is against its stock.
Founded in 1954 and floated in 1973, this £270 million company has just posted resilient annual results – hiring specialist equipment to the construction, housebuilding and oil & gas industries. Figures for the year to end-March 2023 have moderately beaten expectations: revenue rose 6% to £372 million, helping adjusted earnings per share (EPS) grow 11% to 79p and the total dividend by 4% to 37.5p. Average return on capital employed is proclaimed at 14.4%, although my estimation is nearer 6% including leases; and the best figure in recent years was 13.2% in 2017 (see table).
Mind that statutory EPS is a third lower at 58p after £4.5 million amortisation (fair enough) and £5.0 million of exceptional charges – said to be restructuring costs, but you could say are part of normal adaptations to stay competitive.
The outlook statement cites stable markets in the current financial year, if respecting forecasts that housebuilding will see “a moderate contraction in 2023 before recovering in 2024.” More positively, infrastructure “will recover to modest growth after a flat 2022” - driven by rail, water, the Hinkley Point nuclear power station and offshore wind. Non-residential construction is also expected to see modest improvement and repair/maintenance be stable. So rather than a tale of two sides, Vp says its overall outlook “remains positive”.
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The outcome for March 2023 means Vp only needs to have a broadly flat year for (pre-results) consensus of 80p EPS and a 40p dividend to be achieved – on which basis and with the stock currently 670p, implies a price/earnings (PE) multiple around eight and a yield of 6%.
I do, however, recall how the 1991 recession pulled the rug from under hire companies – especially those serving construction, although it was a fierce downturn back then.
Whether value truly exists therefore significantly depends on the UK’s economic trajectory, where Vp derives 90% of its revenue. Sceptics fret that policy is now cornered because stubborn inflation now means interest rates cannot be cut, like has been the practice in past years when the economy has started to weaken. Yet investors have started to glean encouragement from, for example, the International Monetary Fund flipping its forecast – such that the UK will not experience recession. It now expects 0.4% growth in 2023 instead of a 0.3% contraction predicted as recently as April.
Stock rises nearly 4% on better-than-expected results
It is also interesting to see Vp’s international side doing well: annual adjusted operating profit more than doubled to £3.1 million on revenue 24% ahead at £38 million. But this seems more a function of serving renewable energy industries, decommissioning oil & gas operations and cleaning energy infrastructure; industries experiencing growth, rather than exposure to more dynamic economies.
I also pick up on stable £60 million capital investment in the rental fleet “as we responded to specific investment opportunities and our continued transition to more environmentally friendly solutions.” Mind, the table shows capital expenditure absorbing the lion’s share of operating cash flow, such that 2017 and 2018 saw negative free cash flow.
This is relevant to the dividend, where I do not necessarily see twice earnings cover as reassuring. If profits and cash flow fell in a downturn, then the dividend could need swiftly cutting if capex was essential to stay competitive.
Vp - financial summary
|Year-end 31 Mar||2017||2018||2019||2020||2021||2022||2023|
|Turnover (£ million)||249||304||383||363||308||351||372|
|Operating margin (%)||13.4||11.3||10.0||10.3||1.8||12.3||10.6|
|Operating profit (£m)||33.2||34.2||38.3||37.2||5.5||43.0||39.3|
|Net profit (£m)||23.7||24.4||25.8||18.6||-4.6||25.5||23.0|
|EPS - reported (p)||58.6||61.0||63.7||46.2||-11.6||64.5||57.8|
|EPS - normalised (p)||47.4||52.2||66.9||48.6||-1.0||71.2||79.0|
|Operating cashflow/share (p)||155||158||197||211||265||194||200|
|Capital expenditure/share (p)||160||179||184||136||118||173||157|
|Free cashflow/share (p)||-5.0||-21.0||13.0||75.0||147||20.3||43.0|
|Dividends per share (p)||22.0||26.0||30.2||30.5||25.0||36.0||37.5|
|Covered by earnings (x)||2.7||2.3||2.1||1.5||-0.5||1.8||1.5|
|Return on total capital (%)||13.2||9.8||10.7||9.1||2.0||11.6||6.1|
|Net debt (£m)||98.9||179||168||232||183||188||193|
|Net assets (£m)||137||154||169||170||153||167||175|
|Net assets per share (p)||342||385||421||423||381||415||481|
Source: historic company REFS and company accounts
At end-March there was £146 million financial debt, all long-term, and a total £59 million lease liabilities, versus £11 million cash. This is in context of £175 million net assets (of which 33% constitute intangibles) hence net gearing of 77% excluding leases.
The £8.7 million net interest charge was covered 4.6 times by operating profit.
While this level of debt will not help in a slowdown, hire companies do tend to be geared otherwise they would have to substantially own more of their hire fleets.
Comparing financial liabilities against fixed assets can give a sense as to what extent a hire company owns its fleet. But within £59 million leases, it is tricky to know what extent this may relate to equipment or premises, perhaps. Financial debt could also be used to buy equipment for ownership. Anyway, if say you assume leases relate mainly to premises, then £135 million net debt is 54% of £252 million, property/plant equipment – which accords with “around half” the hire fleet being debt-financed, which is fair practice. I concede this is quite muddled an assumption given premises are within that fixed assets number.
Management says both gearing and interest cover are well within covenants. I see it as a potential plus, how a new chief financial officer joined at the start of this year, given a fresh approach may help. She has arrived from the same role at vehicle dealership Lookers LOOK.
72-year-old chair and majority owner likely to negotiate sound exit
While a “controlled” company can involve risks such as de-listing or an egregious remuneration scheme, at Vp Jeremy Pilkington looks to be trying to “do the right thing”.
At end-April 2022, he expressed desire to explore opportunities to sell his 50.2% stake, hence the board launched a formal sale process. This was intended to find the “right” owner who would respect Vp’s heritage, but by mid-August and despite “a pleasing level of interest shown” it did not identify a suitable new owner.
While this is all very responsible capitalism, it meant £1.7 million aborted sale costs within £5.0 million of exceptional charges.
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That saw the stock drop from 870p to 770p, perhaps in a sense not only was the prospect of a bid premium dashed, but also another operator was not ultimately motivated to integrate Vp’s operations with theirs.
The outcome seemed quite too gentlemanly, whereas if Vp was a truly attractive business on the block, you might even have expected an offer to shareholders – over the heads of directors. Perhaps the timing was not best, as companies avoid big moves in an uncertain outlook.
Yet Pilkington will ultimately need to exit, hence Vp could be regarded as a patient tuck-away where, unless the economy turns down, you are locking into a 6% yield able to grow. A recession could also flush genuine takeover interest.
While this does not constitute a margin of safety, it offers a comfort factor for holding Vp through uncertainty.
Trust the chart and valuation benchmark?
Vp’s circa 8x PE and 6% yield combine with a chart that has reverted to an October 2020 low, just before the appearance of Covid vaccines triggered a bull run in equities. Otherwise, you would have to go back to end-2014 to see these prices.
It superficially implies “buy” unless the UK faces chronic stagflation leading to a stagflationary debt crisis which would hit construction-related activity.
Such fears are why a modest valuation exists at all; but if a worst-case scenario factors in say only a 20% probability of that situation occurring, then a case exists to start averaging in.
You therefore need to take a view on the economy. Overall, I rate: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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