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We explain why a superb business may not be a good investment if the rating is too high
Thursday 06 Jul 2017 Author: Steven Frazer

Critics might argue that Porvair (PRV) is an old economy engineering business trading on a technology sector-inflated rating.

That’s a harsh way to describe the company and its share price, but it does pose some interesting questions for investors. These are three of the most important ones:

1. Are revenue and profit predictable?

2. What happens when the next economic shock comes?

3. Does a price to earnings (PE) multiple in excess of 28, and income yield of 0.8%, strike the right balance of risk and reward?

WHAT DOES THE COMPANY DO?

Porvair has its roots in engineering, putting its expertise into developing filters used in several highly regulated industrial markets.

The company splits into two separate divisions; Microfiltration and Metals Filtration. The latter provides filters used in aluminium casting and super alloy manufacturing.

Microfiltration filters are typically used in aviation fuel and cooling supply systems and energy industry gasification equipment (turning fossil fuel or biomass into gas). Laboratory analysis is involved in areas like testing for chemicals in water supply systems, for example.

Both sides of the business supply relatively inexpensive filters. Yet they are vital consumable components for the smooth running of some very expensive capital equipment, costing millions or billions of pounds.

For example, it would cost an aluminium smelting business millions of pounds in a shutdown. It would be a similarly expensive for an airline forced to ground planes because they do not have the right fuel system filters.

COMPETITIVE ADVANTAGE

Metals Filtration components are often patent protected, while Microfiltration defends its market position with bespoke filtration designs specific to customer and product requirements.

That makes it an expensive and long-winded process for an existing customer to go elsewhere because they would need an entirely new filter component designed.

under the bonnet chart

As such, Porvair enjoys lots of repeat business on long lifecycle kit. Finance director Chris Tyler reckons about 80% of annual revenue can recur the following year. That makes revenue relatively predictable year-on-year, although it doesn’t entirely discount an element of lumpiness in sales.

That is illustrated by a track record of solid, if unspectacular, growth. Revenue, pre-tax profit and earnings have growth consistently since 2008.

The Microfiltration arm even managed to sail unscathed through the fallout of the 2008/2009 financial crisis. Metals Filtration did not, falling to a £1.6m operating loss that forced some divisional cutbacks.

HOW MUCH DOES IT CURRENTLY MAKE?

Full year results to 30 November 2016 showed revenue up 14% to £109.4m, or 8% ahead on a constant currency basis. That led to a respectable 10% increase in pre-tax profit.

Half year results to 31 May 2017 chalked up £4.86m pre-tax profit on £55.5m of sales, up 9% and 7% respectively year-on-year.

Like many engineering component suppliers, Porvair’s operating profit margins remain relatively thin at 9.4%, although that is still significantly better than other industries.

It’s worth noting that Microfiltration operating margins are far better at 14.2%, although Metals Filtration’s 4.2% margin is currently being depressed by investment in new production facilities in China.

WHAT’S HAPPENING IN ASIA?

Chinese expansion is a big step for the company – the country is by far the world’s biggest aluminium producer, churning out 31m tonnes during 2016, according to the US Geological Survey. That’s nearly 10-times more than the next biggest, being Russia.

Key challenges are moving the Chinese industry from cost conscious quantity to quality, when better filtration will be needed and opportunities for Porvair will gather scale.

The company has clearly sensed this change coming although it may come in increments over several years. This is acting as a slight drag on near-term profit but the longer-term payback should make it worthwhile.

MANAGEMENT EXPERIENCE

Investors could hardly ask for more experienced hands to judge the balance between business investment and operating performance.

Chief executive Ben Stocks has been running the show since 1998 and remains the chief architect of strategy.

Backing him up are finance chief Tyler and non-executive chairman Charles Matthews, both with on the board for more than a decade.

PRV

Porvair is sometimes called a company built for bull and bear markets, capable of delivering steady returns in operating and financial performance, and paying more and more dividends.

In the teeth of business downturns it will get squeezed, but it appears well placed to manage those periods better than most.

Unfortunately Porvair is no longer flying under investment radars. In five years the share price has cut a path from 125p to the current 549p.

That’s a stunning 340% five-year return that has driven the PE from 12.6 to 28.4 times, the latter based on Peel Hunt’s 19.3p of earnings per share (EPS) for the year to 30 November 2018. A PE ratio of 28.4 is too high for such a business, in our view.

A likely 4.5p per share dividend implies a 0.8% income yield, low enough to be almost meaningless in valuation terms.

Porvair is clearly a class business, but we are hard pushed to justify such a premium rating given the reasonably pedestrian growth. 


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