Is Fenner plc Now A Clear Buy?

The downturns in coal, iron ore and oil have not done many favours for Fenner plc (LON:FENR), which specialises in reinforced polymer technology, and makes products such as the large, heavy duty conveyor belts used in coal mines.

Fenner also makes a range of other polymer products, including hoses, belts, rollers, seals and medical device components. I’ve watched the firm’s share price fall by more than 50% over the last year and have become interested, because as far as I can see, all of Fenner’s products are consumables.

This is significant because while growth might be slowing among some of Fenner’s key customers, they aren’t shutting up shop: the kind of components made by Fenner need regular replacement in order for expensive plant to remain operational.

What’s more, as Fenner is keen to point out, its products are relatively low value, when compared to the kinds of operational and capital expenditure faced by large industrial and commodity firms. This should give Fenner two key advantages, in my view:

• Customers will remain loyal as long as Fenner products maintain their market-leading qualities
• Customers will not be especially price sensitive (within reason)

What about the numbers?

I’ve explained above why I believe Fenner could be an attractive business in which to own shares — the question now is whether the price is right.

Valuation

Let’s take a look at Fenner’s valuation:

• PE10: 10
• 2014 P/E: 9
• 2015/16 forecast P/E: 10
• 2015/16 forecast yield: 5.85%
• Price/book ratio: 1.2

I’m a big fan of the PE10 (current price/10-year average earnings per share) as a tool for identifying stocks that are cheap based on historic average earnings, but that may currently be experiencing short-term problems.

In Fenner’s case, all three P/E measures are broadly equal, highlight the firm’s current out-of-favour status — but also its stability, in my view.

Quality and profitability

I’m satisfied that Fenner looks fairly cheap — the question now is whether it is cheap for a reason. The most likely reasons for this are a lack of growth prospects, and/or poor profit margins.

Growth is likely to be cyclical and also dependent on the firm continuing to innovate and offer products its customers need. That seems a reasonable assumption to me, given the firm’s 153-year track record, so what about profitability?

• 5-year average operating margin: 10.0%
• 2014 operating margin: 6.1%
• 5-year average return on capital employed (ROCE): 12.7%
• 2014 ROCE: 7.7%

It’s clear that Fenner’s profitability varies through the economic cycle. Fenner’s operating margin rose from a low of 3.4% in 2009 to a peak of 13% in 2012. In today’s market, I can live with the current 6.1% margin, given the potential for improvement as the effects of Fenner’s planned cost cutting take effect and/or the firm’s markets become more buoyant.

There’s also the question of debt. Fenner’s closing net debt last year was £117.3m, slightly lower than in 2013. That equates to net gearing of about 35%.

Interest payments were £14m last year, giving interest cover of 4.9 times net cash from operating activities, or more conventionally, 3.2 times operating profit. Both measures seem comfortable enough to me, especially as Fenner expects its cost-cutting  measures to reduce cash overheads by an annualised £9m over the next two years.

Fenner’s dividend may come under pressure, but earnings cover should be around 1.6 times this year, and a reduction in capex should mean that last year’s free cash flow cover can be maintained, protecting shareholders from a cut.

What’s the outlook?

I think Fenner’s performance over the next year or two is likely to be pretty subdued, but as I explained earlier, I don’t expect a wholesale collapse in sales or profits, due to the consumable and essential nature of the firm’s profits, and their wide and diverse installed base.

I’ve recently added some shares in Fenner to my portfolio, as over the next 3-5 years, I expect Fenner to deliver gradual earnings growth and benefit from a re-rating towards a P/E of around 12-13. Combined, these give me a tentative target price of between 250p and 300p.

In the meantime, I’m happy to collect Fenner’s 5.8% dividend yield and await further developments.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author owns shares in Fenner. Do your own research or seek qualified professional advice before making any investment decisions.