This past week I have been running a few screens to look for (potentially) undervalued companies. Whilst there were few companies that met the holy trinity of low P/E, low P/S and low P/B metrics, it seems sensible to begin to relax these parameters given the reasonable valuation of UK indices. One company that I believe warranted more investigation was Avon Rubber PLC (LSE: AVON).
Avon Rubber was formed 132 years ago in Wiltshire, England. Within a few years they began manufacturing rubber products (most notably building a reputation for high quality tyres), leading to the production of twenty million gas masks for use during World War 2. Having diversified into (and subsequently out of) a number of products, they now focus on two core markets: Protection & Defence and Dairy. Revenues generated from these two areas are approximately 70%/30% respectively.
Avon Rubber operate in twelve sites globally, employ over 800 people and contain a number of subsidiaries:
AVON derive the majority of their revenues from the US, however they also have a significant market in Europe. There are smaller (but growing) operations in Asia-Pacific, the Middle East and South America.
As part of their Protection & Defence segment, AVON supply a range of products including masks, mask systems, protective hoods, storage tanks, rebreathers, fire equipment (including thermal imaging cameras), even hovercraft skirts. Their dairy segment supplies products to improve both farm management and improve efficiency through products designed to interact with farm animals. Part of their farm services model includes a monthly business rental arrangement which locks in recurring revenues. Fair to say they have a diversified portfolio of products.
AVON’s interim results were released last month, and suggest a continuing improvement in revenues and net income. Reasonable revenue growth, even at constant currency, of 6%, appears sustainable. The company have been able to improve gross margins in seven of the previous ten years, resulting in post-financial crisis improvements in net income in every year since 2010. This has led to a compound annual growth rate in net income of just below 25%.
The interim results appear positive and well placed to grow revenues further. One particular point stood out from their ‘Dairy’ segment. Recognising the potential in their ‘Farm Services’ model, they state:
The Farm Services model should lead to a more robust and sustainable business model with the potential to grow a significant recurring revenue
stream, which is less susceptible to a cyclical milk price.
“Significant recurring revenue” is a wonderful phrase, isn’t it? The groups overall objective is to generate
shareholder value through developing new products and serving global markets that can deliver long-term sustainable revenues at higher than average margins.
With a large proportion of revenues generated from the US, Avon Rubber could potentially be susceptible to a loss of income due to their sole-source contract with the US DoD, which represents around 38% of revenues. This ten-year contract is set to end in 2018, however I would like to think the likelihood of this partnership ending at that time would be less to do with AVON’s quality of product and more to do with preferences/funding on the part of the DoD. AVON remain one of two suppliers of mask filters for the organisation. Nevertheless, it remains a concern due to a large proportion of revenue being generated through the DoD contract. Avon Rubber have a more than century old reputation for designing and making quality products. AVON’s R&D budget equates to around 5-7% of income.
AVON have a decent balance sheet, with current assets more than covering current liabilities. This includes £15m in cash. There is no long term debt on the balance sheet, although AVON have borrowed in recent years to fund three acquisitions, which have all been integrated successfully. This debt has been promptly paid back. Whilst there is no long term debt, there are pension obligations amounting to around £40m. To mitigate these obligations the company has recently decided to double annual payments from £0.7m to £1.5m. This deficit has increased in recent years and will be necessary to keep an eye on. However at present this payment appears sustainable due to healthy free cash flow conversion.
AVON generate consistent free cash flow due to low capital expenditure costs, amounting to between £3m and £6m per year. This leaves the company able to, as mentioned, repay debt promptly as well as organically fund acquisitions. The company sees no need to expand out of their core businesses, but seek to make bolt-on acquisitions where it is deemed advantageous to do so.
As I said in the outset, AVON isn’t a screaming value play:
- Price/Earnings: 14
- PEG: 0.43
- Price/Sales: 2
- Price/Book: 7
- Price/Cash Flow: 10
- Yield: 0.9%
Whilst revenue has grown at around 5.8% annually for the past five years, previously mentioned improvements in margins have resulted in 5 year net income CAGR of just under 21%. I always like when the P/E is below this growth rate.
So now to look at a discount cash flow valuation. Here are the calculations:
- Free cash flow, whilst positive, has not been entirely consistent during the past ten years. Whilst free cash flow last year was £24m, I think it sensible to conservatively average out FCF and use a figure of £8m.
- As mentioned, five year net income has grown at 21%. Let’s assume this continues due to the company’s regimented approach to margin improvement.
- As I usually do, I assume growth slows to 3% after these five years to reflect an implied average inflation rate.
Based on this calculation this gives a potential intrinsic value of £8.55, against a current valuation of £10.38.
Not a particularly inspiring valuation, and certainly not one that would suggest a screaming buy. However, valuations are particularly susceptible to manipulation. If, for example, we took AVON’s increasing margins and reflected the substantial improvement in free cash flow over the past four years to give us an average FCF of £18.75m? This would give us an intrinsic value of £19.84. Now you’re talking.
I am always conscious of fiddling the numbers to suit the answer I want to get, however in this instance I think it reasonable to suggest there is some consistency building in AVON’s ability to generate higher levels of cash, due both to new acquisitions and improvements in their business model in recent years. So this therefore gives us a potential upper and lower valuation range: £8.55-£19.84. This equates to a possible downside of -17.6% and a possible upside of 91.1%. I believe a margin of safety to be built into the current share price.
I’d love to hear feedback, or any thoughts you have on this article. Contact me on Twitter @britishinvestor, or leave a comment below.