Spirax-Sarco (SPX:) How much should you pay for quality right now?

Spirax-Sarco (SPX) appeared on my SharePad Covid-19 ‘special’ bargain hunt:

https://knowledge.sharescope.co.uk/2020/04/08/screening-for-my-next-long-term-winner-a-covid-19-special/

" I will use Spirax-Sarco (14) as a brief example of the extra research we should all be undertaking right now.

Spirax is a FTSE 100 member that designs and manufactures what it describes as “ industrial and commercial steam systems ”, which apparently include “ condensate management controls and thermal energy management products ”…

Spirax states 85% of its revenue is generated from their customers’ annual maintenance and operational (opex) budgets. The group claims:

Capex budgets are more likely to be cut during periods of slower growth or recession. Therefore, the high proportion of revenue deriving from opex budgets gives us resilience during economic downturns.

What’s more, Spirax notes 50% of revenue is derived from “ defensive, less cyclical end markets ”, such as food and drink manufacturers, pharmaceutical groups and water utilities.

Significant levels of ongoing revenue alongside customers that are not at the forefront of the crisis seem a good combination to me at present.

The market seems to agree. The chart below shows Spirax’s trailing P/E remaining at an elevated 30x (green line, blue circle):"

image

SPX shares were then £78. Now they are £91. The other day they reached an all-time high of £96.

The AGM trading statement commendably gave an idea as to the impact of the pandemic:

“As a result of cost containment and efficiency improvement initiatives that have been put in place, we currently anticipate that the full year drop through of total revenue decline to operating profit in 2020 will be contained to around 45%.”

That reads to me operating profit could fall 45% this year. Bear in mind the "worst of the downturn" will occur in Q2 and Q3…

"While trading in the first four months of the year has held up well, we currently believe the worst of the downturn will occur in the second and third quarters of 2020. Absent a resurgence of the COVID-19 pandemic in the second half of the year, we currently expect trading conditions to improve in the last quarter of 2020, resulting in a lower contraction of organic sales in the second half of 2020 than in the first half. "

…suggesting Q2 and Q3 profit may fall more than 45%.

SPX’s 2019 results showed adjusted earnings of £2.66 per share. The trailing P/E is therefore 34x.

I know investors ought to ‘pay up’ for quality and SPX is a high margin, high ROE business with a good competitive position. I can also understand current shareholders holding on (it has paid to hold onto to ‘highly rated’ quality over time)…

…but why would anyone buy SPX now given the current rating and immediate outlook?

I look at City of London Investment (CLIG) for instance:

Sure, CLIG is a fund manager (with all the issues that brings) and not of the same ‘business quality’ of SPX. But CLIG’s yield is 9% and by my calculations – assuming the market does not undergo a severe, protracted downturn – the dividend is sustainable.

I wonder which investment will do better over the next 5 years. SPX or CLIG? My money is on CLIG (I own the shares!) at 315p versus SPX at £91.

Some quick maths:

For CLIG to return roughly 15% a year during 5 years, the 9% dividend has to be sustained and EPS grow 9% annually from its current lows (assuming the share price follows EPS higher – i.e. the P/E is maintained at c11x).

For SPX to return roughly 15% a year during 5 years, the 1% dividend has to be sustained and EPS grow 14% annually from their £2.66 per share level of 2019 – which could be difficult given profit is already set to drop 45% for 2020.

Any thoughts?

Maynard

Just looking at this for the first time also, although have been aware of the company for quite a long time, always imagining it to be rather expensive only for it to keep getting more expensive. This often happens to good companies of which SPX is definitely one.

Couple of top level concerns for me would be a simple comparison of P/E, Earnings Growth Rates and the PEG factor for each year.
Starting back to 2016 – the numbers read 24; 20 and 1.2 – all pretty healthy
2017 – 25; 29 and 0.9 - arguably even healthier
Jump to 2019 so we are avoiding Covid - The numbers are 33.5; 6 and 5.3 – rather it looks very much like the market has rerated the stock and the company growth has started to tail off. Revenue has continued to grow, but also at a slightly slower rate.
Jump to 2020 and assuming their argument that the substantial revenue is repeatable, it doesn’t stack up that they have a significant fall in revenue, and profits - so the numbers are now 44; -3 and -12.9

Ok the rating is exacerbated by a possible temporary business hiatus, but is it? – we won’t know until the end of 21 or possibly 2022.
I know this comment is some 10 months later, but I feel that the share price has every possibility to be rerated down to the 8XXX level compared to the current 11400 it sits at today.
I wouldn’t be a buyer of the stock at this stage.

The share price has been very stable during the pandemic, which says a lot about investor belief in this such a relatively strong company with probably a leading position in steam equipment.

Games

2 Likes

Just checking in on this topic one year after the original post:

SPX is now £121, up 33%, and CLIG is now 547p, up 74%.

I have to say SPX has performed well. In my original post the 2020 AGM update was implying profit falling 45%. Turns out adjusted EPS for the year was £2.56 per share, down just 3% on the £2.66 for 2019. Clearly SPX enjoyed a much stronger H2 than I had interpreted.

Twelve months on and the 2021 AGM update provided further news of better-than-expected trading:

“The Group operating profit margin in the first four months of the year was higher than previously anticipated for the full year 2021, supported by the strong sales growth and higher operational gearing.

We now anticipate Watson-Marlow’s organic growth in sales to the Pharmaceutical & Biotechnology sector will be over 55% in 2021 due to continuing strong COVID-19 related demand. This sector accounted for over 55% of Watson-Marlow’s sales in 2020. We anticipate the Group’s other revenue streams will deliver organic sales growth in 2021 above the increased forecast for global [industrial production] growth. Additionally, Electric Thermal Solutions ended 2020 with a higher than-normal order book, which should add at least a further £8 million to sales in the year.”

The Watson-Marlow division has proven to be a significant beneficiary of Covid, which probably explains the EPS resilience and share-price gain. Mind you, the EPS resilience and upbeat AGM outlook may be already priced into the £121 shares when they trade at 47x trailing 2020 earnings.

CLIG has performed well following a merger and a rising market boosting its funds under management. There has been no real re-rating though, with a P/E of 11x and yield of 7%-plus based on my latest sums:

So even from here, I would keep my money on CLIG outperforming SPX over the remaining four years. I guess the real question is how long will the market continue to pay lofty, 40x-type ratings for quality earnings from the likes of SPX?

Maynard