Quality at a reasonable price?

The title refers to a stock which has featured in the Compound Income Scores portfolio since its inception in April 2015. At the time it was one of those quality income growth stocks which was trading relatively expensively and only just passed the valuation caps that I apply when selecting stocks for the portfolio. Therefore it only just made it into the portfolio and I had not bought any myself as a result.

Since then however (like Diploma which I looked at recently)  it has drifted off by around 25% and as a result it is starting to look more reasonably priced for the qualities it offers. In addition its Score has now improved all the way to 100 as it scores pretty well across the board. It also scores reasonably well on Stockopedia with rank of 83 & passes 7 of their guru screens too.

As a result of the price move it does not have much price momentum being roughly flat on 12 months and it currently looks oversold. So with all that in mind I think it is time to take a closer look and see how this one measures up.

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The chart shows the fall in the share price of Renishaw (RSW) a £1.3bn market cap. company, which I was talking about. I note that they are now some way below the 200 day moving average, close to being oversold on the RSI and there is a big gap just below 1800p begging to be filled. However, it is worth putting some longer term context on the share price which I'll come back to later after exploring the briefly what they do and the fundamentals next.

About
Renishaw describes itself at its investor relations website (see name link above) as:
"A world leading metrology company. With our highly experienced team, we are confidently driving our future growth through innovative and patented products and processes, efficient, high-quality manufacturing and the ability to provide local support in our expanding global markets."

It is well worth visiting their site to learn more about what they do and how they do it to gain a better understanding of the business and how they generate the returns they do. They also have a good overview  presentation explaining the business and looking at their history which you can download via this link if you want.

Quality
Renishaw scores very well on Quality metrics that I use in the Compound Income Scores. This is because it has had an operating margin in the mid to high 20's in each of the last five years and a return on capital employed (ROCE) of the same magnitude over the same period. Thus it scores 95 on the CIS operating quality measure which looks at the above metrics and 98 on the Stockopedia quality measure which takes in a broader range of statistics.

Valuation
So the quality seems good, what about the price - is that reasonable now? This is where it gets a bit tricky and also where I will come back to the longer term context. On the historic earnings it trades on a very reasonable looking 11x or so which seems like a bargain for such a quality stock and is towards the low end of its recent range. However, this reflects what was a bumper year with exceptional orders coming in from the Far East region. Thus this years earnings based on their current guidance and analysts consensus are currently expected to fall back to by around a third to 111.6p which may leave it on around 16x for the year to June 2016 at the current price of around 1850p.

This reflects the limited visibility in their order book and the high operational gearing inherent in their high margins. Thus the share have been prone to these kind of price and earnings set backs in the past in 2008/9 & 2012/13 for example which have followed periods of strong growth. Orders have then stalled as they have continued to invest in new products before these have then led to another step up in sales as we saw last year. This has led to the share price being quite volatile over the years, although it has kept up with the Mid 250 along the way and out performed the broader market. It does however underline the importance of not chasing it and perhaps waiting for opportunities when it has sold off and underperformed as it has recently.

Hopefully that makes some sense and puts it in context. Otherwise they are expected to pay an increased (+5%)  dividend of around 49p which is still expected to be over 2x covered and would offer a lowish 2.6% yield. It is also backed up by good cash flow and cash on the balance sheet of around £66m. Meanwhile the other value metric I look at, the earnings yield, seems to be at a very attractive 10 to 11% assuming they manage to at least maintain their margins from last year. The other interesting aspect on the earnings yield is the fact that all the operating profit is currently made by the metrology business (£150.7m last year) while the smaller healthcare business made an increased (£6.8m v £4m) loss last year although the company say they remain focused on moving this business into profit. So just getting that to break even could boost profits by around 5%.

Neither of those (maintained margins or losses in healthcare being eliminated) are by any means guaranteed though as on the outlook, they did say in their last trading update in October 2015, that the Group's cost base has grown, reflecting targeted investment opportunities in research and development programmes to accelerate the time to market for new products. Additionally there is significant investment in expanding their international marketing activities to support the introduction of new products planned for this year.

Having said that though they did indicate that revenues were only down around 3% whereas they are still guiding for a bigger fall at the full year stage to a range of £440m to £465m maybe because the large orders from last year annualize later in the year or perhaps they are trying to manage expectations - I guess time will tell on that. Meanwhile they also provided Pre tax profits guidance of £85 to £105m with the analysts earnings estimates of 111.6p coming from this seeming to confirm expectation of a bit of a squeeze on margins.

The other concern on the outlook for this one is probably the on going slow down in China and related problems in emerging markets. Since they had such a bumper time in that region last year, perhaps the hang over this year could be worse than expected? Again time will tell but we shouldn't have too long to wait as they issued a trading update in early January this year. I note s similar quality capital equipment supplier (albeit in different technologies) Spirax Sarco produced an in line update recently and also alluded to a recent pick up in the Far East from a slow first half, but still down year on year.

Management & Major Shareholders
A slightly unusual feature here, for such a relatively large company, is that is is effectively controlled by two directors and their families. These are the Chairman & Chief Executive (also rare these days to have someone doing both jobs) Sir David R McMurtry CBE, RDI, FRS, FREng, CEng, FIMechE who owns a bit over 26m shares or around 36% of the company.. While the deputy chairman John Deer and his wife hold a further 17%.

Otherwise there are just 4 institutional investors with declarable stakes who each hold around 5% namely, Baillie Gifford, Standard Life, Black Rock and The Capital Group so probably only around 32% readily available unless any of the above decide to sell down, which I guess might help to account for the volatile share price. It also means a bid is unlikely unless the senior directors want to sell out and or retire, although the board have all been around for a while so presumably they will have some succession planning.

Summary & Conclusion
As this has already turned into a longer and more messy post than I had hoped I'll bring it to a close and try and sum it up in a few words, alright a lot of words. This one appears to be a high quality operation on the back of plenty of investment in R & D and manufacturing capacity to serve customers around the world with patented and innovative products & processes. It does however lack visibility in its orders and this can lead to their profits and shares being volatile in both directions, although over time they seem to deliver decent profits, earnings and dividend and therefore good shareholder returns.

Thus is has in the past, paid to take advantage of these swings and buy in after a fall in the classic buy low and sell high fashion. However, given the characteristics of this one it is doubtful if you will ever get it that low in price and rating terms, unless we get into another global recession in which case they might be more vulnerable as we saw in 2009 when their profits fell heavily and they saw fit to cut the dividend (see chart below: (Source Renishaw Website). To be fair to them though that was a pretty exceptional period of

time and they have gone onto restore the dividend to well beyond it previous peak prior to that. Indeed if you calculate the growth rate over the 10 years shown here it equates to compound growth of 8.8% per annum and I note the last 5 years have seen over 20% growth per annum.

So in conclusion there is again a lot to like here for the long term given the financial metrics, patent protected products and their on going investment in R&D, manufacturing facilities and support operations. Meanwhile the rating has come back to a more reasonable level with the PE at around 16 or 15 if you adjust for the cash based on this years current forecasts and you at least get a modest 2.6% yield too which, if the past is any guide, we would expect to grow. The earnings yield which may be around 10% is also very attractive and suggest some upside potential.

Looking at the 10 year chart below it looks as though they could be approaching the bottom end of a trend line / channel if you drew one of these from the 2009 low. However I note that there appears to have been more support at around 1600p in recent years. Thus this may be a good opportunity to acquire some or if not then I would suggest it is at least worth watching to see if it does get down to 1800p or less - which is not that far away.

If you are more cautious it may also be worth waiting for the January update just in case that disappoints on the back on Chinese / emerging market problems, although equally, as we saw with Diploma, if it reassures or raises guidance then we could then see the shares rally. As ever - time will tell and you pay your money and take your choice or not as the case may be and don't forget to do your own research too!