Goodwin: All That Matters Now Is What Price To Pay

04 March 2015
By Maynard Paton

Today I’m continuing my hunt for Watch List shares with a look at Goodwin (GDWN).

Here are the initial attractions that prompted this research:

Illustrious financial history: Profits have surged 16-fold since 2000
Owner-orientated bosses: Family management boasts 53%/£107m shareholding
Interesting valuation: The shares are 32% off their high, leaving the trailing P/E at 11

As usual, I’m applying a question-and-answer template to help me pinpoint companies that match the criteria set out in How I Invest. I’m looking for as many Yes answers as possible.

Activity: Specialist engineer of industrial valves and alloy castings
Website: www.goodwin.co.uk
Share price: £28
Shares in issue: 7,200,000
Market capitalisation: £202m

Does the business boast a respectable track record?

Yes.

GDWN was established way back in 1883 and joined the stock market during the late 1950s. The chart below was extracted from GDWN’s 2014 annual report and shows an astonishing total-return performance for the last 20 years:

The 239-fold profit has been due to GDWN’s very impressive financial growth rates:

	2010 to 2014	2005 to 2014	2000 to 2014
Sales CAGR	5.4%	14.4%	11.6%
Pre-tax profit CAGR	12.9%	24.0%	20.3%
Dividend per share CAGR	8.8%	13.6%	19.5%

Setbacks during the last 15 years have occurred only in 2011 (operating profits down 37%) and 2000 (operating profits down 80%, dividend down 50%). Progress otherwise has been up and up.

Recent years have witnessed a buoyant performance, in part due to greater sales to the energy industry and a substantial margin uplift. The special dividend was a nice touch, too:

Year to 30 April	2010	2011	2012	2013	2014
Sales (£k)	92,996	92,908	107,911	126,964	130,828
Operating profit (£k)	14,044	8,860	13,085	21,156	24,541
Share of associate profit (£k)	226	342	393	273	314
Finance income (£k)	(959)	(1,054)	(1,205)	(1,133)	(760)
Pre-tax profit (£k)	13,311	8,148	12,273	20,296	24,095
Earnings per share (p)	118.15	50.89	124.83	211.76	264.38
Dividend per share (p)	27.78	29.17	32.08	35.29	42.35
Special dividend per share (p)	-	-	-	17.65	-

Something to note: Not a single exceptional item has been declared during the last 15 years!

Has the business grown mostly without acquisition?

Yes.

The last 15 years have seen total acquisition spend of just £7m.

Has the business mostly self-funded its growth?

Yes.

The latest balance sheet displays share capital of £0.7m versus earnings retained by the business of £77m.

Does the business possess an asset-strong balance sheet? 

Sort of.

GDWN generally operates with modest net debt — at the last count cash was £7m while borrowings were £22m. The loans do not seem problematic to me with 2014 profits at £25m.

The books also show land and buildings at £21m, which are carried at cost. Given the age of this business, I suspect the current market value of these sites could be substantially more than their accounting value.

Another major plus-point for this venerable operator is the absence of any defined-benefit pension obligations.

Does the business convert profits into free cash?

Not exactly.

Year to 30 April	2010	2011	2012	2013	2014
Operating profit (£k)	14,044	8,860	13,085	21,156	24,541
Depreciation and amortisation (£k)	3,288	3,352	3,809	3,530	4,118
Cash capital expenditure (£k)	(4,235)	(7,398)	(4,569)	(9,409)	(15,082)
Working-capital movement (£k)	(4,798)	(7,656)	(5,156)	(6,384)	5,988
Net debt (£k)	(674)	(9,338)	(11,667)	(13,595)	(3,643)

The last five years have witnessed some £41m of cash capital expenditure versus an aggregate £18m depreciation and amortisation charge. Furthermore, aggregate cash of £18m has been diverted into working-capital requirements. These are material sums when total operating profits for the period were £82m.

All told, it looks as if GDWN has converted about half of its operating profit into free cash since 2010. Generally that’s a poor conversion… unless it’s clear the reinvested money has been put to good use. Thankfully that’s the case at GDWN — profits have nearly doubled in the same time.

The 2014 annual report admits further significant cash investment will be required to support future growth. So I dare say GDWN’s payout ratio — the proportion of profits distributed as a dividend — will remain low at less than 25%.

Does the business enjoy a competitive advantage?

Possibly.

Margins at the larger Mechanical Engineering division reached an attractive 19% during 2013 and 2014. For what it is worth, GDWN claims this division is “world renowned for and the market leader in the design, manufacture and supply of Dual Plate Check Valves for use in the world`s hydrocarbon, energy and process industries”.

This text also caught my eye in the 2011 annual report: “R&D in Goodwin Steel Castings has resulted in a patent being granted to the company for its unique way of producing very large super nickel castings capable of operating at higher temperatures in advanced ultra super critical fossil fuelled power stations.”

And the 2014 annual report mentioned: “Our position as the leading global supplier of super nickel cast alloys…”

I also like the long-term view of the group’s R&D expenditure (from the 2012 annual report): “As a key performance indicator, R&D continues within all group companies whether it is to reduce manufacturing cost or develop new products that we consider there is a significant need for in the market over the next ten or more years.”

Does the business produce a respectable return on equity?

Yes.

Return on average equity for 2014 was £19m/£66m = 29% excluding non-controlling interests. Incredibly, the same calculation has topped 20% every year bar 2011 since 2005.

Does the business employ capable executives?

Yes.

John Goodwin and Richard Goodwin have served as executive chairman and managing director respectively since 1992, and have therefore overseen the outstanding track record above.

Succession plans seem to be in place, too, with three younger members of the Goodwin family also present as board executives.

Does the business employ good-value-for money executives?

Yes.

GDWN’s remuneration policy is worth reading (my bold):

“As will be seen below, the long term ongoing Total Shareholder Return on investment (TSR ) is more than acceptable, whether it be over five years, ten years or twenty years, but this has been achieved by the Directors and the Company taking long term policy decisions that at the time did not necessarily produce what a short term trader would have wanted in terms of annual profit and dividend. It is for this reason that Goodwin PLC has no desire to put excessive annual bonuses as a prime motivator to its Directors as this so often leads to undiscerning decisions being made that detrimentally affect the long term wealth of a company. Directors’ remuneration is designed to promote the long-term success of the Company.

In any company there are specific individual circumstances that on occasions will merit special treatment in a given year for a director either to keep or look after the person, indeed no different than we may do for an employee. In the matrix of remuneration for Directors you will note the Company has given itself flexibility to deal with specific circumstances which may not even be able to be made public for confidentiality reasons of which there are many. However, bearing in mind the performance of the Company over the past 20 years and more and that the Director salaries are anything but excessive versus the norm of other PLCs, this is the Board’s policy.

The Company has found over the years that this method of managing remuneration, which is principally monitored by the Managing Director and audited by the Chairman, has produced a team of cohesive Directors who have achieved results that surpass the average PLC performance, be it of the FTSE 100 or the FTSE 350, by a large margin. The unacceptable results over the past six years of many supposedly Blue Chip companies run with independent boards with very much incentivised executive directors is something that the Board of Goodwin PLC has no intention of emulating…”

Lovely stuff.

Both John and Richard Goodwin have seen their basic pay rise by an average of 8% a year since 2000 to £308k — which seems very fair to me given how pre-tax profits have surged to £25m. There have been no bonuses to speak of and minimal pension contributions as well.

Does the business employ owner-orientated executives?

Yes.

The Goodwin family still control at least 53% of the business — a shareholding presently worth at least £107m. The size of the stake has reduced only slightly I believe during the last decade or so.

I also like the lack of any option scheme and how the share count has remained static since at least 2000.

Does the business enjoy reasonable growth prospects?

Not in the short term.

Interim results issued during December showed sales up 3% and profits up 9%, but the group supplies the embattled oil and gas industry… and the chairman’s statement suggested the next 18 months could see lower profits:

“We have in the first half of this new year seen a continued fall off of activity in the oil and gas industry associated with lower oil barrel prices and the reduced investment by the major oil and gas companies. We started this new financial year with a record work load of £101 million, but this has steadily been decreasing as the order input fell behind our sales output. This decreasing workload will make it likely that the performance in the second half of this financial year and next year will not be as good as the first half of this financial year…”

“2015/16 Outlook
Whilst currently it is declining, we still have a good order book backlog in most of our companies. Time will tell whether we can find satisfactory levels of work to fill the gap temporarily caused by the slow down in the oil and gas industry which we think will be quieter for a couple of years.”

Looking further out, however, the board is more confident. Here’s an extract from the 2014 annual report:

“Whilst the energy mix is changing over the long term, it is considered that fossil fuels will likely remain the dominant energy resource in the future and hold 80% of the energy mix by 2035. Crude oil, natural gas (including shale gas) and coal we think will be evenly split in the energy market and it is unlikely by then that there will be any dominant energy form.

These sectors by definition have a long term future as the world population continues to grow and attain higher living standards, especially in the Pacific Basin. Over the past 50 years the world population has more than doubled from 3.2 billion to 7.3 billion people and in that same time the average energy consumption per person has also gone up by 50%. As the developing world continues to evolve, this average increase in energy consumption per person on the planet is unlikely to subside, so long term there will remain a significant demand for industrial products for the fossil fuel industries.”

Does the share price stand a good chance of becoming a bargain?

Possibly.

GDWN’s enterprise value at £28 a share is its £202m market cap less its cash of £7m plus its debt of £22m… that is, £217m or £30 a share.

Reported earnings for the year to October 2014 were 275p per share, which when interest costs are excluded come to about 282p.

The trailing P/E on my EV and EPS calculations is therefore £30/282p = 10.6.

That multiple does not look expensive to me.

However, profits are set to drop and the experienced management does not foresee any rebound for at least 18 months.

So I have three immediate worries:

• GDWN’s customers in the oil and gas industry stop spending for a protracted period of time (after all, the oil price has nearly halved);

• GDWN’s profits fall heavily, as the group’s recent (and significant) investments in plant, working capital and staff are under-utilised;

• GDWN’s bumper profits from 2013 and 2014 turn out to be ‘freak’ results, making the trailing P/E somewhat academic.

Looking at GDWN’s valuation another way, if I want to double my money during the next five years, I need the share price to reach £56 assuming the dividend is held at 42p per share.

A so-so P/E of 12.5 on that £56 indicates annual earnings would have to advance to 434p per share — up 10% a year on average from the last reported 275p. Such a recovery is possible of course, but positive progress will be back-end loaded during my five-year horizon.

Is it worth watching Goodwin?

Yes.

GDWN’s offers lots of positives for me — the track record is superb, the managers are top-notch and the reported returns on equity are wonderful.

All that matters now I reckon is determining a great entry price. £28 feels reasonable, but I don’t get the feeling it is an obvious bargain. For now, I think it might pay to await a lower price and/or see just far profits do drop. In the meantime, I’ll do more sums.

Maynard Paton

Disclosure: Maynard does not own shares in Goodwin.