Goodwin: I’ve Decided To Keep Watch Despite The High Debt And New LTIP

15 March 2017
By Maynard Paton

Today I’m continuing my hunt for Watch List shares by revisiting Goodwin (GDWN). I first looked at this company during March 2015.

Here are the attractions that prompted this revisit:

* Resilient long-term dividend: The payout was last reduced in 2000 and has since increased 28-fold

* Owner-orientated executives: Veteran family management control a 53%/£69m shareholding

* Opportunity for recovery: Significantly reduced earnings have caused the shares to fall 50% during the last three years

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 manufacturer of industrial valves, slurry pumps and casting plasters
Website: www.goodwin.co.uk
Share price: £18
Shares in issue: 7,200,000
Market capitalisation: £130m

Does the business boast a respectable track record?

Yes.

GDWN was essentially created during 1883 when Ralph Goodwin and his sons established an iron foundry near Stoke. They supplied castings to local pottery, mining and steel businesses.

The company has since evolved to become a prominent designer and manufacturer of check valves for the oil, gas and water industries. The group’s operations also offer heavy-duty machining and fabrication services, alongside the supply of slurry pumps for miners and casting powders for jewellery manufacturers.

GDWN joined the stock market during the late 1950s and although the company’s flotation document has probably disappeared forever, Companies House amazingly carries annual reports all the way back to 1973.

The archives show that revenue was £2m, profit before tax was £204k and the dividend cost £50k during 1972. By 2016, revenue had reached £124m to take pre-tax profit to £12m. The annual dividend now costs £3m.

GDWN boasts an impressive compound average growth rate on a 15- and 20-year basis. However, the group’s progress has moderated during more recent times:

	2011 to 2016	2006 to 2016	2001 to 2016	1996 to 2016
Revenue CAGR	5.9%	7.8%	11.3%	8.8%
Operating profit CAGR	7.5%	8.7%	13.6%	9.1%
Dividend per share CAGR	7.7%	10.7%	16.7%	14.3%

Indeed, GDWN’s five-year growth rates are somewhat flattered because 2011 was a bad year for the group. Back then, revenue stalled at £92m and caused operating profit to drop from £14m to £9m.

All told, the last five years have witnessed strong growth followed by a sizeable downturn due to difficulties in the oil, gas and mining industries:

Year to 30 April	2012	2013	2014	2015	2016
Revenue (£k)	107,911	126,964	130,828	127,049	123,539
Operating profit (£k)	13,085	21,156	24,541	20,447	12,748
Share of associate profit (£k)	393	273	314	288	341
Finance income (£k)	(1,205)	(1,133)	(760)	(682)	(775)
Pre-tax profit (£k)	12,273	20,296	24,095	20,053	12,314
Earnings per share (p)	124.83	211.76	264.38	208.68	122.75
Dividend per share (p)	32.08	35.29	42.35	42.35	42.35
Special dividend per share (p)	-	17.65	-	-	-

It is worth noting that the 2016 operating profit of £13m is lower than that recorded for 2009 and 2010.

As the table above shows, profit setbacks occurred during 2015 and 2016, and it is not unknown for GDWN to suffer lower earnings for several years. The period 1996 to 2000 saw operating profit reduce every year.

At least GDWN’s dividend has never been cut since 2000, and has subsequently ballooned a magnificent 28-fold. The income statement has been free of exceptional items, too.

Has the business grown mostly without acquisition?

Yes.

The last 20 years have seen GDWN spend only £12m on various purchases. In comparison, aggregate earnings produced during the same time have come to £115m.

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 £88m.

Does the business possess an asset-strong balance sheet? 

Not any longer.

I noted two years ago that GDWN had operated “with modest net debt”. Back then, cash was £7m while borrowings were £22m. At the time I concluded “the loans do not seem problematic to me with 2014 profit at £25m”.

Since then, GDWN’s profit has dropped while net debt has increased.

In fact, net debt has swelled to £37m — which is almost three times the level of annual operating profit. (During the last two years alone, in excess of £30m has been spent on plant, property, equipment and various intangibles — more on that later.)

My rule-of-thumb with debt is to be very wary of companies that operate with net borrowings greater than their annual operating profit (that way I minimise the chance of suffering a balance-sheet failure). So from this perspective at least, I have to treat Goodwin with some caution.

For its part, GDWN reckons the debt situation may ease before its next annual results. The following text is extracted from December’s interim statement (my bold):

“The Group cash flow has deteriorated since the start of the new financial year. It is not unusual for the Group to see a deteriorating cash flow picture in the first half of the financial year due to the impact of dividend payments, working capital movements and our capital expenditure programmes.

Whilst the reduced level of capital expenditure, as referred to within the Chairman’s Statement, has been helpful for cash flow in the first half of this financial year, the impact has been offset by the currency effects of Brexit and associated timing issues related to our foreign exchange hedge trades.

The Group’s bank facilities have coped and are coping well with these temporary timing issues. We expect the position to reverse in the second half of the financial year as we rebalance our positions with customer currency inflows.”

On the plus side, GDWN’s books carry land and buildings at cost at £26m. The annual-report small-print implies the sites could be worth an additional £10m-plus.

I’m particularly glad this venerable operator is not burdened with any defined-benefit pension obligations.

Does the business convert profit into free cash?

Not really.

Year to 30 April	2012	2013	2014	2015	2016
Operating profit (£k)	13,085	21,156	24,541	20,447	12,748
Depreciation and amortisation (£k)	3,809	3,530	4,118	5,262	5,331
Net capital expenditure (£k)	(4,396)	(9,000)	(15,036)	(18,105)	(12,488)
Working-capital movement (£k)	(5,156)	(6,384)	5,988	(2,277)	(4,115)
Net debt (£k)	(11,667)	(13,595)	(3,643)	(9,694)	(22,058)

The past five years have witnessed some £59m spent on tangible and intangible assets, versus £22m expensed through the income statement as depreciation and amortisation.

The £37m ‘excess’ is partly explained by £13m spent on land and buildings, with the remaining £24m used to buy plant, equipment and sundry intangibles.

Similarly, working-capital movements have absorbed notable levels of cash. Some £12m has been absorbed into stocks, debtors and creditors since 2012.

The excess £37m of capital expenditure and the extra £12m working-capital funding has helped generate a further £31m (33%) of annual revenue, but not much in the way of additional profit.

As such, it is unclear whether GDWN’s substantial reinvestment into the business has really paid off so far.

What is clear, however, is that GDWN is not one of those companies that can grow at pace while drowning shareholders with surplus cash. The proportion of earnings paid as an ordinary dividend during the last five years has averaged just 21%.

Does the business enjoy a competitive advantage?

Probably.

During the last ten years, GDWN’s operating margin has bobbed between 10% and 19% and has averaged about 15%. Pricing power with customers would therefore appear quite reasonable but not truly spectacular.

GDWN’s 2016 annual report cites the group’s “global reputation for engineering excellence, quality, efficiency, reliability, price and delivery” for helping to differentiate the business from its rivals.

The annual reports frequently cite patents, and the 2015 edition provided a useful insight into various product developments:

“The strategy of creating value for shareholders through emphasis on sustainability and continually introducing new innovative reliable cost effective engineered products needed by growth markets is demonstrated in that in the last two financial years the Company has registered / applied for five patents in 16 countries. 

This is the highest number of patents applied for in the Group’s history and is a reflection of the amount of time, effort and £3.8 million of gross investment in R&D over the past two years. 

These are being expedited into production and to market. It is hoped that within the next three years orders for these products will start to be received and that they will command respectable gross margins.

The patents that relate to the refractory division are AVD® (aqueous vermiculite dispersions) used in fire extinguishers and Micashield® a fire resistant paint for wood structures and other substrates.

The patents in the engineering division are for a new type of axial piston valve and a new type of nozzle check valve and Goodwin Steel Castings has been granted a patent for its new super nickel alloy, G130, developed by the foundry for use in high temperature turbine applications.”

For what it is worth, during the last five years GDWN has expensed £7m on R&D — equivalent to only 1% of total revenue.

That level of R&D investment does not seem that great to me, but R&D accounting between companies can differ and at least GDWN regularly refers to new products.

Does the business produce a respectable return on equity?

Generally, but not recently.

Return on average equity for 2016 was £9m/£85m = 10% excluding non-controlling interests. Adjust for GDWN’s net debt as well and the figure reduces to 9%.

However, the calculation adjusted for non-controlling interests and net debt has topped 15% during ten of the previous eleven years.

Does the business employ capable executives?

Yes.

John Goodwin has worked for the group since 1970, was appointed to the board during 1978 and became executive chairman in 1992.

Meanwhile, Richard Goodwin became a director during the early 1980s and then took on the role of group managing director in 1992.

Both men are now in their 60s, and I am pleased succession plans appear firmly in place. Four other members of the Goodwin family are presently employed as board executives, with this next generation of leadership currently aged between 26 and 35.

Alongside the six Goodwins are two other executive directors, plus the single non-exec who was appointed only the other year.

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

Sort of.

Two years ago I highlighted GDWN’s extremely commendable remuneration policy. Here it is again (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…”

Fast forward to 2017 and sadly you could argue the directors have started to emulate a typical boardroom.

You see, an LTIP was approved by shareholders last year and — in simple terms — could give away up to 8% of the group if the share price heads towards £35 (it’s £18 now) by April 2019.

As far as I can tell from Companies House, GDWN has never before operated a share scheme — and so now the company is no longer the options ‘safe haven’ it once was.

The new LTIP also dilutes the impact of GDWN’s remuneration statement somewhat.

I guess GDWN’s board could now become dominated by the “very much incentivised executive directors” that the statement says it has “no intention of emulating”.

The execs may also focus on operating the business towards April 2019 — while perhaps eyeing individual LTIP bonuses worth £2m or more — rather than preparing GDWN for the years thereafter.

Another danger I suppose is that this LTIP opens the door to further — and more complex — schemes in the future.

For its part, GDWN says:

“The purpose of the LTIP and the TSR [total shareholder return] performance condition is to incentivise Directors to grow the Company in the long-term and deliver value to our shareholders. The use of a single performance measure provides simplicity and focus.”

At least having an LTIP based purely on total shareholder return will mean outside investors ought to have benefited for the scheme to award shares.

(I must add that ace financial writer Richard Beddard has published two comprehensive articles — here and here — covering GDWN’s LTIP scheme. Both articles are well worth your time.

Richard concludes: “My blood isn’t really boiling like the headline of my last article says, but regardless of the outcome at Goodwin, the company’s incentive plan shows that investing in family-owned firms is not necessarily a panacea for the ills of capitalism.”)

Meanwhile, both John and Richard Goodwin have seen their basic pay rise by an average of 5% per annum during the last ten years — which does not seem outrageous to me given the dividend has compounded at 10% during the same time. The two men currently enjoy £308k salaries.

There have been no board bonuses to speak of and minimal pension contributions as well.

Does the business employ owner-orientated executives?

Yes (LTIP aside).

The Goodwin family still control at least 53% of the business — a shareholding presently worth at least £69m. The size of the stake has reduced only slightly I believe during the last decade or so, and remarkably, the current share count has not changed since 1977.

Special dividends declared during 1996, 2009 and 2013 suggest the executives are happy to take the sensible option with surplus profit.

Does the business enjoy reasonable growth prospects?

Not in the short term.

Third-quarter results issued the other week showed nine-month revenue up 21% to £105m but operating profit down 4% to £8.9m. GDWN blamed the ongoing downturn in the oil, gas and mining industries — and the resultant “much fiercer competition” — for the lower profit and margin.

Looking ahead, GDWN admitted its main markets remained “very quiet” and that the group’s order input was 10% down on last year.

Management has also suggested “it would be unrealistic to expect any significant recovery / improvement in pre-tax profitability until after 2018.”

At least the group is not sitting idle, with various new products being currently brought to market:

“As in the five downturns over the past 35 years, we are making good use of this quieter trading time by working hard obtaining approvals and bringing our new products to market, such as our axial piston shut off and control valves, our new range of duplex and high impact resistant carbon steels as well as products that use our AVD™ vermiculite dispersions, such as fire extinguishers, lithium battery transport bags and fire resistant paints. 

For all the mentioned products we have patents applied for and they should provide the Group with a sound base to start growing again, such that we can be as proud of the next twenty years as we have been of the past twenty.” 

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

Well…

…I wasn’t sure two years ago when the shares were £28.

Now the shares are £18, and I am still not sure.

GDWN’s enterprise value at £18 a share is its £130m market cap plus its net debt of £37m… which is £167m or £23 a share.

Operating profit for the year to January 2017 was £12.4m, which after the forthcoming 19% standard rate of UK tax gives earnings of 137p per share.

The P/E using my EV and EPS calculations is therefore £23/137p = 17.

That multiple does not look bargain-basement to me, especially for a business that is likely to witness earnings remain well below their peak for the next year or two.

Is it worth watching Goodwin?

Just about.

Back in 2015 I waxed lyrical about GDWN’s superb track record, top-notch managers and wonderful returns on equity.

However, the intervening two years have since moderated my view.

In particular, borrowings have risen to a high level, a lot of cash is being reinvested into the business with unclear returns, while the board has given in to the wider executive LTIP culture.

I must admit that I did consider relegating GDWN from my watch list, but I thought removing the company could be unfair on its time-tested and ‘old-fashioned’ leadership.

Indeed, with the bosses having largely enriched their family to the tune of £69m-plus, there is the possibility that they actually understand what they are doing with those borrowings, the capital expenditure, the LTIP, and so on.

Furthermore, it is a very rare boardroom that says it wants to be “proud of the next twenty years” — which hopefully signals the family leadership really does remain keen on serving long-term shareholders well.

So for now at least, I shall keep watching GDWN.

Finally, while earnings may have fallen significantly from their 2014 peak, I note revenue has held up relatively well… which may suggest GDWN is winning work from rivals as they all tough it out amid the oil, gas and mining downturn.

In fact, I would not be surprised if GDWN emerged as a stronger business as and when its markets recover. Certainly the group powered to extreme new heights after its previous protracted difficulties of the late 1990s.

Maynard Paton

Disclosure: Maynard does not own shares in Goodwin.