Stock in Focus: Epwin could provide a window of opportunity for investors

My Stock in Focus screen has provided slim pickings in recent weeks. The last time I added a stock to the SIF portfolio was BHP, on 15 October.

As has happened several times before over the past three years, valuation and momentum seem to be the main stumbling blocks. 

• Valuation: Removing my requirement for an earnings yield (EBIT/EV) of 8% or more increases the number of stocks returned by my screen from seven to 27.

• Momentum: Similarly, if I disable my requirement for 1-year relative strength to be greater than zero, then the number of results increases from seven to 18.

I’m not too concerned by this. As SIF is a trading strategy, I only want to buy when valuations look attractive and there’s evidence of positive momentum.

However, I do allow myself some leeway at times like this. This means I can still buy stocks which look attractive but have higher valuations or lower growth rates than I’d usually accept. One such company that’s come onto my radar this week is PVC window and building product manufacturer Epwin (LON: EPWN).

A star turnaround?

It’s worth pointing out that shares in this AIM-listed company are still trading below the level at which they listed in July 2014. Epwin got off to a strong start but then ran into problems in 2017, when the group’s pre-tax profit fell by nearly 50% to just £12m. 

The group was hit by a nasty cocktail of rising input costs and problems relating to the administration of former AIM firm Entu, which went into administration in August 2017.

Epwin and Entu both floated on AIM at around the same time and had some shareholders in common. Paul Scott explained the situation in more detail here – all we need to know today is that Entu retailed some of Epwin’s products, leading to a significant bad debt when Entu went into administration.

It’s fair to say that the failure of Entu coloured my perception of Epwin. I’ve now realised this may have been unfair. Epwin is a very different company and recent trading has been strong. The firm appears to be a significant manufacturer in this sector, with a somewhat differentiated product range and a solid portfolio of B2B brands. 

Stockopedia’s algorithms like Epwin too. The group’s shares currently boast a StockRank of 98, making it one of the top 10 stocks in the AIM market. 

The SIF folio already contains a company with housing market exposure, brickmaker Michelmersh Brick Holdings. So I’m not sure I would want to buy Epwin at the moment. But I do want to take a closer look to see whether it ticks all my boxes and might be worth considering in the future.

A value opportunity?

As Paul commented in September, Epwin appears to have potential as a value investment:

Looking down the list, I can’t see much to dislike here. Epwin’s valuation appears to be cheap without being distressed. Free cash flow generation seems to be good and almost matches earnings, which I see as a good sign.

The only area that looks potentially weak is the balance sheet. The price/book value of 1.4 isn’t too bad, but the StockReport shows a price/tangible book ratio of 11.2:

Such a big difference between P/B and P/TB normally indicates a large quantity of intangible assets on the balance sheet. That’s the case here, with goodwill of £72.2 versus net tangible assets of £10.8m.

I don’t see this as a serious problem, but it does make me wonder whether the group owns much freehold property. September’s half-year results refer to the planned sale and leaseback of a new facility in Telford. This deal is expected to generate £8m of cash inflows this year, reducing debt. 

However, according to the 2018 annual report, Epwin operates three fabrication sites and around 70 distribution centres. Given this, the £1.5m of land and buildings listed in last year’s accounts seems low to me. The presence of £61m of IFRS 16 lease liabilities in the recent half-year figures suggests to me that most – or perhaps all – of the group’s property is leased.

I’m not a massive fan of sale-and-leaseback deals, which I see as providing short-term benefit and long-term risk. But if managed carefully they shouldn’t be a big problem. And of course in many cases, leasing commercial property is the only practical option available for businesses.

Overall, I don’t think the group’s balance sheet is a serious concern. But I think it’s disappointing that this business appears to lack the freehold asset backing offered by some comparable companies.

Margin recovery could help quality score

Epwin scores highly for quality, with a QualityRank of 84 at the time of writing:

Looking at the stock’s Franchise Factors, the numbers look quite good. However, it’s always worth remembering that these are five or six-year average figures. This means that underlying trends aren’t always apparent. 

I find it useful to compare these averages with the profitability figures from the StockReport. Here are the numbers for Epwin:

We can now see that the group’s profitability seems to have declined since its flotation in 2014. However, the TTM (trailing 12 month) operating margin of 6.3% is a significant improvement on last year’s figure of 5.3%. This supports the narrative from the firm that it’s starting to pass cost increases onto customers.

Although return on capital employed (ROCE) is still falling, this has to be seen in the context of this year’s introduction of IFRS 16 accounting, which adds debt-like lease liabilities to company balance sheets. This increases the amount of capital employed from an accounting perspective. So if all else is equal, ROCE will fall.

The company says it’s focusing on areas where it has a greater competitive advantage and where barriers to entry are higher. I wouldn’t expect sky-high margins, but if the group can generate a ROCE of 10%+ going forwards, I’d view that as acceptable.

Uncertain momentum?

Epwin’s customer base includes new home builders, social housing operators, rental landlords and the RMI (Repair, Maintenance and Improvement) sector. This mix should mean that trade won’t completely collapse during a recession. But there’s no doubt that this is a cyclical business. 

We haven’t had a housing market downturn or recession since the group floated in 2014. So it’s hard to say how well this business will negotiate such headwinds. For what it’s worth, the latest outlook statement from the company reports trading in line with expectations, but flags up challenging market conditions.

Brokers appear to have steadied their nerves after a round of downgrades last year. A material 11% rise in earnings is expected for 2020:

Taking a broader look at momentum, price momentum appears strong, while earnings estimates reflect the stability shown in the broker trend chart above:

Epwin stock trades on a rolling 12-month forecast P/E of 7.6, with a dividend yield of 6.5%. Although I have some concerns about the macro outlook, I can see that this could turn out to be a good entry point for investors.

If I didn’t own shares in Michelmersh Brick Holdings, I’d probably add Epwin to the SIF Folio. As things stand, I’ll maintain a watching brief for now.

Disclosure: At the time of publication, Roland owned shares of BHP Group and Michelmersh Brick Holdings.

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