SIF Folio: Macfarlane could have potential in difficult year

The news doesn’t seem overly encouraging at the moment. COVID-19 case numbers are rising sharply. US tech stocks have started to wobble. The FTSE 100 is down nearly 10% from its May high of c.6,500. And a hard Brexit might be on the cards again, as press reports suggest the UK government may choose to override parts of the EU withdrawal agreement. 

Against this backdrop, it’s encouraging to find companies that have performed well in 2020 and are expected to continue doing so. One such company is last week’s selection, FTSE 250 gold miner Centamin. 

This week another stock which trades in the Basic Materials sector has appeared in my Stock in Focus screening results –  small cap packaging group Macfarlane (LON: MACF). This £140m business has previous form in my SIF fund. In 2016, a previous position resulted in a disappointing 10% loss. In 2018/19 my Macfarlane trade delivered a more credible 30% gain for SIF. 

Macfarlane (LON: MACF) – opportunity from adversity?

Macfarlane’s share price has bounced around since late 2019, but has not really gone anywhere. However, the firm’s recent half-year results looked fairly positive to me. Strong demand for packaging items for internet retail, household goods and medical products helped to offset weaker demand from the automotive sector and high street retailers. 

Although H1 sales and earnings were down slightly on the same period last year, the decline was fairly modest in my view:

Macfarlane passes all of my screening tests. Stockopedia’s algorithms appear to like it too:

With the firm’s peak trading period still ahead of it this year in Q4, this could be an opportunity to buy into a stock with the potential to beat expectations.

What could go wrong?

Playing devil’s advocate for a moment, it’s certainly easy enough to construct a generic case against this group. 

In general, I’d imagine that there will always be pressure on profit margins from rivals and customers. Macfarlane may also lack the economies of scale and diversity of larger rivals.

A more specific concern for me is whether the group’s manufacturing division really justifies its presence in the group. Whereas Macfarlane’s packaging distribution business generated  an operating profit of £12.4m in 2019 at a margin of 6.3%, manufacturing contributed just £1.2m at a margin of 4.3%.

It’s not clear to me how much overlap there is between the distribution and manufacturing businesses. However, it’s interesting to note that one management objective for 2020 is to “create both sales and cost synergies” between the two divisions. The firm is also aiming to increase sales of new “higher added value” products in order to boost manufacturing margins.

Shareholder dilution?

Finally, any analysis of potential weaknesses cannot ignore Macfarlane’s long-running buy-and-build strategy. The firm has made 12 acquisitions since 2014, part-funding these by issuing new shares. As a result, the share count has risen steadily over this period:

This kind of strategy can work well, but it can also lead to a slow drip-feed of value destruction for shareholders. 

So far, the evidence is mixed. On the one hand, the group’s strategy does seem to have delivered steady progress in recent years:

However, although reported net income has risen by 120% since 2014, earnings per share have risen by 63%. The difference between these two numbers suggests that shareholders have suffered significant dilution from as a result of the increase in the group’s share count. 

Even so, I think it’s fair to say that shareholders have enjoyed net benefits from the group’s growth. Most acquisitions have been relatively small and thus readily integrated. As we’ll see, the group’s quality metrics suggest they have also been reasonably priced. 

At this point, I would give management the benefit of the doubt.

I think there’s enough potential here to make the stock a contender for the SIF folio, so let’s review each of Macfarlane’s factor scores.

Value: not obviously cheap

Macfarlane’s ValueRank of 59 suggests a mixed bag. I’d share this view. The group trades on 14.5 times trailing earnings and at nearly twice its book value. As Stocko’s valuation graphic shows, tangible assets are minimal – the balance sheet is loaded with goodwill and intangibles resulting from past acquisitions.

On the other hand, there are a couple of bright spots. Macfarlane’s earnings yield (EBIT/EV) of 8% is at a level I’d consider attractive. 

The stock’s trailing price/free cash flow ratio of 5.4 also looks very promising. Although H1 cash flow appears to have been boosted by favourable working capital movements, the company does have a track record of decent cash generation. 

Debt: Debt looks reasonable to me, too. Macfarlane’s net bank debt was just £4.6m at the end of June, adjusting for various government support measures. The company has a £30m bank facility, so does not appear to be in any danger of suffering a liquidity crunch.

Pension: One possible concern is a pension deficit of £6m. Although this seems a manageable figure, cash pension contributions are running at about £3m per year. 

The problem is that on common with many older industrial companies, Macfarlane has a large legacy pension scheme. The group’s total pension liabilities were reported at £94.5m at the end of 2019. I think that servicing these could be a significant drain on cash for some time to come.

Overall, my view on Macfarlane’s valuation is neutral. Given the firm’s pension liabilities and the outlook for this year – which I’ll discuss shortly – I think the shares are probably fairly priced.

Quality: I’m happy with these numbers

The picture here is more encouraging. Macfarlane’s QualityRank of 97 is its highest factor score. To a large extent, I share this positive view.

There are two particular highlights I’d like to draw your attention to. 

The first is the stock’s Piotroski F-Score of 8/9. You can click on the graphic in the StockReport for more info – I find this a very useful snap check of a company’s fundamental health.

The second point I want to make relates to the apparent profitability of the group’s acquisitions. 

Since 2014, Macfarlane’s book value has increased from £30.2m to £71.6m. 

Broadly speaking, this increase represents assets added through organic growth and acquisitions. 

Over the same period, the group’s profitability metrics have been fairly stable:

The combination of stable profitability and rising capital employed suggests to me that the firm’s investment in growth projects and acquisitions are generating returns consistent with older parts of the business. 

In general terms, I see this as evidence that management is executing well and not overpaying for acquisitions.

If this combination of growth and consistent profitability can be maintained, then I think Macfarlane could deliver attractive future returns for shareholders.

Momentum: mixed picture

Macfarlane’s MomentumRank of 60 is cautiously optimistic, but I think the picture is pretty mixed. Momentum has two elements, price (technical) momentum and earnings estimates. 

Earnings estimates: Stockopedia is showing unchanged forecasts since March for 2020 and 2021. 

However, I’m not convinced these forecasts are still valid. From what I’ve seen elsewhere, I believe broker forecasts are now suggesting earnings of around 6p for 2020 and 8p for 2021. If this is correct, then earnings are expected to be flat this year before returning to growth next year.

This wouldn’t be a bad result, but it does mean that the stock trades on about 15 times rolling forecast earnings, rather than Stocko’s forward P/E of 10.5. 

It’s also worth remembering that Macfarlane’s management has warned that the outlook remains uncertain and the risk of bad debts has increased this year.

Price momentum: Macfarlane’s price momentum also appears mixed. 

The easiest way to view this is through the momentum graphic that’s to the right of the share price chart on the Stockreport. The traffic light colours give you an idea of how attractive each number is:

On the whole, I think Macfarlane’s short-term momentum is uncertain. Although I would note that the 1yr relative strength figure I use in my screen is positive, which I see as a good indicator for medium-term performance.

My verdict

I’m a little unsure about whether to add Macfarlane to the SIF folio. On the whole, I think it’s a decent business that could recover well in 2021.

On the other hand, there are a number of risks inherent in the group’s strategy and in its near-term outlook. The pension liability is also a drain on cash that could constrain dividends and growth investment.

The easiest way to resolve this dilemma is by taking refuge in my rules. To reflect the alternative broker estimates I’m working with, I’ve recalculated the following ratios:

• Rolling forecast eps growth

• Rolling PEG ratio

• Rolling forecast sales growth

Although my revised earnings growth figures still pass my screening rules, my sums suggest that sales growth could be negative. My screen requires positive sales growth, so on that basis I’m not going to add Macfarlane to the SIF folio this week.

Let me know what you think – am I being too pedantic, or is the good news already in the price?

Disclosure: Roland owns shares of Centamin.

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