Renishaw shows strength in a cyclical sector

Cyclical stocks can be troublesome for investors. Sectors such as building and discretionary goods often outperform when the economy is growing but sentiment can change in the blink of an eye. Even if you are adroit at cutting positions ahead of harsher economic conditions, thereby sparing yourself painful losses, calling the turning point to capture the rebound can be equally difficult.

Not all cyclical-at-first-sight companies fit neatly into the category. Many are better described as having cyclical characteristics while others have expanded their revenue mix, giving them protection in a downturn. Shares in catering company Compass tanked along with the economy during the pandemic lockdown but grim forecasts were soon replaced with strong revenue growth and that momentum hasn’t stopped. While some of Compass’s sales could be vulnerable in a recession, others, such as student catering contracts, would not.

Equipment hire firm Ashtead, which operates in the highly cyclical construction sector, also has some built-in protection, provided by the size of its market share in the UK and the US and its exposure to mega-projects that would carry on even in the event of an economic crunch in the future.

Metering and measuring specialist Renishaw is another semi-cyclical with growth qualities. It may look highly correlated to the broader economy but should be less prone to recession risk thanks to the diversity of its revenue streams and the highly specialist nature of its products, which can help other companies become increasingly efficient.

BUY: Renishaw (RSW)

The recovery in Renishaw’s financial performance may be taking longer to materialise than envisaged when we featured the company in our ideas section a year ago but it looks like a case of a rebound that has been delayed rather than denied, writes Michael Fahy.

Conditions in the semiconductor market have been “challenging”, according to chief executive Will Lee. This meant revenue in the company’s core manufacturing technologies arm was flat, although the pace picked up sequentially over each of the four quarters.

Adjusted pre-tax profit fell 13 per cent due to currency headwinds and higher staff costs. Capital expenditure also remained elevated at £65.2mn, although lower than last year’s peak of £73.8mn, as it fitted out the first of two new halls at its Miskin plant in Wales, which will eventually boost capacity by 50 per cent. On top of this, it bought a new distribution base in the United Arab Emirates and built another in Brazil.

Group finance director Allen Roberts said that although it would continue to invest in new equipment, property spending should be much lower, meaning capex is expected to fall by about £25mn to £40mn.

The heavy investments made in the past few years — and the fact that this spending is now receding — led the company to set out a series of new goals. It plans to lift its through-cycle revenue growth (measured over a five-year period) above 7 per cent and its adjusted operating margin above 20 per cent, from 15.7 per cent currently. It also wants to convert at least 70 per cent of operating profit into cash and achieve a return of at least 15 per cent on invested capital.

Alongside a continued improvement in demand from semiconductor manufacturers, Renishaw is looking to achieve this by rolling out new products in existing markets and entering into new ones where it already has a firm grip both on the technology and the customer base. This has included industrial automation products, where it has secured business from a big global aerospace customer.

Renishaw’s shares initially rose by around a third after featuring in our ideas section but have since drifted back down to the level they were — at about 19 times forecast earnings, well below their five-year average of 30 times. At this price, we remain of the opinion that it looks like a solid long-term investment.

HOLD: Kingfisher (KGF)

Kingfisher’s shares rose 7 per cent on release of these results as the business raised its free cash flow guidance and narrowed its adjusted profit outlook to the upper end of its current range, writes Natasha Voase.

The business, which owns the B&Q and Screwfix chains, is far from in the clear. Sales were down 2 per cent compared with last year, at £6.8bn, and adjusted pre-tax profit was down 1 per cent at £334mn.  

Kingfisher is still progressing with its Castorama France store restructuring and modernisation plan, with works now completed or in motion on 13 low-performing stores. As a result, operating costs were down 3 per cent in France, with like-for-like sales down 7.2 per cent. Like-for-like sales in the UK and Ireland were down 0.2 per cent.

Land is in sight though as Kingfisher upgraded its full-year guidance, adjusting free cash flow to between £410mn and £460mn (previously £350mn to £410mn). Adjusted profit before tax guidance was also lifted to between £510mn and £550mn (previously £490mn to £550mn). Profit guidance was held back by the poor performance of its 50 per cent Turkish joint venture, which is expected to contribute an overall net loss of around £25mn to the adjusted profit before tax.

Kingfisher has initiated a “comprehensive restructuring programme” in Turkey, including “a large reduction in headcount, store closures and rightsizings”.

Kingfisher’s shares are currently trading 32 per cent higher than they were a year ago at 14 times forward earnings, which is towards the upper end of its historical range. However, the French restructuring is entering its fourth year and the initiation of a new Turkish restructuring suggests that the waters are still choppy.

SELL: THG (THG)

Half-year figures for THG were overshadowed by news that the ecommerce technology group plans to demerge its technology infrastructure arm, Ingenuity, from its ecommerce business. Taking the business private would allow THG to retain the material free cash flow generated by its other operations — THG Beauty and THG Nutrition, writes Mark Robinson.

Demerger aside, the latter business unit acted as a drag on the interim figures. Nutrition margins have been under pressure, partly due to old branding clearance sales, in addition to some input inflationary pressures. However, management expects revenue growth here to return during the third quarter, “supported by a recovery in average selling prices”. Management notes that currency effects, specifically in relation to the Japanese yen, could weigh on results, so it is guiding towards the lower end of the analyst consensus earnings before interest, tax, depreciation and amortisation range for 2024.

As ever, there is a marked difference between statutory and adjusted metrics in the period, partly due to the discontinuation of some underperforming assets. The statutory gross margin contracted by 220 basis points to 39.8 per cent and adjusted administrative costs as a percentage of revenue increased in the period. The group booked an operating loss of £84.4mn against £99.5mn last time around.

Some might view the potential demerger as inevitable, but the rationale isn’t altogether clear. Matthew Moulding, chief executive, points out that “further contract wins within Ingenuity is underpinning a steady acceleration in external revenue growth following the repositioning of the business to focus on higher-value, multi-service clients”. But it is difficult to understand why Ingenuity would attract the attention of investors once it’s outside the fold, although one imagines that private equity could conceivably play a role. As for THG, it seems a work perpetually in progress and the demerger will do little to dispel this impression.