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ARB waits for better days

Reduced expenditure by key customers hurts earnings and prospects.

REDUCED EXPENDITURE BY KEY CUSTOMERS HURTS EARNINGS AND PROSPECTS

The poor local and global economic dynamics have seen most of ARB’s key customers tightening the purse on capital spending. This has hit earnings in the electrical division which contributes more than 80% of group revenue.

RECOMMENDATION: HOLD

The macro environment is against ARB – when it recovers, ARB will be healthier. The mining sector is suffering from depressed global commodity prices while idiosyncratic problems at its core customer, Eskom, paint a gloomy capex picture in the foreseeable future. Manufacturing and construction companies as well as households are trying to cut spending, which may be compounded by rising interest rates.

Against this backdrop we have taken a conservative short- to medium-term outlook which is reflected in our valuation. The share has lost about 10% of its value since the beginning of the year compared with a flat all share index.

ARB does, however, have some virtues that we believe will help it through these tough times. It stands to benefit from maintenance expenditure. It is also a well-run company with a management team vested in the equity of the firm, aligning their interests with shareholders. The group is working on increasing market share through acquisitions, rolling out more outlets and expanding product breadth. Its ungeared, healthy cash position – which has improved with its growing income base over the years – is levered by good working capital management practices, which include insuring its debtors’ book. However, the electrical division has traditionally had a high degree of operating leverage which is now adversely exposing it as sales fall. Still, operating leverage, including the lighting segment, has improved overall, albeit marginally. 

graph

Revenue retreated 3% to R2.15bn in the year to end-June. The main cause was the electrical division’s heavy reliance on infrastructure expenditure and Eskom’s rural electrification programme. Reduced capex at Eskom affected sales of ARB’s overhead lines. The trading margin improved to 24.1% from 23.8% because of an increased revenue contribution by the higher-margin lighting division, which now contributes 18% of group revenue from 16% previously.

We like the way management has put a grip on operating costs in the face of declining sales. That stemmed the fall in operating profit to be in line with that of revenue. Operating profit was 3.2% lower and the operating margin declined to 9.1% from 9.2%. Headline earnings fell marginally to 49.99c/share (FY14: 50.28c). With an improvement in its ungeared cash resources, the dividend was maintained at 20.1c/share

The company has strategic plans to grow both organically and through acquisitions. The group is considering a significant “third pillar” acquisition to improve diversification as well as “bolt-on” smaller ones. Now that the new CEO, William Neasham, has settled in after taking the reins towards the end of last year, we think corporate action may well be back on track. ARB has in the past made some value-adding acquisitions. The lighting division, which was acquired in 2012, now provides respite in these tough times.

ARB generates only 4% of its business in other Africa countries and says it will use caution when it comes to growing its African business. There is a serious power infrastructure gap on the continent, offering growth potential. In addition, the electrical division plans to increase its geographical footprint through store expansion while the lighting segment is set to increase its product range in order to gain market share. A concern here is the adverse effects of exchange rate movements on margins in the lighting division, which imports most of its merchandise.

Given the parched but competitive operating environment, value has to come from within. Management says it will extract operational efficiencies through managing overhead costs and working capital.

The share price has already been rerated downwards by the market and our conservative discounted cash-flow model suggests it is within its intrinsic value range with limited upside potential until earnings growth visibility improves.

The poor local and global economic dynamics have seen most of ARB’s key customers tightening the purse on capital spending. This has hit earnings in the electrical division which contributes more than 80% of group revenue.

The macro environment is against ARB – when it recovers, ARB will be healthier. The mining sector is suffering from depressed global commodity prices while idiosyncratic problems at its core customer, Eskom, paint a gloomy capex picture in the foreseeable future. Manufacturing and construction companies as well as households are trying to cut spending, which may be compounded by rising interest rates.

Against this backdrop we have taken a conservative short- to medium-term outlook which is reflected in our valuation. The share has lost about 10% of its value since the beginning of the year compared with a flat all share index.

ARB does, however, have some virtues that we believe will help it through these tough times. It stands to benefit from maintenance expenditure. It is also a well-run company with a management team vested in the equity of the firm, aligning their interests with shareholders. The group is working on increasing market share through acquisitions, rolling out more outlets and expanding product breadth. Its ungeared, healthy cash position – which has improved with its growing income base over the years – is levered by good working capital management practices, which include insuring its debtors’ book. However, the electrical division has traditionally had a high degree of operating leverage which is now adversely exposing it as sales fall. Still, operating leverage, including the lighting segment, has improved overall, albeit marginally.

Revenue retreated 3% to R2.15bn in the year to end-June. The main cause was the electrical division’s heavy reliance on infrastructure expenditure and Eskom’s rural electrification programme. Reduced capex at Eskom affected sales of ARB’s overhead lines. The trading margin improved to 24.1% from 23.8% because of an increased revenue contribution by the higher-margin lighting division, which now contributes 18% of group revenue from 16% previously.

We like the way management has put a grip on operating costs in the face of declining sales. That stemmed the fall in operating profit to be in line with that of revenue. Operating profit was 3.2% lower and the operating margin declined to 9.1% from 9.2%. Headline earnings fell marginally to 49.99c/share (FY14: 50.28c). With an improvement in its ungeared cash resources, the dividend was maintained at 20.1c/share

The company has strategic plans to grow both organically and through acquisitions. The group is considering a significant “third pillar” acquisition to improve diversification as well as “bolt-on” smaller ones. Now that the new CEO, William Neasham, has settled in after taking the reins towards the end of last year, we think corporate action may well be back on track. ARB has in the past made some value-adding acquisitions. The lighting division, which was acquired in 2012, now provides respite in these tough times.

ARB generates only 4% of its business in other Africa countries and says it will use caution when it comes to growing its African business. There is a serious power infrastructure gap on the continent, offering growth potential. In addition, the electrical division plans to increase its geographical footprint through store expansion while the lighting segment is set to increase its product range in order to gain market share. A concern here is the adverse effects of exchange rate movements on margins in the lighting division, which imports most of its merchandise.

Given the parched but competitive operating environment, value has to come from within. Management says it will extract operational efficiencies through managing overhead costs and working capital.

The share price has already been rerated downwards by the market and our conservative discounted cash-flow model suggests it is within its intrinsic value range with limited upside potential until earnings growth visibility improves.

Nature of business: An investment holding company involved in the trading and distribution of electrical, lighting and related products to the mining, industrial, construction, parastatal, retail and domestic markets across South Africa and southern Africa. ARB Holdings has two main operating divisions: electrical and lighting. It also holds exclusive rights to distribute various international electrical products into the SADC region

Disclosures: The analyst Phibion Makuwerere has no financial exposure to the instrument discussed. The opinion represents his true view.

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