This article was first published in the latest issue of the Moneyweb Investor. To read the magazine click here.
We remain bullish on Rolfes, which has transformed itself from just being a pigment business into a diversified specialised chemical business. Even after a strong rally that started in June, its market valuation, with a price:earnings (PE) ratio of seven, still doesn’t fully capture the growth promise that the stock now offers. Our model shows a fair value for Rolfes should be around R4.69/share, 24% ahead of its spot price.
Rolfes has instituted a number of good initiatives. It discontinued its loss-making resins business, disposed of lower-margin businesses in the agricultural and chemicals divisions and is expanding its higher-margin agriculture and water interests through minority buyouts and acquisitions. This has left the company with highly profitable businesses capable of consistently posting good growth numbers. The market, however, doesn’t seem to have fully credited the company for these value-enhancing developments.
The group also took a bold step last year in moving into the food chemicals market with the acquisition of Bragan Chemicals, an importer and distributor of chemicals used in the food industry. The acquisition comes with higher operating margins than Rolfes’ existing operations. Apart from diversifying Rolfes’ sector exposure, it also provides opportunities to supply its product range to Bragan’s customer base.
These events have bolstered Rolfes’ growth trajectory. We expect the operating margin to expand to around 10.5% (FY15: 7%) and headline earnings per share to be between 60c and 65c in FY17. Average earnings growth of 15% should be achievable over the next three years. Our projections imply a rolling one-year PE of 5.8, which we think undervalues this company substantially. Stocks usually trade on low PEs due to a poor profitability profile, poor prospects, a high risk profile or poor track record. Rolfes doesn’t seem to exhibit any of these qualities. Its past performance has been decent when compared with its peers, whose over-dependence on the mining industry has seen them faltering since the collapse of commodity prices.
Rolfes share price (rebased)
Rolfes reported a 20% jump in revenue for the year to end-June as the inclusion of nine months’ income from Bragan more than offset the loss of revenue from the discontinuation and disposal of the low-margin product lines. Operating profit climbed 72% to R137 million (FY15: R80 million) at a margin of 10.1% of revenue. The group issued new ordinary shares for cash to fund the Bragan acquisition and to buy out minority shareholders of Agchem, which resulted in a 37% increase in the weighted average number of shares. This diluted growth in headline earnings, which grew 39% to 53.2c/share (FY15: 38.2c/share). Bolstered by the improvement in the gearing ratio to 35% (FY15:41%), the board declared a dividend of 6c/share (FY15: nil).
Rolfes management intends to continue pursuing strategic acquisitions and organic growth opportunities in the chemicals and related products markets. It will target acquisitions that will enhance its international footprint as well as sectors with high barriers to entry where a business possesses intellectual property, infrastructural development capabilities or product registrations. Given the group’s net debt of 35% of the book value of equity and a supportive shareholder base, the growth ambitions are achievable.
That said, the bulk of Rolfes products are sold into the manufacturing, mining and industrial markets which are under pressure. That will certainly make it difficult for Rolfes to grow from existing operations but we expect the following to drive further margin expansions.
- Only nine months of Bragan Chemicals income was included in this year’s financials and in FY17 revenue and margins will benefit from the full inclusion. Bragan’s higher margins are likely pull up Rolfes’ overall profit margins.
- The backward integration in the agricultural procurement unit and vertical integration of the logistics capabilities of the industrial and water divisions were instrumental in the improvement of margins of these divisions in the current financial year. We think more cost savings and margin benefits will come through in FY17.
- Rolfes has room to extend its product basket and range of services and pursue new clients. All these aspects are embodied in the expansion strategy.
- Consolidation of acquisitions and further streamlining of divisional structures will drive further margin expansions.
- Expansion into non-South African markets. Rolfes CEO Lizette Lynch says the company will start distributing its products in Egypt, Ethiopia, Tunisia and Brazil during FY17. This provides the company with exciting growth opportunities and geographic diversification.
Assuming average annual earnings growth of 15%/year over the next three years, a conservative continuous growth estimate of 1.5% and a highly punitive discount rate of 14.04%, our discounted cash-flow model arrives at a fair value of R4.69/share. Based on that we maintain our buy recommendation.
- Bragan acquisition has potential to bring in new customers, new markets and cross-selling opportunities
- Diversified revenue streams across domestic and export markets
- Strong customer base with leading positions in niche markets
- Weather conditions affect agricultural division’s earnings
- Patchy or slower-than-expected growth in manufacturing and mining sectors
Nature of business: Rolfes is a diversified manufacturing technology holding company. It manufactures and distributes the following products:
- Organic and inorganic colour pigments for the coatings, plastics, vinyl, leather construction and ink industries, and pigment dispersion and pastes for coatings and plastics applications (through Rolfes Colour Pigments International);
- Specialty chemicals for the coatings, plastics and construction industries (through Rolfes Chemicals); and
- Pure beneficial silica for the metallurgical, filtration and construction industries (through Rolfes Silica).
Disclosures: The analyst has no financial exposure to the instrument discussed. The opinion represents his true view. For Intellidex’s full disclaimer, methodologies and definitions please click here.