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Diversification and tax resolution pay off for Hudaco

Intellidex advises ‘holding’ the share.

After being bruised during the 2008/09 economic crisis, Hudaco Industries learnt its lessons and has focused on diversifying the business from the vulnerable mining and manufacturing sectors. The strategy, which was achieved by acquiring targets which supply consumer-related sectors, is now proving an important strength. However, a strong upward share price rerating earlier this year has left little further value.

Core demand for Hudaco’s product range is relatively stable, influenced more by the performance of the broader economy than new fixed investments, in common with other industrial goods suppliers. This provides useful protection in the current environment where most institutional consumers (mining and manufacturing) are either delaying or putting new capital investments on hold.

Revenue for the interim period to end-May leaped 21% to R2.55 billion (2014: R2.11 billion) thanks to its acquisition strategy which has reduced the company’s dependence on the SA mining and manufacturing sectors. Growth was driven by Partquip’s R318 million contribution and a one-off large communication equipment sales contract.

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On a like-for-like basis, revenue grew 6%, which underscores the tough trading environment. Headline earnings were 20% higher at 548c (2014: 448C) spurred by the contribution of the new acquisition as well as improved operating profitability from ongoing operations. A dividend of 180c/share was declared, which is 16% higher than the 155c/share declared in the comparable half.

The group’s exposure to the local mining and manufacturing sectors has fallen significantly to about 37% of revenue from more than 50% five years ago. While this is a boon, until economic circumstances improve, we foresee only modest organic volume sales growth in SA. Growth in exports into Africa should be better but these constitute just about a tenth of group sales. National Treasury projects GDP growth of 2% in 2015, rising to 3% by 2017. With this outlook it’s going to be challenging for Hudaco to register double-digit growth numbers from ongoing operations without the mining and manufacturing sectors coming to the party.

While we are encouraged by the group’s sector diversification, a substantial proportion of its income is still derived from the distressed manufacturing and mining industries. These sectors are suffering under various negative factors including rising administered input costs, increased regulatory demands, weak commodity prices and power outages. Labour strife is also a possibility with wage negotiations commencing. While the consumer-related businesses, which we expect will continue holding up, provide comfort, we think the weak mining and manufacturing businesses will be a drag on the group’s financials.

Nonetheless, with help from acquisitions, we estimate that the group’s normalised earnings will be 25%-30% higher in the current financial year. In December last year Hudaco acquired Partquip, a distributor of automotive components. With estimated annual revenue of around R628 million, this addition is geared to contribute much of the groups’ growth this financial year. It also comes with an operating margin superior to the existing operations.

Hudaco boasts highly cash-generative operations. Despite substantial outflows of R730 million for a tax settlement, the Partquip acquisition and dividend payment, it’s financial and cash-flow positions remain fairly sound. Net interest debt is just above 50% of equity but we expect this to come down significantly in the second half.

After factoring in these projections, Intellidex’s discounted cash-flow valuation model presents a 12-month target price of R133.13/share and a forward price:earnings ratio of 10.3.

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We think the share’s strong run earlier this year after the resolution of a prolonged tax dispute with Sars drove it closer to its intrinsic value.

Based on this valuation and outlook we issue a ‘hold’ recommendation.

Bull factors

  • Acquisitions have provided increased capacity which should support long-term earnings growth
  • Sustained weakness in rand bodes well for manufacturing sector
  • Management is in a better position to focus on growing the business following the tax dispute resolution

Bear factors

  • Still significantly exposed to SA’s mining and manufacturing sectors
  • Construction activity under tremendous pressure

Nature of business:
Background: Hudaco Industries is a group of companies specialising in the importation and value-added distribution of branded industrial and security products in the southern African region. Its operations are divided into three: bearings & power transmission products; powered products; and security equipment.

Analyst: Orin Tambo, CFA; Editor: Colin Anthony

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.

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