A cyclical masquerading as a stalwart

Honeymoon over before the wedding

I’m grateful to Rijk, John Kingham and Trident for giving me something to think about as I stumbled through equipment hire company Vp’s past annual reports.

There’s a danger, voiced most succinctly by Franko, that I’ve already made my mind up about Vp, without having done all the research. Enthusiasm can tarnish analysis when I torture the facts to give me the conclusion I want (Buy! Buy! Buy!), rather than letting them speak for themselves.

I thought Vp was a stalwart masquerading as a cyclical. It may be the other way around.

Rijk warned:

…looks like the business requires levels of capex equal or exceeding operating cash flow….. consequently fcf doesn’t look that great

I just don’t see that in the data. Here’s ten years of profits and cash flows scaled by equity (i.e. profit and cash flow return on equity):

The median return on equity is 14% and the median free cash flow cash flow return on equity is 16%. Since Vp is a growing business I’d expect free cash flow to be lower than accounting profit as the company uses cash to invest in more fork-lift trucks etc. The fact that it’s not, typically, is a good sign.

In 2008 and 2009 though, Rijk was right. Capital expenditure gobbled up free cash flow (green line), which blemishes management’s record because those years were the peak of an investment orgy that started in 2005. Actually, orgy is too strong a word, as unlike so many other companies that over-invested in the go-go years leading up to the recession, Vp has not had to cut the dividend, or come to the market for more money.

Instead it’s compounded shareholder wealth (earnings and dividends) at an average annual rate of 10%:

The blemish has more to do with debt. Vp geared up to acquire a new division, TPA , and smaller acquisitions for its other businesses (Including some, to continue a theme, with funny names, like U-Mole). In 2005 net debt stood at £2.4m. By 2009 it was £65.8m.

We can see this transformation in the ratio of assets to equity in the Du Pont analysis (though not as clearly as I’d like due to the scales):

Total assets rose from a comfortable 1.8 times equity to a risky 2.5 times equity (pink bars). But, in response to recession, Vp stopped buying businesses, reduced investment in new equipment, and used the cash flows to pay off debt. In its half year results published in November, net debt was down to £43.5m, the ratio of assets to equity was more acceptable, at 2, and the company has started to increase capital investment again. With sales and profits up, it looks as if the business is stabilising.

We can also see the expansion in the shareholder wealth chart as the proportion of intangible assets rises (yellow segments, above).

So the 10 year analysis does not reveal the perfection I’d like from a stalwart. I think management embarked on a poorly timed expansion, but the business is fundamentally strong so, unlike many of the businesses I consider, catastrophe was averted.

It has, however, left the company at the upper limit of my tolerance for indebtedness, and as John Kingham pointed out:

…interest is only covered 6 times

That figure is from the 2011 results, which reported the second of two years of falling profits. Vp’s biggest division,  Hire Station , is sensitive to the construction industry, and so is its second biggest, Groundforce.

Trident suggests stress testing interest cover under various scenarios. This is hard (for me) to do. There are too many variables. It depends on the agreements (covenants) Vp has with its banks, which are not disclosed, and how effectively Vp can cut its cost-base to avoid breaching them if profits dive again. They’re the kinds of calculations management should be doing. I must decide whether I trust management to draw the right conclusions.

On the one hand they were reckless between 2006 and 2009 and I don’t detect much humility in the annual reports. On the other hand, they acted promptly, have averted catastrophe so far, and by dint of their shareholdings have more to lose if it happens.

Having survived the last three or four years, I hope Vp’s learned a lesson about debt. The  danger is it might think it’s invincible.