Ricardo engineers value in awful auto sector
Posted on October 13, 2009 by Richard Beddard
Filed Under Companies, Thrifty 30 |
In practice:
Diversification: good, diworseification bad
I fell in love with Ricardo (RCDO) when I saw the artwork on the front cover of its annual report:
The bold, calm design oozes technology, quality and environmental concern, which represent a big danger for investors in the automotive engineering consultancy.
It’s easy to get carried away by the promise of fuel efficient engines, and entirely new hybrid, hydrogen and electric vehicle systems, and the company’s new interest in the other end of the electricity grid, putting power in through wind and waves.
We need to improve or change the way we travel, but, if the shares are expensive, the company is financially weak, or the business isn’t already performing, then, however alluring the future, the shares are too much of a gamble.
The obvious danger, is the state of the auto industry.
Wild swings in fuel prices and a collapse in credit have decimated demand for cars and, along with environmental legislation, increased costs, in what chief executive Dave Shemmans describes as a ‘perfect storm’.
Two of the big three American car makers are in Chapter 11 bankruptcy protection, factories are closing, workers are working shorter weeks and car sales are propped up by government funded scrappage schemes.
Since car makers are Ricardo’s biggest customers, these events explain the dramatic fall in its share price between October last year and March this year.
It’s recovered since, but the shares are still reasonably cheap, costing twelve times average annual profits over the last ten years.
As the recession ends, though, many of the problems reverse. Demand recovers, companies increase production and investment. At first, still nervous about whether an incipient recovery will last, they may favour using the expertise of consultants, rather than developing it themselves.
If Ricardo can tough it out, it should do well.
Unfortunately its F_Score, a measure of financial strength, indicates otherwise.
Normally a score of four out of nine would rule Ricardo out of the Thrifty 30 portfolio, because it implies a significantly increased risk the company will go bust or suffer a long-term decline in profits.
But, some of Ricardo’s individual scores are marginal, or irrelevant, so I think the company is much stronger than the number implies.
Long-term debt has risen from £3m in round numbers to £4m which counts against Ricardo, but £4m is only 2% of total assets so I think it’s insignificant. Likewise Ricardo issued a small number of shares and if you strictly apply the rules, that’s also negative.
If a company must raise funds, either by borrowing, or by selling more shares, it’s a sign of weakness, particularly in a company going through difficult times. In the case of Ricardo, though, the increase in debt is incidental and so is the increase in the number of shares, which were issued not to raise funds, but reward executives.
Arguably, the company is more profitable than last year so they probably deserve a reward, although the F_Score says it is slightly less profitable. The discrepancy depends on whether you compare profit to average assets or assets at the beginning of the year, but either way, unlike its customers, Ricardo was making healthy profits in a very tough environment.
Its apparent weakness, but probable strength, is an important reminder to interpret financial statistics, and when, as in the case of the F_Score, the statistic is an amalgamation of other statistics, to decompose it into its components first.
How did Ricardo do so well, when its customers are faring so badly?
Mindful of the pressure to increase fuel efficiency, and concerned to maintain competitiveness, some manufacturers have maintained their research and development budgets.
Meanwhile, possibly as a reaction to 2004 when a recession in the automotive industry led to the cancellation of three projects and losses at Ricardo, the company, which will be a hundred years old in 2015, began diversifying.
In its financial statements, Ricardo separates its operations into two segments, technology consulting and strategic (management) consulting. The second is a product of its diversification policy, and accounts for less than 10% of sales (£10m, against £123m for technical consulting). While strategic consulting is profitable, it’s still a pretty small business.
Three charts on page 10 of the annual report show order intake for the year, by territory, sector. and product. The company’s biggest territories are still the UK, Germany, and the USA from where over two thirds of orders come, but the company is diversifying into Russia and Asia.
Likewise, the biggest sector (54%) is still passenger cars, but this year the fall off in demand for cars was partially offset by defence (15%), commercial vehicles (23%) and motorsport (8%).
In terms of products, it’s still a pretty car-oriented company (see chart). Wind and wave turbines, don’t seem to feature at all in its 2009 order book, despite the artwork on the annual report.
Diversification is risky, because the company is changing. Whether it works in the company’s, and investors’, favour depends I think, on its speed and extent.
I gain confidence from Ricardo’s ‘one company’ philosophy and think most of what it calls ‘diversification’ might equally be labelled ‘growth’. The car industry is global, so moving into new territories is growth, likewise it seems a fairly short hop from passenger and commercial vehicles to military ones. Why shouldn’t Ricardo apply the expertise it’s gathered developing vehicle transmissions to transmissions in wind turbines? Strategic consultancy was a home-grown development of its technical consulting.
I think this could be an example of good diversification, as opposed to diworseification, a phrase coined by the fund manager Peter Lynch. Companies that diworseify, blow money on expensive acquisitions in unrelated businesses that fail to live up to their price tags.
Finding successful companies in depressed sectors is one way of tilting the odds in your favour, because prices are generally low, so I’m putting Ricardo in the Thrifty 30 portfolio at Friday’s close of 255p.
Here’s the portfolio:
Notes:
First transaction: 9 September 2009
Valuation date: 9 October 2009
Cost includes £10 broker fee and £5 stamp duty
Cash earns no interest
Dividends and sale proceeds are credited to the cash balance
What I don’t know:
I don’t know how long this recession will last, and therefore whether Ricardo’s profits will rise or fall next year. Management thinks the first half of the year, which it’s already in, will be tough, but expects to recover in the second half to June 2010. Obviously the first half is fast becoming fact, while the second half is more speculative.
I’m not an engineer. So when I write sentences like “Why shouldn’t Ricardo apply the expertise it’s gathered developing vehicle transmissions to transmissions in wind turbines?” I expect a thousand engineers to email me with their reasons 
-
We all love Peter Lynch (audio).
In theory:
Capitalism: The Ponzi Scheme
The Economist’s Buttonwood gets pretty close to saying capitalism is a Ponzi scheme.
Analyst Dylan Grice, says we’re going the way of Rome in 300AD, and the first great inflation.
Simon Johnson, blogger, academic and former chief economist of the IMF, says Barack Obama missed his moment to break the power of the big investment banks (video) and prevent the next great depression.
Legendary capitalist Warren Buffett honours his mentor Benjamin Graham.
Moneyterms defines the F_Score.
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[...] contrarian ideas go, the auto industry is hard-core, yet, despite having added engineering consultancy Ricardo to the Thrifty 30 model portfolio last week I haven’t finished with the [...]
Ricardo is haemmoraging its best engineers , designers and business development people , Specially since the management at Shoreham engine facility have been infiltrating and taking command at the transmission business in the midlands. Their mismangement of Ricardo MTC is ruining the transmission business because the shoreham high and mighty attitude is imposing working practices that do not gel with the midland auto industry workforce .