Ricardo, crawling out of recession

Keeping faith

The best that can be said of Ricardo‘s (RCDO) performance in 2010 is it remained profitable. Profitability (green lines) fell, though, as the company, which designs and manufactures advanced engines and transmissions primarily for motor vehicles, earned 15% return on equity.

Despite the relatively poor performance, perhaps forgivable in a year marked by recession, Ricardo continues to make investors wealthier (yellow and orange bars) as it expands in Asia, and related industries like defence, and clean energy. The dividends it has paid over the last decade and the equity retained in the company, adds up to more than double the company’s equity in 2001.

Ricardo doesn’t pass the statistical tests for inclusion in the Thrifty 30 now, though. With an F_Score of four out of nine it looks financially weak, and costing nearly fourteen times average earnings, it doesn’t look particularly cheap, so if I were a purist, I’d eject it from the Thrifty 30 model portfolio.

But profitability is the most important factor in the F_Score and, judging by the annual report, diversification seems to have protected it from the complete collapse in profits it experienced in 2004, the last time business from auto manufacturers all but dried up. In 2010, 44% of orders were for passenger vehicles, which may sound like a lot, but in 2006 52% were.

The other factors, mostly negative this year, were only marginally so. Current assets at the end of the year, for example, are 2.7 times current liabilities, a shade lower than last year, but still comfortably above levels at which the company might be unable to fund its operations. The company has very low levels of bank debt.

One potential bogie, though, is the pension scheme. Ricardo has finally closed it to new contributions from existing members, having previously closed it to new members. That’s a good thing as it’s big. The pension obligation is over £100m, and the value of the fund is £34m less. I think the company is unlikely to pay off the deficit, as planned, by 2016, but at least its done what it can to reduce the pressure.

According to Sharescope, Ricardo has not cut its dividend since the data starts in 1992, and it’s maintained the pay-out in 2010. This, says new chairman Michael Harper :

…reflects the Board’s confidence in the prospects of the Company, based on the improving market conditions and the work that has been undertaken to prepare the Company to take advantage of them.

Outside India and China, which are small but booming markets for Ricardo, the company expects to profit from economic recovery as vehicle manufacturers, which unlike Ricardo cut back on R&D during the recession, lack the capability to develop new products on their own. Until demand for new cars picks up, though, Ricardo’s customers are innovating little more than they have to, to meet new emissions regulations. Longer term it expects to benefit from renewed interest in engineering that reduces emissions and fuel costs.

Having added the shares at £2.55, they ‘re now a third of the way to the my target of £3.95. I’m always unsettled when a company in the Thrifty 30 has a lacklustre year, but it’s important to keep things in perspective. Ricardo is profitable, financially sound, and has skills that are likely to be in demand in the future. So far, it’s weathered contraction in the auto industry better than it did last decade.

My son will be delighted I’m keeping faith in the company that designs and manufactures dual clutch transmissions for Top Gear‘s favourite car, the Bugatti Veyron.

Thrifty 30 updates

The current Thrifty 30 portfolio

Northgate’s chairman buys lots of shares.

Northamber buys back a small quantity of shares, and the company publishes a positive update by it’s standards. Management’s mood has changed from death-watch to caution.

Ricardo engineers value in awful auto sector

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

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We all love Peter Lynch (audio).

In theory:

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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.