Description

Flowtech is a value-add distributor of critical pneumatic and hydraulic parts to a diverse range of sectors and end users, predominantly across the UK. Flow had problems pre-pandemic driven by lack of acquisition integration driving a bloated cost base, poor working capital controls, and deteriorating cash flow coupled with deteriorating leverage metrics. There has now been strategic and management overhaul including a new well-regarded chairman who has bought £750k of shares (c1%). The new strategy is bearing fruit and we see scope for Flow to be a much more efficient organisation with a clear pathway to at least return to historic levels of earnings plus £5m of cost savings and improved working capital with c4x stock turn.

Flowtech is a true value investment – unloved, coming through a turnaround, and beaten up through COVID – still trading on

Overall, we don’t think that £20m+ of EBITDA with a 15-20x multiple is a stretch in the fullness of time with larger peers trading on 50-100% higher than this. This points us to over 500p versus the current 120p share price.

Description

Flowtech came to market in 2014 with a strategic aim of consolidating the Fluidpower space, which it somewhat successfully did until Q32018. Unfortunately, the business was stuck in a cycle of overpromising to try to keep the share price high to facilitate further acquisitions which resulted in a large miss. A change of management (CEO) was announced along with a change of strategy which was to pause the buy and build and focus inwardly. This new strategy was outlined well, but management were slow to execute the restructuring, with a lax board, until things came to a head in 2020 with COVID and aggravated shareholders. A new chairman, Roger McDowell, well versed in turnarounds, came in with the support of majority shareholders.

Flowtech generates revenues though a component distribution business (c84% of revenue) which delivers essential components and solutions into various industries and onto other re-sellers. The services business (16% of revenue) is a somewhat struggling division which designs bespoke industrial products to a customers’ specification. This business is in turnaround and lost c£1m of operating profit last year but we expect it to recover in line with guidance to c£0.8m of profit in the near term.

Fluid power is utilised across every industrial sector and is split c70% hydraulics, 20% pneumatics and 10% conduits for gases and liquids. The markets are fragmented and in hydraulics Flowtech are typically supplying to OEMs or resellers into OEMs. Pneumatics are typically supplied directly to end-users or to resellers who sell to end-users, as such, pneumatics is more typical recurring MRO type spend, whereas hydraulics is more capex type. Flowtech estimate they are more heavily weighted into MRO pneumatics (40%) than hydraulics (60%).

Market

Flowtech have a c10% share of the UK market. Management think that as we come out of COVID they will take share as they are better financed and will have better stock availability than small players. Management think that they can grow at 3% above market rates over the coming years aided by the above and supply chain consolidation across the OEM space. We think that roughly translates to 18%/ 9%/ 8%/ 7% growth in 2021 through 2024, respectively (we forecast more conservatively than this as per the valuation section)

Investment thesis

> Value add service drives attractive economics: Flow provides a value-add service through maintaining stock of critical components and providing expedited, typically same day or overnight delivery. This is crucial for customers who have experienced an outage and require parts to get back online. In turn, this drives higher than average gross margins of c35%. We think that there is scope to grow this nearer to 40% as the business scales and makes more efficient use of its fixed direct cost base.

> Emerging operating leverage from site rationalisation: management outlined a plan to make £5m of cost savings through site, headcount and systems rationalisation. Following years of unintegrated acquisitions, the business was fat with over 20 sites and multiple systems. 2020 drove a significant amount of restructuring with £1.6m of annualised cost savings (a further £1m identified, out of a total of £5m expected in time) primarily relocating the regional distribution sites to the primary centres in Skelmersdale and Leicester with a corresponding 45 headcount reduction. These sites have plenty of capacity to grow. The £1m saving identified is expected through automation investments (mainly Kardex machines which improve picking efficiency and optimise floorspace allocated to stock). The balance to £5m is expected through procurement synergies as the business grows. There will be investments required to support growth and transition to e-commerce and optimising systems/ IT but less than the cost savings outlined.

> Improved working capital controls improve cash conversion: Russel Cash has impressed us with his focus to sustainably drive cash from the business through better working capital practices. As a distributor, availability of stock is key with Flowtech stocking over 55k products. Stock turn has historically trended around 2.5x but with the inventory progress made in the year we think the business has the foundations to improve turns closer to 4x. This, combined with work around payable and debtor days has driven over £9m of w/c savings albeit with some reinvestment required to grow post COVID.

> Setting up to beat: the business has historically been in position of over promising and under delivering. With management changes and COVID they withdrew forecasts and waited longer than most others to reinstate guidance, but this time we think that they have set expectations very (too) conservatively. Combined with our growth drivers set out below, we note the revised remuneration structure which will pay out cash bonuses for significantly exceeding market expectations, it makes sense that management will have set the market expectations conservatively.

We also note other guidance within the annual report such as target to beat market growth by 3%, combined with the BFPA guidance which we set up above, which drives the following growth rate ranges which are significantly ahead of where consensus is set:

And finally, the assumptions around the intangibles forecasting based on management’s internal budget which we think point to higher than consensus growth rates. These taper down to the long term 2% growth rates but are somewhat higher than consensus.

> Multiple drivers underpinning this growth: two main drivers for growth are organic and inorganic. Organically, we think there are strong tailwinds emerging. Firstly, the British Fluidpower Association has published guidance for the markets which we have already discussed above.

We expect post COVID stimulus tailwinds as spending filters into construction sectors alongside already reasonably established large infrastructure projects such as HS2. Perhaps more significant is the UK Super deduction scheme which was announced in the 2021 budget. This will run from April 2021 to April 2023 and will provide companies with tax deductible capital allowances for investment made in this period. For every £1 invested, companies should reduce taxes by 25p and this should naturally drive increased capital investment and also pull forward planned investment.

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/967202/Super_deduction_factsheet.pdf

 Inorganically, there remains a massive market of regional distributors which could be consolidated, both in the UK and in Europe. The BFPA website lists over 700 such businesses in the UK alone. Flowtech is only c10% of the market so we think could quite feasibly acquire and take share up to 20% of the market. This would likely require some investment in further distribution hubs, but should still drive very significant operating synergies overall.

> Multiple expansion driven by return to growth...: when Flow was executing its buy and build strategy (in hindsight, poorly) it had been rated around mid-teens EBITDA. We think that it should at least return to this level, but with the added benefits of being fundamentally a better business with improved margins and working capital management driving better cash conversion. We do not think that a 15-20x EBITDA multiple would be particularly challenging for:

·         A business with a fragmented market to consolidate;

·         Which can acquire bolt-ons dilution and debt free from its own balance sheet

·         Which would generate synergies by plugging into existing distribution infrastructure (this wasn’t done last time)

·         With strong short- and medium-term organic tailwinds

·         And GDP+ growth on an underlying basis

> ...and e-commerce optionality: the new Chairman has specifically earmarked investment into a more advanced e-commerce platform with the aim of generating something akin to Amazon Prime for fluidpower parts. The initial investment in 2021 of £1.25m has already been made and will go live in the latter part of this year. With over 11,000 customers but relatively little and/or unconnected sales data, we think that there is great opportunity here to increase wallet share of existing customers and attract new ones. Flowtech would be one of the first adopters in this space with most competitors too small to justify the investment in this channel. A single platform would also allow the business to scale much more efficiently internationally which would open more attractive M&A opportunities. The ecommerce investment is being lead by Paul Gedman who was previously CEO of wellness division within The Hut Group.

> Aligned and incentivised management team: as explained above, the incentive scheme has been overhauled with a cash bonus linked to beating market expectations this year. Chairman, Roger McDowell, has also recently purchased 750,000 shares, over 1% of the equity, which we deem significant. Roger has a good track record for creating value in small UK listed companies, many of which are turnarounds.

> And an engaged shareholder register: finally, Flowtech has attracted the attention of several UK smaller company investors some of whom are activist or quasi-activist. Our conversations with other investors highlight many of the same points we have already made: great opportunity in the recovery; highly cash generative; low hanging fruit; strong consolidation play; but has lacked focus and execution. There is a general feeling that this business with a mediocre history does have the attributes to be great over time and with the right attention paid by the management team. We think that the involvement of these holders will drive this agenda over the short and medium term.

Valuation

Happy to post a model if there is interest, but will keep it light for now.

Consensus is as below:

2021/ 2022/ 2023

Revenue: 102/110/114 (historically has done £112m so these are not stretching)

EBITDA: 7.4/ 11.4/ 11.3 (historically has achieved £12m albeit with some flattering exceptionals)

Net debt today £11m

EV/ EBITDA: 11.4/ 7.4/ 7.4 (reasonably cheap given where valuations are across the market)

As above, we think these numbers are light in terms of revenue growth and set up so that management can significantly beat.

We see the business growing to £135m of revenue by 2025 which would be only +c3% share gain versus the current position. This should generate c£17-18m of EBITDA based on reasonable margin assumptions (35.4% gross – should be upside to this) and some cost savings coming through.

Assuming less than perfect execution against the working cap targets we think this drops through to c£12m+ of free cash flow. Management have outlined M&A targets in the region of £10m revenue, assuming £0.5m contribution on day1 and some efficiencies, we see ample runway to achieve £20m+ EBITDA from organic free cash flow. We think that this sort of growth profile should be reasonably highly rated by the market at 15x or better. 10x would still generate a target price well over 300p.

Catalysts

Stabilisation/ recovery

Earnings upgrades in near term

Tailwinds from market drivers – UK recovery spend and super deduction

Progress on cost savings towards £5m target

Efficiency and e-commerce investment

Improving cash generation with better working capital

Consolidation longer term

Risks

Poor execution - bears will focus on the lack of execution in the past particularly since the CFO from the bad days is now the CEO. We think that the lack of execution historically was mostly driven the ex-CEO and a board largely posted missing. We think that the new CEO (ex CFO) can execute this strategy. We take comfort that the chairman has a significant vested interested here, that he has a strong record of creating value in public markets, and that a large proportion of the register is in the form of active/ activist investors. 

Low visibility - 48 hours of visibility is typical in the components business. The services business is very lumpy and has been the source of a profit warning in the past with the delayed Thames Tideway project (still in the order book and growing...). Management are now more prudent around Services and setting guidance generally.

Another round of COVID - would affect revenue and operating deleverage but already seen the resilience of the cash generation and now refinanced facilities.

Dividend cut completely - this is unlikely given recent guidance to begin paying a dividend again, but if this did happen we estimate there is 15-20% of the shareholder register as legacy income fund holders who may be forced sellers.

E-commerce flop - this channel is grassroots and could fail after consuming cash to develop. We think that this is unlikely given the general direction of travel and the careful approach by management around investment. 

Catalyst

Catalysts

Stabilisation/ recovery

Earnings upgrades in near term

Tailwinds from market drivers – UK recovery spend and super deduction

Progress on cost savings towards £5m target

Efficiency and e-commerce investment

Improving cash generation with better working capital

Consolidation longer term