Product testing and certification specialist Intertek has set fresh hurdles to win back favour with investors. By improving underlying revenue growth and margins, the FTSE 100 group hopes to revive a flagging share price, but there are potential stumbling blocks.
The group hopes to push annual like-for-like revenue growth up by mid-single digits and return the adjusted operating margin to a former peak of 17.5 per cent, and then some. Over the past decade, the former has been shaky at best, coming in at a low-single digit rate.
Performance over the past two years was better, at 5.6 per cent in 2021 and 4.9 per cent in 2022. But both years contained pandemic-related skews.
Intertek reckons it can squeeze better and more consistent growth by focusing on markets with higher structural growth, such as health and safety, green energy and assurance. Such markets account for just over half group revenue and are capable of increasing underlying sales at a mid-to-high single digit rate.
Assurance work involves evaluating a product’s supply chain rather than more basic product testing, attempting to root out issues such as contamination and slave labour. Without the need for the same extensive laboratory systems, assurance work is more capital light and higher margin. After a restructure that increased the number of divisions from three to five, this arm accounts for 20 per cent of revenue, double the size it was in 2014. The idea is that by leaning more towards such activities, it can push the adjusted margin beyond the 17.5 per cent-mark.
The market isn’t convinced. The shares are close to their lowest in almost a decade, at 18 times forward earnings. China, which accounts for about a fifth of underlying revenue, could provide an easy fillip this year. But the risk of geopolitical tensions between Beijing and the West, and moves by some major manufacturers to shift production elsewhere, remains an existential risk.
More immediate is the risk of shakier consumer demand. Testing, inspection and authentication of consumer products accounted for just under a third of revenue last year. That income stream might not be linked to the volume of products sold, but it is tied to the number of product ranges launched, which is less appealing when the potential payoff could be curtailed by the macroeconomic downturn.
The real test of whether Intertek can deliver on new revenue and margin targets starts next year. Analysts at Shore Capital have forecast organic growth a little under 6 per cent and a margin of 17.6 per cent. Sustaining progress may prove tricky, as the brokerage points out.
Why? Two main reasons. One, attractive structural growth markets might soon attract more competition as they mature, Shore Capital thinks. That could impact sales volumes or pricing. Two is the risk that a battle for skills means wage inflation becomes more of a burden. In the current era of racy pay increases, Intertek has offset roughly half via increasing prices and the rest by operating efficiencies. That might be harder to continue as price inflation eases across the market.
Acquiring higher margin businesses will be an easy way to improve profitability and Intertek has the funds to do more deals. Net debt stood at 1.1 times adjusted earnings at the end of last year, below a target multiple of between 1.3 and 1.8. Cash generation is also strong, which also means there is room to increase capital expenditure to 5 per cent of revenue, in line with rivals like SGS and Veritas. Proving it can expand the top line by its own volition will be a tougher test to pass.
ADVICE Hold
WHY Investors are right to reserve judgment on whether the group can meet medium-term targets
Diploma
Market cap £3.82 billion | Half-year revenue £583m
Slowing inflation should help investors to carve out companies capable of generating genuine growth. Take the industrial distribution specialist Diploma, which has raised organic revenue and margin guidance for the year despite most of the price inflation passed through in the past two years being largely spent.
The FTSE 250 group expects revenue to rise by about 7 per cent this year, better than a consensus forecast of just over 5 per cent. Sales volumes have done most of the heavy lifting in the first half of the year, accounting for more than half of the 10 per cent organic growth, and are expected to account for an even greater share during the final six months. Pushing forward the top line ahead of cost growth means that the margin is also expected to come in at about 19 per cent, better than previously thought.
The group sources and supplies industrial seals, gaskets, specialist wiring and cabling to a wide array of industries, ranging from renewable energy to healthcare. It is coming off a period of elevated sales growth, caused by inflation and stockpiling by manufacturers in the era of snarled-up supply chains after the pandemic. Yet organic growth is bang in line with historic rates, defying any expectations of a decline in demand amid the macroeconomic downturn.
That comedown from a post-Covid high is reflected in a forward price/earnings ratio of 24, down from a peak of 38 and below the average since November 2020. That might still seem a toppy valuation, but Diploma’s premium is justified by a consistent earnings record of a compound average of 12.5 per cent over the past decade.
A recent £233 million fundraising has given Diploma plenty of cash to spend on more bolt-on deals, designed to broaden its reach further into the US and continental Europe and into structural growth markets. The group has a solid record of deploying funds efficiently: a return on capital employed of 17.8 per cent easily outweighs an average cost of capital of just under 10 per cent. If it can buy up more companies with higher margins, such as the cable specialist Windy City Wire, margins could also rise faster.
ADVICE Buy
WHY Boosting margins could push the share price higher
