When investors dived for cover during last year’s market crash, Halma had a better chance of maintaining its already expensive valuation — but now an exorbitant forward earnings multiple of 45, based on forecasts for next year, makes the safety equipment manufacturer’s shares ripe for correction at a time when inflation is rising at such a clip.
With hindsight, the fact that investors flocked to the FTSE 100 constituent last year was predictable enough. There is a reliability to its earnings stream and there are high barriers to entry, which have led to it generating a gross margin of between 63 per cent and 65 per cent for the past three decades. Since March last year Halma’s shares have risen by 87 per cent and are at a near-record high.
Its operating companies design and make products for safety and hazard detection uses through three main divisions: safety, medical and environmental and analysis. Its products include blood pressure testing monitors, fire detectors and water quality testing equipment.
The deferral of project-based work and the difficulty accessing installation sites caused a blip in revenue and profit growth during the early days of the pandemic, breaking a 17-year run, but it returned to form in the first half of this year. Revenue was ahead by almost a quarter on the same period last year and adjusted pre-tax profits rebounded by almost a third on a constant currency basis.
Yet all that was against weak comparators. Revenue growth during the second half of the year is expected to be a more normal 7 per cent to 10 per cent. The return of variable costs such as travel and trade show expenses will moderate the return on sales — roughly calculated as sales less manufacturing and operating costs — to an historical norm of between 19 per cent and 21 per cent.
The aim over the next five years is to boost organic revenue at an annual rate of 5 per cent or more and to double earnings through an even split of organic growth and acquisitions. That target looks achievable. The structural growth drivers for the manufacturer are evident over the longer term: increasing health and safety regulation, demand for healthcare services in developing countries and broader population growth, to name but a few.
Ten deals were completed in the first half and Halma has got the balance sheet strength to pursue more bolt-on purchases, with net debt sitting at only £280 million, or just under eight times earnings before tax and other charges. Getting those companies to increase their addressable market by adding product lines or entering new locations is one way of generating a better return on their investment.
Investors usually would be grateful for that sort of growth rate, but when they’re asked to pay for shares trading with a forward earnings multiple more akin to a racy tech stock, it’s not good enough. Jefferies, the broker, has set a price target of £24.35 on the stock, below the present share price of £31.24.
The pandemic can’t be blamed for all the froth in the share price — the market had slapped a forward price-earnings multiple of 35 on the shares in February last year — but rising inflation and the prospect of an increase in interest rates, which erodes the present day value of future earnings, could stretch investors’ tolerance. There isn’t a spectacular dividend, either. An increased interim dividend of 7.35p a share is expected to total 19.01p this year, equivalent to a paltry 0.6 per cent yield, given the share price rise.
Advice Avoid
Why The shares look overvalued in light of rising inflation and a likely increase in interest rates, which could prompt a correction
LondonMetric
Unlike those who are investing in retail or office property, the chief question for shareholders in industrial real estate investment trusts is not whether tenants will pay up or if property values will hold steady, but if the premium attached to the shares is still justified.
As UK-listed warehouses landlords go, LondonMetric is second only to Segro in value, with shares at a — prohibitive — 30 per cent premium to net asset value at the end of March next year. There’s no doubt that LondonMetric’s portfolio is in good shape, though. The trust’s net tangible asset value increased ahead of analysts’ expectations at 12 per cent of the first half of the year as rental values and property values headed north, alongside an occupancy rate of almost 99 per cent across its buildings.
It now plans to raise £175 million via a share placing, along with a separate offer for retail investors, the majority of which will be used to forward-fund development and the refurbishment of logistics assets.
The higher returns on offer from development are part of efforts to navigate the high price that commercial landlords need to stump up for warehouse property in generating a decent return. Portfolio deals are another, as are site refurbishments, and the company’s management doesn’t rule out more mergers and acquisitions activity of the same ilk as the A&J Mucklow deal that was completed in 2019.
Deals aren’t doing all the heavy lifting — rent reviews generated an average 13 per cent increase on previous passing rents during the first half, which rises to 25 per cent on urban logistics assets alone. There’s also an inflation link in about 43 per cent of leases, with another 40 per cent subject to open market rent reviews — not a problem, given the ferocious appetite for space at present.
An interim dividend of 4.4p a share, covered 1.1 times by earnings, is expected to come in at 8.61p a share by analysts, equivalent to a 3.2 per cent yield at the present share price. But there’s better income on offer from smaller, more cheaply valued, rivals that are trading on the London market.
Advice Hold
Why Shares’ rich valuation prices in further growth
