I initially invested in Flowtech (epic FLO) in January 2015. About 9 months after the company went public. At that time the company was a broadline distributor of fluid power products.
As an investor I like broadline distribution as it is fundamentally simple to understand, (though not necessarily easy to implement). In short you need the correct product on the shelf, priced sensibly. Provided you do that well you can make money. Aside from the obvious issues involved in stock holding, too much, too little or too late, the need, for the most part, to price in relation to the competition means that for a large part of the portfolio a broadline distributor is a price taker. By this I mean they do not get to set a price but have to take the price prevailing in the market. (In reality there are premiums available for service, proper stocking, product knowledge but these allow a variation from the market price not a completely different price).
However broadline distributors can create niches where significantly higher margins are available. As an example I used to work in an industry where the standard colour pallet was, black, grey or white. Other colours, such as red and blue where available but they were 5 times the price. Most people never went there, but if you wanted that colour and the project could absorb the cost then you had to go to whoever controlled that niche product and pay their price.
The emphasis of a broadliner has to be on service and cost control. Automation and digital commerce plays a significant part in today's broadliner.
There are all sorts of markets that require fluid power products but the big market in the UK is of course the oil and gas market.
So when I first invested in FLO it was an easy to understand business with the future headwind of an expected improvement in its core market. It had a PE ratio around 10 and a dividend yield of around 3%. I do not recall where it stood on Mkt Cap to NTAV but that was one area that I was less keen on. There were already a lot of intangibles on the balance sheet. Turnover was £37.8m and underlying PBT £6m.
Since then I have been disappointed in the way the business has developed. The company has significantly grown revenue to £53.8m. But has failed to grow the bottom line. It has engaged in an acquisition strategy which has helped the share price and revenue but does give me cause for concern.
My concerns are fourfold.
Firstly the company has acquired non-broadline businesses. Flo is not the first broadliner to do this and it will not be the last. Broadliners tend to look enviously at specialist and technical distributors margin as it is invariably higher. But do not always see the different model below the line. Specialists need a higher (more costly) technical skill base. The customer acquisition model is very different and you have to invest to win business. Those broadliners that make a success of their specialist divisions, and many do not, invariably end up running them as semi autonomous and potentially in competition to the broadline business. Money can be made but if I as a shareholder wanted to invest in a competitor I could buy shares in it.
Secondly UK distributors by and large don’t get good synergies from acquisitions. I understand if you are in the cement business you need local depots. But a UK facing distributor can cover the whole country overnight. An acquisition overseas or to bring on a new franchise or product area can be effective. But almost anything else is paying full price for a competitor that is not worth as much once you have taken it over.
Thirdly acquisitions increase costs, dilute shareholders and require complications over systems and training and structures. It makes it very difficult to maintain the ruthless cost control that a broadliner needs. (In 2014 excluding the IPO costs, Admin expenses were £5.5m. in 2016 they were £10.5m).
Fourthly the ongoing acquisitions and inherent reorganisation and changes in reporting make it difficult to monitor whether the company is making real progress. In 2014 revenue was £37.8m. In 2016 the Flowtechnology reporting segment did only £36.8m. These numbers are probably not directly comparable. But FLO isn’t making it easy to be sure.
On top of this concern FLO has also become one of those companies that feel the need to report a lot of non-GAAP numbers. Liberal usage of * and other items to validate the fact that the numbers you are being shown are management rather than validated by any auditor or statutory body.
FLO continues to deliver an above 3% yield. The historic PE is now 13.6 and the forecast 11.5. Price to NTAV is now 9.4. I am not aware of a direct competitor, though there are plenty of competitors. I also see that the oil and gas market has further recovery in it. I am however lowering my MoS on this share. I have been looking for a price of 190 and will now be moving this down and waiting for further information from FLO.
It is worth noting that FLO is moving to quarterly updates. I am not generally a fan of this. I would rather management look to build a successful long term business rather than looking to generate a news cycle every few months. But whilst I have FLO on watch for a downgrade I will be reading the RNS with interest.
Always do your own research and be aware I may trade out or in of FLO before I post any transaction on the trading sheet on this website.