Flowtech Fluidpower plc, founded as Flowtech in 1983, is a UK supplier of technical fluid power products with distribution facilities in the UK and Benelux. It offers a range of Original Equipment Manufacturer (OEM) and Exclusive Brand products to over 3,600 distributors and resellers. Its catalogue contains approximately 52,000 individual product lines and is distributed to more than 85,000 industrial end users. Over 80% of product is stocked and if ordered by 10pm, can be delivered next day in the UK. The Group’s headquarters and main distribution centre is in Skelmersdale, Lancashire with further distribution centres in the Netherlands and China. The Power Motion Control Division (PMC) has operations in Merseyside, Northern Ireland and the Republic of Ireland.
Distribution
Like many businesses Flowtech as a distributor has been significantly affected by technology over the last few years. Principally through disintermediation. By this I mean that in 1983 when the company was founded most buyers were potentially unaware of sources of supply and unaware of the prices for products. When they bought they bought from the one or two names they knew and these were often local. Today for a standard product Google makes the world your oyster. You can get pricing and availability on a worldwide basis and if a part is €50 in Germany it cannot be £100 in the UK if the courier cost is only £10.
Disintermediation has also removed much of the skill gap that the distributor had over the customer (a) the internet allows customers to skill up should they wish, comparatively easily and comparatively cheaply (b) the internet allows customers to go directly to the manufacturer with queries on application and best product.
This means that distributors have had to follow various strategies;
- Source ever cheaper product, usually using your “Own Brand” label to validate it.
- Get into a niche where you have either non-standard parts, that others do not have. Or you can add value around the offering. If people come to you for support and that enables you to offer the ABC123, you can charge a little more as its not worth their while to go and source the ABC123 from someone else. Or better still use your own part number so they have to run the risk of respecifying to your competitor.
- Cut costs out of the business by moving operations to a low cost environment or investing in technology to deliver cost savings.
- Get scale so you can afford to operate at a lower margin as there is more revenue across which to spread the costs.
- Hold higher stocks than you might wish to as customers want specific parts rather than close to, and the distributors added value is in short time delivery.
To its credit management seem to be well aware of this and driving forward on all fronts. It is however an ongoing issue for any distribution model. You sit between a rock (the manufacturer who thinks your margin is depriving him of sales) and a hard place (the customer who always is looking for a cheaper source of quick supply).
Current Results
I entitled this report “Not as good as management would have you think’” following the last set of results. The interims for 30th June 2016.
In the period compared to the same period last year revenue went up 28%. (£27.4m from £21.4m). Which I do consider to be progress, but it is because they bought revenue through acquisitions
At the same time GP went up 33% from £7.2m to £9.6m largely for the same reasons.
What has me wondering is management then declare that the underlying profit has gone from £3.4m to £4.1m a growth of only 19%. Suggesting “underlying” cost growth is running ahead of gross profit growth as a percentage. Not optimum.
Now regular readers will know that there is in my opinion a fine line between the word “underlying” (accountant speak) and “made up” (common understanding). Accountants may be dull, but they certainly do not set standards such as GAAP and IFRS to mislead and so I believe any reader should always look at the GAAP profitability and look very, very carefully at the reconciliation between the two.
Under GAAP the pre tax profits have only moved from £3m to £3.3m. Given I have rounded its about a 9.3% increase. This is not nearly as good as management is trying to present. Not even half as good.
Clearly it begs the question as to how valid the two different numbers are and within the accounts there is a reconciliation.
Management Operating Profit £4,059,000
Acquisition Costs -£238,000
Amortisation of Intangibles -£264,000
Share base payments -£149,000
Restructuring -£118,000
UK GAAP Operating Profit £3,290,000
Frankly I think the deductions are in Flowtech’s case rubbish.
Going through them one at a time;
Acquisition Costs
This is a business with an avowed acquisition strategy. To then say the costs of implementing the strategy should not be reflected is pretty weak. I am sure management are not going to ignore the revenue or the gross profit of the strategy so why would they regard ignoring the cost as legitimate.
This is even more reinforced to my mind if you focus on one part of any of the deals they have done. In each acquisition they have picked up staff. Why if they were to hire, train, pay the staff and pay the recruitment company would the cost be legitimate, but if they buy the staff ready to go its not a legitimate cost.
There are limited situations where stripping out acquisition costs make sense, but seldom in an avowed acquisition strategy and seldom for the type of acquisitions Flowtech is acquiring.
Amortisation of Intangibles
There is a reasonably nuanced discussion to have about amortising intangibles. It is quite dull and I do not intend to try and synopsise it here. All I would say is that Flowtech in its treatment of each acquisition note (Note 7 to the interims) shows that it is not operating a block policy but has different amortisation rates. This does not suggest to me that amortisation in the Flowtech business model is inherently wrong. On top of which and perhaps more importantly for an acquisition model it is a very real expenditure. When management tell you it’s a non cashflow entry, that can be true, but only because they have already given the money away. As it is with the acquisitions in the period it is in fact a cashflow in the period.
Share based payments
I am sorry but anyone who claims share based payments are not a cost should be taken out and shamed in public.
Just as an example I hold 5 shares in a £10 note and you hold the other 5 shares. We both hold shares worth £5. We then do a share based payment to you of 5 shares. There are now 15 shares in the £10 note and my 5 shares have gone from being worth £5 to being worth £3.33. You have taken £1.67 from me to you.
That is share based payment and it is incredibly expensive, because in reality when we invest in a firm we are doing it because we expect the £10 to become worth £20. So by issuing the 5 extra shares we account for a £1.67 cost. But in reality it costs £3.34 as it is also costing out of my future gain though that is not recorded.
Restructuring
Management made a mistake, the wrong people were hired, the wrong office opened, the IT system did not perform. In the accounts it is called “activities of an operational nature”. As far as I can see it’s a category where if management don’t want something to be counted against their performance they can put it in here and it’s not their mistake. It can all be swept under the restructuring carpet.
More normally restructuring gets stripped out as a category (though this is not in Flowtech’s notes) because it relates very clearly to an acquisition and the steps needed to bring it into the group. But if you have an acquisition strategy then its just a different part of the standard business model you are going to run and so to not count it in evaluating management is to my mind fairly ridiculous. Flowtech is going to buy businesses, it will restructure them and the efficiency with which it does that is a core requirement of the management.
Holding FLO.
I am currently a shareholder in Flowtech.
I think distribution businesses are usually easy to understand and management have been working along the general plan they set. I like managements that set out their stall and then deliver.
I also think one set of results is only one set of results and I need to be careful to make too much of them.
However I am very aware that if you don’t know who the patsy is, you’re the patsy and Flowtech with their “underlying” figures do seem to think the shareholders are dumber than management.
Given these results, and there is a lot more to them than just the parts I have mentioned here, (including the growth in debt), I am not particularly looking to buy. But I am not planning to go and sell. I will hold and hope the delivery has improved between now and the final accounts such that the difference between GAAP and underlying is not so large.
But I am wavering between seeing management as broadly saying and then doing, which was a core part of my original investment thesis, and being a bit sly and over-egging their performance.