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Barloworld sees the green shoots of recovery

The Investec Equity Fund invests in shares where future earnings expectations are being revised upwards (or are highly likely to be revised upwards), while trading at reasonable valuations. In mid-2016 we started buying Barloworld and we currently hold an overweight position.

Founded in 1902, Barloworld is one of South Africa’s oldest companies. In the early years, the company sold woollen goods, including blankets and coats, but over time expanded into many areas including motor retail, building materials, handling equipment, consumer electronics and steel manufacturing.

As part of its evolution, the company has sold non-core assets and repositioned itself as a distributor of leading global brands such as Caterpillar, Avis, Budget, Audi, BMW, Ford, Jaguar Land Rover, Mazda, Mercedes-Benz, Toyota, Volkswagen, Hyster and Massey Ferguson.

Barloworld’s core divisions comprise Equipment (earthmoving and power systems), Automotive and Logistics. While we have a substantial holding in Barloworld, the market remains fairly sceptical about the company’s prospects. So why do we like Barloworld?

Since 2012, precious and base metal prices have been on a downward trend. These sub-economic price levels put mining companies under significant pressure, resulting in global order books drying up as production slowed.

A substantial portion of Barloworld’s revenue comes from the sale of Caterpillar equipment, which is extensively used in mining operations. Not surprisingly, the company faced a low market rating due to a depressed order book.

We, however, did not expect the capital expenditure “strike” that prevailed through the tail end of 2015 to mid-2016 to continue indefinitely. This was due to the ageing profile of global equipment parts, the increasingly positive global GDP growth outlook and signs of a better commodity price environment.

In the second half of 2016, green shoots were indeed evident in the form of better commodity prices that in turn breathed some life in the capital expenditure cycle.

In March 2017, the group order book increased by R1.3bn ($100m) from the September year-end and almost doubled year-on-year. We believe the order book should grow by a further R2bn ($150m) when Barloworld reports its profits for the 2017 financial year (as at 30 September).

In our experience, the market is underestimating the extent of Barloworld’s profit recovery in the 2018 financial year. We believe the market is not fairly pricing in its upside potential.

Yellow equipment (Caterpillar) represents more than 50% of Barloworld’s operating profits. The profit margin on parts and services is far higher than that of the sale of new equipment. Over its working life, revenues from parts and services are typically four to five times that of new equipment sold, and typically 10 times that in margin terms.

Therefore, if new equipment is sold at a 2% margin, the parts and services margin will be 20% over the equipment’s life cycle. Using this relationship, we estimate that for each additional rand in new equipment sold, Barloworld’s after-tax net present value cash flow rises by approximately 25 cents.

With the order book now recovering, future earnings should begin to show better growth. Besides better earnings per share (EPS) growth prospects, we also saw Barloworld’s low market rating relative to Caterpillar as a buying opportunity. Barloworld’s relative price-to-earnings ratio (P/E) to Caterpillar was close to its lows when we initiated our position in mid-2016. This signified a buying opportunity to us.

Barloworld’s Automotive and Logistics divisions have been under pressure, largely due to weak demand amid poor economic conditions and no interest rate relief for five years. From a low base in 2016, passenger car sales are beginning to recover, with green shoots evident in the monthly trading data in July and August 2017.

In our view, the expected 5% decline in new vehicle sales by market participants is too conservative. Provided these positive sales trends persist, we would expect to see better earnings prospects for Barloworld’s vehicle division.

In conclusion, investors became overly negative about the prospects for global mining equipment spend as well as domestic car rentals and vehicle sales. Barloworld’s market rating reflected this bearish sentiment.

However, higher commodity prices, a recovery in mining equipment orders and an improvement in the group’s operations in the Democratic Republic of Congo should drive the profit growth recovery in the 2017 and 2018 financial years. A declining interest rate cycle should also provide some underpin to new vehicle sales, another important contributor to profits.

We are confident that the new leadership team’s restructuring efforts will help to create more value for shareholders.

This article originally appeared in the 2 November edition of finweek. Buy and download the magazine here.

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