A Portfolio of AIM Shares (6); Nichols PLC and Advanced Medical Solutions PLC

Note: For the preliminary filters used to select AIM stocks, see http://thejoyfulinvestor.blogspot.co.uk/2013_09_08_archive.html

Nichols PLC

Nichols's Vimto, courtesy Wikipedia

 

Nichols is a soft drinks company based on Merseyside. In 2004, the company transferred its listing from the Main market to AIM, explaining that, after selling its foods business, the size of the company did not warrant the costs associated with a Main listing. Nichols has a good trading history, a high return on equity and holds net cash of 31 million pounds, 7% of its market value.

Nichols is currently eligible for 100% business relief for inheritance tax, it has a 'free float' of 73%, a market capitalization of 428 million pounds and it trades on a bid to offer spread of just over 1%. The Nichols family owns about 27% of the company's shares.

Although Nichols's brands either owned or under license, cover all main segments of the soft drinks market, except for water, its share of the UK market is only about 1%. And the total market has grown by a compound average of 3% since 2006 (British Soft Drinks Association):

Drink sales UK	Nichols's brands	Total UK Sales in Pounds Million	% Total growth 2006 to 2012
Carbonates	Vimto, Panda, Sunkist, Levi Roots	8,707	30% value
Still & Juice drinks	Vimto,	1,820	14% value
Dilutables	Vimto, Weight Watchers	955	20% value
Fruit Juices & Smoothies	Weight Watchers	1,860	2% value
Total		13,147	20% value
Sports & Energy drinks (Included in carbonates and still drinks)	Extreme Energy and Sport	1,665	82% volume

From 2013 Refreshing the Nation, British Soft Drinks Association.

However, while the total drinks market (excluding bottled water) has grown by 20% in value, Nichols's sales have more than doubled. Nichols does not give sales figures by brands, but it is reasonable to assume that this is the result of acquisitions and license agreements:

•     2005 - Panda (including Panda Cola, the 3rd cola drink after Coca-Cola and Pepsi in the UK),   was purchased for 5.5 million pounds.

·         2010 licensed Levi Roots (Caribbean flavoured carbonates) worldwide rights.

·         2011 licensed Weight Watchers cordials and fruit juices for the UK and Ireland.

·         2012 licensed Extreme Sport and Energy for the UK.

Vimto is the brand Nichols launched in 1908. And Cabana is the third largest supplier of dispensed soft drinks, to pubs etc., in the UK, after Britvic and Coca-Cola Enterprises.

Vimto exports account for 21% of Nichols's sales, mainly to the Middle East and Africa.

Shares in Nichols (in blue) have outperformed the FTSE All Share (in green) by a wide margin.

Courtesy Yahoo, click to enlarge

Nichols runs a very lean organization. It bills 660,000 pounds per employee. The company relies on contracting out production, which keeps capital expenditure and inventory low while avoiding any temptation, as its CEO remarks, "to feed the factory." 

Financial results are excellent:

 

1. Earnings per share have increased by a compound 16% per annum since 2004, and equity per share has increased by a compound 12% per annum in the same period. 

2. Net margins are a comfortable 15% of sales. 

3.  Return on equity, both historically and on retained earnings, averages 35%, and this is without any financial leverage. The company holds 31 million pounds in net cash. 

4. 5-year net operating cash flow, after small amounts of capital expenditure, covers the dividend 2.2 times, leaving 19 million pounds to build up its cash holding. 

5. The only concern is its 6.6 million pound liability for its defined benefit pension scheme. Though the scheme is closed to new entrants, this liability will only rise. 

2013 has begun well. In the interim report at June, Nichols reports an 11% increase in earnings and a 13% increase in the dividend. 

At 1,145p, Nichols trades on an historical PE ratio of 28 and yields 1.5%. The outlook in the interim report is positive: 

"UK consumer spending remains cautious and for the remainder of 2013 we expect the soft drinks market to be characterised by low volume growth and significant promotional activity. Against this backdrop, we are pleased with the Group’s performance in the first half of 2013, in particular the success of our strategy to improve margin and increase profitability. 

   In the second half of 2013, we will be finalising our revenue growth plans for 2014 and beyond including the introduction of further new products, entering new international markets and importantly continuing to invest in our existing core brands. 

   We expect Group performance for the remainder of 2013 will be similar to the first half of the year and therefore anticipate the full year results will be in line with current expectations."

My valuation model values Nichols' shares at about 1,000p.* This is not far from its present price of 1,145p, which is just 7% off its all-time high.

 *Assumptions: earnings per share growth 10% p.a.; equity per share growth 10% p.a.; return on equity 30%; dividend payout 43% of earnings; average PE ratio of 21.5, all discounted at 10.8% (3.8% SLXX + 2% operating risk + 5% margin of safety) for the years 2013-18.

 

The cautious investor will note that: 

1. Nichols has a new CEO. She is the former managing director of the Vimto brand. 

2. The company has moved its promotion from carbonate to still drinks. While margins are better at the still drinks business, it does imply that its 2005 purchase of Panda has not worked out as expected. 

3. The soft drinks business is fiercely competitive. Nichols is dwarfed by Coca-Cola, Pepsi, Snapple, Suntory, Britvic and A G Barr (see http://thejoyfulinvestor.blogspot.co.uk/2013_09_01_archive.html). This makes it very difficult for Nichols to get shelf space in the supermarket chains.  

4. The underlying soft drinks business is not growing in volume terms. Nichols management has proven to be wily. It has improved margins and licensed new products. But, can it match its past performance?

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Advanced Medical Solutions PLC

Sticking plaster, courtesy Wikipedia

Every once in a while an undeserving company, from an investor's viewpoint, slips through my filters. I read its annual and interim reports and run some numbers to confirm that it is a financially solid business with decent growth prospects at a reasonable price in the stock market. Then, after spending hours on researching its history, its market, its management and its accounts, I detect a decidedly fishy scent.  Normally, I would spend no more time or thought on the company.

However, Advanced Medical Solutions (AMS) is an example of a company that looks good on the surface, but is the classic trap for the unwary investor. So that is why I am discussing it in this blog. The name suggests a company run by science PhDs with laboratories of white-coated scientists developing new advanced solutions to medicine. The world, one might imagine, is their oyster. And a quick look at their accounts shows sales have grown at a compounded 22% since 2004 and net debt, at only 3% of equity, is expected to be paid off by December this year. Trading on a PE ratio of just 19, and Cheshire-based AMS would seem to be a snip.

But consider:

1. Most companies that list on AIM require funds to grow their business. And they are often owned by their founders or directors. AMS came to AIM in 2002 from the main market, where it had been listed since 1996. AMS's shares tumbled in value as the company ran up years of losses and then raised funds via an emergency issue of new shares. Long-term investors have not recovered their money. AMS shares (in blue, FTSE All Share in green) are 20% below their 1996 issue price.

Graph courtesy of Yahoo, click to enlarge.

2. AMS's wound care products are pretty low tech - sticking plasters, super glue and collagen sutures that surgeons use for sealing and stitching wounds.

3.  The company has a tiny market share in wound care products, both in the US and globally. In the US 80% of wound care products are sold by Johnson and Johnson, compared to 1% by AMS.

4. Half AMS's business is providing 'white label products' and bulk materials for concerns such as Boots, which then add their own label. So about a half of its revenues is by nature a commodity business.

5. AMS has bought growth, rather than generated growth organically. In 2002, it acquired Medlogic, which had developed LiquiBand and Liquishield liquid sealants, for 2.5 million pounds. In 2009, it paid €4.8 million for Corpura, a Dutch company manufacturing foam dressings for wounds. And in 2012, the company increased its revenues by 50% with the purchase of Resorba for 55 million pounds. Roserba is a German company specialising in collagen sutures. On each occasion, AMS has issued shares to pay for part, or all, of the purchase cost.

6. Management, in its annual and interim reports, largely avoids references to market share, its main competitors or overall market dynamics. This is strange coming from a company that is essentially a marketing and acquisition-based concern.

AMS has succeeded in integrating its acquisitions and improving their profitability. Net margins are now (2013 interim report) at 22% and its most recent return on equity is a respectable 15%. With its end market, wound care, growing slowly (by 3% in the US and by nothing in the UK) AMS must acquire more companies to keep growing. So although 2012 sales were 55% ahead of 2011, all but 3% was due to its acquisition of Resorba. And the problem, for the shareholder, is that the company must issue new equity to finance its purchases. It does not generate sufficient cash from its business. This also explains the miserly dividend payout of just 11% of earnings, giving a yield of 0.5%.

The long-term investor will want to avoid companies that:

1. Must regularly issue new shares to finance their growth. The constant call on new capital is a drag on performance.

2. Carry an unfounded aura of technology at the forefront of their industry. Many companies survive on the fringes of a large market. But, from the investor's viewpoint, the main hope is that they will be bought out by a bigger competitor. This is not a good reason to buy their shares.

3. Employ management that obscures the trading conditions of the market where it operates.

4. Beware of public relations reports masquerading as analyst reports. For example, City Insights begins by describing AMS in the following terms:

"Founded in 1991, AMS is a leader in the development and manufacture of innovative and technologically advanced products for the US$15 billion global wound care market. These products are sold in countries across the globe either directly or through strategic partners and distributors."

With a turnover of $84 million, AMS's global market share is 0.6%. A leader it is not.