Interactive Investor

Cut big-spending Renishaw some slack

28th October 2016 15:29

Richard Beddard from interactive investor

At a recent UK Individual Shareholders Association (ShareSoc) meeting I mentioned I was going to Renishaw's Annual General Meeting the following morning.

The investor I was talking to laughed, and replied: "They're the ones levelling the playing field between institutional investors and private investors. They tell institutional investors bugger all as well!"

Renishaw has a reputation for being tight-lipped. Journalists say the same. I must admit to harbouring doubts about the wisdom of driving cross-country from Cambridge to Wotton-under-Edge in Gloucestershire, which might as well be in Wales, if the chances were I'd learn nothing.

Then again, I've never been to an AGM where I've learned nothing.

At the meeting, Phil Oakley, ShareScope's analyst, gave a presentation on the cash flow statement and the ratios you can derive from it.

Phil prefers to invest in companies that are already succeeding and his preferred method for determining success is not accounting profit, which in its enthusiasm for presenting an accurate account of corporate performance by matching expenses to revenues, can mislead investors if the revenues don't materialise.

Say a company invests in a new factory to make a new product. Accountants spread the cost of new machines out for as many years as they are expected to be productive. Instead of deducting the cost from the profit and loss account in one year, they depreciate it incrementally, year after year.

That improves the profit figure a lot in the year the money is spent, and dampens it a bit in subsequent years. The cost of the machine is expensed only as it is used up, or worn out.

That's fine if the company profits from the machine. If the product is a dud, though, and nobody buys it, the company may write-off its investment, which means the money was wasted and the profit that may have given investors the confidence to invest in the company was inflated.

A less forgiving view

The cash flow account is not so forgiving. The whole lot gets deducted as the money's spent. Phil judges a company by its free cash flow. His definition is slightly more complicated but, at its simplest, free cash flow is cash generated from operations (i.e. after operating costs - the cost of making and selling things and running the business) less capital expenditure (investment).

The idea is to see how much money the company has left, to pay a dividend, say, and whether it is generating enough cash to stay in business. If not, it might have to raise money, slash capital expenditure, or, one shudders the thought, go bust.

At Renishaw, investment has had a disconcerting impact on free cash flow and return on capitalLet's say our company had not only invested in the new factory but also manufactured lots of the new product, building up stock to sell to customers. The impact on profit at the year-end would be limited. The cost of the investment would be depreciated, spread out, so only a portion would be expensed in the year. And if the stock had not been sold yet, it would not be expensed either.

The cost of the stock is parked on the balance sheet as inventory, and the residual cost of the investment after depreciation is parked there too, as property plant and equipment.

However, the company has had to pay for the additional stock, and it's had to pay for the machinery, so it's all deducted from cash flow.

This is not an academic exercise. I have just described Renishaw in its most recent financial year. Investment has had a disconcerting impact on the two key performance measures, free cash flow, and return on capital.

Renishaw's numbers explained

In 2015, Renishaw's investment in stock, notably the new RenAM 500M additive manufacturing (aka 3D printing) machine, and property plant and equipment, as well as other less significant items of expenditure, wiped out the cash flow Renishaw earned from selling countless tools to automate factories, its core business.

A company can't sustain negative free cash flow forever, at some point it will run out of moneyIn other words, free cash flow (by my crude definition) turned negative. Return on capital fell too. Return is profit, and that almost halved in 2015 compared to a bonanza year in 2014. But damage was also done by an increase in the denominator of the return on capital calculation: capital. Renishaw had much more operating capital in 2015 than it did in 2014, at least the way I measure it.

In 2014, Renishaw had a lot of cash, which I deduct from operating capital, but in 2015 it spent it on machine tools, the refurbishment of its facility at Miskin in Wales, IT infrastructure, a new facility in Chicago and, notably, making RenAM 500M machines and additive manufacturing solution centres, which will introduce the new machines to Renishaw's customers. It turned cash, which could be paid to investors, into capital the company requires to grow.

The result: profitability more than halved from a record return on capital of 27% to 13%, the lowest level since the Credit Crunch, and the company's cash balance (it has no borrowings) fell from £81 million to £31 million.

Perhaps Renishaw's done all the spending it needs to on plant and equipment for a whileProfitability down, free cash flow negative, cash depleted. It doesn't sound good, does it? A company can't sustain negative free cash flow forever, at some point it will run out of money.

There are three ways to staunch the flow of cash: either the company generates more profit and cash from its investments to pay for future capital expenditure, it borrows, or it slakes its thirst and reduces investment. Perhaps Renishaw's done all the spending it needs to on plant and equipment for a while.

I went to Renishaw's AGM wondering which route it expects to take.

A far from cosy AGM

Accustomed to the AGMs of smaller companies, I was overwhelmed by Renishaw's. It was more like an iPhone launch than a cosy chat with the directors.

In the Innovation Centre, where the meeting takes place, you're rubbing shoulders with demonstration machines as well as staff and shareholders. The machines cycle silently through routines, eerily whisking their way around components, probing and measuring them.

At 50, I almost certainly reduced the average age of the audience of shareholders At 50, I almost certainly reduced the average age of the audience, although my presence would have been more decisive had the gathering of silver-haired shareholders not numbered more than 200. I decided they must be former employees checking up on the business paying their pensions. They weren't there to ask questions. Despite the roving microphones only two people asked questions.

I wasn't one of them. Always a bit slow to get going, I was caught out when everyone trooped off to lunch, but I buttonholed a director on the way out.

I don't think Renishaw will ease up on capital expenditure much. It expects to fund future investment from growing cash flows, which is exciting. That, along with the export-boosting devalued pound, probably explains why the share price is at an all-time high after a year in which profit almost halved.

But I wonder if, in their enthusiasm, investors are right in taking growing cash flows for granted.

Renishaw believes its 3D printer could move the tech from quick prototyping to industrial productionI've highlighted the investment in additive manufacturing machines and solutions centres because they were highlighted to me. These are big photo-booth sized machines, not the probes and gauges that are Renishaw's meat and drink. Both product groups incorporate much of the same technology, but the machines are on a different scale, a scale that is perhaps only matched by Renishaw's ambition.

One of the advances Renishaw has made in the RenAM 500M is a powder recirculation system that reduces the need for manual handling. Metal powder is the raw material the machine uses to manufacture things layer by layer. In other words, the RenAM 500M is more automated.

Renishaw believes it's sufficiently automated to turn additive manufacturing from a quick way of prototyping components that will ultimately be manufactured by machine tools into a mainstream technology for industrial production.

Bigger challenges ahead

No doubt Renishaw faces more challenges than I can imagine if manufacturers are to switch part of their production lines to additive manufacturing. For centuries they have shaped components with machine tools. While there are advantages - additive manufacturing can make more complex shapes for example - manufacturers are fully invested in tried and tested technologies.

Renishaw's medical arm is also investing in tomorrow's technology, but it's lost money since 2010This is why Renishaw is building solution centres, which allow customers to work with Renishaw to increase their knowledge and confidence in additive manufacturing, and develop new manufacturing processes and designs that incorporate the machines.

The solution centres are manufacturing facilities, which include private incubation cells with machines. At year-end Renishaw had built four of them, and a global network spanning the UK, Europe, USA, Canada, India and China should be almost complete now.

I haven't even mentioned surgical robots! Renishaw's medical division is also investing heavily in tomorrow's technology, but it's been making losses since Renishaw started disclosing its results in 2010.

The company now has robots installed in hospitals in Barcelona, London, Cardiff and Liverpool, and it's built a mock-operating theatre at its facility in Miskin to train surgeons.

Renishaw expects to profit from robot sales, and from the consumables they use, but the lesson of surgical robots is that it can take a long time and a lot of money to commercialise new technology.

Investors seem to have cut Renishaw some slack vis-à-vis its cash flow problemsRenishaw's cash flow was bothering me before I made the journey across to Wotton-under-edge. It was bothering me at the masterclass during Phil's talk.

I asked him. What about companies that are genuinely investing for the long-term future? Renishaw has a long and illustrious history of investment and innovation. Surely we have to cut companies like these a bit of slack?

Recognising the importance of investment to the economy he said we do. He might give a company a few years for the investments to pay off and return on capital to improve.

Investors seem to have taken that decision, to cut Renishaw some slack and, somewhat nervously, I have too.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

Details of all recommendations issued by ii during the previous 12-month period can be found here.

ii adheres to a strict code of conduct.  Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.

In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.

Related Categories