Value.able: The makers

PORTFOLIO POINT: Reports of the death of Australian manufacturing are greatly overstated. Some companies are thriving.

“Manufacturing in Australia is dead,” goes the cry. High salaries, higher rents, the strong Australian dollar and “level-playing-field” policies that result in Australian businesses becoming the doormats on which foreign competitors wipe their feet ensure a bleak long-term future for Australia when the resource boom runs its course.

Successive governments, whose self-interest ensures short-term “wants” trump long-term “needs”, have done little to improve this situation. An uncompetitive retail sector, little in the way of self-sustaining manufacturing, continued growth in foreign ownership agricultural assets and ineffectual attempts to create a regional finance hub will ensure that once the resource boom is over, we might all be running around serving each other lattes.

At least we can make a decent coffee.

But are things really that bleak? Sure our tax system should be rewritten to reward businesses that generate attractive returns rather than incentivise businesses to lose money, but even within an environment that is broadly regarded as uncertain, some manufacturing businesses are producing attractive results.

There are many sources of success in manufacturing. Businesses that deal in low-priced and/or bulky items have an advantage over other participants because such items are prohibitively expensive to ship and so cannot be exploited by the generation of consumers used to shopping from the family laptop. Until Ikea figures out how to flat pack a caravan, the manufacturing of such items here will continue.

Investors looking for manufacturers that have a chance of succeeding in this environment should seek out companies that:

• Have built a brand and or reputation for quality, value or innovation.
• Is vertically integrated; that is, it owns or operates the distribution channel.
• Make a highly specialised product and is not competing on price alone.

While it’s a shame that successive governments have allowed manufacturing to “die”, there are pockets in the sector in which investors can succeed, especially when the market’s manic phase turns depressive.

Currency considerations

Before tabling some of Australia’s listed manufacturers, it’s worth explaining how the currency impacts the sector. Put simply, if there is an imported alternative, a high Australian dollar makes Australian buyers more inclined to purchase the overseas product.

At the same time, overseas buyers are more reluctant to purchase an Australian-made item, because it costs them more, in their own currency, than a similar item available elsewhere in the world. Australian manufacturers and those who are also exporters therefore become less “competitive”.

By way of an example, the ABS notes car production is now at its lowest level in more than 50 years. The Chamber of Commerce and Industry Queensland cited recent research that shows almost two in three Queensland businesses have been hurt by the ongoing strength of the Australian dollar and subsequently found that 56% had altered their business practices (code for laying off staff and importing cheaper inputs) because of the high Australian dollar and are concerned about their decreasing competitive advantage

The strong Australian dollar is a double blow for our agriculture sector because as the strong Australian dollar sends growers to the wall, cashed-up foreign buyers have entered the fray to pick up the scraps, owning the land we then plough for them.

Some listed manufacturing exporters note the high Australian dollar also has the benefit of making their imported inputs cheaper. The positive impact is limited, however, as this table shows.

-Higher dollar, lower profits
AUD	US55¢	$US1.10
Revenues	5454.55	2727.27
Inputs	1818.18	909.09
x
Gross profit	3636.36	1818.18

If we assume a manufacturing exporter buys 1000 tonnes of inputs at $US1000 a tonne and sells its 1000 tonnes of exports at $US3000 a tonne, you can see that when the Australian dollar rises from US55¢ to $US1.10 the price of inputs halves. This is the improvement raw material importers frequently cite when the Australian dollar rises.

But if sales are also priced in US dollars, they halve in Australian dollar terms and therefore so does the gross profit and as you can see it’s the reduction in revenue that hurts the manufacturing sector the most. Currency hedging in such an environment can limit the extent of the deterioration in gross profit in a rising currency environment, however, having the means to execute this properly is another matter entirely. Many highly regarded companies have found themselves on the “wrong side of the hedge” at one time or another.

Who’s who?

Australia still has a multitude of manufacturers producing a huge variety of products, as you can see from the following table. Many of them are shifting more of their manufacturing offshore because of the high Australian dollar while retaining the design and IP development, quality control and marketing at home.

-Listed manufacturers, ranked by Montgomery Quality Rating (MQR)
Company	ASX	Abbreviated products or brands	MQR	ROE	Intrinsic value	IV f'cast change
Norfolk	NFK	energy measurement tech	A1	23.67%	$2.02	8.01%
ARB Corporation	ARP	4WD Equipment	A1	30.03%	$10.07	9.47%
Fleetwood Corp	FWD	Caravans & Portable Accom.	A1	24.41%	$9.85	8.72%
Sirtex	SRX	liver cancer treatments	A2	31.68%	$5.06	N/A
Fantastic Furniture	FAN	Furniture	A2	21.92%	$2.47	10.02%
Alesco	ALS	Garage Doors	A2	5.68%	$1.61	19.20%
Coventry Group	CYG	Gaskets	A2	3.20%	$0.97	23.02%
Breville Group	BRG	Breville/ Kambrook	A2	23.34%	$3.80	7.58%
GUD Holdings	GUD	Sunbeam/Ryco/Davey	A2	20.88%	$7.34	11.30%
UGL	UGL	Rolling Stock	A2	14.57%	$11.53	10.30%
Structural Systems	STS	Post Tensioners	A3	18.07%	$0.89	N/A
RCR Tomlinson	RCR	materials handlinga nd processing equipment	A3	9.58%	$1.05	24.76%
Pacific Brands	PBG	Bonds/Berlei/Holeproof	A3	7.00%	$0.64	17.70%
Kresta	KRS	Blinds	A3	11.52%	$0.11	1.02%
Imdex	IMD	Drilling Fluids	B1	26.75%	$2.54	7.36%
Zicom Group	ZGL	Hoists/concerte mixers	B2	19.78%	$0.59	17%
Little World Beverages	LWB	Beer	B2	23.01%	$1.34	18.20%
Capral	CAA	Aluminium Products	B2	1.49%	$0.03	100%
Paperlinx	PPX	Paper Products	B2	-2.14%	$0.02	0%
Austin Engineering	ANG	Mining Equipment	B2	25.86%	$5.05	-2%
Coca Cola Amatil	CCL	Softdrinks	B2	28.45%	$10.14	11.70%
CSR Ltd	CSR	Building Products	B2	9.81%	$1.94	17.10%
Adelaide Brighton	ABC	Cement	B2	16.50%	$2.38	12.90%
Incitec Pivot	IPL	Agricultural Fertilizers & Explosives	B2	13.27%	$3.30	0.96%
MaxiTrans	MXI	Trailers/Tippers	B3	7.42%	$0.17	24%
McPherson's	MCP	Cutlery/Personal Care	B3	13.93%	$3.54	5.86%
Patties Foods	PFL	Four'n'Twenty	B3	15.33%	$1.26	14.70%
Gerard Lighting	GLG	Lights	B3	16.16%	$0.99	15%
Maryborough Sugar	MSF	Sugar	B3	10.23%	$1.60	-8.00%
Ridley Corp	RIC	Stockfeed	B3	10.99%	$0.85	11.80%
GWA	GWA	Toilets/Sinks	B3	14.16%	$1.98	9.50%
Boral	BLD	Bricks	B3	6.52%	$2.20	45.90%
Downer EDI	DOW	Trains	B3	12.30%	$3.48	14.30%
Hills Industries	HIL	Water Tanks, Ladders Clothes Hoists	B3	8.09%	$0.90	14.80%
Amcor	AMC	Packaging	B3	17.23%	$5.53	19.20%
Orica	ORI	Industrial and Food Chemicals & Steel Bolts	B3	20.05%	$24.43	13.90%
Symex Holdings	SYM	Soap/glycerine	B4	8.19%	$0.38	7.85%
Penrice Soda	PSH	Sodium Bicarbonate	B4	1.61%	$0.01	200%
Warnambool Cheese	WCB	Cheese	B4	14.83%	$2.69	7.78%
Goodman Fielder	GFF	Food ingredients	B4	8.06%	$0.76	0.86%
Dulux Group	DLX	Paint	B4	51%	$2.69	-1.00%
Nufarm	NUF	Agricultural Chemicals	B5	7.43%	$2.91	8.30%
Nomad Building	NOD	Prefab Portable Accom	C4	12.63%	$0.11	100%
Aust. Vintage	AVG	Wine	C4	5.37%	$0.42	3.99%
Foster's Group	FGL	Beer	C4	95.74%	$3.08	10.20%
James Hardie	JHX	Fibre Cement	C5	50%	$0.00	0.00%
* Subject to change (automatically upon company announcements)
Source: Forthcoming A1 Service

As you can see, Australian manufacturers produce a comprehensive array of products from pharmaceuticals and chemicals, to beer and toilets. Can you figure out which of these have a competitive advantage?

The table reveals a surprising number of manufacturers although you might not immediately identify the company with the sector. Many of these have a long history of operating through a variety of economic conditions. I have ranked them from A1 to C5 (and could have included CSL and Cochlear near the top) so that you can immediately see the broad spread of quality, although I would not ignore those at the bottom of the table. I frequently find looking at the tails of such lists to be just as important as the top.

I have also included estimated intrinsic values, but you should be aware that these valuations can and do change automatically, particularly when a company announces an acquisition, a share issue or buyback or updates its profit guidance – events that can happen at any moment in time and indeed may have taken place between me writing this column and you reading it.

So, once we take a peek behind the hyperbole and examine the detail we can reveal that manufacturing in Australia, while declining in volume, is far from dead. In fact some businesses are positively raking it in. Manufacturing is tough and because inflation is always running against a business with a high proportion of fixed assets; smart managerial decisions are constantly required. I wonder if any studies on longevity have compared owners of manufacturers to those of, say, an internet café.

Somewhat counterintuitively considering all the headwinds – manufacturing businesses with little or no debt, high rates of return on equity with bright prospects for intrinsic value growth and are trading at substantial discounts to intrinsic value, may just prove to be the one truly defensive investment while also being positioned to leverage any broader economic recovery locally and globally.

PostScript: Zicom

Eagle-eyed readers asking for an update on Zicom (ZGL), which I first wrote about on April 6, have noted that Value.able no longer holds a position in the company. For an insight as to why, the accompanying chart of the share price plotted against my estimate of its current and projected intrinsic value offers an explanation. You can see that Zicom Group rallied substantially earlier this year. However, using more conservative assumptions following feedback from my contacts that business in Singapore is slowing, it became apparent that the price was above forecast valuations for 2013, which is one of my five rules for selling.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.