Value.able: Why I love ARB

Driving better profits from a sound business model means four-wheel drive specialist ARB remains a favourite

PORTFOLIO POINT: Making accessories for the four-wheel drive market might sound boring, but the latest figures offer exciting reading.

I am most excited about companies that are in boring industries. You might recall my column (here) enthusiastically discussing Embelton, a manufacturer and distributor of '¦ wait for it '¦ hardwood flooring. Since that article the stock has surged to new all-time highs. Great companies that are run by reliable and trustworthy managers can produce returns that are anything but boring.

Right now, retail and other sectors such as property have declined in prominence in the various indices. As a result, fund managers worried about their “tracking error” don’t need to own as much of these companies’ shares, which in turn means brokers don’t receive sufficient brokerage fees to warrant an analyst covering them. The net result is that analysts are made redundant, and coverage of the stocks declines along with the price multiples being asked for the shares. For a long-term value investor, this is bliss.

And with that we turn to the results of another of my candidates for most boring industry award: ARB Corporation. ARB manufactures and distributes 4WD aftermarket accessories. Think bull bars, snorkels, fridge-freezers and winches (among other items) manufactured in Thailand and Kilsyth and distributed around the world, now through 43 stores (16 company owned – think of the long-term store rollout potential!) from Africa and the Emirates to Mongolia.

Strong local demand has protected ARB from the impact of Thai floods on vehicle supply and a very strong previous corresponding period (thanks to a large order). And just as local demand in January (holidays) and February (job losses) will trim sales, a restoration of car manufacturing supply chains offshore will offset it.

In the most recent half, ARB increased sales 2.3% to $132.1 million, maintained its EBIT of $24.9 million, increased its net profit by 1.6% to $18.3 million and its earnings per share by 1.6% to 25.2¢. The interim dividend also rose by one cent to 11¢ a share.

Many investors might be concerned about the flat EBIT. Don’t be. This reflects increased staffing and in particular staff in the research & development department. It’s this department that is responsible for the company’s innovative product lineup that included the release of the Sahara bull bar range (2000), the Emu Dakar leaf springs (2005), the recovery strap range (2007) and the fridge freezer (2008). While the cost is expensed, investors should think of it as an investment in the future. EBIT was also flat thanks to store expansion and the NPAT increase merely reflected an increased interest income item. Like I said, don’t get too excited!

Some of our “informers” have, however, explained that price rises have been possible and if you have read my book Value.able (click here), you will discover just why I think this is the most valuable competitive advantage.

The resource boom in Queensland and WA is having a positive impact on smoothing the company’s revenues and earnings in addition to the obvious direct impact on aftermarket product sales. The company’s production facilities have been running full-tilt and this appears to have resulted in some buildup of inventory, which in turn has had an impact (not material) on cash flows and the value of materials and consumables used compared to sales.

Full capacity production facilities add to inventory that has become backlogged as a result of slow vehicle throughput, due to the Thai floods and Japanese earthquake. I expect the inventory will run down again as deliveries of post-flood vehicles overseas ramps up.

I am encouraged by the Thai facility being at full production so soon after commissioning, because it suggests that management were unduly conservative in their estimation of their global reputation. I expected more cash to be needed for an upgrade or expansion and that has been announced. With returns on equity the envy of their listed peers, I am delighted to see the company invest more.

At an ASX seminar I presented yesterday, one attendee asked about the impact of currency on the company. This was a very good question: It’s important to note that for ARB there are two impacts. The first is a strong Australian dollar is great for margins when inputs are purchased from overseas. The flipside is that marked-up revenues earned offshore are impacted negatively as the dollar strengthens and those revenues are repatriated.

Historically, the company has a record of paying special dividends and, with $32 million in the bank, it is understandable that many analysts would use this line to woo investors into the stock (as an owner of the stock; “go for it” I say!). But the large cash balance is partly the result of $7 million raised in 2010 (through an underwritten DRP if I recall correctly) and special dividends will also be dependent on the level of investment the company makes in plant:

Such an outcome is not beyond the realms of possibility but neither is a permanently higher dividend payout ratio. The latter of course reduces the intrinsic value of the company – better that MD Roger Brown keeps the money in ARB and reinvests it at near 30% returns on equity.

At the current price of about $8.63, ARB is trading just above its 2012 intrinsic value estimate. With only 43 stores globally and only 16 company owned, fully utilised production facilities suggest the company has scope to grow while sustaining high rates of return on incremental capital for decades, notwithstanding management’s energy to do so. It seems boring but slow and steady seems to be winning the race.

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

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