ARB focus leaves CMI behind

The difference between maintaining a sharp focus and taking your eye off the ball can be stark. And in this article, we’ll compare two similar industrial companies—ARB Corporation and CMI—that are poles apart in terms of focus.

If ever there was total focus in the headquarters of CMI, we don’t see it today. It’s true that Max Hofmeister is the kind of straight-talking leader we respect. And we’ve even recommended the stock in the past, taking advantage of a dirt cheap share price to make what turned out to be a quick profit. But we wouldn’t touch it at anything other than a bargain price.

We ran the rule over it again recently, with the stock down 44% since our last mention in issue 145/Feb 04 (Sell—$2.21), but we remain unconvinced. The company owns businesses such as CMI Operations, a broad label covering several engineering and manufacturing businesses, and Toowoomba Metal Technologies (TMT).

The part most similar to ARB Corporation, however, is TJM, the second-largest four wheel drive accessory manufacturer in the country. TJM was acquired by CMI in 1999, and we considered it a pretty canny acquisition from a company already experienced in the automotive parts industry.

Browner shade of turquoise

While we’d choose ARB in any head on, the TJM assets are quite valuable. CMI Operations and TMT are tougher, more competitive, and generally lower margin businesses. But they have value nonetheless, and this engineering side of the conglomerate has a worth that at least approximates to the sum of its parts. Such diversification within an industry sector can be justified, although the logic is overrated if you ask us.

As those of you lucky enough not to be colour blind will know, if you take the base colour blue and add some white and a hint of yellow, you’ll end up with a rather mesmerising turquoise. But add just a few more colours and you’ll get brown. We can pinpoint the exact moment that CMI lost its turquoise and became brown—it was back in 2003 when it bought Capitalcorp, a chattel finance broker. In our opinion, this acquisition made about as much sense as Ian Thorpe adding archery to his event list.

Judging by what the company has said about the acquisition, we suspect that one of the main reasons for it was to reduce CMI’s exposure to its other, tougher, businesses.

We’re very sceptical of this ‘acquire your way out of a tough business’ attitude and it brings to mind a quote from a book called, funnily enough, Focus, by Al Ries: ‘Familiarity breeds respect. Companies that know their own industry inside out often feel that they can’t make any more progress in the business they’re already in. The competition is just too smart and too tough. Unfamiliarity breeds contempt. On the other hand, they confidently wade into a business they don’t know, secure in the knowledge that the competition is dumb and easy to overcome.’

We could talk at length about the risks of non-financial companies acting like complete bankers, but the Capitalcorp business doesn’t seem a particularly risky one to us. What does concern us, however, is how it might take management’s eye off its other balls. When Capitalcorp is soaking up time, how closely can management be watching, say, TJM’s main competitor?

Dogged determination

Which brings us to ARB. How has this company responded to difficulties presented by high petroleum prices, high steel prices and a skilled labour shortage? With focus and a dogged determination to be the best at what it does. With oil prices on the rise, the company has doubled its efforts on products for the four wheel drive utilities market, where sales of the smaller, diesel powered vehicles have grown significantly of late.

High steel prices are outside management’s control. But that hasn’t stopped it from firing shots at BlueScope Steel, and the company is continually searching for better deals. And, while the shortage in skilled labour is affecting output from its Melbourne factory, the company will soon be opening a new plant in Thailand, where there is no shortage of skilled welders prepared to work for a fraction of the wages here.

While CMI was buying companies in other areas, ARB bought the four wheel drive business Kingsley Enterprises, as well as buying back its Western Australian distribution business when the opportunity arose. Even more has been invested in building up ARB’s network of branded stores.

We won’t bang on about ARB too much, as we’ve said it all before and you can read it all on our website. But we firmly believe that management is tackling the issues head-on and focusing on the business it knows best.

ARB has built a strong business and has some valuable patented products, such as the ARB Air Locker, so it should outperform CMI. But much of its success can also be put down to focus.

As you’ll see in the table on the previous page, average growth in sales and profits over the past five years have been remarkably similar for the two companies. But that’s where the similarities end. Where it really counts, ARB has whipped CMI’s pants in earnings and dividend per share growth. As you can see in the accompanying share price chart, that’s made a huge difference to the fortunes of the companies’ respective shareholders.

Cash generation

There’s a reason ARB has been able to turn its sales and profit growth into similar growth in earnings and dividends per share, while CMI hasn’t come close. ARB’s much higher profit margins and return on capital mean it has generated the cash to fund its growth internally (refer to the Investor’s College articles in issue 181/Aug 05 and issue 170/Mar 05 for more about these measures). CMI, on the other hand, has relied on debt and new share issues to stoke the fires of growth.

Perhaps it’s a little unfair to be making this comparison. CMI is a reasonably well-run operation, but we’re putting it head-to-head with one of the stockmarket’s best performers of the past 20 years. CMI has plenty going for it, not the least of which is a 12 cent annual dividend, putting it on a fully franked yield of 9.8%. But, if history is any guide, that’s unlikely to grow quickly, and it could indeed take a backward step at some stage.

Little room for error

In recent years, most of the free cash flow has gone to pay dividends, so there’s little room for error. With the stock down significantly, we’re keeping our eyes peeled because it could offer compelling value at some stage. For those who continue to own it, we’re upgrading to HOLD FOR YIELD. We also keep an eye on the CMI Preference shares, but don’t yet find them compelling either.

ARB Corporation, as you’d expect, doesn’t look as cheap as CMI. Its historical PER of 17 and yield of 3.4% don’t make it a bargain. But the company has an excellent track record of growing earnings. In the recent past, it’s managed to maintain underlying earnings in the face of rising oil and steel prices, and the latest third-quarter sales figures, discussed in issue 199/May 06 (Long Term Buy—$3.35), looked strong.

We expect the stock to put in a decent effort over the years in spite of tougher conditions. And if oil were to get a little cheaper, it might hurt our collective holdings in Roc Oil, but it would do wonders for ARB Corporation. Our recommendation remains LONG TERM BUY.

Disclosure: The author, Gareth Brown, and other staff members own shares in ARB Corp. and Roc Oil.