IN THE MIX - JSE MAGAZINE

IN THE MIX

The variety offered by the diversified industrials sector may be more interesting to investors in a time of volatile markets

IN THE MIX

As the JSE classification ‘diversified industrials’ suggests, this disparate collection of firms don’t have much in common apart from a goal to use a mixture of businesses as a model to spread risk.

Because of these differences, it is not useful to compare them in the way an investor might analyse the relationship between a ‘pure’ sector and the interest-rate cycle before ranking these peer companies in terms of financial prospects.

Despite the differences between the constituents of the diversified industrials board, there are some shared sectors. Bidvest and Barloworld both distribute goods and sell cars. Barloworld and Eqstra both service ‘yellow equipment’ used to build bridges and dig mines, leaving them directly exposed to the slump in construction and extractive commodities. The sector is also not the only place diversity can be found.

Still, Bidvest argues that ‘by spanning such a broad spectrum of businesses, sustained growth in the short, medium and long term remains possible even during economic downturns’.

In SA, a country with a fragile currency and anaemic economic growth, international geographic diversity presented by the sector may be more interesting to investors than an offering of unconnected domestic businesses.

Over recent decades, Bidvest has been the star performer, achieving a 29.2% compound annual growth rate in the 22 years to 2013. In areas such as distribution, where there are low margins, Bidvest has built a massive scale, with an annual group turnover now close to R200 billion.

Led by Brian Joffe, Bidvest has, in general, been able to execute a disciplined acquisitive growth strategy, building an SA logistics operation into a global firm. It now includes a sizeable business in one of the most stable economies: the UK.

Despite this move, Bidvest has not abandoned the SA market, characterised by growing threats, including to the rule of law. Quite the contrary.

In 2014, Bidvest snatched a strategic 34.5% investment in local drug firm Adcock Ingram Holdings. With support from fellow shareholder, the state’s Public Investment Corporation, Bidvest was able to block a R12.8 billion bid by Chilean company CFR Pharmaceuticals.

While the transaction was obviously not a PR exercise, the deal to keep Adcock SA will have done Bidvest no harm in projecting a favourable image to government. Good government relations can be important for many reasons.

Winning official permission – and political endorsement – to continue its own offshore-growth strategy is one.

All the while, Bidvest continued a twin strategy of pushing geographic diversification into developed and more volatile emerging markets. Through European acquisitions in June 2015, it will maintain its model of adding scale and integrating smaller firms into its logistics business, the biggest in the group.

In the fragmented Italian food logistics market, it acquired 60% of food distributor Gruppo Dac as well as a controlling stake in the UK-based PCL 24/7 in 2014, for a combined £95 million.

By June 2014, the trading profit contribution from its international foodservice operations had risen from 32% to 36%.

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‘Barloworld’s building-equipment sales depend on the tail end of the cycle, when fixed capital formation peaks’

REUBEN BEELDERS, CHIEF INVESTMENT OFFICER, GRYPHON ASSET MANAGEMENT

Despite this steady expansion into food distribution in Europe, Joffe remains cautious about how an increased dynamism in business can benefit Bidvest. He argues that while African economic growth rates are high, many economies remain small, particularly in sectors such as industrial and corporate logistics. This suggests Joffe does not feel the continent is yet a fit for Bidvest’s model of extracting efficiency from economies of scale.

‘Our consumer products business also has many African customers. This clearly gives added weight to our Africa growth strategy, but it would be premature to think Bidvest is now positioned for substantial and rapid African expansion,’ Joffe states in Bidvest’s 2014 annual integrated report.

To some degree, the diversified industrials are similar to traditional conglomerates, such as the old Anglo American and the current General Electric, that were a popular model until the 1980s.

A number of these conglomerates were built by acquiring underperforming companies or firms at bargain prices. The model was fuelled by rapid economic expansion, and in the case of apartheid SA, being cut off from the global economy.

A firm dominant in a core domestic sector had few expansion options other than to move into new sectors.

According to chief investment officer at Gryphon Asset Management Reuben Beelders, conglomerates traditionally focused more on opportunities offering earnings-enhancing deals, rather than on a specific company or industry strategy.

‘A number of these companies acquired businesses at good values and were ruthlessly efficient in taking out excess costs in the operational structures of the businesses acquired,’ he says, pointing to the success of Bidvest’s CEO in buying underperforming firms.

‘Joffe has been able to cut expenses to the bone and make a profit where others could not.’

This relentless drive to increase efficiency in subsidiaries sets conglomerates apart from firms that chase the fatter profit margins that can come from innovation. In modern-speak, conglomerates are not disrupters (such as Apple) but firms that squeeze out profits.

As a result, says Beelders, company performance at conglomerate targets (after some initial gains from cutting costs) is more a function of underlying economic growth than anything else.

Bidvest, with its exposure to steadier sectors in the economic cycle – such as food distribution – is relatively defensive, he says.

This is contrasted with the earnings performance at Barloworld, where the biggest businesses, construction and mining machinery, are even more influenced by the economic cycle.

‘Barloworld’s building-equipment sales depend on the tail end of the cycle, when fixed capital formation peaks,’ says Beelders.

This is because infrastructure developers and miners usually have the confidence and funding to commit to big capital expenditure only when an economic upturn is well under way. By the time they get to ‘breaking ground’ with diggers and drills, it is often already deeper into the cycle.

However, Beelders says this ‘late cycle bias’ at Barloworld is mitigated by an increasing focus on generating steadier income from maintaining clients’ equipment through the cycle. In addition, performance at the vehicle-sales division peaks at an earlier stage in the cycle than businesses associated with big capex.

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Barloworld, built on securing the local rights to Caterpillar equipment sales in 1920, was once the classical diversified industrial giant. By 1989, it was number 79 in the Fortune 500 list of top companies. But within 10 years, the model of the enormous conglomerate at Barloworld had begun to unravel, indicating that massive diverse companies can become too complicated to manage efficiently.

The group was radically downsized and committed to stricter financial performance metrics. However, it never abandoned diversity to concentrate on a single sector.

Today, the biggest business remains equipment sales, including the Caterpillar brand, and automotive, including SA car dealerships. Geographic diversity has been maintained in equipment but, during the global financial crisis, it had the misfortune of exposure to Spain, a country hit hard by the disaster. More recently, Barloworld has (for now) been able to ride out the storm in Russia, where financial sanctions and low oil prices are predicted to drive the economy into a recession.

Eqstra, like Barloworld, also leases capital equipment. In 2015, it was forced to curtail capital expenditure and suspend dividend payments after lenders were reluctant to refinance its heavy debt burden, owing to the depressed construction sector.

‘A general slowdown in mining and infrastructure activity in SA continued,’ Eqstra says, commenting on the business environment in the six months to December 2014.

RECM portfolio manager Paul Whitburn says: ‘Eqstra was spun out of Imperial Holdings due to the capital-intensive nature of the asset base and the underperformance of the contract mining division. The passenger and industrial-leasing businesses are good operations with strong market shares locally but the mining division continues to underperform because of a tough environment.

‘Management has actively tried to shrink the mining business and allocate more capital to the performing businesses.’

Remgro, although dwarfing the other firms in the sector in terms of market cap, is ‘the odd man out’ among the diversified industrials. While diversified by sector, it is more of an investment holding firm than a diversified industrial. This is because it does not control most of the companies that it invests in. Despite this, Remgro does have influence at these firms, frequently through formal agreements. Investments are also not limited to industrials. Indeed, Remgro’s biggest investments are in the FirstRand banking group – including its holding company RMB Holdings – and Mediclinic. Both investments had stock market valuations of about R36 billion on 31 December 2014.

Of interest to investors is Remgro’s continued focus on the Southern African region – even risks in SA, the most sophisticated economy, have risen.

‘Remgro focuses on the Southern African market but international opportunities will be considered with reputable partners,’ the group states in its 2014 integrated annual report.

Remgro’s investee companies are not limited to having businesses inside Southern Africa and many do, such as Mediclinic’s Swiss business. However, Remgro has little direct exposure to foreign firms.

Chairman Johann Rupert publicly advocates a mix of SA patriotism and outspoken criticism of its government. To date, there has been no sea change in Remgro’s geographic strategy, such as a major direct investment in a foreign firm. As recently as June, Remgro announced it would help Mediclinic buy 29.9% of UK firm Spire Healthcare for about R8.6 billion.

In a statement, Remgro said: ‘In addition to investing in a growing developed market, the Spire acquisition provides Mediclinic with a further opportunity to diversify into an attractive new geography with a strong currency.’

However, the Mediclinic move could represent more of a gradual geographical realignment than a fundamental change. If threats associated with SA persist, it will be interesting to see if the investment strategy changes to push further north into Africa or Europe.

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[p4]Of interest to investors is Remgro’s continued focus on the Southern African region

KAP, a transporter of industrial goods and manufacturer of wood products, has recently catapulted from a small-cap firm on the JSE into a medium cap, following the 2012 acquisition of Steinhoff Africa’s industrial assets.

The firm has since been simplifying its structure into two clearly defined units – diversified logistics and diversified industrial – shedding underperforming subsidiaries along the way.

Over time, the Steinhoff deal (which resulted in Steinhoff International increasing its control over KAP), will potentially continue to give KAP access to funding and deal-making opportunities. This makes it a space to watch.

For small-cap firm Argent Industrial, the challenge is more concrete – continuing its welcome return to profitability in 2015. As a local steel trader and manufacturer of steel products, such as Xpanda security gates and Jetmaster fireplaces, the company trades in two of the country’s toughest segments: steel and local manufacturing.

‘Argent has not escaped the downturn in demand for steel and beneficiated steel products that has followed the drop-off in construction activity in SA,’ says Whitburn. ‘The same underlying economics have also negatively impacted the ArcelorMittal and Aveng market valuations.’

The domestic steel industry and metal beneficiation are two sectors government talks most about supporting and reinforcing with enabling legislation. However, until this discourse is followed with concrete support, it is speculative to assume there could be any benefit to Argent. It is of concern that, to other sectors, the disadvantages of state interference in the market could be significant.

For conglomerates in general, a return to the heyday of the diversified industrial model in SA seems slim. Currently, there are few drivers – and no immediate signs of rapid economic expansion to fuel the acquisitions. While risks to the state and business must be seen on the downside, there is little indication of a return to the extreme situation where SA was cut off from the global economy. This scenario could pressurise firms to make local acquisitions outside their expertise to keep growing.

These ideas are vague parameters – nobody can predict the future. For investors, the only measure of certainty will come from thorough research into the tangible ‘nuts and bolts’ in the sector.

By Tom Robbins
Image: Andreas Eiselen/HSMimages