I think that the thing about ARB that has confounded investors for many years is a thing that is so very easy to understand, but which I sense very few people do in fact, truly understand, and that is the phenomenon of the compounding effect.
The way I view ARB today is informed by an experience that I had, which is one that I learned that I first observed about the business in the early- to mid-2000’s: In 2002, about a year after I had bought my very first modest parcel of shares in ARB, the price of steel started to rise, after having been on a multi-year downtrend before that. The steel price continued going up for the next two years, basically trebling in 3 years.
At first I paid no attention to this (truth be told, I did not consider it to be a big deal for ARB’s earnings even though I knew that steel tubing was obviously a raw material input into the business).
In late 2004 some analysts (of the few that followed the stock at the time) were starting to write about the earnings risks to ARB due to their rising input prices, and they started to downgrade their earnings forecasts for the FY05 and FY06 financial year. The stock, having rising from around $1.80 to when I bought it in 2001 to almost $4.00 by late 2004, started to fall. In my naivety, I – being somewhat less street-wise than I am today and also less-loathsome of broking analysts – duly sold my shares at a touch above $2.90 in 2005.
While I had missed the share price “peak” by some way, I had still done OK, I told myself.
Especially if there was a margin crunch looming, as analysts and even the popular financial media, were predicting.
Well, the FY2005 result was published, and there was no signs in it whatsoever of being affected by the steel prices that had been rising the preceding 12 to 18 months.
Gross Profit Margins were, in fact, firming, and not being squeezed, as conventional wisdom had been suggesting.
ARB’s GP Margins during the Great Steel Price Spike of 2002 to 2005:
While this outcome surprised me somewhat, I put it down to the fact that ARB was that – because ARB was accounting for its raw material inventory at historical prices – that it still had “cheaper” steel in stock from which it had been drawing down in the FY2005 year, which had temporarily shielded the company’s margins from the higher mark-to-market pricing of steel raw materials.
This financial headwind would surely be evident in the FY2006 year, I thought.
(After all, there was no way the analysts could possibly be wrong, was there?)
Well, when the FY2006 result was announced, and I saw the GP Margin come in at 51.2%, the penny dropped for me: this company had some decent pricing power.
For context:
Over the four-year period that I had followed the company (three as shareholder, and one as interested onlooker), between FY2002 and FY2006:
Revenue went from $79m to $126m (a rise of 60%),
EBIT went from $12m to $19.5m (up 65%)
And DPS went from 6.5cps to 11.5cps (up 77%)
Lo and behold… the analysts were wrong.
Very, very wrong.
On digesting the FY2006 financial result, and what it meant, I duly bought as many shares as I could afford, having to pay north of $3.50.
I clearly remember about this sequence of events. I had:
- paid $1.80 for a stock,
- sold it at $2.90. (incurring a capital gains tax liability in the process), and the
- bought it back again at $3.60.
Pretty dumb.
A lesson in how not to invest.
Of course, my stockbroker did OK out of this, clipping the brokerage ticket 3 times.
They got paid for…well… getting it completely wrong.
(As an aside, it was this sequence of events that first made me realise that analysts are complete tools, and are never to be trusted for good investment insights)
Where I am going with this long diatribe of personal history is a demonstration of the sometimes deceptive notion of “valuation” derived from placing point valuation multiples on single-period earnings metrics.
For the subsequent 12 months’ EPS reported by ARB came to 20.1cps, meaning that I was effectively paying a prospective P/E multiple of: 360/20.1 = 17.9x.
At the time it seemed like a bit much to pay, but I did so on the basis that even if the company got some way to repeating the stellar financial performance of the past 4 years, then the growth in EPS would soon eat into the rich multiple.
Well, what actually happened is that the growth, from an already heady level, actually accelerated:
In the 4 years from FY2006 to FY2010:
Revenue increased by 80%, EBIT went up 130%, EPS increased by an eye-popping 150%, and DPS increased by 70%.
This meant that based on my entry price, the P/E multiple of 17.9x on prospective earnings in 2006, reduced to just 7.5x in relation to 2010.
It’s fair to say that the stock didn’t trade at this 7.5x multiple; instead, the stock price had ratcheted up to over $7.00 by then.
I think you can see where I am heading with all of this.
And that is, if the company continues growing for the next decade like it has done for the past two decades, it will matter little whether one pays a multiple of 15x, 20x or even 25x of current earnings.
To assess the scope for this to occur, the questions that I think need to be asked are:
1. Does ARB have the management vision, expertise and appetite for this?
2. Does ARB have the scale and the systems to do so (or, at least, can it build the scale and the systems that are required)?
3. Does ARB have a brand that packs enough of a punch to support this sort of growth?
4. Can ARB’s management fund this growth without taking on undue financial and operational risk?
5. Is it physically practical for ARB’s Revenue’s to rise further by a factor of almost three times (i.e., is the addressable market big enough to absorb that much ARB product)?
On points 1 to 4, I would answer quite unequivocally in the affirmative.
Point 5 is open to some conjecture: ARB’s current sales come to around $360m.
I think that, to be happy to buy the stock today - at the current forward P/E multiple of 25x and EV/EBITDA multiple of 15x - requires the belief that ARB’s sales will, at some stage in the next 10 years, breach the $1.0bn mark (i.e., another near-trebling of current Revenue in the next decade).
For, at this level of Revenue, ARB’s Net Profit will be close to $160m (up from some $47m today).
And in such a situation, even if the stock was to de-rate from its current P/E multiple of 25x, to its historical average in the high teens (around 17 times), the market value of the company would be around $2.7bn, which is double its value today.
That translates to capital gains of around 7.5% per annum which, when added to the 2.5% pa dividend, gives at total shareholder return close to 10%.
Compared to inflation, I would consider that to be a more than acceptable return, especially on a risk-adjusted basis.
Which is why I own the stock today, and which is why, if I did not have the meaningful position that I already do, I would certainly make my debut purchase.
Put yet another way, if an old aunt died and left me a few squillion dollars, would I buy more ARB shares?
Yes. I definitely certainly would.
..
ARB Price at posting:
$16.55 Sentiment: Hold Disclosure: Held
(20min delay)