Spirax-Sarco is a FTSE 100 industrial engineering company based in Cheltenham. It has a history of over 130 years and was listed on the London Stock Exchange in 1959. Spirax-Sarco is a specialist engineer with a heritage in steam engineering. It has since branched out into two other niche product lines: electric thermal solutions and niche pumps and fluid path technologies. However hard it may be to get excited about steam engineering, Spirax has delivered a fantastic return for investors over its long history as a listed business. A 450% rise in the share price over the last ten years is impressive, with Spirax well outperforming the S&P500 or the much beleaguered FTSE100 over the same time period. So, what is behind the fantastic results at Spirax-Sarco over the years, and, more importantly, should we be interested in Spirax as an addition to a long-term portfolio?
As previously mentioned, Spirax-Sarco splits itself into three specific business units. Firstly, the core Steam Specialties unit, which accounts for 58% of company revenues and an array of products such as valves, steam traps, boiler controls and pumps that service the end need of heating, cleaning, sterilising, generating hot water and controlling humidity in industry applications and personal use. The second largest unit, which accounts for approximately 27% of group revenues, is the Electric Thermal Solutions unit, operating under the brands Thermocoax and Chromalox. This part of the business provides industrial electric heating systems that serve the end need of industrial mission-critical heating and freeze protection for pipes and fluid tanks. Lastly, the smallest part of the business, known as Watson-Marlow, contributed 15% to group revenues and is involved in the production and supply of complex pumps for industrial uses such as fluid management in biopharmaceutical production.
Looking at Spirax-Sarco’s business units, we can derive a few main insights as investors. Firstly, the business operates in quite complex and highly regulated markets. Steam creates a serious workplace hazard if managed improperly, so Spirax-Sarco’s leading market position as a quality supplier with technical knowhow and regulatory clout provides a significant barrier to entry for lower-priced competitors. Secondly, the end uses for Spirax-Sarco’s products are numerous. The chart above shows how diverse Spirax-Sarco’s customer base is with the highest contribution derived from the pharmaceutical industry at 21% of revenues. This is incredibly diverse for an industrial company, and I would argue that this significantly improves Spirax-Sarco’s resilience should a specific industry or set of industries take a downturn. Lastly, Spirax-Sarco’s products in the majority serve an installed base of industrial machinery with revenue mostly derived from maintenance budgets. These maintenance budgets are typically better protected in times of financial hardship than say new projects or installations.
In terms of recent performance, Spirax-Sarco has held up pretty well during 2020. Full year revenues were down by only 3%. On a business unit basis, negative performance in both the Steam segment and the Electric Thermal Solutions segment of 5.5% and 12% respectively on an organic basis were offset by a strong performance in Watson-Marlow with a 9% gain. This was due to increased sales to biopharmaceutical companies focused on vaccine production.
In terms of outlook, the company issued reasonably positive guidance, underpinned by a key input figure for Spirax-Sarco's global industrial production, which has returned to growth post-2020. In the latest investor presentation, Spirax-Sarco claims that their business usually tracks at 2 times the rate of industrial production over the long term, so global industrial recovery in 2021 is set to deliver a resuming of organic growth for Spirax-Sarco. In the recent report, Spirax-Sarco also alluded to the potential of penetrating their existing market, which to their estimates sits at an addressable £10bn. Considering Spirax-Sarco’s 2020 revenues were £1.2bn, there is still lots of potential to grow within the current market through increasing market share and through bolt-on acquisitions.
Looking at the financial metrics for Spirax-Sarco, growth has been achieved in all of the years prior to 2020, with much resilience in 2020 despite a global slowdown in industrial activity. Revenue was boosted in 2017 by a large acquisition of the Electric Thermal Solutions business unit. However, growth before and after the acquisition was also strong. Operating margins are consistently above 20%, which shows signs of financial strength and pricing power. Adjustments to operating profit are also small, reflecting honest accounting principles. Return on invested capital is also strong, owing to the company’s ability to turn profits from its capital investments.
With growth moderating in 2019 to 7.7% and growth not expected to return to high double digits in 2021, it could be that the recent acquisition was a ‘shot in the arm’ for Spirax-Sarco, and it is likely that growth will moderate in the 7-11% region over the medium term. Overall, financially speaking, Spirax-Sarco is a robust operator.
Looking at the balance sheet also paints a picture of Spirax-Sarco as a well-run company. A small net debt position of £229m is the equivalent to 0.7 times EBITDA in 2020, which is well within reason for a company of Spirax-Sarco’s quality.
However, the company’s prospect for investors somewhat stumbles when looking at the price the market is willing to pay for shares in Spirax-Sarco. The current P/E for projected earnings in 2021 is 45, falling to 42 in 2022. This is a significant premium to the wider market and industrial companies alike. Looking at the free cash flow yield (a sign of how much investors are willing to pay for the company’s underlying cash generation) Spirax-Sarco trades at a yield of 2.35%. This is pretty expensive considering that Amazon currently trades at an FCF yield of >3%.
I have taken a look at historical P/E ratios based on forward earnings for each year to derive the price the market was willing to pay for Spirax-Sarco over its recent history. This is helpful in determining whether the gain in the share price over the last few years has been fuelled by underlying earnings growth (good) or primarily by multiple expansion, which is an increase in the price multiple the market is willing to pay for the shares (not so good). The chart above shows a green line for the P/E ratio in each respective year starting in 2016 and ending in 2021. You will be able to see that in 2016 Spirax-Sarco was actually trading at 15.6 times the earnings in 2017. Over the last five years, the market has generally been willing to pay ever higher multiples for quality stocks like Spirax-Sarco and the forward P/E has more than doubled to over 40. Although the market may be willing to pay more for the company than it has over the prior years, growth has in fact slowed. Shown by the gold-coloured line, post the acquisition in 2017, Spirax-Sarco’s growth rate has moderated. This shows a slight juxtaposition with how a market typically values companies — i.e companies that start to grow faster become subject to multiple expansion. In Spirax-Sarco’s case, the opposite has happened!
Looking at the valuation of Spirax-Sarco, it is clear that much of the latent gains in the shares have been derived by multiple expansion — the price the market is willing to pay has increased from a typical 17-22 times earnings to an above 40 times earnings. Whether the market is willing to pay 40 times earnings for Spirax-Sarco in the future is anybody’s guess, however, I would be heavily inclined to believe that this sort of multiple expansion cannot carry on from here and that it is unlikely the market will be willing to pay 60-80 times earnings for Spirax-Sarco in the future. Therefore, future gains for investors will have to be derived from revenue growth and growth in underlying earnings, which probably aren't going to grow at a rate higher than 10% over the long term.
In summary, Spirax-Sarco is a very high-quality business. However, the market’s thirst for quality has pushed its shares to a significantly high premium that the business is unlikely to grow out from underneath. Without the benefit of multiple expansion to come to the investor’s aid in the medium term, I think an investment is better off elsewhere at current prices.