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August 2021

Share price: £13.03

Dividend yield: 2%

Historic P/E ratio (based on earnings per share for year ended 31 Dec 2020 of £0.57): 23

Prospective P/E ratio (based on forecast earnings for year ended 31 Dec 2021 of £1): 13

Grafton Group was one of three stocks highlighted in our recent technical analysis of Irish stocks. In April  2021, the shares broke through the previous all time high of £10.84, that it had reached way back in February 2007. Breaking through a previous all time high, in particular one that was reached some time ago, is about as bullish a chart indicator that you can get.

Also, stocks normally encounter major resistance at the previous all time high (due to selling from those who had bought at that previous all time high, and were therefore sitting on a loss for some time, but are now happy to get out at break-even). No resistance at all in Grafton's case, so this sudden burst of strength in the share price could mean that there is something brewing here.

Retail investors are often very wary of buying shares that have recently hit a new all time high. But ask yourself this question - If you could go back in time to any year, in the past 25 years, and you were told you could either buy all the stocks that had reached a new all time high, or an all time low, in that year - which would you pick? In most years, you would have done much better by investing in the former rather than in the latter.

The 'Celtic Tiger' boom peaked in early 2007, and Grafton, being a supplier of building materials and a DIY retailer was heavily exposed to the housing market. The strong balance sheet and the diversification of earnings due to its UK business (where the downturn was shorter and less severe than in Ireland), protected the company and its shareholders from the 2008/2009 crash.

The shares have since recovered all of these losses, and are now looking technically very strong. What is going on?

It may be that a private equity fund is circling Grafton and is about to make a bid. We have seen a bidding war breakout between the equity funds for Morrison's (supermarkets) in the past few weeks, and Grafton has everything that Morrison's has, together with a lower market capitalisation of £3.1 billion (versus £6.7 billion for Morrison's, albeit now inflated by the bid on the table and more to come).

Here's how the numbers would work for a private equity fund - were it to bid for Grafton. The key attractive feature of Grafton is that it has very low debt of only £800 million, together with over £400 million in cash.

In addition, it owns most of the properties it operates in (and leases the rest). It has not revalued its properties since 1998, and property values have risen over 200% since then, in both Ireland and the UK. Property, Plant & Equipment is valued on the balance sheet at £972 million, but is worth far more. Say approximately £750 million of that relates to freehold properties, then these could be revalued upwards by £1.5 billion.

Grafton's net profit margins are not that great - only 4.2% of turnover in 2020 (4.4% in 2019). It is a tricky business, as one must buy enough (but not too much) of the right products that will be in demand. Inevitably, there will be some write-offs due to buying errors. Reading through the 2020 annual report, I found that Grafton usually has to write off around 15% of its stock, because the stuff just is not selling (it euphemistically refers to this as "shrinkage"!).

However, Grafton's cash flow is much higher than its annual net profit, as the latter is depressed by non-cash expenses such as depreciation on plant and machinery, and the amortisation of goodwill on the many acquisitions it has made down through the years.

Grafton expects to make around £240 million net profit for 2021.

A private equity fund could bid up to £16 per share, giving it a market cap of just over £3.8 billion. It could increase the debt level to around 6 times the £240 million net profit, to £1.44 billion, thereby increasing borrowings by £640 million.'

In addition, the private equity fund could sell and lease back the freehold properties, thereby realising around £2.25 billion.

So that is a total of £2.89 billion cash that could be raised, post-takeover. Plus there is £400 million cash sitting on the balance sheet, resulting in total cash available to the private equity fund of almost £3.3 billion.

That means a private equity fund could recoup £3.3 billion of the £3.8 billion purchase price, in year one. And with Grafton making £240 million per year, the fund would have recouped its entire purchase price within three years (allowing for the increased overhead in rent paid for the properties previously owned).

That is a payback period of three years, and the norm in the industry is a payback period of ten years.

Why are Grafton shares so cheap? Because the company is hoarding cash, instead of paying it out to shareholders. Alternatively it should be making an earnings enhancing acquisition, financed in part with this cash, and with low cost borrowings that are readily available.

Yes, it has announced a relatively small acquisition of a Scandinavian company recently, but that, and the proposed sale of underperforming parts of its business, is only scratching at the surface.

Grafton could easily afford to double its dividend and pay out around 50p per share, giving a yield of 4% on the current share price. That dividend would be covered twice by earnings per share. And that is just for starters, before any increase in debt level or sale/revaluation of the properties.

If the directors of Grafton continue to neglect shareholders' interests, by paying out only 27p in dividends per share, with earnings per share expected to be around 100p for 2021, then it is only a matter of time before someone else comes in and does the job for them.

Private equity funds are usually not interested in being long term shareholders, and do not have the knowledge or inclination to build and grow a business. But they do have a valuable role in the market when stocks are undervalued as a result of managerial actions, or lack thereof. The recent burst of strength in the shares could foreshadow a bid, as that is often a good indicator - whether that strength is caused by a predator building up a stake, or well founded rumours circulating in the market, or buying by insiders. 

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