F.W. Thorpe: A Good Business Making Durable Products that May Have Already Peaked
Today’s initial interest post is a company I like a lot. It’s trading at a price that could be justifiable – possibly – based on that company’s past performance. But, it’s not a stock I’m going to give a very high initial interest level too. The reason for that is uncertainty about the future.
I’ll get to that uncertainty in a second. First, I want to describe what FW Thorpe does. The company makes lights. I won’t go into too much detail here. You can always read a company’s annual report for yourself. So, I hate to go into analysis free re-hashes of a company’s basic business model. I’ll do that a little here, though, because I don’t want you to think FW Thorpe makes light bulbs for your house.
The company’s focus in on professional lighting with the lowest cost of total ownership. It makes lights for everything from clean rooms to warehouses to retail shops. FW Thorpe’s products are used for street lights, in tunnels, up on the ceiling of the office you may be working in now (though, if you’re not in the U.K. or the Netherlands – it’s a lot less likely that’s an FW Thorpe product). The company also makes lighting for emergency signs. It has a business unit that seems to me to be focused on making emergency sign lighting that complies with regulations while looking aesthetically pleasing (the customers all seem like locations that care about the look of the interior of their building). Some lighting is used to illuminate advertisements and things like that. It’s a whole variety of professional lighting where the main focus is not having the cheapest initial purchase price. It’s about what the lighting does and how little it’ll cost you in electricity bills, replacement, etc. over many years into the future.
Basically: FW Thorpe makes lights. Decades ago, lighting was not a very durable product. But, that changed in recent years. Unfortunately, not so recent that we’re still in the middle of this shift from more disposal lighting to more durable lighting. What was once often fluorescent (and incandescent) lighting became LED. As you probably know, a lot of governments put in rules phasing out incandescent lighting. Many of these rules were put in place anywhere from 5-15 years ago. So, again – we’re talking about a tailwind that was stronger in the past than it will be in the future.
I’m sure there are people reading this who know more about the lifespans of incandescent, fluorescent, and LED lights. But, from what checks I could make – it seems that a typical LED light can have a life as much as 10 times that of a typical fluorescent lamp. I was, however, able to find references to some fluorescent lamps designed to have similar lifespans to LED lights. So, companies have probably always been working on extending the lifespan of any of these types of lighting. For us as investors here – the problem is that Thorpe’s results show an upgrade cycle where they went from having like 3% of their lighting be LED to now having more than 90% of the lighting be LED. The company also says we’ve reached “peak LED” in the sense of new sales. Sure, the installed base of LED lights may grow over time. But, given the long lifetime of LED lights and the young age of many of the newly installed ones – there will no longer be a need for the world to buy as many LED lights in any one year. This is the familiar problems faced by all sorts of consumer innovations from radios to TVs to flat screen TVs to smartphones to even things like memory foam mattresses. If a large number of people adopt these things for the first time – sales spike. But, these products aren’t like energy drinks. There’s no need to keep buying them each year. So, for companies – like Thorpe – that produce a durable “new” product, annual sales may peak long before there’s 100% adoption. In essence, the lifespan of LED lights may be so long that although the population of LED lights will grow each year – the number of new “births” will decline. In fact, Thorpe has already said it has. This doesn’t necessarily mean that Thorpe’s sales will decline. Their annual report is sort of hopeful about possible record sales being hit again sometime soon. However, that record would be hit through market share gains, a business they acquired recently, product line extension, additional innovations, some sort of “smart” non-lighting stuff being added to their lights, etc. Nothing the company has said suggests that actual demand for LED lights as providers of light will increase overall in the years ahead. So, Thorpe may be an excellent organization. In fact, I think it is. But, the past record and the current stock price don’t really add up to something you’d want to buy if the industry overall is so mature that it may continually decline in the future.
Let’s walk through some of those numbers. We’ll start with the one that concerns me the most. Thorpe’s valuation has risen at the same time the LED market has matured. Basically, the stock has been recognized as having a growth stock past at a time when it may not have a growth stock future. Before the fallout from the financial crisis – in fiscal years ended during the calendar years of 2006, 2007, and 2008 – the company was growing EPS at more than 15% a year with a P/E of less than 13. Sometimes it was growing quite a bit faster than 15% a year. And sometimes the P/E ratio got far below 10. But, that’s cherry picking certain years. If we just go with the general tendency: it’s clear you could’ve often bought this stock on any random day with a year-over-year EPS growth rate of 15% or better and a P/E of 13 or lower. Basically, Thorpe was an unrecognized growth stock. The record over the last 10 years is not as clearly that of a growth stock. It’s fine. At times, it’s good. Growth in 2015-2017 or so looks very solid, for example. But, things like the P/E ratio are as high as ever now. The P/E has been 20-30 times for much of the last 3 years. Now, there are stocks that deserve P/E ratios of 20-30 times. For example, I’ve talked about OTCMarkets (OTCM) before. But, Thorpe is not that kind of company. OTCMarkets converts a huge amount of its reported EPS into free cash flow. The company has float. And it has almost no tangible assets. This leads to extremely high returns on equity. And the returns I really care about – the actual amount of cash generated for shareholders this year versus the amount of equity in the business – is sky high. That’s not the case at Thorpe. It has had free cash flow conversion over the last 10-15 years in a range of like 50% to 100%. I’m excluding some outliers. What’s important though is the timing of the high conversion years. Thorpe generally can’t have a series of years where it converts a high amount of EPS into free cash flow while also growing EPS. That makes sense. It’s true for most companies. The more you need to grow next year and the year after that – the more you need to retain and invest in additional inventory, receivables, property, etc. instead of taking out of the business in cash. There’s nothing wrong with this. But, it’s very important to understand the kind of difference this makes to valuation. If one company can grow 4-5% a year while having a 4-5% free cash flow yield – it can match the market (return 8-10% a year) even while trading at 20-25 times earnings. This is true if – like at OTCMarkets – free cash flow and earnings are (when growing that fast) awfully close to each other. This is not possible at a company like Thorpe. So, if Thorpe has a P/E ratio of 20-25 and is growing EPS by 4-5% a year, it can’t also be converting nearly 100% of EPS into free cash flow. I know this sounds like sort of a personal preference of mine for companies that convert a huge amount of EPS into free cash flow. But, it’s a lot more than that. It’s critical to understanding the appropriate valuation level for certain companies that do both grow – but that have differing returns on equity. Thorpe’s return on equity is fine. But, it’s nothing like OTCM’s return on equity. Historically, it has been about 13-21% a year (over the last 10-15 years). That obviously adds value over time. But, it also means that growth is costly enough that the company has to trade at a much higher price to free cash flow ratio than price to earnings ratio. To put it the way I like to think: if Thorpe trades at like a 6% earnings yield – it might only be trading at a 4% free cash flow yield. As I write this, the stock trades at 23 times earnings. That’s a 4.3% earnings yield. In an average year – that’d translate to less than a 3% free cash flow yield. This is where my concerns about “peak LED” comes in.
If Thorpe really is trading at a level that’s around a 3% normalized free cash flow yield – then, it would need to grow about 7% a year to give a return of around 10% a year in the stock. This isn’t exactly true if we’re thinking perpetually about a buy and hold forever stock. But, if we’re thinking more realistically about say a 10-year investment case here – what I said is roughly right. Thorpe’s P/E is 23. We can’t expect multiple expansion from here while we own the stock. The multiple might even contract. So, the only return we’ll get is from cash generated by the business and not reinvested in that business (true free cash flow that can be used to pile up cash, pay dividends, acquire growth, etc.) and then Thorpe’s growth rate in that free cash flow. If the stock’s price multiple is the same the day we buy and sell the stock and it also pays out, buys back stock, etc. equal to 3% of our purchase price, we need 7% a year growth to get a 10% return here. Now, it’s possible I’m being unfair to Thorpe here and the earnings yield and free cash flow yield are actually more similar. So, Thorpe might have a 4.3% free cash flow yield. The company’s 6-year growth rate in sales is like 12% a year. So, the past record easily suggests this stock is a buy. If it keeps growing 12% a year and has a 4% free cash flow yield, it could return 16% a year while you own it without multiple expansion. And it’s not impossible – though I still don’t like betting on it – that a stock growing 12% a year will have a P/E over 30 when you sell it. So, the multiple could expand. But, Thorpe is warning us that LED lighting sales have peaked and that growth at the company has to come from figuring out how to take market share, expand into other countries (65% of sales are in the U.K. and another 10% in the Netherlands), add other features to the lighting, etc. Overall, the impression the company gives is that the upgrade cycle will be longer than in the past. The other concern is environmental. A lot of companies made the switch to various Thorpe LED offerings for two reasons. One, they wanted the lowest total cost of ownership (low electricity costs, less replacement costs, less maintenance, etc.). Two, they wanted to go “greener”. This second part is a bit of a problem. It’s less purely rational than the first part. It may be harder to successfully push for faster upgrades of existing products when arguing only that a company can lower its total cost of ownership of the lighting. Companies that weren’t using LEDs and now are using LEDs made a very visible switch to a greener product. They saved on energy, yes. But, they also showed their commitment to environmental values in a way they really can’t again. Thorpe talks a little about this in the annual report. And I think it’s a valid concern. It may be something that better marketing on Thorpe’s part can overcome. They may have to come up with better ways to explain the value of other benefits their newer products can offer. Thorpe talks a lot about additional features – sensors basically – of some newer lighting which can monitor the movement of people in the areas being lit, can monitor air quality, etc. This is useful stuff. In some countries and some locations, it’s conceivable that lighting could actually save a really big amount of dollars versus its cost if it did anything to help better utilize labor. In developed countries – and Thorpe’s biggest market is the U.K. – labor costs are very high versus electricity costs. So, reducing man hours even a little bit can be as good as reducing megawatt hours by a lot. But, this is stuff that customers have to be sold on through marketing in a way saving electricity and eliminating certain types of lighting didn’t have to be. Customers were pre-sold on green. FW Thorpe needs to sell them on other kinds of improvements. This is a very superficial judgment here – but, just reading about how Thorpe presents itself, I was impressed by the company’s innovations based on knowledge of the customer. I was less impressed by the company’s sales efforts. Compared to other companies I’ve seen, Thorpe looks strong in tweaking products to meet very specific end user needs (making things safer, simpler, easier, etc. for the organization actually using the lights). There was a lot less information about how the company explained the benefits of its products in a way that might stimulate additional upgrades and things like that.
Overall, FW Thorpe is an organization I like a lot. It’s something of a Phil Fisher company in a few ways. It is overlooked (especially for a company of this quality). The company has been around for more than 80 years and public for more than 50 years, but it actually went from the London Stock Exchange to AIM many years ago. It’s largely family held. I think there is now one great grandson of the founder involved with the company. The current co-CEOs (one has a technical background, the other a financial background) seem to be the first non-family people at the top here. There are a couple older Thorpe brothers with major shareholdings. The board is quite simple too. The only committee they use is for remuneration (which is probably unavoidable, because the co-CEOs are part of the full board). The full board takes care of other issues without use of committees. It’s family controlled and simple. It de-listed from a major exchange many years ago. Yet, it produces a great annual report. It uses a reputable auditor. I’m not concerned about anything like that here.
I’m just concerned that this is too durable a product. There’s nothing wrong with a durable product that has been mature for a long time. Cars are durable. But, almost everyone – as a percent of the population – who wants a car has had a car for many, many decades. There just hasn’t been much of an increase in the saturation of cars in the total population over the last 20 years. There has been in LED lighting. So, original equipment sales here would worry me in much the same way they would with smartphones and memory foam mattresses and so on. That’s not a problem if the stock is cheap, the ROE is sky high, etc.
I think FW Thorpe is a great organization. But, I also think it’ll take a great organization to grow anywhere like 7% a year indefinitely in lighting now that so many LEDs have already been sold. And I think that a stock as expensive as this one would require a growth rate of like 7% a year far into the future to you give you market beating returns.
So, the current stock price is too high and the future growth trends for the overall industry too low for me to consider this stock. Thorpe could grow through market share gains. It has a nice looking collection of specialist businesses. It has a philosophy of not duplicating itself competitively in the businesses it’s in. So, it basically buys stuff it wants to expand into and then does its best to apply its expertise to those areas. It’s hard to be so positive on the organization – and, it’s a great annual report I recommend everyone read – while at the same time being so negative on the stock.
But, FW Thorpe is a pass for me.
Geoff’s Initial Interest: 30%