The mid-term elections are coming up next month in the US. And this could be bad news for companies that rely on the Chinese export industry. Why? One word – protectionism. As the US government is currently under serious pressure from the Republicans, there is now a real danger that the current sabre-rattling between Washington and Beijing, over the manipulation of the yuan/dollar exchange rate, could end up unleashing a crippling trade war.
If this happens, then Intertek, the global product-testing firm would be badly affected. That’s because it makes its money by verifying the quality and safety of products ranging from fibre-optic cables and car airbags to toys and shoes. It does this for a diverse range of blue-chip clients, from General Electric to McDonald’s, with much of this volume being shipped eastwards from China to America.
The business model itself is sound. In light of several recent high-profile product recalls – such as those from car manufacturer Toyota, Mattel (toys) and electronics giant Sony (batteries) – the regulatory landscape has become far tighter and more complex.
Intertek (LSE: ITRK), rated outperform by Seymour Pierce
For instance, in 2009 the US introduced the Consumer Product Safety Improvement Act, which led to a surge in lead-paint testing on products for children. This tougher stance is causing great consternation for many companies. And with boards unwilling to take on more costs than they need to, they are seeking to outsource this type of work to specialists like Intertek, rather than rely on own in-house teams.
So there’s nothing wrong with the company itself. But given the potential hit to exports, what does worry me is Intertek’s stratospheric rating – the stock is nudging towards all-time highs. I think it is overvalued on just about every metric – p/e and PEG ratios, dividend yield, EV/EBITA and price-to-book/cash-flow multiples.
And protectionism is not the only dark cloud on the horizon. Slowing global output will be a major headache in 2011, and any protracted slump would badly hit the firm’s consumer-related activities, which generate around half of its profits. To compound this, Intertek will also have to contend with the inevitable deceleration of new product launches as corporate R&D budgets are trimmed.
Finally, the model carries significant litigation risk, in that if Intertek fails to perform its contracted services correctly and a harmful product goes undetected, this could hurt sales and damage the group’s reputation.
The City expects 2010 sales and underlying EPS of £1.3bn and 89.3p, rising to £1.4bn and 100.7p in 2011. That puts the stock on jaw-dropping p/e multiples of 20 and 18, while paying a frugal 2% dividend yield. I would value the stock on a ten times EBITA multiple – assuming through-cycle margins of 15% – which, after deducting the £240m debt pile, gives an intrinsic worth of £11 per share.
With all of this in mind, it’s time to sell and recycle the proceeds into more compelling opportunities.
Recommendation: Priced to perfection. SELL at £18.36
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments