Undervalued stock of the week - Lycopodium

November 5, 2012, 2:41 pm John Abernethy Yahoo!7

With sound fundamentals and a strong balance sheet, Australian engineering group Lycopodium’s stocks currently look undervalued.

Lycopodium Limited is an Australian engineering and consultancy group that provides services primarily to the mining, infrastructure and manufacturing sectors.

LYL was established in 1992, listed on the ASX in 2004, and today operates globally, with operations in Australia, Asia, Africa and North America. Despite a softening of some domestic operations, many of its international projects are still expanding and contributing to an overall impressive business performance.

However, its share price has fallen significantly since March amid broad concerns about the domestic mining sector, which we think presents a good buying opportunity - for several reasons.

Firstly, LYL earns about 50 per cent of its revenue from overseas and those operations continue to look healthy. Those earnings could also become doubly valuable if the Australian dollar falls, which many people are predicting should commodity prices decline (commodity prices and the Aussie dollar are closely linked).

In such a scenario, those earnings from overseas would buy even more Aussie dollars when they are brought back home, and would translate straight to LYL’s bottom line through enhanced revenues.

Current performance remains strong. LYL recently delivered a good result for FY2012. Revenue was up 37 per cent to $232m whilst profit increased 31 per cent to a record $22.1m.

Management were pleased with the results, saying that the strong performance came from continued demand across the group and over a range of commodities and mining projects.

However, LYL is more diverse than a pure mining play due to its offshore entities, ongoing maintenance revenue and manufacturing client base. (The company can be employed by a mine from initial feasibility reports through construction and operation and production, providing revenues right throughout a mine’s life.)

This means Lycopodium is relatively well placed should we see an anticipated contraction in Australian mining investment by mining companies over the medium to long term.

LYL has sound fundamentals. The balance sheet is strong, with minimal intangibles and net cash of $24.6m. Operating cash flow has historically been solid, whilst profitability has been exceptional since listing. LYL has in fact averaged a return on equity in excess of 50% over the previous 5 years.

In order to justify our forecast value of $7.68 - an increase of 25 per cent on its current market price - LYL only needs to achieve a return on equity of 14.5 per cent. That is a fraction of its recent performance. Even taking into account a softening of domestic markets it is difficult to envisage the company not achieving this level of return. Indeed the company has a forecast return on equity this year of 46 per cent – well in excess of what is required.

LYL recently announced a fully franked dividend of 21 cents per share. Management has historically retained a reasonable portion of its earnings to fund organic growth. This suggests LYL offers investors the opportunity for both franked income of around 5.5 per cent, and capital growth over time.

Company: Lycopodium
Current price: $6.06 (5th November)
Forecast value: $7.68 and above ++

Potential upside: 25%

Readers of Yahoo!7 Finance can obtain a free 14-day trial offer of the MyClime online share valuation and research service at www.clime.com.au.

Investors should not rely on this information alone and should seek independent financial advice from a qualified expert before considering any share market investment.

++Fair or forecast value is the price placed on the share after calculating a range of factors including profitability, assets, debt and, most importantly, Return on Equity – the same measure used by Warren Buffett to assess long-term value.

Shares are assessed by Clime Asset Management to calculate which companies are undervalued or over-valued based on their return on equity. History has shown that the most successful companies are those that produce the highest returns per dollar of shareholders' equity, yet this is not typically how shares are valued. This system highlights shares that are undervalued on this key measure. Shares are expected to reach this value in 3-5 years, as price tends to follow value in time.

Information is intended as a guide only. For specific advice contact your financial services professional.

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