Published - 16th August 2010

Continuing a recent theme of my articles (see BP and Rok/Connaught), today I'm going to look at another company that has been beaten down by recent bad news: De La Rue.

De La Rue are the world's largest commercial security printer and paper maker, as well as being involved in various related areas such as passports, cash sorting equipment, etc.. The vast majority of their revenue comes from currency - either providing banknote paper or actual banknotes.

This is the sort of business that is hard for new entrants to get into - after all, what central bank is going to rely on some untested upstart to provide banknotes when there's a well-established, well-trusted market leader. De La Rue have been around for almost 200 years, and have been printing banknotes since 1860.

As you'd expect with such a strong position in their market, De La Rue achieve impressive margins. Last year they made pre-tax profits of £97m on revenue of £560m. Their cash flow is equally healthy - £95m from operating activities and £65m after deducting purchase of intangibles, property plant, and equipment.

Furthermore, De La Rue haven't heavily leveraged their position as some might have done. Their net debt at the time of their last annual report was a mere £11m - although they do have a slightly nasty £127m hole in their pension plan.

Finally this isn't even a low-growth business - De La Rue have achieved average annual revenue growth of 12% for the past 4 years.

The Bad News

On 20th July De La Rue announced "quality and production irregularities", meaning that "some paper production has failed to meet certain quality specifications". As a result "it is now expected that paper production and sales in 2010/11 will be materially lower than originally planned". The share price fell 15% on the news.

On 12th August De La Rue announced that James Hussey, their CEO was resigning as a consequence. Although there were no further details, the tone of the statement was significantly more negative: the Board considers the irregularities to be "of a serious nature". The Board is also assessing "the financial and operational implications on the current financial year's results and on the Group's prospects". The share price fell a further 10%.

The overall drop in De La Rue's market capitalisation amounts to £210m. They are now valued at just over £700m, putting them on a P/E ratio of 10 and a yield of almost 6%.

Valuation

In the absence of these recent quality problems, and given their dominant position in an attractive industry, I think De La Rue would warrant a P/E ratio of around 14. That would be about 1000p per share.

There's then the question of (a) how much this problem will cost them in the short run, and (b) whether it will affect their long-term prospects.

The problem has been hit at their Overton mill, which produces the majority of their banknote paper. Currency contributes about £410m to their annual revenue, so if this mill were out of action for, say, 4 months, that could mean ~£100m of lost sales - and that would wipe out this year's profits.

On the other hand, I find it hard to believe that this will have a significant impact on De La Rue's business in the long run. De La Rue’s internal quality controls have caught the problem, as they should have, and presumably they will put it right. Yes it's embarrassing, but will it really cause any of De La Rue's customers to go elsewhere?

Even with this problem I think De La Rue are still worth in the region of 900p. Their current share price of 710p therefore offers upside of about 25%, with (in my view) very little risk. That's reasonably attractive, but perhaps not quite enough for me - I think I‘ll sit this one out for now and hope for an opportunity to buy at 600p.