This article was written by Peter Shearlock and published in The IRS Report in April 2011

Value at Invensys as sales and profits boom

When Invensys, the high-technology engineering business, announced the sudden departure of its chief executive late last month, the shares fell 4.5% in one day. Even though the company assured investors that profits in the year to end-March would be "broadly in line with market expectations", traders not unreasonably reckoned there was trouble at t'mill and dumped the stock.

One day on, and there was an impressive bounce. Press coverage of the affair made it clear that the departing CEO, Ulf Henriksson, had rubbed up both the chairman Sir Nigel Rudd and some of the operating management. He had been on the back foot ever since some unguarded comments in November suggesting Invensys could be bought out by its partner in China. His replacement, chief finance officer Wayne Edmunds, appears to be well respected in the City.

At broker Evolution Securities, analyst Harry Philips had no doubt that the shares were a buy after the price fall. "There is no change to our valuation assumptions so the consideration is one of sentiment," he wrote: "Wayne Edmunds will be a better communicator...which will help in highlighting the unique positioning (Invensys') businesses have in their respective markets."

Evolution's valuation assumptions are worth a good look for any value investor who likes to buy undervalued assets. Using a sum-of-the-parts approach, the firm reckons Invensys is worth 497p a share - a long way ahead of the recent 348.8p. That valuation, it reckons, could be achieved either through organic growth or "corporate activity". In other words, if Invensys doesn't get its share price up through its own endeavours, it is likely to be bought out.

One reason for that vulnerability is that each of the company's three divisions is a smallish fish in a very big pond. In its primary areas of operations management - providing the controls that make power stations or refineries work - and rail signalling and control systems, Invensys is competing with the likes of GE, Siemens and Thales. It now does so very effectively, but it still looks a tasty morsel for any number of multinationals to snap up.

It was not always so. The product of a 1999 merger between Siebe and BTR, Invensys struggled to survive in its first five years. It needed a debt restructuring and some major disposals to put it back on track. It made a loss as recently as 2005/6, but has since turned in annual profits ranging from £165m to £199m before tax. In the year that ended on March 31st, it is expected to have made around £205m. That should be the prelude to a further sharp climb to £250m-plus in 2011-12 and £300m the year after.

The turnaround on the profit front has been mirrored in the balance sheet. Invensys had £336m net cash at the half-way stage last September. The lingering fly in the ointment is a £600m pension deficit. If that hole can be plugged - and the incoming chief executive has been working on that - it will remove one of the few deterrents to a takeover bid.

The key to Invensys' turnaround in recent years is the breakthrough it has achieved in emerging markets - particularly the Middle East, South-East Asia and China. Three years ago, emerging markets made up about a sixth of the order book. Today, they account for nearly half.

Certainly, the orders are flooding in. In November, the operations management division reported a record £1bn order book, with a £4bn pipeline of prospects. Big, greenfield projects in emerging markets, and especially China, account for a large chunk of those orders but Invensys has also been benefiting from an upsurge in spending in North America by the big oil and gas companies.

The rail division saw a downturn in first-half orders but the situation was expected to reverse in the second half. Here the pipeline of prospects amounts to £9bn, which is not bad for a business turning over £700m a year.

Invensys' third division is its controls business - which makes components and systems for domestic appliances, heating, air conditioning and refrigeration units. Here a strong first half is likely to have been followed by a more sedate second half.

Invensys shares look good value on a number of measures. Although they sell for about 15 times likely 2010/11 earnings, within two years the multiple could fall to about 11 on anticipated profits growth. With no debt, Invensys has an enterprise value equivalent to about 0.8 times annual sales. An EV/sales ratio of anything less than one denotes good value.

Then there is the sum-of-the-parts valuation that takes the underlying businesses and tots up what they are worth. Clearly, Evolution's calculations suggest a break-up bid could prove highly profitable - even though some of that value may be heading the way of the company pension fund.

Only the lack of a worthwhile dividend yield mars the picture. The shares currently yield a little over 1%. However, this may be about to change. At the half-way stage, the company raised the interim payment by a half and is committed to a progressive payout. It is also promising to spell out a formal dividend policy when it reports its full-year figures in May. It may need to keep shareholders sweet if a bidder materialises.