Cube Midcap Report (19 May 2020) – Thinking about the virus

Cube Midcap Report (19 May 2020) – Thinking about the virus

Good morning!

Apologies for the lack of service yesterday. I’ve found myself increasingly distracted by the virus – I want to know as much data around it as I can. It feels like it might be the most important macro event of my lifetime.

That said, the relevance of its details to investing is questionable. Even if I can gain insights into whether the virus is dangerous/not dangerous, and various government policies are justified/not justified, does it really help us to invest better? I’m not sure. I also know that controversial topics can end up alienating people, so there is a limit to how far I want to cover them.

Some general thoughts:

Ireland seems to be in a similar position to Scotland/Wales/NI. All non-essential travel is banned. You need a good excuse to go outside. Exercise is permitted within a small radius of your home.

England is a little better – you have unlimited exercise, and can travel anwhere you like for walks, golf and tennis. Also very importantly, people are going to back to work if their workplaces are open and they are unable to work from home.

Debating this on Twitter, I’m inclined to think that many (most?) people don’t appreciate the scale of the economic devastation that is being caused. I’m reminded that for many people, the economy is an abstraction and can be easily fixed through printing money or tax-and-spend. I’m also reminded that for many people, answering life-and-death questions on the basis of facts and evidence is not an option. Emotive subjects lead to emotional responses.

One of the very first things you learn in economics is that there are tradeoffs – not all needs can be met, and decisions have to be made to choose between them. To act rationally, governments must consider the costs of lockdown and weigh them against the expected and probable benefits. Not all needs can be met.

There is the principle that decisions have to be made to maximise the expected return. This applies (or should apply) to healthcare economics and public health.

One of the crucial lessons in finance is that you have to take uncertainty into account. If it’s not clear what the benefits of a particular plan might be, it is often prudent so assume that the benefits are low. Risk has to managed in both directions – costs and benefits.

Another thing you learn in finance is to have scepticism towards statistical models. Predicting the future isn’t easy. Even something simple such as Apple’s earnings next year is extremely difficult for professional, full-time analysts who spend their entire working lives studying the company.

Something more complicated like the weather or the spread of a virus through the population? That’s on a completely different level.

I’ve been dismayed by the willingness of so many people to put their trust in models, even after it becomes clear that these models have no predictive power.

It’s not because the people building these models are unintelligent – far from it. It’s because the things they are trying to model are very complicated, and they don’t have a firm basis for their model assumptions.

And yet, these models are wielded with great certainty, even when their predictions fail.

In finance as in epimiology, it’s better to know and accept that you don’t know something, instead of acting with certainty on a false belief.

On with the company news.


Today I’m interested in:

  • Imperial Brands (IMB)
  • Compass Group (CPG)
  • Beazley (BEZ)

Didn’t cover: Micro Focus International (MCRO) and Homeserve (HSV). Might look at them later in the week if requested by readers or if news is light.


In small-caps, I see that French Connection (FCCN) has warned that it might run out of funds “in the coming months”, if current restrictions continue and trading does not improve. The market cap is a rather pitiful £5 million.

It might pull through, but either way it’s a sad state of affairs for a company which had the potential to generate a good terminal value for shareholders. The CEO/Chairman’s reluctance to aggressively shut down stores and failure to sell up when there were interested parties has now led to a position where it might need a bailout.

In small companies, it’s all about management. Stephen Marks owns 41% of French Connection and has managed it continuously for nearly fifty years.

It is reasonable to presume that a highly invested Chairman will be motivated to steer his company to a good outcome.

But if you’ve been watching French Connection for a while, you’ll know that this particular Chairman has been too slow to fix the problems at his company. While progress has been made closing stores, he has continued to open stores and concessions when there was no need to do so. The retailing side of the business needed to be shut down ASAP, and this hasn’t happened.

I hope that the equity isn’t wiped out but am inclined to think that this is the most likely eventual outcome.

Back in 2015, I briefly owned shares in this business. Those were the days when a rich balance sheet impressed me more than the quality of a business and its management. Thankfully, I figured out that the odds were poor at this one.


Imperial Brands

  • Loading stock data...
Market cap £14.6 billion
RNS Half-year Report
Writer disclosure No position in IMB. Long BATS.

These adjusted results are in line with expectations:

  • at constant FX, H1 net revenus is down 0.9%
  • within this, tobacco is +0.9% and “next generation products” (NGP) are down over 43%
  • adjusted operating profit down 7.7%, driven by write-downs in NGP
  • net debt increases by half a billion pounds to £13.5 billion.

It’s a nasty fall in NGP, which now accounts for just 2% of total revenue. The company has been giving up on this category (or “right-sized” its investment, in corporate speak):

We have reduced our NGP spend following the poor returns on investment last year and this, together with recent weaknesses in the vapour category, has resulted in lower NGP revenue.

I’ve written before about how Imperial’s vaping flavours were vulnerable to the recent regulatory attack in the US.

In the most recent period, customers “destocked” their vaping inventories and it’s hard to imagine a quick rebound, particularly seeing as Imperial no longer wishes to invest heavily in this business.

The overall statutory results are significantly worse than the adjusted numbers. Operating profit is down 20% and net debt is at £14.1 billion. The main “adjusted” costs are the usual suspects: amortisation of intangibles and restructuring costs, both of which increased this year.

Covid Impact

I noted at the end of March that there had been “no material impact” on Imperial from the Covid-19 crisis. But it’s starting to bite:

“Overall, COVID-19 has so far had only a small impact on trading but we expect this to be more pronounced in the second half due to continued pressures on our duty free and travel retail business, changes in consumption patterns including downtrading and a reversal of some first half inventory build.”

The H1 inventory build by customers saved the H1 performance, but H2 will suffer the reverse of that trend.


This catches the headlines. The dividend gets cut by 33%, because “deleveraging remains a key priority”. Annual dividend is now 137.7p (for a yield of 9%).

That will be a source of great frustration for many shareholders who live off their dividends. But with a debt load in and around £14 billion, versus existing forecast EBIT of £3.7 billion this year, it looks like a prudent decision to me.

Debt has increased because of: “adverse FX, payments for share buybacks, the Von Erl acquisition, a Russian excise settlement, and lower profit partly offset by lower working capital“.

In addition to the reduced dividends, debt will now also be reduced by the sale of the Premium Cigars division for €1.2 billion (c. £1.1 billion).

Indeed, I wish that BATS would do the same thing and cut its dividend, to make it safer.

For what it’s worth, I note that the BATS share price has not reacted much to IMB’s news today.

IMB’s target leverage multiple is 2-2.5x, and it wants to gert there by the end of 2022.


We get a profit warning for the rest of the year.

Imperial now expects a “low single digit impact” on EPS. In simple English, that would be c. 2%-3%, and it’s on top of current expectations for EPS to fall 2%.

The existing forecast is 261p. So EPS might come in around 255p, perhaps?

At least we are still getting guidance, and still getting dividends – so many other companies have given up completely on both. The tobacco industry, in my view, has demonstrated its resilience during the crisis.

Some words of warning from the company that there are still many uncertainties:

…we also recognise no company is immune and there are external factors outside our control at this time, such as the severity and duration of the pandemic and how lockdown measures might affect our supply chain, retail channels and consumer behaviour. These are expected to have a more significant impact on our second half, although at this early stage it is difficult to assess their extent.

Sources of risk include the continued closure of duty free/travel shopping (Imperial assumes no recovery this year), further downtrading by customers (although Imperial argues it has low exposure to premium products) and restraints on manufacturing at its 38 factories (Imperial expects full capacity again by the end of June).

My view

The market is naturally disappointed that there is an extra impact coming from Covid, which had not already been pencilled in.

But valuation really matters and the earnings multiple here is now around 6x.

This is for a company with an investment-grade (albeit only just) credit rating, that has just announced a significant dividend cut to enable faster debt reduction.

As of February, it was rated BBB/Baa3/BBB by the rating agencies, negative outlook at Fitch but stable at the other two.

While other companies have suspended dividends and guidance entirely, Imperial continues to offer a high yield to equity investors and very clear guidance.

I’m fully invested at present but I would consider adding this to my portfolio at current levels.

Its major weakness is that it has obviously failed to achieve much in vaping and other new smoking products, and is almost a pure-play on tobacco. It does face headwinds and an overall shrinking market for the long-term.

But will it provide enough puffs to justify investing at current levels? Personally, I suspect that it will.



  • Loading stock data...
Market cap £17.0 billion
RNS Update on Covid-19 and Half Year Results
Writer disclosure No position.

I’ve been nervous/worried about this one for a while.

Last month, I noted that a halving in EBITDA could bring Compass uncomfortably close to a covenant breach. Net debt had risen sharply to £4.9 billion.

As of the end of March, net debt/trailing EBITDA was 2.0x. It needs to stay below 4x, to satisfy covenants.

Today, Compass announces that it has decided to raise £2 billion in fresh equity.

That infusion would certainly be enough to quash any immediate balance sheet worries. The company wants “a strong investment grade rating and net debt to EBITDA range of 1-1.5x”.

Covid-19 measures:

  • monthly costs reduced by £500 million (better than the £450 million reported in the last update)
  • reduced capex, no dividend
  • temporary covenant waiver on the debt that needs it
  • increased debt facility

Revenue was down 46% in April – not as bad as it could have been, considering that 55% of activities (by revenue) are said to have closed.

The H1 results to the end of March don’t seem very important to me, in the context of the crisis.

My view

If this succeeds, it will take most of the risk out of CPG shares, at least in the short-term.

And it’s nice to see that there’s a retail offer on Primary Bid.

The company’s activities don’t interest me as a potential investment but this is good news for furloughed employees and everyone else involved. A disruptive breakdown of the PLC is much less likely.



  • Loading stock data...
Market cap £1.9 billion ($2.3 billion)
RNS Update on Covid-19 and Half Year Results
Writer disclosure No position.

This placing was officially proposed last night.

Gross proceeds fof £247 million ($300 million) have now been raised at 315p – a 5% discount to last night’s closing price.

With positivity today, there is already a very tidy mark-to-market profit for anyone who got involved.

Discussing Beazley last month, I noted that it was expecting a $175 million hit from Covid-19, including from bespoke business interruption policies. Unlike Hiscox (HSX), the exposure of Beazley appeared to be more limited. Even so, its wiggle room over the capital needed to function was “not as much as you would like to see”.

The placing announced today will help to restore that wiggle room.

But like Hiscox, Beazley says that rates are rising and it wants to grow organically in this rising insurance market:

As a result of the elevated claim numbers in recent years, the Company has seen rates rise steadily across its core markets… rate changes for the three months ended 31 March 2020 were particularly encouraging, with an average rate increase of eight per cent., with three divisions achieving double digit increases.  This strong momentum is expected to continue.

My view

I’m slightly less cynical about this raise than I was towards the Hiscox raise, but I still think it’s strange that growth is being given as the number one reason for the raise.

Consider the following issues:

  • $175 million in Covid-19 claims
  • low investment returns year-to-date, with a $55 million loss in Q1
  • significant investment banking fees on a $300 million placing

Compared to their expectations at the end of 2019, in a pre-Covid world, will this $300 million placing really give them that much extra firepower?

No, I think the placing is mostly to fill the gap caused by weak returns and Covid-19.

Whatever is left is the real extra growth capital.

The company is safer now and does have more capital with which to grow, so I do think the placing is good news.

There is a big premium to book value to be paid for these shares and I’m inclined to believe that they are fairly priced.



Hanging up my pen there, cheers!




Wordpress (2)
  • comment-avatar

    “tax-and-spend” – Morning Graham. I do worry that this is the option our government might choose. After all this time of the majority of workers being paid 80% of salaries (admittedly with caps) to sit at home and, especially, small company owners having to work extremely hard to get their businesses up and running again are increases in taxes going to end up counter productive?

    What might they choose:-

    Increase VAT – hardly likely to lead to increased sales with customers trying to repair their personal balance sheets

    Increase N.I. and/or corporation tax – small company owners deciding running a business is simply not worth it

    Increase property taxes – hardly a help to get the property markets going again

    I’m struggling to think of a tax that they can raise that’s going to help get the economy firing again.

    FCCN – could this be one that BooHoo has it’s eye on – could be quite a tasty morsel without the stores.

    Apologies if I’ve made a mess of the formatting (I do try).

  • comment-avatar

    I enjoy your ruminations on the macro. I’m not good at it, I always call it wrong.

    If you are interested I recommend US fund manager Douglas Boneparth’s tweets repeatedly incredulous with the markets for rising on increasingly terrible economic news.

  • Your Cart