Cube Midcap Report (21 April 2020) – Quality pays dividends #LSE #HLMA #ABF

Cube Midcap Report (21 April 2020) – Quality pays dividends #LSE #HLMA #ABF

Good morning, it’s Roland here with today’s Midcap report.

Today I want to take a brief look at dramatic events last night in the US oil market, which appear to be impacting some London-listed oil stocks this morning.

I’m then going to move on to focus on a number of high quality companies in our Midcap universe which have reported today. These three FTSE 100 firms will be covered first:

  • London Stock Exchange (LSE)
  • Halma (HLMA)
  • Associated British Foods (ABF)

The appeal of quality stocks is also the theme of Graham Neary’s latest investing diary, “A collection of fortresses”. This is available to our Gold members and covers Graham’s five largest holdings, including two popular midcap stocks.

WTI Oil goes negative

I have an interest in the oil market and can’t ignore the events of yesterday, which saw the May futures contract for WTI crude oil (the main US blend) close Monday’s session at -$37.63. That means a limited number of oil traders were paying nearly $40 per barrel to offload their contracts.

The problem is storage. Traders are scared of being left holding futures contracts which must be settled for physical delivery when they can’t find any storage capacity. Today (Tuesday) is the last day of the May contract, so we may could see more volatility (although most traders and commodity funds have already moved on to trade June futures).

Storage constraints could hit US shale producers: WTI mainly reflects demand for oil produced by US onshore producers. As such, the market is mostly domestic and storage capacity is limited to existing facilities. These are nearly full and very little unleased capacity is available.

Continued oil price weakness seems likely to accelerate production cuts (and bankruptcies) among US shale producers, in my view. However, while I sympathise with the human cost of such cuts, the reality is that many of these operators have never produced any free cash flow. They have been reliant on cheap debt to fund growth. In my opinion, a rationalisation of this sector is long overdue.

UK oil stocks are sliding too: UK-listed oil firms sell (mostly) seaborne crude, such as Brent. This hasn’t yet run up against storage constraints because traders are able to charter oil tankers to use as temporary storage facilities.

Brent pricing has been more stable than WTI, but Brent is still down nearly 25% today, at $19. Traders appear to think there’s a risk that Brent production could eventually exceed storage capacity.

Here’s a flavour of how the market is reacting to this prospect this morning:

  • Royal Dutch Shell (RDSB): -4.6% (disclosure: I hold RDSB)
  • BP (BP): -5%
  • Tullow Oil (TLW): -10%
  • Premier Oil (PMO): -13%
  • Enquest (ENQ): -13%

Enquest and Premier (and also Tullow) are falling further because they are carrying high levels of debt. In a weak market, this means the equity is effectively a leveraged play on the oil price. This leads to wild share price swings. Premier is down by about 80% so far this year, but the PMO share price has also doubled from its 52-week low of 10p.

This kind of thing is too speculative for me. Let’s look at some quality stocks instead.

London Stock Exchange Group

  • Stock data should display here.
Market cap £27.1bn
RNS LSE Q1 trading statement
Writer disclosure No position

We’ve already seen a number of positive trading reports from brokers this year. Companies which benefit from trading fees and spreads have had a terrific Q1.

The owner of the London Stock Exchange (and the Borsa Italiana) is no different. LSE Group saw “total income” (revenue + other income) rise by 13% to £615m during Q1, thanks to “increased equity trading”and “higher clearing activity”.

Dividend update: Investors need have no fear about the dividend. In today’s update, LSE confirms that “reflecting the strong 2019 results and ongoing financial strength” the 2019 final dividend will be paid as planned, subject to AGM approval. Last year’s dividend was covered c.2x by free cash flow, so looks safe to me. But the yield is low, at under 1%.

Refinitiv acquisition: Historically, LSE has focused on trading-related services such as these. But the group is also becoming a major player in the market for financial data. As part of this move its currently in the middle of a proposed $27bn all-share acquisition of Refinitiv (formerly Thomson Reuters). This deal will see Refinitiv shareholders gain a 37% economic interest in LSE with “less than 30%” of voting rights.

Management confirm that the Refinitiv acquisition is continuing to progress. Completion is expected in H2 2020.

My view

I think that London Stock Exchange is an excellent business with an enviable moat.

The group enjoys an operating margin of more than 30%, strong free cash flow and a sizeable share of several major markets. Its shift into the market for financial data seems well-timed and likely to provide more sticky clients. The Refinitiv acquisition is expected to increase LSE’s recurring revenue from 40% to 70% of total revenue.

However, much of this good news is already in the share price. LSE shares trade on 35 times 2020 forecast earnings and yield less than 1%. That’s a little too rich for me.


  • Stock data should display here.
Market cap £8.1bn
RNS COVID-19 & FY update
Writer disclosure No position

Halma’s performance in recent years serves as a good example of why you should probably never sell shares in successful, high-quality businesses. This FTSE 100 manufacturing group makes a wide range of safety products, serving industrial, consumer and medical markets.

Halma 5yr share price chart

Source: Google Finance

Halma stock has doubled since May 2017 and always seem to look expensive. Perhaps I’m wrong about LSE’s valuation, too….

FY trading update: Today’s update is typical of what I’d expect from this well-run business. Profits for the year ended 31 March are expected to be in line with previous guidance of £265m-£270m. Year-end net debt excluding lease liabilities should be manageable at c.£320m. Committed debt facilities total £750m, with no significant near-term maturities.

The company notes the difficulty of auditing a geographically-dispersed group and says that its preliminary results will be published on 14 July. Fair enough — we already know they’ll be okay.

COVID-19 update: Halma has confirmed it’s eligible for the government’s COVID Corporate Financing Facility but has no current plans to use this facility.

The company says it was first affected by COVID-19 in China in January. Unlike the UK government, Halma appears to have used this opportunity to prepare a comprehensive plan for handling the impact of the pandemic.

Halma has 54 operating facilities in the UK, USA, Europe and Asia. Currently, only two are closed due to lockdown restrictions. Others are impacted but continuing to trade. A number of facilities are making medical PPE and other healthcare equipment.

Actions taken so far are expected to save £20m during Q1 (April-June), compared to the Q4 run rate. The board has taken a 20% salary reduction and although a small number of employees have been furloughed, this will be funded by the company, rather than the UK government scheme.

My view

Halma says that COVID-19 is expected to have “a net adverse impact on our markets and our full year financial results to 31 March 2021“. Understandably, management are reluctant to commit to full-year guidance at this stage.

There was no word on the dividend in today’s update, but the company’s reluctance (and lack of need) to draw on government funding suggests to me that this is one of the safer dividends in today’s market.

Despite the uncertain outlook, I think shareholders can sleep easy. Whether Halma stock is worth 35 times forecast earnings is another question. But I certainly wouldn’t sell.

Associated British Foods

  • Stock data should display here.
Market cap £15.0bn
RNS Interim results
Writer disclosure No position

Associated British Foods is an old-fashioned family-owned conglomerate. It owns fashion retailer Primark and a range of food businesses such as Twinings, Patak and Kingsmill, which make it the UK’s largest food producer.

ABF has been a very successful long-term investment, despite the prevailing wisdom that conglomerates are inefficient. Perhaps this doesn’t hold true when the founding family still control a majority stake in the business (and a family member is CEO).

However, the group is facing tough times at the moment due to the complete closure of Primark, which does not sell online. This is costing around £650m per month in lost sales. Today’s interim results begin with a tribute to two group employees who have died from COVID-19 and also to hard-pressed staff in ABF’s UK food factories. CEO George Weston describes their performance in this year’s trying circumstances as “the finest thing I have seen in a career in business”.

Kind words. I’m confident that Mr Weston will oversee a gradual reconstruction of the Primark business. But he warns this is likely to be a slow process. The ABF share price is down by 5% today. As investors, should we hold back or could now be a good time to consider buying?

H1 results: The firm’s half-year figures cover the six months to 29 February, so are largely unaffected by COVID-19. They are as impressive as you might expect:

ABF H1 2020 results

Spot the missing dividend!

Dividend cut reflects Primark closure: Net cash held up well, at £801m ex-IFRS16. But the interim dividend has been cancelled. This looks prudent in respect of the likely cash outflows that will be required to preserve and restart the Primark business.

These costs include £600m of stock in that was in transit in March when Primark stores were closed. The group now has £1.5bn of inventory it can’t currently sell. Today’s results include a relatively modest £284m impairment against the value of this stock — management appear confident that much of it will still be saleable.

I think it’s also fair to say that it would be inappropriate for ABF to pay a dividend while simultaneously drawing on government furlough schemes for 68,000 employees across Europe.

Outlook: ABF’s half-year results confirm for me that in normal times this is an excellent business with a strong balance sheet. I’m confident that this will be enough protect equity holders from dilution or permanent losses. But what about the outlook for H2?

Food business: According to the company, the outlook for the Sugar, Grocery, Ingredients and Agriculture businesses is unchanged for the second half of the year.

Primark: ABF expects to be able to “mitigate half of the operating costs of the Primark business while stores remain closed”, leaving a monthly cash outflow of £100m. Management are confident Primark has the finanical resources it will need to survive, but warn that the process of reopening “is likely to be complex”.

Group guidance: Understandably, ABF does not feel able to provide earnings guidance for the remainder of the financial year.

My view

I think today’s statement from ABF is interesting for a number of reasons.

Existing lockdown will be difficult and risky: Management admit that reopening Primark will be a gradual process. Supply chain considerations and social distancing requirements could mean that sales and profits will take time to ramp up.

I see the process of reopening as a key risk which could expose weaker retailers, hotels and restaurants. They will all need to commit to cash outflows to reinstate damaged supply chains and inventories. At the same time, government support measures will probably be tapering. Customer demand is likely to be uncertain at first, so firms who get it wrong could be left dangerously exposed.

It could be a Darwinian period that will expose weaker businesses. This could apply to other sectors too, notably automotive manufacturing.

Does ABF offer value at current levels? Associated British Foods is a business I’ve admired for some time. But it’s worth remembering that Primark generated nearly 65% of group operating profit last year. It may be some time before we see profits return to 2018/19 levels.

The shares currently trade on about 15 times trailing earnings. At previous levels, the dividend would have provided a yield of around 2.5%.

The group’s strong balance sheet and good management suggest to me that on a long-term view, the shares may offer some value at current levels. I’m not yet sufficiently convinced to buy, but I am watching closely.

I’m going to wrap up today’s report with honourable mentions for FTSE 250 utility reseller Telecom Plus (TEP) and shipping broker Clarksons (CKN). Both firms issued reassuring updates today and have also maintained their planned dividends (so far).

That’s all I’ve got time for today. Thanks for reading.





Wordpress (5)
  • comment-avatar

    Thanks for for thoughts re oil gyrations. I had hopked that Shell would have been hit even harder this morning so that I could up my stake. Oh well (sorry), will have to hold off a bit longer.

    Do you think we will see sub 1,000p again?

    • comment-avatar

      Hi Laughton, I don’t expect to see Shell (disc: I hold) fall below 1,000p again unless oil stays at current levels for a considerable period of time. The oil price has a habit of overshooting. My hope is that’s what we’re now seeing. Of course, I may be completely wrong… DYOR!

      • comment-avatar

        Great commentary on oil, thanks Roland.

        I’ve been looking at Shell and wondering whether the 1000p level would really be great value.

        TLDR: Is the Shell of today, for around the same price of the shell of 2008, going to benefit from the same conditions as in 2008?

        The last time it was around this level was the tail end of 2008. Back then, oil prices were over $80 a barrel, so although falling (to around $40 at end 2008), multiples of the current price. Additionally, whether investors know it or not, we were about to enter the longest bull run in history and demand for oil increased significantly. Shell had much lower, and reducing, debt.

        With the share price around the same levels now, and oil (perhaps temporarily) through the floor, the (admittedly very slow) switch to renewables, secular changes in societies around the world such as increased WFH (although perhaps this is overdone?). I don’t know how confident I am about the demand for oil going forward.

      • comment-avatar

        One other comment I’d make about Shell (I hold) is that it’s a different company to 2008 and indeed 2016. Costs, especially, are much lower. As far as I can see, it doesn’t need more than about $50 per barrel to achieve cash flow breakeven. So there’s a lot more flexibility.
        On the other hand, there are certainly questions about long-term demand patterns, etc. Only time will tell. I remain of the view – although it sounds cynical – that gradually running of the oil business for cash while developing the gas/electricity/renewable operations will probably enable the group to transform itself.

  • comment-avatar

    Great “heads up ” ( If you had a £ for every ………) today Rollers .

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