Cube Midcap Report (25 Feb 2020) – Pru gets a letter #CRDA #MGGT #TSCO #PRU
Today we have the following announcements:
- Croda (CRDA) – Results for the year ended 31 December 2019
- Meggitt (MGGT) – 2019 Full Year Results
- Tesco (TSCO) – Agrees to sell 20% share in Chinese JV
- Prudential (PRU) – Receives letter from Third Point LLC
Finished at 3.30pm.
I’ve been a little distracted by my options trading over the past 24 hours.
Even though the size of the trade was very small, relative to my overall portfolio, I really want to get this strategy right.
The trade is currently offside, but of course it’s impossible to get the timing perfect. As an option seller, I’m only very rarely going to “call the top” in the options market. All I can do is make sure that I get good value at entry. After that, the market will do whatever it wants to do.
- Share price: £48.11
- Market cap: £6.2 billion
This specialty chemical company has been a raging success for investors over the past decade. The shares are up ten-fold over this timeframe.
The products and markets it serves are incredibly diverse – here’s the list.
Today’s results show a modest reduction in sales (2.3%) and PBT (3.7%) at constant FX. The CEO talks about “subdued market conditions”. The only major bright spot is free cash flow, which is up by nearly £50 million to £200 million.
That free cash flow figure might not sound very large, relative to Croda’s market cap. Indeed, share price gains here have been a combination of both earnings growth and multiple expansion. Croda trades at c. 25x earnings and at a very large multiple of cash flow, too.
The market rates Croda highly, and understandably so. Gross margins are a very healthy 37% and ROCE is consistently ahead of the market. It’s an unfortunate feature of the current market that high-quality companies, even without growth, trade at very high multiples relative to historic norms.
Outlook – performance is to be “underpinned” by innovation, organic growth in capacity, technology acquisitions, and the reinvestment of cost savings for growth.
“In the year ahead, subject to trading conditions remaining similar, we expect to make further progress in our consumer markets, whilst demand in industrial markets is expected to remain weak but stable. Our growth will be second half weighted.”
With exposure to such a wide range of industries, Croda investors must sleep soundly at night. When some parts underperform, something else can shine. Sales in performance technologies fell by 7.3% in 2019, but life sciences increased by 5.9% (and by even more than that at actual exchange rates).
The declining global automotive sector, and poor industrial markets generally, are responsible for the decline in Croda’s performance technologies. In contrast, health care is booming and this is reflected in Croda’s result for life sciences.
Geographically, all regions suffered from weaker sales. The European economy seems to be in a perpetual state of despair, while North America was hit by the US/China trade dispute. Even the Asian economy was “unusually weak”.
Coronavirus impact sounds very limited for Croda. None of its employees are proven to have been infected, sales offices in China have reopened, and China is responsible for only 2% of its production (and 6% of sales).
I’ve had a positive impression of this company for years, but never saw fit to put it in my personal portfolio. An expensive mistake!
In my defence, it has only very rarely looked like a bargain. Even today, I’m more comfortable owning it as part of a FTSE-100 index fund (the same as I said yesterday about ABF). If my short FTSE option trade gets exercised below 6600, I might yet end up owning a few shares in Croda!
- Share price: 578p (-3%)
- Market cap: £4.5 billion
This is a large engineering group providing components and systems for 3 core sectors: aerospace (aircraft parts) (54% of revenue), defence (36%) and energy (10%).
I don’t invest in this sector because a) I lack specialist knowledge, and b) I’m sceptical about the quality of companies (i.e. whether it is possible for them to protect a competitive advantage).
That disclaimer out of the way, I should acknowledge that Meggitt has achieved a lot for shareholders, judging by the long-term price chart. Let’s see how it’s doing in the short-term.
- orders +10% organically
- revenue +8% organically
- underlying PBT +8% organically
- actual PBT +33%
For the reported, rather than organic performance, you can add a few percentage points to the above revenue and underlying PBT numbers, i.e. acquisitions also had a small positive impact.
Book-to-bill was 1.09x, i.e. orders were received faster than customers were invoiced. This is reflected in orders growing faster than revenues.
Note that the strong growth in actual PBT was thanks to a healthy reduction in adjusting items in 2019 – fewer exceptional items, plus some profits on forward currency contracts being used for hedging purposes.
I fully endorse Meggitt’s choice to exclude hedging profits from the underlying result. For that reason, I would give stronger weight to Meggitt’s “underlying” performance than I do for most companies.
ROCE – Meggitt is good enough to calculate its own ROCE, which it thinks was 11% in 2019 (up from 9.9% the year before). Not bad.
Outlook – here are the key points.
- 737 MAX and Coronavirus supply chain disruption to “hold back margin progression in the short term”.
- 2020: organic revenue growth 2% – 4%, underlying operating margin +30 bps to +50bps (from 17.7% in 2019).
- Free cash flow to weaken from capex/opex relating to the move to Coventry Technology Park and other one-off hits.
- 2021: mid to low single digit organic revenue growth and underlying operating margin 18.5% – 19%.
Full marks to Meggitt for the clarity of its statement, and well done on a pretty decent performance.
- Share price: 246.85p (-1%)
- Market cap: £24.2 billion
No surprise here. Tesco gives up on another foreign misadventure, this time in China.
It’s a good news story for Tesco shareholders, as management can proceed now without distraction. Net proceeds of £275 million won’t hurt, either.
As I’ve noted before, Tesco’s £12 billion debt mountain makes it one of my least favourite supermarket shares. When it comes to chipping away at the debt, I guess it’s true that every little helps.
- Share price: £14.38 (+1.3%)
- Market cap: £37.4 billion
Many readers will be aware that Prudential has this year already spun out the fund manager M&G (MNG), which currently has a market cap of around £6 billion (and appears strangely cheap at a P/E multiple of 6x!).
Third Point wants more change. Dan Loeb writes:
While we applaud Prudential plc (the “Company”) for taking the initial step of separating its European operations into M&G plc, we believe that a more significant opportunity exists: separate the Company’s Asian and United States operations to increase investment in both businesses, optimize growth, and drive higher valuation.
Third Point declares an “economic stake” in Prudential (via shares and derivatives) of 5%, putting it second only to Blackrock on the shareholder register.
The rationale is straightforward:
Prudential plc’s two separately managed franchises, Prudential Corporation Asia (“PruAsia”) and Jackson National Life (“Jackson”), have distinct strengths but share no discernable benefit from being operated under the same corporate umbrella.
Third Point goes on to explain why it thinks shares in Prudential have made no progress over the past five years, and sit on a P/E multiple of less than 10x:
- the “conglomerate discount” (it doesn’t use this phrase, but that’s what it’s talking about) – having complex, dissimilar businesses in the same wrapper.
- a “short-sighted” and “illogical” dividend policy, focusing on dividend growth over reinvestment. While this may be true, many large UK companies prioritise dividends over reinvestment.
- head office executives too far away from PruAsia and lacking Asian experience.
The letter finished on a hopeful note. Dan Loeb is “confident” that the Board of Prudential will “see merit in our suggestions”.
The response by Prudential today is polite and constructive:
Prudential proactively engages with shareholders with regards to Group strategy and structure, and looks forward to commencing a dialogue with Third Point with regard to the views outlined in its letter.
I’m intrigued. Prudential does look superficially cheap, and breaking it up could help to reveal the value in its constituent parts.
This has already happened to an extent with M&G, even though the share price at M&G is yet to re-rate higher. While I don’t need the dividends, the prospective 7.7% yield at M&G warrants further attention, in my view.
Both Pru and M&G are worthy of further research, in my view. Even if Third Point’s efforts don’t catalyse change at the Pru, they could help to highlight the value of its portfolio to the investment community. On a relatively short timeframe, both shares therefore look promising.
All done for today. See you tomorrow!