Cube Midcap Report (25 July 2019) – COB, BUR, AZN, VCT

Cube Midcap Report (25 July 2019) – COB, BUR, AZN, VCT

Good morning, it’s Roland here. Welcome back to the Cube Midcap Report.

It’s a busy day on the newsfeed today. Here are the companies I’m planning to look at:

Cobham (COB)

  • Share price: 165p (+35%)
  • Market cap: £3.95bn

Recommended offer & interim results

Cobham shares are up by 35% this morning thanks to a 165p per share cash offer for the company from private equity outfit Advent International.

This represents a 34.4% premium to yesterday’s closing price and a 45.8% premium to the volume weighted average share price of 113p over the last month.

This defence engineering business has been through a difficult period in recent years. A combination of overpriced acquisitions, problems on a Boeing refuelling tanker project and a UK tax dispute left the balance sheet laden with debt and caused profits to slump.

Rights issues were required in 2016 and 2017 to shore up the balance sheet.

My view

I’ve followed this story but not managed to convince myself of the right time to get involved. However, today’s half-year results suggest to me that things are getting back on track.

I suppose the Advent bid is some consolation for shareholders who’ve supported the firm through two rights issues. But at 165p, it only takes Cobham’s share price back to the level it was at before problems came to light in April 2016. Since then, the dividend has been suspended and the begging bowl has been out twice.

I can’t help feeling that this is a better deal for the buyers than for loyal shareholders, many of whom may be exiting at a loss.

However, the offer has been unanimously recommended by the board, on the grounds that “it represents an opportunity for shareholders to realise their investment in Cobham in cash in the near term”.

Perhaps there’s pressure from large institutional shareholders to accept? I note that the firm’s fourth-largest holder, Artemis Investment Management, has already agreed to vote its 5% shareholding in favour.

I suspect this is a done deal, so let’s move on.

Burford Capital (BUR)

  • Share price: 1,723p (+3.3%)
  • Market cap: £3.8bn

Interim results

This £3.8bn litigation financing company is now the largest company on the AIM market. The Burford share price is up slightly this morning after half-year results showed after-tax profit rising by 37% to $220m during the first half of 2019.

As usual, this company’s growth rate and profitability appear deeply impressive:

  • Income (revenue): +42% to $292m
  • Operating profit: +39% to $246m
  • Operating margin: 84%
  • After-tax profit: +37% to $220m
  • Assets under management: $2.8bn

According to the firm, demand remains robust for Burford’s capital. The firm made new investment commitments of $751m during the period, a 36% increase on the $553m committed during the same period last year.

The company’s return on invested capital (ROIC) on its core balance sheet portfolio (excluding external funds) was 98% during the period, compared to 85% last year.

Profits vs. cash flow

During the first half of 2019, 49% of Burford’s reported profits come from unrealised valuation gains on cases that have not yet concluded. This is slightly lower than recent years, which have averaged 54%.

Obviously this means roughly half of the firm’s reported profits each year are potentially subject to future revision. Burford attracts some scepticism on this count, as the calculation of these unrealised gains is by its nature fairly subjective.

In its defence, the company rightly points out that IFRS accounting rules require it to operate in this way. So-called Level 3 assets, which are illiquid and hard to value, must be valued at fair value by using the best information available in the circumstances. Other companies which own illiquid and unlisted assets use similar approaches.

My take on this is that if the company’s valuation methodology is reliable and accurate, reported profits will be broadly comparable to cash proceeds from investments. Although these numbers aren’t equivalent, my view is that today’s cash proceeds can reasonably be seen as giving credibility to tomorrow’s profits.

When I’ve looked at this company in the past, I’ve found that cash generation has been consistently strong and broadly in proportion to the company’s growing asset base. Today’s results show a similar story. Cash proceeds from investments of $315m during the period suggest to me that the reported operating profit of $246m is credible.

The reason that Burford always scores terribly for free cash flow on financial data services is that all of this cash — and more — is routinely recycled into new investments.

My view

I was talking about this business with another investor earlier this year. We agreed that we didn’t know whether litigation finance was a genuinely new asset class, or one that had simply been operated discretely and privately before.

It may be genuinely new. I read recently that large pharma firms used to treat legal costs as exceptional items, but now account for them as routine operating costs. If this trend is extended across the US and UK corporate sectors, then a whole new asset class may have been created.

If any readers have any insight on the litigation financing sector, please feel free to share in the comments. I’d love to know more, given the apparently limitless and highly profitable opportunities Burford continues to report.

In order to maintain its pace of growth without becoming excessively indebted, Burford is increasingly investing other people’s cash. Last year it announced deals to provide $1.3bn of new funding from institutional investors, with the company providing just $333m. The terms seemed very favourable to BUR, in my view.

Burford seems to be on the way to becoming a specialist fund manager business, and indeed uses this term within today’s half-year report.

If we compare the firm’s £3.7bn market cap against its net asset value of $1.6bn (£1.3bn), then Burford stock looks expensive.

But if we look at the group’s return on equity of c.30% and its forecast P/E of 15, then the price seems fairer.

I can’t shake off a feeling that this is all too good to last. But I may well be wrong. Burford’s scale, sophistication and first mover status appears to be providing strong tailwinds. This business could well be a good investment for years to come. But it won’t be in my portfolio.

AstraZeneca (AZN)

  • Share price: 6,707p (+5.5%)
  • Market cap: £88bn

Interim results

This is just a short diversion to highlight a potential concern of mine regarding AstraZeneca’s true financial situation.

Today’s half-year results from the FTSE 100 pharma giant were well-received by the market. The shares are up by more than 5% as I type.

The numbers show sales growth and “core earnings” ahead of expectations for the second quarter, at $5.8bn and $0.73 per share respectively. The company now expects five of its new medicines to reach blockbuster status (sales of >$1bn) this year.

So far, so good. But the scale of the adjustments applied to Astra’s reported profits is worth noting, in my view.

AstraZeneca 1H18 profits

As you can see, core earnings per share for the half year are nearly three times greater than reported eps. Core operating profit is roughly double reported operating profit.

This isn’t’ a one-off — the firm’s 2017 and 2018 accounts show similar, huge, adjustments.

I think it’s worth questioning what’s really being reported (and excluded) in these numbers. After all, AstraZeneca’s reported earnings have not covered its dividend since 2012. Over the same period, net debt has risen from under £500m to £13.1bn. How much of this borrowed cash has been used for growth investments, and how much has been paid out to shareholders?

My sums suggest that shareholders might reasonably have some concerns, especially after March’s $3.5bn placing.

If you’d like to know more about exactly how core earnings are calculated and what this might suggest for shareholders, I’d recommend this note from Hardman & Co.

My view: I feel AstraZeneca looks very expensive at current levels. I wouldn’t invest at this time.

Victrex (VCT)

  • Share price: 1,983p (-4%)
  • Market cap: £1.7bn

Q3 trading update

Victrex is a highly profitable chemicals company that makes “high performance polymer solutions”. It’s the world’s largest manufacturer of polyetheretherketone (PEEK).

Customers include the automotive, aviation, oil and medical industries. PEEK is essentially a very strong plastic that can be used to make parts where metal might normally be used. This saves weight and provides easier manufacturing.

Historically, this has been a superb investment. Victrex’s operating margin has averaged 40% since 2013. It’s generated return on capital employed of more than 20% over this period and maintained a cash-rich balance sheet.

Victrex share price chart

Source: Google Finance

However, today’s trading update tells us that cyclical headwinds in the automotive and electronics are continuing to put pressure on sales and profits. These problems first emerged at the end of last year. The Victrex share price has fallen by 40% since the start of October 2018.

The company says that it doesn’t expect any improvement in market conditions during its fiscal fourth quarter, but that its own initiatives should result in “a more stable performance”.

My view

Victrex looked expensive to me last year, but I’m starting to think that its valuation might be coming down to a more attractive level.

After today’s drop, I estimate the shares are trading on about 18 times FY19 forecast earnings, with a dividend yield of 3.3%.

I expect margins to remain healthy and free cash flow cover to be maintained for the dividend.

Market conditions may continue to weaken for a little while longer yet, but given the group’s track record of high returns, I plan to keep a close eye on the shares. If the shares continue to fall, I think VCT could offer a decent buying opportunity.

I’m afraid that’s all I’ve got time for on this rather warm day.

I’ll be back tomorrow with more midcap coverage.





Wordpress (4)
  • comment-avatar

    Great commentary and analysis thanks. I’ve been watching Victrex for some time, so this was of particular value. Also, as an extremely happy AZN I share your concerns that at some point the adjustments have to come home to roost. Terry Smith has been vocal on it in the past. The market however, seems to pay little heed to this fact. One to ponder. Cheers, Paul

  • comment-avatar

    Great analysis. Tx. Interested in BUR simply because I struggle to understand the financials of this business! Not one for my portfolio but agree VCT could get interesting

  • comment-avatar

    WRT Burford, becoming a law firm that increasingly has fund management interests, it made mne think of Law Debenture, an investment trust that has a “sideline” in litigation.

    Maybe Burford has aspirations to become something like that. I hope litigation isn’t a new asset class as it doesn’t sound like its a healthy thing for society, but I guess that never stopped anyone if money was to be made!

    • comment-avatar

      I agree, the whole idea of litigation financing seems depressingly cynical to me. It also seems likely to tip the balance even further in favour of vested interests and large corporates.

      But I guess the use of litigation has become so widespread that perhaps it does make sense…


  • Your Cart