Cube Midcap Report (5 Dec) – Softer results put dividend on hold #VCT #IGG #AJB #DNLM

Cube Midcap Report (5 Dec) – Softer results put dividend on hold #VCT #IGG #AJB #DNLM

Good morning, it’s Roland here with the Midcap Report.

There’s a lot of news from our sector of the market today. Here’s a list of the companies that have caught my interest.

This report is now finished (11.45).

Victrex (VCT)

  • Share price: 2,308p (-1.4%)
  • Market cap: £2.0bn

Full-year results

FTSE 250 polymer specialist makes high-tech plastic parts for a wide range of markets including the automotive, aerospace, electronics and healthcare sectors. Put simply, the firm’s PEEK polymer is light and strong and can be used to replace metal parts, cutting cost and weight.

Unfortunately, cyclical weakness in the automotive and electronics sectors is putting a serious drag on the firm’s results at the moment. Revenue has fallen by 10% over the last year, while pre-tax profit was 18% lower:

VCT FY19 results summary

In fairness, this weakness was flagged up earlier this year. Today’s numbers are in line with expectations and still show an attractive level of profitability.

But the numbers are bad enough for the board to have held the dividend unchanged this year. As far as I can tell, it’s only the second time in 23 years that Victrex has not increased its payout (the other time was in 2016). Naturally, there will be no repeat of last year’s special dividend this year.

As I explained in July, I rate this company highly. It generates consistently high margins, boasts strong cash generation, and has created a lot of wealth for long-term shareholders. It’s a stock I’d like to own at the right price. Let’s take a closer look.

Short-term weakness?

Looking across the group’s segments, the company says that it’s seeing good growth in the Aerospace, Medical and Energy sectors. Unfortunately this is being offset by cyclical weakness in the Automotive and Electronics sectors and lower sales to ‘Value Added Resellers’  — presumably companies who integrate PEEK into other products.

Here’s a snapshot from today’s results presentation showing how volumes changed over the last year:

VCT FY19 PEEK volumes

This is the short-term picture. I think there’s some risk we could see further softening in demand this year. The company notes a “cautious” outlook for automotive for the year ahead, with a neutral stance on the electronics and energy sectors. Only aerospace and medical markets qualify for an optimistic outlook.

‘Structural megatrends’

Looking further ahead, I think the company makes a credible case for continued long-term structural growth:

  • ‘Structural megatrends’ in Automotive: Attributes such as lightweighting, CO2 reduction, durability, comfort and heat resistance are expected to drive long-term demand for more PEEK parts to replace existing metal components. This seems plausible to me.
  • Aerospace: Similar factors are expected to drive long-term growth in aerospace.
  • Mega programmes: Victrex is working on what it calls ‘mega programmes’ to develop new product ranges for both aerospace and medical customers. It’s expected to be several more years before these generate significant revenue, but the aim is to support structural growth in PEEK sales volumes.
Medical growth opportunity?

I’m particularly interested in the size of the opportunity for medical PEEK volumes.

Victrex doesn’t provide a full segmental breakdown of profit, limiting itself to a split between medical sales and industrial sales (everything else). But what we can see from this is that margins are much higher in the medical market:

VCT FY19 segmental profits

Medical sales generated  gross margin of 83% last year, compared to 54% for the group’s industrial business. If medical revenue can become a larger slice of the total, this could have a very beneficial effect on profits.

The size of the medical opportunity isn’t clear to me. Revenue from this segment rose by 4% last year, while volumes were 2% higher. This is a very modest rate of growth. But if the firm can increase this over time, it could be a very valuable business in my view.

High returns and strong cash flow

My sums suggest that Victrex generated an operating margin of 35% and a return on capital employed of 20.9% last year. These are impressive figures, albeit lower than last year, when the equivalent numbers were 38.9% and 24.8%.

However, cash generation remained strong and the company ended the year with net cash of £72.8m. This was achieved despite a Brexit-related stock build in a new warehouse in Germany.

I don’t have any concerns about the financial quality of this business.

My view

This is the kind of stock that I like to buy when the market is throwing its toys out of the pram. We’re not there yet — today’s results value Victrex shares on 22 times earnings, with a dividend yield of 2.5%.

I don’t think that’s an excessive valuation for such a profitable and well-financed business. But I think there’s a chance that performance could worsen this year, providing us with a better buying opportunity.

If I was a long-term holder I’d certainly sit tight. But as a potential buyer, I plan to wait in hope of a truly outstanding buying opportunity. I accept, of course, that this could mean that I miss the boat altogether.

IG Group Holdings (IGG)

  • Share price: 665p (-3.4%)
  • Market cap: £2.5bn

Pre-close trading update

(At the time of publication, Roland had a long position in IG Group)

I last wrote about this FTSE 250 financial trading firm back in September, when IG reported a strong set of Q1 results. Today’s H1 trading update hasn’t enthused the market quite as much, but I don’t see anything especially untoward in the numbers.

The company says that net trading revenue for the first half of the year is expected to be £250m, compared to a figure of £251m for the same period last year.

However, H1 last year included two months of trading before new ESMA restrictions on leverage were imposed on retail traders. This has had a negative impact on trading, so the fact that IG has kept revenue unchanged suggests its managing to generate compensating growth elsewhere.

Extra detail provided by the company seems to confirm this. H1 revenue from core markets (UK and Western Europe) is expected to be around £210m, 6% lower than last year. But revenue from businesses being targeted for growth rose by 43% to £40m, offsetting this weakness. Japan and Emerging Markets are highlighted as the source of this growth.

My view

IG Group is clearly still going through a period of transition. But the firm remains the market leader in its core markets and is still highly profitable and cash generative. I don’t see anything in today’s update to change my investment thesis, and remain happy to hold.

Dunelm (DNLM)

  • Share price: 986p (+18.5%)
  • Market cap: £2.0bn

Trading update

Sometimes businesses go through a phase where it seems they can do no wrong. Investors often get quite excited when this happens. Dunelm is a case in point. The homeware retailer’s recovery under chief executive Nick Wilkinson has been very impressive and the shares have risen by 58% over the last year.

Today’s update extends this strong record with another upgrade to profit guidance.

The company says that the transition to its new digital platform has been completed without any impact on sales performance. This new ‘cloud native’ platform is now expected to support further development of the retailer’s omnichannel offering.

In addition to this, sourcing gains and good cost control mean that gross margins have been higher than expected. Pre-tax profit is now expected to be ahead of previous guidance, barring any change to consumer demand following the election.

I’m not sure that a general election result is likely to change many people’s plans to purchase soft furnishings, but I suppose it’s a risk.

My view

My prediction in October that the Dunelm share price might have peaked has proved wide of the mark. DNLM shares have shot higher today and are up by nearly 19% at the time of writing. Where does this leave the valuation of this surprisingly successful retailer?

Unfortunately management haven’t seen fit to quantify the expected increase in profits this year. But the share price reaction suggests to me that the market is pricing in an upgrade of at least 10%.

Using this as a guide, I estimate that the stock is now trading on about 17 times forecast earnings, with a dividend yield of perhaps 4.2%. That’s an attractive yield, but dividend cover is relatively low, at 1.4x. I think it’s also worth remembering that this is probably a fairly mature business — prior to today, City forecasts were for earnings growth of about 5% next year.

Dunelm has a track record of strong cash generation, a 10%+ operating margin and minimal debt. I think it’s a good business, but I’m not sure how big the remaining growth opportunity is likely to be. My feeling is that most of the good news is probably in the price.

AJ Bell (AJB)

  • Share price: 388p (-4.9%)
  • Market cap: £1.6bn

Full-year results

Today’s full-year results from this highly-rated investment platform appear to have been a minor disappointment to the market. Why might this be?

The group’s full-year earnings of 7.47p and dividend of 4.83p are marginally below the consensus figures I can see of 7.56p and 4.9p. But I’m not sure this is the reason for today’s minor sell off.

With the stock trading on about 54 times earnings and offering a yield of just 1.2%, I think today’s fall is most likely to represent a round of profit taking. I can see two reasons for this.

The first is that while AJ Bell’s growth rate and profitability is impressive, it’s not necessarily enough to justify such a high price tag:

  • Assets under administration £52.3bn (+13%)
  • Retail customers: 232,066 (+17%)
  • FY19 revenue: £104.9m (+17%)
  • FY19 pre-tax profit: £37.7m (+33%)
  • FY19 pre-tax profit margin: 35.9% (+4.3%)

Strong numbers. But analysts expect profit growth to slow to about 22% during the current year, which could put pressure on the current valuation.

There’s also a second potential concern. AJ Bell continues to trade at a significant premium to its larger rival Hargreaves Lansdown. This FTSE 100 firm has been tarnished by the Neil Woodford scandal. But it has an impressive track record and is available to buy on 31 times forecast earnings, despite enjoying an operating margin of 63% — nearly double the AJB figure.

The only point I’d make in AJ Bell’s defence is that its profit margins are rising, while margins at Hargreaves have been falling over the last two years. So operational gearing could work in Bell’s favour and against HL. But it’s still a big gap to bridge.

Although HL’s earnings are only expected to grow by about 11% this year — roughly half the rate expected for AJB — I’m still not convinced that AJ Bell deserves such a hefty valuation premium.

My view

I think that AJ Bell is a good quality business. But the shares look expensive to me at present, and are not something I’d consider buying at current levels.

That’s all I’ve got time for today, thank you for reading.


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