Cube Midcap Report (6 Aug 2019) – DOM, ROR, RR

Cube Midcap Report (6 Aug 2019) – DOM, ROR, RR

Good morning! Welcome back to the Cube Midcap Report. Today I’m looking at:

We also had numbers today from Intercontinental HotelsSynthomer and Meggitt.


Domino’s Pizza

  • Share price: 237.7p (+2%)
  • Market cap: £1,100 million

Interim Results

Domino’s Pizza shares have experienced a big re-rating (lower) in recent years, as growth has slipped.

Today, it reports H1 system sales up by <5% and underlying PBT down 7.4%.

On a statutory basis, PBT is down by a hefty 27%.

There are huge differences in the performance of “UK & Ireland” versus “International”.

UK & ROI underlying operating profit is up 7.1% to £51.6 million, while losses widened at the International segment to £6.4 million. Difficulties are reported everywhere: in Norway, Sweden, Switzerland, and Iceland.

LHS: 2019 £millions. Middle: 2018 £millions. RHS: % change.

DOM has had a hard time making the formula work in other jurisdictions As a shareholder in DP Eurasia (Russia and Turkey operations), this is a worry for me.

And the outlook statement does not inspire confidence:

International visibility remains limited and trading is challenging. Focused on improving operational capabilities and performance

Cash flow

Net debt has increased by £36 million to £239 million, or 2.2x EBITDA.

Some of this is due to Brexit and “timing issues”, which are expected to unwind. But with dividends and share buybacks of £42 million during the period, a bear could argue that shareholder rewards have been funded almost entirely through borrowing (this can’t last over the long-term, but maybe it’s not so serious over a six-month period).

CEO role

The CEO is moving on after five years, but there will be an orderly transition. Today’s positive share price reaction has been interpreted as a response to his departure. The Chairman is also leaving.

Franchisee issues

This hints at the seriousness of the problems with UK franchisees:

Against the backdrop of ongoing discussions with our franchisees, we are seeing franchisees delay opening new stores. This means that we are unable to give guidance on the number of new stores this year, although we continue to expect a materially lower number compared to 2018.

Quite an awful situation for a pizza store company, and it goes a long way to explaining why the share price has soured.

Perhaps the problem for DOM is the concentration of franchisees: “the largest two franchisees account for 39% of stores, with the third largest accounting for a further 7%”.

This means that nearly half of all UK stores are controlled by three parties, and they clearly feel that their pricing power has not been recognised by HQ. It’s a straight-up battle between shareholders and franchisees, and maybe the franchisees are winning?

The rationale for owning shares in a company like DOM is that there is a monopolistic income stream to be earned from owning shares in the master franchisor. But even a monopoly has some limits on what it can charge its counterparties, and DOM might have hit the limits in terms of how it treats its franchisees.

Other issues

The normal challenges of the pizza delivery business are as you would expect – sourcing labour and ingredients. This paragraph also hints at the importance of the skill level of the franchisee:

The biggest challenge for franchisees remains the cost and availability of labour, particularly delivery drivers. 2019 food cost inflation for franchisees remains between 3% – 3.5%. There remains a headwind for some franchisees from donor stores from recent store splits, which are seeing longer profit recovery periods than has previously been the case. There is a wide range of EBITDA margins achieved both at a store and franchisee level, and we are focused on working with franchisees to optimise store and franchisee level profitability.

Guidance

There will be no more share buybacks in the current financial year – good, although I think I would prefer if the dividend got cut first! With the shares currently at a P/E multiple of around 13.5x, they could add real value for remaining shareholders if the company makes a successful turnaround.

Non-underlying item: eCommerce Fund

There is a major (£7.1 million) non-underlying item which I think needs to be highlighted, as the company has excluded it from “underlying” profits.

Scroll down to Note 8 (a) and you find that the company spent £7.1 million on upgrading its e-commerce platform. This type of development expense is “ordinarily borne” by franchisees, but was borne by the Group in this instance, so it has been treated as non-underlying.

We need to be sceptical of this treatment: while it should benefit Group sales in future periods, and should not be repeated on a regular basis, I would still view it as a real business expense. So we need to be careful about trusting the “underlying” profits too much.

My view

Despite the issues and the risks, I find this share highly interesting at the current valuation. It’s not easy to find a company earning huge ROE and returns on capital at a cheap-ish valuation.

What it requires is some insight into the strength of the brand persisting and the company working its way through the negotiations with its franchisees. You also need to satisfy yourself that disruption from the likes of Deliveroo will not end up disrupting Domino’s into oblivion. And you need some level of comfort with wage rates and possible food price inflation. There is a lot that can go wrong, and that has already gone wrong, and this is why the shares are now “cheap”.

I haven’t made my final decision yet, but I am leaning towards opening a starter position in this.


Rotork (ROR)

  • Share price: 310p (+8%)
  • Market cap: £2,700 million

Half year results

This is a business that rarely gets talked about, perhaps because it doesn’t make too many mistakes and therefore does not attract interesting headlines.

It designs and manufactures actuators, which are machine components that control the flow of gases and liquids. These components have applications in a very wide range of industries: oil and gas, power generation, sewage, marine and mining.

Today’s results show revenues down by 4.3% on an organic constant currency (OCC) basis. This is my preferred measurement of underlying performance.

But the “adjusted” profitability numbers are ok, with adjusted PBT up by 1.1% on an organic consant currency basis. So if you’re happy to exclude the amortisation of intangibles, restructuring costs, etc., then the company is doing fine.

Order book – while H1 orders are down marginally compared to the previous year, the company offers some green shots on the basis of the quarterly order flow:

Q2 order intake was ahead sequentially and year-on-year on an OCC basis, continuing the gradual improvement in overall activity levels we have seen in recent quarters.

Return on capital employed – the company gets a big tick mark from me for disclosing its ROCE and using this as a key performance indicator. It also gets a big tick mark from me because its ROCE is so good: 29.7% in H1, up from 27.2% in H1 last year, according to its own calculations.

Note that financial software programs, since they don’t adjust the figures, will show a much lower but still very respectable annual ROCE for this company of betwen 19% and 21%.

Outlook is ok:

We are committed to delivering sustainable mid to high single digit revenue growth and mid 20s adjusted operating margins over time, and are pleased to report good progress in H1 despite sales, as expected, reducing year-on-year. 

Whilst macroeconomic uncertainty remains, with recent order intake and the momentum of our Growth Acceleration Programme we now expect to deliver flat sales on an OCC basis in 2019, with full year adjusted operating margins showing clear progress year-on-year.

My view

This is a good example of a solid industrial midcap which is run professionally and pumping out decent returns for shareholders (pun intended). At a forward PER in excess of 20x, I can’t think of any reason why the current share price would make for a particularly good entry point, but I do think it’s worth keeping on watchlists.


Rolls-Royce (RR.)

  • Share price: 790p (-3%)
  • Market cap: £14,980 million

Half year results

A nice clear headline from Rolls-Royce today: full year guidance maintained.

This huge manufacturer of engines has been a tough place for investors in recent years. 2018 saw a large reported operating loss after the company incurred huge expenses associated with its Trent 1000 engine.

The company remains bullish on its medium-term prospects, pledging today that there will be “at least £1bn free cash flow in FY 2020; mid-term ambition > £1 CPS” (i.e. more than 100p in annual free cash flow per share).

At the current share count, that implies nearly £2 billion in free cash flow. Based on its historical track record, this should be achievable at least from time to time, but doing it sustainably is another matter. For one thing, Rolls-Royce tends to experience mind-blowing swings in working capital. So I would expect the cash performance to remain extremely lumpy.

Trent 1000

Problems persist with this engine:

“Progress made on Trent 1000, increasing our MRO capacity to help minimise disruption and reducing AOGs, albeit pace of decline has been slightly below our original plans; in-service cost estimates increased by a total of £100m across the next three years.”

(MRO: Maintenance, Repair & Overhaul. AOG: Aircraft on Ground.)

My view

I respect Rolls-Royce’s heritage and long-term track record as a manufacturer, but this isn’t the sort of stock that I like to invest in. It’s just too heavy, complicated and capital-intensive.

As someone remarked recently about Toyota: it’s the best-in-class car manufacturer, but its share price still hasn’t been able to make much progress for shareholders over the past twenty years or so. There are some industries where it is simply very difficult to make big compound returns.

Making engines, I fear, is one of those, so I wouldn’t buy Rolls-Royce shares unless they ventured into “absurdly cheap” valuation territory.


All done for today: I’ll be back again with more tomorrow. Cheers!

Graham

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