Cube Midcap Report (9 March 2020) – Eye of the storm as oil crashes #CINE #ABC
Good morning, it’s Roland here with today’s Midcap report.
The scene is set for a memorable and perhaps traumatic day in the markets today. As I write, just after 7am, Brent Crude oil is down 25% at $33.91. FTSE 100 futures are showing a drop of 8.5% to around 5,920 on IG Index (I hold IGG).
Of course, we shouldn’t forget that behind this financial drama is a much more serious human drama.
Cases of coronavirus are continuing to rise rapidly in many countries. In Italy, the number of coronavirus fatalities doubled to 366 over the weekend. The Italian government has now quarantined around one quarter of its population (16m) in the country’s northern region. France has banned gatherings of more than 1,000 people.
The number of new cases in the UK is now said to have reached 278, with three people dead.
What to do now
Hand washing, restricted movement and social distancing appear to be the best way to slow the progress of coronavirus. But what about our investments?
Analysing company news may seem somewhat crass in the context of the coronavirus outbreak, but many investors will be understandably anxious this morning.
Today I plan to explain what I’m doing with my investments, discuss what’s happening in the oil market, and take a look at today’s midcap news.
Whatever you’re doing, I hope you’re able to stay safe and calm in the face of this uncomfortable situation.
This report will be complete by 1pm.
Why are oil prices crashing?
Apologies for the break in service — I had to step out for a personal appointment.
Let’s get back to the news. The price of oil has been falling for some weeks, but has crashed sharply today. Why?
The gradual fall seen during February was caused by rational fears that oil demand would weaken this year as a result of the coronavirus.
Last week, Saudi Arabia, Opec and Russia — known as Opec+ — met to try and agree a further round of production cuts aimed at supporting the oil price. Russia and Saudi Arabia have worked together since 2016 to stabilise oil prices. But this time round, Russia is said to have refused to take part.
As a result, the planned deal fell apart. From 1 April, there will be no agreed restrictions on Opec or Russian production.
Saudi Arabia has promised to open the taps and ramp up production, launching a price war. This is why the price has crashed. The kingdom has been producing under 10m barrels per day recently, but is said to have the capacity to produce up to 12m. To put this in context, global oil demand is around 100mb/d.
As I write, the FTSE 100 is down by 6.2%. In no small measure, this has been caused by the oil price crash — Royal Dutch Shell (disclosure: I hold) and BP are both down by 15% or more. Together, these heavyweights have an outsized influence on the FTSE index.
What’s happening and why?
The rapid growth of US shale oil production over the last decade has made the country the world’s swing producer — a country that can turn on the taps at short notice when oil demand (and prices) rise. This was a role previously fulfilled by Opec leader Saudi Arabia.
As a result, Opec has lost the pricing power it once had. This has caused some frustration for both Russia and Saudi Arabia, who have seen their market share challenged and in some cases eroded by US oil. For Russia in particular, US energy nationalism has also resulted in threats to the geopolitical influence the Kremlin can exert on buyers of its oil and gas.
The only problem is that US shale oil has never been very profitable. Although costs have come down, many producers are heavily indebted and generate very little free cash flow. Refinancing these operations has become more difficult. Oil prices under $50 seem likely to result in further difficulties, once hedging protection runs out.
During the last oil price crash, in 2015/16, Saudi Arabia flooded the market in an effort to put US oil producers out of business. Cheap debt, falling costs and technical innovation meant that this strategy failed. Petrostates such as Saudi — whose national budgets depend on oil revenues — suffered badly.
Ultimately, the kingdom had to admit defeat and cut production, in partnership with Russia.
Saudi Arabia won’t take the pain of production cuts alone. And the Russians appear to have tired of handing market share and geopolitical influence to US producers.
As a result, Russia and Saudi both appear poised to flood the market with cheap oil in an effort to take market share from each other, and from US producers. Their hope, I guess, is that some US oil firms will be forced out of business by a period of low prices.
Will this strategy succeed the second time round? I don’t know. But it is clear that oil majors such as BP and Shell are likely to come under some pressure this year. Depending on how quickly the market recovers, this could affect planned shareholder returns.
I don’t think either company is likely to cut its dividend in a hurry, but we could see spending cuts and buybacks suspended.
The only crumb of comfort I would highlight for oil investors is that the oil market tends to overshoot to the upside and to the downside. I’d be surprised if we see oil stay below $45 per barrel for more than a short period.
Of course, oil consumers are set to benefit from cheaper prices. This could benefit a number of sectors, including travel firms able to opportunistically hedge in future supplies at lower costs.
I’m not taking any action in relation to my own portfolio, which is fully invested and ungeared. I don’t know whether we’re going to see a long bear market or a quick rebound, but my plan is the same. Sell nothing and buy when I have cash available.
I have already topped up a few of my holdings over the last week or so. These purchases were made at prices that seemed attractive at the time. Although I could have done better by waiting, I’m still fairly comfortable with what I paid.
However, I would say this is one of my weaknesses. When the market slumps, I tend to rush in and buy too soon. A more patient approach would have helped me secure better prices.
The FTSE 100 seems to have steadied since this morning and is now down by 6.5% at around 6,040. At this level my general view would be that the index offers good value. However, this relies on the assumption that the impact of the coronavirus outbreak on corporate earnings will be restricted to 2020 and will not herald the start of a deeper downturn.
I don’t really have an informed view on this. From what I can see, bulls and bears both offer some credible arguments.
The technical picture seems equally uncertain to me. Here’s a chart showing the FTSE 100 since April 2006. I’ve highlighted an approximate channel within which the index has traded since the 2008 crash:
I’m not a technical analyst, but the chart suggests two options to me.
- The market could bounce back very quickly to within the lower bound of the channel
- The bull market that’s been in place since 2008 has just come to an end.
I plan to continue focusing on individual stocks. If prices stay low, then I’ll continue to buy over the coming months. History suggests there will be some attractive prices on offer.
Let’s move on to today’s midcap company news.
- Share price: 108p (-2.4%)
- Market cap: £1.5bn
Cineworld’s largest shareholder is selling £116m of stock in order to convert a margin loan into “a new secured corporate loan facility“. The shareholder in question, Global City Theatres BV (GCT), is a company controlled by Cineworld’s CEO and deputy CEO, Moshe and Israel Greidinger. The sale will reduce GCT’s stake in Cineworld from 27.9% to 20%.
My understanding from today’s announcement is that at least part of GCT’s shareholding in Cineworld has been funded with a margin loan. I’d guess that the collapse of the Cineworld share price may have triggered a margin call.
In any case, GCT has decided to scale back its shareholding. This will allow it to obtain a secured loan with no connection to the price of Cineworld shares. As far as I can see, this will still mean that at least part of GCT’s Cineworld shareholding has been used to secure a loan.
Are founders extracting cash from CINE?
I don’t know the backstory here.
But I think it’s worth pointing out that in recent years, we’ve seen a number of instances where founders have extracted cash from a business by borrowing against their shareholdings. This allows them to cash out without appearing to sell stock.
This strategy has not always delivered good outcomes for lenders or for the investee company’s ordinary shareholders. Two recent high-profile examples are South African conglomerate Steinhoff and the shared office space group WeWork, founded by Adam Neumann.
Graham and I have both written about this heavily-indebted and acquisitive cinema chain recently (see the archives). I was cautious about Cineworld in December due to the group’s high level of leverage.
The shares have fallen by nearly 50% since then, as the coronavirus outbreak has heightened concerns about the outlook for leisure business. Cineworld remains one of the most heavily-shorted stocks in the FTSE 250, with a net short position of 7% at the time of writing.
Today’s news does not reflect directly on Cineworld’s trading performance or its financial situation.
But on balance, today’s disclosures would make me more reluctant to get involved with such a highly-geared business. My concern is that the Greidingers may be better protected than ordinary shareholders from any adverse consequences of Cineworld’s high leverage.
- Share price: 1,145p (-9.1%)
- Market cap: £2.4bn
Abcam is a FTSE 250 life science company which provides research tools for use in laboratories. The group produces “high quality biological reagents and tools” which are used in “drug discovery, diagnostics and basic research”.
The details of this business are beyond my understanding. But it seems that the firm’s products are widely used by medical laboratories and are an essential part of many research activities. Abcam appears to have a strong reputation and a big market share in this sector.
This isn’t a company I know very well, but I’ve had a consistently good impression of it over the years. Here’s a snapshot of the main figures from today’s half-year results. Profits are down sharply, but sales performance looks strong:
According to Stockopedia, Abcam has generated a five-year average operating margin of 28% and a five-year average return on capital employed (ROCE) of 18%.
However, these figures clearly show a sharp deterioration in these figures — today’s results show a six-month operating margin of 19%. There’s no major seasonality to the company’s performance, as far as I can see.
The company says that the fall in profits is as expected and due to a five-year strategy to invest in new growth opportunities and to an “expected step up in non-cash items …”
However, capital expenditure actually fell by £2.6m to £17.1m during the period. The reduction in profitability appears to relate to a sharp rise in costs and non-cash items.
I estimate that these factors contributed £8.9m to a £14.5m (or 32%) increase in SG&A costs:
If I was considering investing, I’d want to understand a bit more about the group’s cost base.
However, it is worth noting that cash generation remained very strong. The balance sheet looks good too, with net cash of £88.5m excluding lease liabilities.
Dividend vs acquisitions
Abcam’s management have been on the acquisition trail recently, spending a total of £120m since July 2019.
Further deals seem likely as the firm believes that “significant investment opportunities” are available. As part of the capital allocation process, the dividend is under review. The Board intends to consult with shareholders on this.
At around 1,145p, Abcam shares are well down from their all-time high of over 1,500p. But according to consensus forecasts on Stockopedia, today’s share price still equates to a forecast price/earnings ratio of 39 for the current year. The dividend yield is around 1%.
On balance, I believe that Abcam could continue to be a long-term compounder that generates significant wealth for shareholders. The balance sheet is strong, margins are attractive and cash generation is good.
However, profits are down, costs are up and management are spending heavily on acquisitions. The shares also look expensive to me, notwithstanding the company’s attractive qualities.
If I was to consider an investment, I’d want to understand more about the outlook and valuation for the business. So I’m going to reserve judgement today. If any readers have a more informed view on this stock, please feel free to share in the comments — this is a team sport, after all!
- Share price: 238p (-1%)
- Market cap: £23.3bn
Just a brief mention for the UK’s largest supermarket. Tesco is the top performer in the FTSE 100 today, with a fall of just 1%.
Although the coronavirus outbreak is forcing the group to ration sales of staple items in its UK stores, the wider business is continuing to evolve under departing CEO Dave Lewis.
Today, Tesco has announced plans to sell its Thai and Malaysian businesses to a combination of local investors for an enterprise value of £8.2bn. This is said to imply a EV/EBITDA multiple of 12.5x. Net cash proceeds will be £8bn.
Some of this cash will be used to fund a £2.5bn pension contribution. This is expected to eliminate the group’s current funding deficit.
The result will be a smaller business that’s focused on the UK, Ireland and Central Europe.
My view: This disposal seems logical and consistent with the strategy put in place by Mr Lewis. Although the Asian business is more profitable than the UK operation, it’s also much smaller. Asia revenue is around 10% of sales in the UK and Ireland. Arguably, it’s subscale.
We’ve discussed Tesco a few times before (see the archives). Most recently, Graham commented on the group’s continuing struggle to reduce its debt levels. Today’s news appears to be another chapter in this story.
My view on this stock is somewhere between neutral and positive. I’d hold at current levels.
- Share price: 1,807p (-6%)
- Market cap: £6.1bn
What do company bosses do when the market is crashing around their ears? In the case of good businesses, they get on with executing their business model and managing the real-life challenges faced by their business. This shouldn’t include worrying about the share price.
I mention Bunzl today as an example of this. This FTSE 100 company provides a huge range of consumable items to businesses around the world. Its business model is built around regular small acquisitions. Today’s deal to acquire Bodyguard Workwear in Birmingham is typical. This small firm provides safety wear for rail workers and had revenue of £8m last year.
Management say “the acquisition pipeline continues to be promising”.
Bunzl has been doing this for as long as I’ve followed the stock market. Its share price has risen by about 150% over the last 10 years, but has now fallen back to a level last seen five years ago.
Return on capital employed has hovered between 14% and 16% over this time. The dividend has grown by about 7% each year. The balance sheet is sensible and cash generation is good.
At c.1,800p, the shares now trade on about 14 times 2020 forecast earnings, with a yield of nearly 3%. I think that could be an attractive level at which to buy for a long-term position.
That’s all I’ve got time for today.
I’m afraid I haven’t got time to look at results from life insurance specialist Phoenix (PHNX) — a stock I rate highly for income investors. But from what I can see, today’s figures suggest more of the same. I remain a fan.
I’ll be back later this month, hopefully against a calmer backdrop.
Until then, stay safe.
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