Cube Midcap Report (Fri 25 Oct) – Macro worries spill profits at Synthomer #SYNT #WPP #BARC

Cube Midcap Report (Fri 25 Oct) – Macro worries spill profits at Synthomer #SYNT #WPP #BARC

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

I’m planning to look at the following companies today:

  • Synthomer (SYNT) – a profit warning this morning from this FTSE 250 chemicals firm.
  • Barclays (BARC) – this Q3 update has lifted the Barclays share price in early trade
  • WPP (WPP) – Q3 update – can the ad giant find its way back to growth?

Today’s report is now complete (noon).


Synthomer (SYNT)

  • Share price: 270 (-12%)
  • Market cap: £1.2bn

Q3 trading update

We’ve got a profit warning this morning from FTSE 250 chemicals firm Synthomer, which is a leading supplier of aqueous polymers. These appear to be used in a wide range of foam and rubber products, including carpets, footwear, adhesives and medical products.

The company suffered a shareholder revolt earlier this year, when 35% of shareholders voted against the re-election of chairman Neil Johnson. Synthomer’s shareholders are said to be worried about over-boarding — Mr Johnson is also chair of FTSE 250 defence group QinetiQ and FTSE SmallCap-listed Electra Private Equity.

Mr Johnson has retained all three of his positions for now, but today’s profit warning from Synthomer may reinforce shareholders’ feelings that their company deserves a little more of his attention.

“Challenging backdrop”

In its Q3 update today, Synthomer has rolled out a full suite of macro excuses:

  • “Growing weakness in the global economy”
  • “Depressed European industrial activity”
  • “Increased political and economic uncertainties”

Taken together, these are said to have created a “challenging backdrop” for the chemical industry, resulting in a slower trading environment.

As a result, the group’s underlying pre-tax profit is now expected to fall by about 10% in 2019.

The picture is complicated by a major acquisition that’s underway, so let’s take a closer look at some of the moving parts here.

What’s gone wrong?

The sales shortfall which has lead to today’s profit warning appears to be limited to one product range, Styrene Butadiene Rubber Latex (SBR). This is produced by the Performance Elastomers division, whose rubber products are used in gloves, coatings for paper and packaging and in carpets.

Performance Elastomers is Synthomer’s largest and most profitable division. In 2018, it generated 43% of sales and 61% of underlying operating profit.

The company flagged up weaker demand for SBR Latex in August’s H1 results, where it also warned of possible customer bad debts. According to today’s statement, volumes have continued to weaken. Management now expect SBR volumes to be down by 10% compared to last year, with lower unit margins.

As a result, the firm expects underlying pre-tax profit for the whole group to also fall by 10%.

The group’s other products are all said to be performing in line with expectations, including NBR Latex, which is also produced by the Performance Elastomers division.

The fact that a 10% fall in SBR sales is expected to wipe 10% off profits for the whole group suggests to me that SBR carries high margins and/or high operating leverage.

This apparent heavy dependency on one product could be a concern, in my opinion.

Acquisition leverage

In July, Synthomer’s management agreed a $473m deal to acquire US firm Omnova. To help fund the deal, shareholders supported a £204m 1-for-4 rights issue. They also agreed to increase the borrowing limit set out in the group’s Articles of Association from £750m to £1,500m.

The Omnova deal should add about $770m of revenue and around $85m of EBITDA to Synthomer’s results. To put this in context, the equivalent figures for Synthomer last year were £1,619m (c.$2,073m) and £181m (c.$233m). So Omnova is a very material acquisition.

The acquisition is expected to complete later this year. When it does, management expect the combined group to have a net debt/EBITDA ratio of 2.5x. This is expected to fall below 2x by the end of 2021, helped by $30m of expected synergies.

My view

Synthomer appears to be suffering from falling sales of a key product, at the same time as it’s about to take on a lot of new debt to integrate a major acquisition.

The rationale for the acquisition — which will increase its US market share — seem reasonable to me. But such large acquisitions always carry some risk. If the deal coincides with a continued market slowdown, then deleveraging the combined group could take longer than expected.

At first glance, this seems like it could be an attractive business. But I’m not convinced that now is the right time to buy. Based on today’s profit warning, I estimate that underlying pre-tax profit could fall to around £122m. This would leave the stock trading on about nine time forecast earnings, with a yield of 4.4%.

This looks cheap, but I think that’s fair at the moment. I’ll be interested to watch how this situation plays out, but I don’t see any rush to buy.


Barclays (BARC)
  • Share price: 169p (+1.5%)
  • Market cap: £29.2bn

Q3 results

Yesterday’s results from RBS (in which I own shares) highlighted the problems that can come from owning a sub-scale investment bank. Is Barclays — where boss Jes Staley has made investment banking a key part of his strategy — managing better?

Today’s third-quarter numbers suggest a mixed picture, albeit with some good points.

Results summary

Barclays’ pre-tax profit for the first nine months of 2019 was £3.3bn (3Q18 YTD £3.1bn). However, this increase appears to be due to a reduction in misconduct charges. Excluding litigation and conduct costs, the bank’s YTD pre-tax profit has fallen from £5.3bn last year to £4.9bn.

Like RBS, Barclays took a big hit from PPI during the third quarter. The bank made an additional provision of £1.4bn for the final tranche of claims. Excluding this, profits from the UK high street business have fallen from £2bn to £1.9bn so far this year. The company says this is due to margin pressure on lending, which offset growth in mortgages and deposits.

Over at Barclays International, which includes investment banking, pre-tax profit fell from £3.6bn to £3.5bn during the first nine month of 2019. Increases in income were offset by higher operating expenses and an extra £500m of credit impairment charges, which rose to £800m.

Group return on tangible equity (RoTE) for the year-to-date was 9.7%, with a Q3 figure of 10.2%. Both numbers exclude litigation and [mis]conduct charges.

Like RBS, Barclays is also still struggling unsuccessfully to get its cost: income ratio below 60%. So far this year, the bank has managed a figure of 62%, excluding litigation and conduct charges (72% including these costs).

In fairness, the bank has reported positive jaws (the gap between income and operating expenses). This suggests to me that its cost base is under control.

My view

Barclays appears to be treading water in difficult market conditions. The bank is targeting RoTE of >9% for 2019 and >10% for 2020.

Today’s results would seem to suggest this should be easily achievable. However, the bank says that low interest rates and macro uncertainty mean that “it has become more challenging to achieve these targets, particularly with respect to 2020”.

This cautious sentiment has been reflected in weakening forecasts for 2020. This screenshot from Stockopedia shows how consensus forecasts for 2020 have been cut faster than those for 2019 over the last 12 months:

BARC broker consensus trend 251019

Source: Stockopedia

I don’t claim any insight into the macro outlook or the end game for negative interest rates. But I do see some value in banking stocks such as Barclays, which trades at a 38% discount to its tangible net asset value of 274p and offers a 5% dividend yield.

My view is based on the general belief that banks remain essential to the global economy and that they will find a way to remain viable and profitable.

On that basis, I’d be happy to buy shares in BARC at current levels.


WPP (WPP)

  • Share price: 972p (+6%)
  • Market cap: £12.3bn

Q3 trading update

At the time of writing, Roland owned shares in WPP

I’m going to wrap up with a quick look at a stock I hold, advertising giant WPP. Since the dramatic departure of Sir Martin Sorrell in 2018, his replacement Mark Read has embarked on a restructuring programme that’s seen the group make dozens of disposals, including (soon) a 60% stake in the Kantar market research business.

Mr Read’s changes appear to have left the group more closely integrated and focused. They’ve also reduced net debt to more comfortable levels, a process that should be complete following the Kantar sale.

His next challenge is to return the business to growth. This is expected to take another couple of years, but today’s figures show a return to revenue growth. This continues the positive trend we’ve seen this year:

WPP Q3 revenue analysis

Drilling down into these numbers, it appears that the US is still the main area of weakness. All other regions reported growth during Q3, led by the Rest of the World region(!):

WPP Q319 geographical revenue breakdown

Big wins: The company says it has won $3.9bn of new business during the first nine months of the year, including “major wins”during the third quarter with US consumer goods group Mondelez and with eBay.

By way of comparison, the group reported net new business of $4bn during the first nine months of last year. This suggests the business is stable, but not yet growing.

My view

In fairness, Mr Read has left 2019 guidance unchanged and reiterated his expectation that the company will return to growth “in line with our peers” in 2021.

The jury is still out on this FTSE 100 turnaround, but I’m comfortable with progress so far. As things stand, the shares trade on less than 10 times forecast earnings and offer an unchanged 6.5% yield. I remain happy to hold and collect an income that has historically been covered by free cash flow.


That’s all for today and indeed for this week. I hope you have a happy and restful weekend.

Regards,

Roland

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rogergreen

Thanks for a great report as always Roland. Interesting to read the over-boarding concerns. Callum Maclean Synthomer CEO also sits on the board of SABIC and Clariant. One could forgive shareholders for thinking he might want to focus on the day job a bit more during a period of tough markets and a very lumpy acquisition. I’m a bit concerned that SBR latex is such a. Profit driver, not a product I would normally think of as being very sexy. A major use is carpet backing and my sense is trends are against that business at present. I have no… Read more »

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