Cube Midcap Report (Mon 17 June 2019) – BAB, SCIN, BATS

Cube Midcap Report (Mon 17 June 2019) – BAB, SCIN, BATS

Good morning folks,

This is the Cube Midcap Report for Monday, 17th June.

Some news for us today:

Given that it’s a light news day, I’m also going to scroll back and look at the trading update from British American Tobacco (BATS).

Babcock International (BAB)

  • Share price: 464.6p (pre-market)
  • Market cap: £2,349 million

Statement regarding media speculation

We start with a brief statement by this engineering company:

“…on 23 January 2019 it received an unsolicited and highly preliminary proposal from Serco Group Plc (“Serco”) regarding a potential all-share combination between the two companies (the “Proposal”) and confirms that no further proposal has been received.”

Serco (SRP) (market cap £1.7 bllion) is the public services group which, like Babcock, has a rather troubled share price history. These labour-intensive corporations managing large, complex projects have had difficulty generating sustainable returns for investors.

Serco peaked at 550p in 2013:


Babock, meanwhile, has been in decline since 2014:


Serco’s proposal to Babcock was “unanimously rejected” by Babcock’s Board of Directors, as “a combination of the two companies had no strategic merit”.

My view – I tend  to agree with Babcock’s Board. While the two groups have some overlap in the sense that they both serve the public sector (in particular, they both do a lot of work in defence), Babcock has a clear focus on engineering while Serco does not. Broadly speaking, Serco’s work is more to do with people management – immigration, hospital management, prison management, etc.

Serco must have big ambitions to move into the engineering space, as we can see from its recent $225 million acquisition of a naval design and engineering business.

That’s fine for Serco, but it’s not obvious to me that Babcock investors should want to own a bunch of people management businesses.

I tend to avoid this sector entirely, as it is just too accident-prone.

Scottish Investment Trust (SCIN)

  • Share price: 804p (-0.1%)
  • Market cap: £610 million

Half-year Report

We don’t normally cover investment trusts on this website. I’m happy to make an exception on a quiet-ish Monday!

This trust describes itself as having a “high conviction, global contrarian investment approach”.


It has had a poor H1, with its NAV declining by 0.1% while major global and UK indexes motored ahead by 6% – 7%.

It blames its contrarian investment approach for the underperformance, seeing itself as a temporary casualty of the fact that value investing has fallen out of favour. It has deliberately avoided the entire sphere of overvalued, “disruptive” technology stocks.

Discount/Buybacks – The most recently reported NAV per share is 885.5p (with borrowings at market value) or 918p (borrowings at par value).

This means we have a 9% (market value) – 12% (par value) discount to NAV, based on the current share price of 804p. It wants to maintain the discount at or below 9%, and bought back nearly 1 million shares for cancellation during H1.

Outlook – some macro commentary followed by a statement that the current portfolio holdings are “undervalued and unreasonably out of favour”.

“We continue to concentrate on firmly establishing the Company as a differentiated, cost competitive, and attractive investment vehicle focused on delivering above-average returns and dividend growth over the longer term.”

Manager commentary – I couldn’t agree more with the manager’s scepticism around “disruption”, unicorns, and the recent wave of technology IPOs. It’s very well-written and I recommend that you read the original.

Strategy – the company’s strategy reflects the fact that it takes a contrarian approach. Unfortunately, this means that two of its three categories consist of companies with a history of poor operating performance:

  • Ugly ducklings – unloved shares with an extended period of poor operating performance and an uninspiring near-term outlook. Looking for an upside surprise from these shares.
  • Change is afoot – a long period of poor operating performance, but prospects have significantly improved and the market doesn’t fully appreciate this.
  • More to come – good businesses but scope for further improvement is not yet fully recognised.

Overall, it’s a mix of value and turnaround strategies.  In the manager’s own words, “we actively seek unfashionable and unpopular investments that we believe can recover.

This is a difficult strategy, since struggling and poor-quality companies rarely make good long-term investments. After their predicted turnaround and recovery, the right thing to do is often to sell them! This means that a constant stream of new ideas is needed.

Holdings – a mix of miners (BHP), pharmaceuticals (GSK), telecoms, retail (TSCO, MKS), financial (STAN), energy, and others.

The top 5 holdings are TescoNewcrest Minding (Australia), GlaxoSmithKlineSumitomo Mitsui (Japan), Standard Chartered.

Long-term performance – the company’s website says that it achieved a 5-year NAV return of 49.7% to May 31st, 2019.

By way of comparison, the FTSE All-Share Total Return Index increased by 29% over the same period. So we have a beat against the FTSE All-Share Index.

My view – the portfolio holdings look very unattractive to me, which is perhaps no great surprise. After all, the Trust is actively seeking out the companies that other investors recoil from! It’s working: I would have zero interest in the majority of its holdings (or at least the ones which are familiar to me).

Tesco represented 5.4% of net assets as of April 2019. There is significant sector exposure in physical retailers, banks and pharmaceuticals.

Given the Trust’s willingness to buy back its shares, I do think it’s reasonable for the market to put a floor on the share price around the current level.

British American Tobacco

  • Share price: 2840.5p (-1.6%)
  • Market cap: £65.2 billion

First Half Pre-Close Trading Update

At the time of publication, I have a long position in BATS.

This has been a problem holding for me, but I continue to hold.

At face value, this H1 trading update seemed fine: full-year guidance was unchanged.

Comments on volumes in the US were negative, as expected: down 5.3% year to date, with a full-year forecast of -4% to -5%. BATS said that the US volume decline “remains within historic ranges”, in contrast with very negative Nielsen data published recently.

Global industry volume is expected to be lower this year by 3.5%.

Leverage – a key point for investors, this is expected to reduce by 0.4x to 3.6x with respect to net debt / adjusted EBITDA. The company is satisfied with its investment-grade credit rating from S&P, but is targting an upgrade in the medium-term at Moody’s from Baa2 to Baa1. Adjusted net debt was £43.4 billion at the previous year-end.

It would suit me down to the ground if the company relaxed its dividend policy and reduced debt at a faster rate, enabling it to get rid of financial risk and achieve a higher credit rating much sooner. However, I doubt this would be popular among most other shareholders, who are in it for the dividend. The forecast yield is in excess of 7%.

Alternatives – BATS says it’s on track for constant-currency revenue growth of 30%-50% in the “New Categories” segment.

The market was not impressed, however, as the update included the dreaded H2-weighting. Revenue growth needs to accelerate in H2 to hit the middle of the growth target. So the update could be interpreted as a pre-warning of a potential miss.

Key properties in this segment are Vuse, Vype, glo, EPOK and LYFT (nicotine pouches, not taxis!). While BATS is not a market leader in alternatives, its brands do have significant market share in a wide range of international markets.

My view – So long as solvency is not a concern, I’m happy to remain involved and let the dividend payments make up for the capital loss that I’m currently sitting on.

However, this is not a comfortable holding. I mistimed my entry point, have suffered a lot of bearish news flow during my holding period, and can’t top up my position during these circumstances.

As the deleveraging process continues, and on the basis that growth in new categories and international markets will offset some of the losses in the traditional segment in the US, I do think the market could rediscover value in this company. It sits on a forecast P/E multiple of 9x. An unfashionable share in an unpopular sector in an out-of-favour stock market. Perhaps the Scottish Investment Trust would be interested?


Thanks for joining me and I’ll see you again tomorrow!





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