We have previously written about Apple whose lacklustre earnings have parted company with their skyrocketing share price (put in link to previous blog on Apple). Clive Hale updated this concept recently in his excellent ‘Views from the Bridge’ Blog .
Here in the UK, there are stocks which appear in the top ten of all the quality growth funds which don’t appear to be producing much growth and are therefore of questionable quality. Despite this, investors are pricing them as if they are double digit growers.
In the case of Diageo , the company has proven more cyclical that some imagine. Earnings declined by 15% between 2013 and 2015 as the Asian economy turned down and fell by a similar amount on the back of coronavirus.
Looking at the company’s growth trajectory from 2013 to 2019 (the company has a June year-end) before the onset of coronavirus shows the following; organic sales growth was 3% p.a., split evenly between volume growth and price/mix effects. Margins were steady, fluctuating between 28% and 32%. Adjusted earnings per share grew by around 4% p.a., however, this was after the benefit of a 10% decline in sterling (principally on the back of the Brexit vote). Adjusting for the fall in sterling reduces the earnings growth rate to around 2% p.a.. The company has undertaken some M&A however this has not been significant and therefore debt levels have remained fairly constant at around 2.5x EBITDA. The average cash flow conversion rate has been around 85% over the period, which is good although not spectacular. The shares trade on a current year P/E of 26x, which equates to a FCF yield of around 3.3%.
Reckitt Benckiser hit a wall in around 2015, with organic sales growth slowing from 6% in that year to 0.0% in 2017, 3.0% in 2018 and 0.8% in 2019. The company’s margins had also reached very elevated levels (28% in 2016) and the company was therefore overearning. It did however have the benefit of a strong balance sheet (net debt/EBITDA 0.5x 2016) and this gave it the one-time opportunity to buy some growth as the underlying business stagnated. In 2017, RB announced the purchase of Mead Johnson for $18bn at 17.4x 2016 EBITDA or 14.0x EBITDA assuming the company delivered cost saves of £200m on the deal. The company therefore bought around £1bn of EBITDA including the cost saves, or around £800m in EBIT. In the four year period to 2020, EBIT increased by just over £500m, indicating that the underlying business saw its EBIT decline by around £300m or 10% as margins reset downwards from 28% to 24%. Even this includes the benefit of sterling depreciation over this period and after adjusting for this, the underlying decline was in the order of 15% to 20%. FCF conversion has been very good at almost 100%. Post the MJ deal the company has net debt/EBITDA of around 2.6x. The shares trade on a P/E of 21x. RB is a great example of where a company does a large deal in order to cover up the problems that it faces in its existing business.
Having watched The Wizard of Oz at Christmas for the twentieth time, these stocks remind me of the illusion being pulled by the Great Oz and I have a feeling that the curtain has just been pulled back!
The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. This article does not constitute investment advice and the names shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment