Each month Richard Beddard trawls through annual corporate results for his Watchlist and the ShareSleuth portfolio of companies that satisfy key valuation metrics such as earnings yield and return on capital – and profiles the most interesting candidates.
Churchill China (CHH) Hospitality delivers
Profitability at pottery manufacturer Churchill China is following a trend that should excite any investor. The company has increased its return on capital every year since 2010.
Helped by the weak pound, which boosted export revenue to about 50 per cent of the total, Churchill China experienced a banner year to December 2016. Revenue increased 9 per cent, adjusted profit increased 29 per cent and the company increased its cash balance to nearly £10 million. It has no debt.
A simple comparison between 2010 and 2016 shows how Churchill China has resolutely focused on the hospitality sector – restaurants, pubs and caterers – at the expense of retail sales, which have declined from 37 per cent of total revenue to 14 per cent. It has increased operating profit margins in both markets, from 15 per cent to 21 per cent in hospitality and from 5 per cent to 15 per cent in retail – an achievement that has grown profit much faster than revenue. Profit from the hospitality industry has increased 127 per cent compared to a 60 per cent increase in revenue. Profit from retail has increased 16 per cent, which may seem paltry until you consider retail revenue actually declined by more than half.
Churchill says the hospitality industry is attractive because customers are more demanding. Plates get a bashing in canteens, restaurants and commercial kitchens and fewer manufacturers have the expertise and capability to produce durable and attractive tableware for this market. Meanwhile, designs go out of fashion less quickly and customers come back more often for repeat purchases.
Churchill China has a focused strategy that is likely to reinforce itself over time. As it continues to invest in production and distribution, it should become an even more formidable competitor. But it’s difficult to recommend the shares at the current price of £10.90. This values the enterprise at about £120 million, or about 23 times adjusted profi t. The earnings yield is just 4 per cent.
Revenue in Churchill’s biggest market, the UK, has not increased since 2010. Instead the company has looked abroad for growth. Its first priority, Europe – where it benefits from antidumping duties on Chinese imports – has been its biggest success by far, but the prospect for continuing growth in Europe once the UK has left the EU is more than usually uncertain.
Greggs (GRG) Overhaul doubles profit
It would be easy to conclude from Greggs’ long association with British high streets that the former chain of bakers is a fusty old stalwart. In fact, it’s undergoing a radical transformation from local baker to modern centralised fast food chain. In 2015, the company founded by John Gregg in the 1930s stopped selling loaves of bread in many of its stores.
It still bakes – one of Greggs’ distinguishing features is that it makes its own food – but the bread is baked in large bakeries and sent to the stores to be made into sandwiches. These days you can fi nd Greggs in industrial estates, railway stations and shopping centres serving up breakfasts, sandwiches, soup, falafel, coffee and salad from nearly 1,800 shops.
In 2013, when chief executive Roger Whiteside joined, Greggs sharpened its focus on ‘food on-the-go’, as opposed to food you might take home. It started programmes to improve the food, the shops and their locations, and began decommissioning in-store bakeries, moving production to regional ones. It invested in IT to improve efficiency. The process is still ongoing – Greggs is now rationalising the regional bakeries and investing in distribution hubs – but the strategy has already coincided with a doubling of profit.
Return on capital was 13 per cent in the year to December 2016 and although the company is investing heavily, cash flow remains strong. There’s little doubt Greggs is a distinctive well-managed business, but the shares aren’t obviously cheap. A share price of £10.70 values the enterprise at about £1.4 billion, 18 times adjusted profit in the year to December 2016. The earnings yield is 5 per cent.
Greggs expects to open substantially more than 2,000 shops, but as with all retail rollouts the question left hanging is how it grows once it reaches that mark, which at the current rate of openings could be only a few years away. It may simply keep going, if it hasn’t reached the point where the law of diminishing returns kicks in.
Next (NXT) Model of solidity
Next’s proud record of profit growth, unbroken since the credit crunch nine years ago, came to an end in the year to January 2017. Revenue fell 2 per cent and adjusted profi t fell 2 per cent; those may be minor dents in its illustrious record, but it looks as though things will get worse before they get better.
Like many larger companies, the retailer provides guidance, a forecast of how it will perform in the forthcoming year. Revenue may fall marginally again in the year to January 2018, and Next expects pre-tax profit to fall by between 1 and 14 per cent. Not only is the direction of travel unusual, but the broad range of outcomes is too.
Looking backwards, Next is a model of solidity. Even during the credit crunch when profitability dipped, it didn’t dip much. At its low point, while other retailers were losing money or even going out of business, Next earned an 18 per cent return on capital. Even though it took a step back in the year to January 2017, return on capital was 22 per cent.
Next has prospered as it has migrated its huge Next Directory mail order business online. While the stores still earn more revenue, Directory, which also sells other brands, now earns more profit. But revenue is coming under pressure because, Next says, people are favouring buying experiences over buying things. We’re eating out rather than buying clothes, and the combination of lower demand and rising import costs due to the weakness of the pound is making it harder to earn fat profit margins. Consumer trends reverse, and unless the pound weakens further the threat to profit is limited; but future profitability also depends on how Next manages its store portfolio if retail revenue continues to fall. The company published the results of a stress test on its store portfolio in its recent annual report. It shows that even if like-for-like sales fell 6 per cent a year for a decade, it would still earn a 10 per cent return on sales from its stores, assuming it shuts unprofitable shops when their leases expire.
Directory is still growing revenue and profit, but the doubts of traders have driven the share price down to £43, which values the enterprise at about £9 billion or 12 times adjusted profit – a very attractive valuation for a company with Next’s pedigree.
Xaar (XAR) Buying opportunity?
A sell-off in Xaar shares since the end of last year may provide investors with an opportunity to buy into the company, but only if they are brave. A share price of 375p values the enterprise at £260 million, about 17 times adjusted profit. The shares aren’t cheap, but the company has bags of potential that it has hitherto realised only sporadically.
Xaar’s story starts with research and development. It invests an enormous proportion of annual revenue, more than 20 per cent in the year to December 2016, in developing new digital printheads for industrial and commercial printers. Being first to market with the new technology has enabled Xaar to gain market leadership, as industries supplying advertising banners and ceramic tiles have converted from analogue printing to digital.
Xaar’s financial statements are etched with dramatic windfall profits when industries first adopt its technology, and then the erosion of those profits when customers – printer manufacturers – slip into a more sedate replacement cycle and rivals develop printheads.
The boom-bust cycle is exacerbated by the investment required to develop new printheads and the time it takes Xaar’s partners to design them into their printers. Xaar’s full-year results illustrate the uncertainty shareholders must feel when it’s in-between booms, investing heavily as profitability dwindles. The results drip with promise delayed.
Surprisingly, perhaps 97 per cent of printing is still analogue; to accelerate conversion of promising processes for conversion, such as printing directly on products and packaging, Xaar is partnering with industry giants like Xerox. In a bid to double revenue by 2020, Xaar has also made its first acquisition, Engineered Printed Solutions, a printer manufacturer and customer for Xaar’s printheads. The new strategy, to turn Xaar’s focus outwards and drive the adoption of digital technology, is a logical step to moderate the boom-bust cycle, but Xaar is still dependent on waves of conversion.
Shareholders must not only be patient, therefore, but resolute in their belief that Xaar’s logical but untested strategy will result in high and more stable profitability in future.
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