Interactive Investor

Stockwatch: kicking the tyres of a classic value investment

23rd June 2023 11:15

by Edmond Jackson from interactive investor

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A low valuation and attractive dividend have caught the eye of analyst Edmond Jackson, who explains whether this FTSE 100 company is worth owning.

Conducting some research into an investment 600

Does an apparently sound yield of near 7% and twice-covered by earnings, with a valuation multiple below eight times, now constitute value in a quality ‘cyclical’ stock? 

I apply inverted commas to cyclical because packaging is generally assumed to be so. Related stocks fell this week in response to delivery giant FedEx Corp (NYSE:FDX) citing quarterly revenue down 10% and with tepid guidance for its May 2024 financial year. 

Fallers included Smith (DS) (LSE:SMDS), a British multinational packaging group listed in the FTSE 100 index - deriving a modest 8% of revenue from the US, its majority 92% being Europe-wide. This shows how change in the US is often regarded as a leading indicator of what happens next here. 

Smith has continued to fall, down to 270p currently, although it’s not quite the 238p low seen early last October. The current share price accords with a March 2020 low following the Covid-induced sell-off, after which it powered to over 450p by September 2021. Online shopping drove demand for consumer goods deliveries during lockdowns, and Smith reaped the benefit. 

Resilience in the aftermath of the 2009 recession 

Management often says the group’s orientation towards fast-moving consumer goods – currently around 84% of revenue - mitigates cyclicality. 

Indeed, looking back to the April 2010 annual accounts, both revenue and net profit were very stable – around £2 billion and £50 million, respectively.  

Moreover, the total dividend back then edged up from 4.4p to 4.6p, which lends some comfort as to the dependability of recent consensus for the latest 18p a share dividend to edge up by 0.1p in each of the next two financial years.  

This represents a 6.7% prospective yield covered twice by the consensus for earnings per share (EPS) of 37.2p this current year to April 2024, although EPS modestly lower at 36.3p is targeted for 2025. 

Page 10 of the latest annual results presentation on Smith’s website - “current capital allocation priorities” - cites a “progressive” dividend with 2.0-2.3 times, earnings cover. 

Ostensibly, it would need a tough recession, then impaired demand for consumer goods across Europe, to break this scenario. 

Aspects of a classic value stock  

Not to white-wash economic cyclical risks, but Smith appears to be a classic example of investment value as defined by Graham & Dodd’s Security Analysis, the mid-20th century financial bible that greatly influenced Warren Buffett. 

Best seek businesses well-established in proven markets, whose equity has fallen out of favour due to a lack of near-term growth appeal. 

DS Smith originated in 1940 making cartons and has been listed since the late 1950s, steadily diversifying (albeit with strategic focus) – with an aspect of vertical integration such as paper. It is currently capitalised at just under £4 billion; so it’s a substantive business. 

There have indeed been times when some disconnect has been apparent between market value and business performance. 

Smith traded quite boringly around 100p in the early 1990s, then halved during the 2008 crisis, which appeared to help set up a strong bull run to over 500p by mid-2018.  

It then plunged 40% to around 300p by end-2018, but I cannot find any evidence of a jolt to fundamentals. A September 2018 update cited operational momentum in the year to date, during which a significant acquisition and equity fund-raising was made to raise Smith’s profile in the Iberian Peninsula. 

A pre-close statement in November 2018 cited the business performing in line with expectations, with like-for-like operating profit materially ahead after recovering higher input costs. There was “good volume growth from our highly resilient business serving fast-moving consumer goods,” it said.

That the stock has since traded sideways in a circa 275p to 450p range suggests its 2018 de-rating was a mean-reversion from unsustainable valuation at the time. 

Admittedly, the financial summary table shows Smith only now, breaking back into a normalised EPS range of 30p that it achieved in 2018. The 500p high in May 2018 implied a price/earnings (PE) of 23 times reported EPS of 21p – a growth-type rating that was unsustainable. 

Latest annual numbers to 30 April are broadly good 

Headline growth dynamics are eye-catching: adjusted operating profit up 35% on revenue up 11%, with reported EPS up 71%, or 34% normalised. Management’s definition for return on average capital employed is over 14% and there has been £354 million annual free cash flow. 

(A strong historic profile of free cash flow also supports pay-out capability, aside from Covid’s disruption in 2020.) 

All this is based on organic performance, as per recent years’ strategy to focus on supporting growth with major customers. 

Illustrating the dilemma for central banks now struggling to rein back endemic inflation: Smith has recently managed to pass on price rises, but also cut some costs, such that strong overall financial growth was achieved despite reduced volumes of packaging. 

Its November to April second half-year saw customer de-stocking and weak customer demand, such that like-for-like box volumes fell nearly 6%. 

A sceptic might ask how sustainable are the April 2023 numbers if consumer demand continues to fall as higher interest/mortgage rates work through? Smith cannot continue to cut costs without reaching muscle instead of fat, and customers may balk at continued price rises, especially if “higher interest rates for longer” bear down on consumer demand. 

Current market pricing therefore looks an effort to reflect this risk, despite a “steady as she goes” outlook statement: 

The company said: “While economic conditions have continued to be volatile and volumes have remained lower than normal, trading for the year to date is in line with our expectations. Our strong customer relations in resilient, fast-moving consumer goods, together with the investments we are making to drive cost efficiencies and growth, give us confidence for the future.”  

DS Smith - financial summary 
Year-end 30 Apr

Turnover (£ million)4,7815,5186,1716,0435,9767,2418,221
Operating margin (%)
Operating profit (£m)316317412448304443733
Net profit (£m)209259274527194280503
Reported EPS (p)20.421.119.721.013.220.335.5
Normalised EPS (p)26.432.728.227.118.423.136.8
Earnings per share growth (%)3.823.6-13.6-4.0-31.925.159
Return on total capital (%)
Operating cashflow/share (p)51.238.839.946.254.566.662.5
Capex/share (p)23.929.222.727.324.031.239.3
Free cashflow/share (p)27.39.617.218.930.535.523.2
Dividend per share (p)14.114.416.
Covered by earnings (x)
Cash (£m)139297382595813819472
Net debt (£m)1,1401,7052,3722,1481,8121,5291,672
Net assets/share (p)132183227244257308297

Source: historic company REFS and company accounts

Market share gains position Smith well for long term

They have followed from management’s focus on quality and service, augmenting a case to buy the stock while sentiment is against it, looking forward to the next economic upturn. 

Mind that if European consumer demand does indeed de-rate for some years, this stock may continue to bump along in a sideways range – albeit with a decent-quality yield as compensation. 

If this was a small to mid-cap packaging stock, Smith would be exposed to a takeover, although I tend to think that is less likely given an acquirer would need to muster £5 billion or higher, and interest rates have risen.  

Net debt nudges near £1.7 billion 

High debt may also be a factor why the stock is down as interest rates rise. 

It is explained by a £121 million annual working capital outflow, as net capital expenditure rose 27% to £526 million, also higher tax payments. Energy and carbon hedges were also maintained at a high level during the financial year. 

A critic could say that the dividend – also acceleration of the 2022/23 interim dividend payment to January 2023 – meant an additional payment of £83 million in the year, which bumped up debt and was imprudent. Companies should not at all borrow to pay out, unless you want to respect exceptional factors. 

It meant net interest payments rose 23% to £76 million, albeit covered nearly 10 times by operating profit. This cost will rise with interest rates. 

So, mind how the 18p dividend has been made possible through financial wangling relative to other demands on cash flow. 

I still conclude positively, if suggesting “average in” than assert a conviction stock. Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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