Interactive Investor

Stockwatch: is this profit warning a red flag for UK cyclicals?

1st November 2022 09:45

Edmond Jackson from interactive investor

There has been a flurry of negative updates in recent weeks and more are likely, and this company could be a canary in the coal mine. Analyst Edmond Jackson studies two companies and possible outcomes for UK stock markets.

Yesterday’s initial 20% drop in the share price of specialty packaging group James Cropper (LSE:CRPR), after a profit warning, caught little attention as a sub-£100 million company.

Yet it sounds like a canary in the coal mine where energy costs affect companies, and I find it interesting to compare with FTSE 100 firm Smith (DS) (LSE:SMDS) – another packaging group, which tends to get touted as a quality cyclical stock.

I may be alert to confirmation bias here, but despite the general market mood twitching bullishly, I expect a rise in profit warnings as companies get caught in a pincer of lower revenues and higher costs. This is especially the case with smaller companies where 2023 projections may need downgrading.

Revenue momentum but a dilemma of higher costs

The company’s end-July AGM had cited a strong start to the March 2023 financial year, with revenue up 36%. It’s unclear quite whether this was a general sign of “as good as it gets” for a year or more.

Cropper is now becoming one – excuse the pun – due to a 148% hike in gas prices and raw materials (the larger element of costs) up 20%. Given it was not possible to pass on such increases to customers within the company’s first-half-year to end-September, margins were squeezed.

If things are as bad as this already, we must hope for a mild winter continuing to check gas prices, although my chief concern is whether a new UK chancellor and prime minister leave industry more exposed to higher energy prices, as they try to tame government debt.

Reflecting how assumptions towards small-caps can swiftly change, it’s worth noting that Cropper only achieved break-even in its first-half-year, and despite a recovery via product price hikes and continued sales growth, full-year profit is downgraded to £2.0 million versus market consensus for £5.4 million.

Despite the stock having limited its fall to 15% at 850p, the 2023 price/earnings (PE) multiple is a whopping 50x, assuming earnings per share (EPS) of around 17p. That implies 1.5x cover for the recent dividend consensus of 11p, and a yield barely over 1%. End-March net assets were 364p a share.

Such valuation criteria seem rosy considering low-single-digit operating margins over recent years, also quite erratic free cash flow due to varied capital expenditure needs.

James Cropper - financial summary
Year end 26 Mar

 201720182019202020212022
Turnover (£ million)92.496.310110578.8105
Operating margin (%)6.75.73.46.33.13.5
Operating profit (£m)6.25.43.46.62.53.7
Net profit (£m)4.64.12.34.81.61.4
Reported earnings/share (p)49.043.024.350.516.414.2
Normalised earnings/share (p)48.543.124.453.620.513.3
Operating cashflow/share (p)71.158.035.413783.135.1
Capex/share (p)56.220.354.996.232.770.8
Free cashflow/share (p)14.937.7-19.640.850.4-35.7
Dividend per share (p)11.813.513.52.50.010.0
Covered by earnings (x)4.23.21.820.20.01.4
Return on Total Capital (%)12.610.56.410.64.35.2
Cash (£m)1.95.62.49.06.87.8
Net debt (£m)7.44.88.611.17.512.6
Net assets (£m)19.123.321.334.429.934.8
Net assets per share (p)202246223360313364

Source: historic company REFS and company accounts

The next key question is whether a recession undermines revenue despite Cropper making paper for luxury product packaging – where affluent people’s spending might prove relatively resilient.

This group also has a technical fibre products side making wet-laid nonwovens – used in a variety of industries such as aerospace, fuel cells, wind energy and medical. Composite materials are also involved such as metal-coated fibres. It sounds plenty-advanced and oriented to growth segments, but who knows how recession-resilient this will prove.

I suspect the revenue narrative is going to moderate, from “momentum” to consolidation at least, perhaps described as “robust”.

The chart has anyway been in a volatile-sideways consolidation since testing 1,900p in August 2017, although mind it was down at 75p in March 2009:

Cropper’s risk/reward profile is therefore unappealing if we are only at the early stages of a downturn. At best, the stock rates a "hold" and needs ongoing evaluation.

I cite it partly to illustrate the macro risk generally with small-caps – this is a circa £80 million company – but also out of curiosity, why its £4 billion big brother in the packaging industry has so far declared itself immune from material cost issues.

DS Smith has a far more attractive valuation, for now

Despite a “packaging industry profit warning”, DS Smith’s share price firmed slightly yesterday with the market, just over 290p.

This company is well-diversified in packaging-related products, corrugated pallets and cushioning material. As if mitigating cyclicality, given packaging demand relates to that for consumer items, it engaged in recycling – from paper to plastics.

My sense, however, is such listed plc’s trying to be distinctive from regular packaging suppliers. But when a recession hits, “specialty” does not guarantee immunity.

While the summary table shows better operating margins than Cropper, mid-single-digit percentages are not exactly a cushion should costs rise.

DS Smith - financial summary
Year end 30 Apr

 201720182019202020212022
Turnover (£ million)4,7815,5186,1716,0435,9767,241
Operating margin (%)6.65.76.77.45.16.1
Operating profit (£m)316317412448304441
Net profit (£m)209259274527194280
Reported earnings/share (p)20.421.119.721.013.220.3
Normalised earnings/share (p)26.432.728.227.118.423.1
Operating cashflow/share (p)51.238.839.946.254.566.6
Capex/share (p)23.929.222.727.324.031.2
Free cashflow/share (p)27.39.617.218.930.535.4
Dividend per share (p)14.114.416.20.012.115.0
Covered by earnings (x)1.51.51.20.01.11.4
Return on Total Capital (%)11.17.46.87.04.97.0
Cash (£m)139297382595813819
Net debt (£m)1,1401,7052,3722,1481,8121,529
Net assets (£m)1,3531,1093,1113,3503,5334,232
Net assets per share (p)132183227244257308

Source: historic company REFS and company accounts

Consensus is for a bold 58% uplift in net profit to £503 million in respect of Smith’s year to April 2023, and then effectively flat for April 2024 – which seems a compromise because no-one knows what will unfold in highly uncertain times.

While Cropper derives 39% of group revenue from the UK, 28% continental Europe and 21% the Americas, as a larger group Smith is more diversified - just 15% is UK albeit 48% continental Europe and Smith does not whinge about Brexit. If much of a recession takes hold, however, I expect that would involve Europe and the US anyway.

You could say, Smith’s forward PE being a modest 8x and the dividend yield testing 6% (given consensus for the dividend per share to rise from 16.7p this financial year to 17.4p next) broadly prices this in.

Its equity is also seemingly fully covered by last April’s underlying net asset value of 308p a share, albeit 69% of which constituted intangibles.

On fundamentals it is quite enticing, but as with most industrial cyclicals right now, the dilemma might be “priced low for good reason” – if a recession beckons.

Smith’s chart has common features with Cropper: a strong run from the last major recession up to 2017, then a volatile-sideways consolidation – with the stock currently looking at a critical juncture. Yet the chart offers no clue as to what might happen next.

10 October trading update raised full-year expectations

Trading was said to be “very good and consistent with trends described in the 6 September AGM statement” – also “effective cost mitigation” means adjusted operating profit for the six months to end-October should be at least £400 million. “We look forward to the remainder of the year with confidence.”

The stock has since crept up 7% from 270p as enough investors regard recent pricing as a glass-half-empty view.

It is ironic how Cropper has been so hard hit unless its speciality materials aspect is energy-intensive, but there is a clear disparity here on input costs generally.

Either Smith has managed them better or is due to feel some pressure; or perhaps a recession will contain such costs.

It is why the crux question remains macro: do you anticipate a relatively short, muddling-through type of recession, in which industrial cyclicals such as Smith merit holding for a material yield?

Or might it be chronic stagflation or a tough long recession? In this scenario, you would not put fresh money into cyclicals – unless stocks were bouncing off lows and you hope to trade sentiment.

Interestingly, the economist Mohamed El-Erian says that is exactly what is happening in US stocks right now, because traders have experienced so many liquidity-driven rallies. Yet future fundamentals alone will support this.

Meanwhile, on 27 September, a Smith non-executive director bought £33,000 worth of equity at 262p which is looking astute. Yes, he was only appointed last June, and convention says company directors should own equity, but the amount was significant.

If the chancellor’s autumn statement aids UK credibility in markets, perhaps London equities will continue to rally. I remain cautious of industrial cyclicals, hence: Hold.

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

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