24 January 2020

Phil Oakley’s Weekly Round-Up

Listening to what comes out of the Davos forum is of little use in my opinion, instead I focus on information like company reports

The companies mentioned this week are: n Forterra n Fevertree n Sage n WH Smith n AJ Bell n JD Wetherspoon

One of the best things I have done in recent weeks has been to stop watching and listening to the news on main- stream TV channels and radio stations. This is because a lot of what is on there is of no use to me whatsoever. Instead, I confine myself to reading newspapers and other publications where I can just concentrate on what I want and need to. I think this is a great approach to investing as well. By shutting out the noise and chatter on mainstream and social media, you can absorb yourself, free yourself from distractions and focus on companies and how they are getting on. This is not only a more enjoyable and calm experience, but a hugely beneficial one as well. Reading company results, annual reports and the quality bits of the investment media you can form your own views and develop your abilities as an independent thinker, which I think is so vital for long-term learning and investment success. This week we will see the fawning of politicians, big business and lobbyists at the Swiss ski resort of Davos. You will learn little or nothing from listening to these people, many of whom caused the problems the world Alpha Production Editor: Sameera Hai Baig economy has faced over the past decade; failed to spot www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

1 them or profited from the attempts to clear them up. It’s never been more important to tune out from the noise. This is for our personal well being, as well as the health of our investments. I remain firmly convinced that those investors who read company annual reports and the RNS statements from the stock exchange will develop their own tailored process and mindset that will serve them well in the years ahead. I never cease to be amazed at how much public infor- mation is missed or ignored by investors. If you read a company’s annual report and use the information in it, you will be far better informed about a company and its business than the vast majority of investors. This has been my experience as both a professional analyst and a writer and has been the focus of my work in both roles. It takes time and effort, but the more you follow the pro- cess the more you learn and the easier it becomes to work out what is going on. I cannot recommend it enough.

Fantasy Sipp & UK Quality Shares Portfolios Portfolio % returns 1 month Year to date 1 year 2 years Martin Currie Global Portfolio 5.3 7.1 37.8 34.2 LF Blue Whale Growth Fund 3.8 5.4 28.4 39.6 Fundsmith Equity T Acc 3.0 4.7 28.2 31.0 Phil Oakley Fantasy Sipp 3.5 4.2 33.6 38.4 Vanguard S&P 500 ETF 1.5 3.8 25.9 24.6 Mid Wynd International Inv Trust 2.3 3.0 30.4 22.6 Scottish Mortgage Investment Trust 2.4 2.9 27.7 26.8 Smithson Investment Trust 1.1 2.9 29.7 Castlefield CFP SDL UK Buffettology Fund 2.9 2.9 24.8 31.1 Phil Oakley UK Quality Shares 2.3 Lindsell Train Global Funds -1.0 0.9 18.2 31.8 FTSE All-Share – Total Return -0.4 0.3 16.6 7.6 Vanguard FTSE 100 ETF -0.8 0.2 15.5 6.1 Finsbury Growth & Income Trust -3.5 -1.0 18.3 21.0 Source: SharePad

Forterra I like brick-making businesses. They have scarce assets of clay reserves that keep new entrants at bay. This allows them to make good profits over an economic cycle albeit with a few up and down years thrown in. Forterra (FORT) is part of my UK Quality Shares port- folio. It is well-positioned in a UK brick market which is undersupplied and is adding new capacity to exploit this. It also has a leading position in the repairs, maintenance and improvement market with its London Brick business. This week’s trading statement can only be described as disappointing. Profits for 2019 are expected to be in line with current forecasts, but the soft market seen in the second half of last year is expected to recover slowly. This means first- half profits for 2020 are likely to be lower than 2019’s. www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

2 Given the company made half-year pre-tax profits of £32.7m and applying a material shortfall of at least 10 per cent, this suggests half-year profits of £29m or perhaps lower in 2020. If growth does not pick up in the second half of this year then the company will struggle to make pre-tax profits of £60m this year, compared with current consensus forecasts of £65.8m. There is nothing wrong with demand for bricks for new- build housing, but there has been weak sales to distribu- tors. There have also been delays in a number of contracts for the Bison precast concrete business and the higher margins this was supposed to bring. There was no update on the situation here in this week’s statement, but they should come through eventually. Longer term, I still remain upbeat on this business. The UK needs to build lots of new homes and will need to get the bricks from somewhere. The company’s new brick- making plant at Desford in Leicestershire will be fitted out in the spring, which will bring new capacity and efficiency gains that bode well for future profits. Unsurprisingly, Forterra shares fell 5 per cent on Wednesday to 337p after having been on a stellar run in 2019. Assuming 2020 pre-tax profits get downgraded to around £60m/24.7p EPS, the shares would trade on a fore- cast PE of 13.6 times and a dividend yield of around 3.5 per cent, which is not expensive. I am going to stick with the shares in my UK portfolio, but acknowledge that growth needs to get going again.

Forterra forecasts Year (£m) 2019 2020 2021 Turnover 379.9 391.9 405.2 Ebitda 81.8 85.4 89 Ebit 65.4 68.6 70.3 Pre-tax profit 62.5 65.8 68.3 Post-tax profit 51.6 54.3 56.4 EPS (p) 25.7 27.2 28.1 Dividend (p) 11.6 12.2 12.8 Capex 38.8 44.8 45.2 Free cash flow 31.4 30.4 31.4 Net borrowing 47.5 52.3 53.5 Source: SharePad

Fevertree I take no pleasure in this, but I’ve been expecting a significant profit warning from Fevertree for some time and explained why in an Investors Chronicle article back in November. Fevertree (FEVR) had become too reliant on the UK market and tonic and particular. After stellar growth in 2018, it was always going to be hard to keep growth in the UK going. Sales progress in the US and Europe has been www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

3 decent, but from a much lower base in the UK, and profits from these markets aren’t yet big enough to take over the growth baton. Yet, the biggest problem has been the continued high valuation of Fevertree shares and the high expectations of future growth it implied. This was the main reason for my bearishness, as I just don’t buy into the long-term growth potential of Fevertree’s products. I have been analysing and writing about shares for near- ly 23 years and have seen several drink crazes come and go from alcopops to cider, to craft beer and now to gin. My colleague Mark Robinson has written an interesting piece on Fevertree this week, where he cites a research report from broker Bernstein suggesting that UK gin sales – and interestingly sales of premium gins – may have peaked. This week’s profit warning is alarming for a couple of reasons. First is that Christmas sales in the UK appear to have fallen off a cliff. Back in November, the company guided towards 2 per cent sales growth for the UK for 2019. This implied zero growth for second-half sales. They actu- ally fell by 5.6 per cent. Second is the guidance that US sales growth will fall from 33 per cent in 2019 to a low double-digit rate of growth in 2020. This is due to the company investing in the brand to deliver growth: “Given this progress, we will be investing further in the brand over the course of 2020. The group has already conducted a number of success- ful trials with key customers, providing both parties with compelling evidence of our ability to unlock the wider potential of this very significant market over the medium and longer term. However, implementing these initiatives is expected to result in a one-off impact on net revenue growth in 2020 and, as a result, we are revising our growth forecasts for the US business to low double digit for the year ahead before returning to previously expected growth rates thereafter.” There’s something about this that doesn’t feel right to me. The company supposedly has a national distribution agreement in place in the US to sell its products. I am puz- zled as to what investment in the brand is going on that would slash the growth rate for a year before it started growing strongly again. Even without this, I am yet to be convinced that Fevertree mixers have the same potential in the US as they do in the UK. Finally, the guidance on lower gross profits and earnings before interest, tax, depreciation and amortisation (Ebitda) margins should send alarm bells ringing. Fevertree’s high profit margins are a function of its high selling prices for its products. I would go as far to say that £1.70 for 500ml of tonic water in my local Tesco is a just a rip off. It’s more www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

4 expensive than premium bottled beers of the same size (around £1.60) which have 47p of alcohol duty in their price. The problem that Fevertree faces is that barriers to entry in making mixers is pretty low. It is proof of this itself as it owns no factories or bottling plants. There is therefore no reason why others cannot do the same and there is grow- ing evidence that they are. I think profit forecasts for 2020 are too high still. I do not think it will be easy for the UK to return to growth this year given the challenging market conditions. Assum- ing flat sales growth in the UK, 12 per cent growth in the US, 13 per cent growth in Europe, 15 per cent for the rest of the world and using the company’s 28 per cent Ebitda margin guidance gives me revenues of £276.9m and Ebitda of £77.5m would feed through to EPS of around 51p. If UK sales fall again, and there’s good reason to think they could, then this forecast could be too optimistic.

Fevertree forecasts Year (£m) 2019 2020 2021 Turnover 260.3 287.6 319.4 Ebitda 78.8 82.8 90.9 Ebit 75.3 78.9 86.3 Pre-tax profit 74.9 78 84.9 Post-tax profit 60.3 62.8 68.4 EPS (p) 52.5 55.1 60.6 Dividend (p) 15.1 16.2 18 Capex 2.4 2.2 2.3 Free cash flow 58.9 60.4 65.9 Net borrowing -123.6 -166.7 -212.6 NAV 229.3 272.5 322.2 Source: SharePad

Unsurprisingly, talk of Fevertee being a takeover target has resurfaced this week. Anything is possible, but I think this is unlikely. I don’t see why Diageo needs to buy a mixer business to drive sales of its spirits. Nor do I see why even the likes of Coca-Cola or PepsiCo would pay a hefty premium to Fevertree’s current market capi- talisation of £1.9bn to buy a business that they could easily replicate themselves. In fact, Coca-Cola has recently launched its Signature Mixers brand to be used with dark spirits which could ultimately see off Fevertree in the US. If my 51p forecast is in the right ballpark then, at 1,630p per share, the valuation is still a very punchy 32 times. This is bordering on ridiculous for a business that looks like it has gone ex-growth in its key market. If further profit downgrades are forthcoming then inves- tors are at risk of significant PE compression. On a gener- ous 20 times, the shares would trade at 1,000p and show that significant downside risk remains. For me, this looks more like a share to interest short-sellers right now. www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

5 Sage Software companies can make great investments. If they make a great product that customers like and stick with then the economics of the business can become very at- tractive. Once a company has sold enough products or licences to cover a largely fixed cost base then each additional sale costs next to nothing and virtually all drops through to profit. Sage’s (SGE) accounting and business software has achieved this by becoming a popular product with pro- fessional book keepers and small- and medium-sized businesses. It makes high profit margins, high returns on capital employed and has strong free cash flows. In short, it has a lot of the financial characteristics that investors love and this was the reason I bought the shares for my Sipp (now Fantasy Sipp) back in February 2018. It has proven to be a very disappointing investment, so far delivering me total returns of just 9.7 per cent. It is also the business I worry about most in the portfolio, as I feel it has lost its grip on its core market to its main rival Intuit, which is having huge success with its Quickbooks software. The year 2018 was a terrible one for Sage shares, but 2019 was better with total returns of 27.9 per cent. The business has been struggling with its strategy of migrating its customers from software, which sits on their desktop computers to one that resides in the Sage Business Cloud. Sage also want to move its products away from licence sales to monthly or yearly subscriptions. I don’t think there can be any doubt that this is the right thing to do for the business, but it has not been carried out well. Costs have shot up and taken a big bite out of the company’s profit margins, which fell from 28 per cent to 23 per cent last year. At the same time, Intuit has grabbed the initiative in the UK market and has become the num- ber one provider of cloud based accounting software subscriptions. Sage and Quickbooks offer similar functionality to their customers, with Sage offering a little bit more for more advanced users. Sage is seen as more useful for profes- sional book keepers and businesses who want help with managing projects. Quickbooks is seen as being far more user-friendly and ideal for small businesses with no accounting expertise. This is the message it is getting across with its TV adverts in the UK. I had some experi- ence with Sage a few years ago when I was doing account- ing courses and I did not like it as I found it very hard to use. Although, I am sure that as with most things, I would have got the hang of it eventually. In terms of growing their businesses, Intuit is outper- www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

6 forming Sage by some margin. Sage’s first-quarter trading update this week was fairly reasonable with recurring revenue growth of 10.7 per cent (its cloud and subscription business). The declining traditional licensing business meant that total organic sales growth was 6.7 per cent. Sage maintained its 2020 guidance for organic recurring revenue growth of 8-9 per cent with profit margins of 23 per cent. The shares reacted well to the news that forecasts would be maintained. However, Intuit is growing at a faster rate. Its first- quarter results released in October saw revenue growth of 15 per cent. Quickbooks online accounting revenue increased by 41 per cent with its online pay wall and payments business growing revenues by 27 per cent. The company is on course to generate profit margins of 34 per cent and grow its earnings per share (EPS) by nearly 30 per cent in 2020.

Sage forecasts Year (£m) 2020 2021 2022 Turnover 1,950.10 2,064.30 2,206.50 Ebitda 501.6 531.3 576 Ebit 441.3 474.8 522.1 Pre-tax profit 425.4 463 508.1 Post-tax profit 319.5 344.6 379.9 EPS (p) 29.5 32 35.1 Dividend (p) 17.4 17.9 18.3 Capex 38.1 38.6 41 Free cash flow 306 347.8 376.9 Net borrowing 292 125.9 -67 Source: SharePad

I very much like the small- and medium-sized business software as a place to invest given that this is where the real growth engines are found in most economies. The Fantasy Sipp portfolio has owned shares of Paychex – a leading US provider of outsourced payroll solutions in these markets – since March 2018 and has received total returns of 49 per cent. I am therefore very tempted to swap an investment in Sage for one in Intuit. The one thing holding me back is the very high valuation of Intuit shares. Sage trades on a 2020F PE of 26 times at a share price of 762p. Intuit at $290 per share trades on a 2020F PE of 38.4 times, which reflects its fast growth. One of my favourite tools of weighing up the valuation of a share is by looking at the yield on cost. I like this because it gives me the perspective of a return to someone owning a business outright. You can use it with earnings per share, free cash flow per share or dividend per share and divide by the current share price to get a yield. You then take forecasts of growth for your chosen measure and www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

7 Sage and Intuit: Earnings yield divide by the current share price to see the trend in your on current share price yield on cost. % Over time, you want to see a rising yield on cost. Hold a 5 Sage Intuit share for long enough and you can get some very impres- 4.5 4 sive yields on cost. For example, Warren Buffett’s dividend 3.5 yield on his 1988 purchase of Coca-Cola shares is now 3 around 50 per cent. Anyone who bought shares in Greggs 2.5 the bakers when it floated at 150p per share in 1984 and 2 has held on to them is getting a dividend yield on cost of 1.5 238 per cent. 1 The high valuations of both Sage and Intuit mean that 0.5 0 their earnings yields of cost (EPS divided by the share 2020 2021 2022 price) are very low. Based on current forecast, Sage will Source: SharePad & Investors Chronicle still have a higher yield on cost by some margin in 2022 even though Intuit is expected to grow its earnings faster. However, my gut feeling is that if I was to take a 10 year view, I will have a higher yield on cost owning Intuit shares. I am going to ponder this dilemma and update you next week.

WH Smith I am a big fan of WH Smith’s (SMWH) travel retail business. Its captive customers in airports, railway stations, hospitals and service stations have generated excellent returns for shareholders and I expect them to continue doing so. The shares have delivered a total return to the Fantasy Sipp portfolio of 21 per cent since they were added in March last year. This week’s trading statement for the first 20 weeks of the 2019-20 financial year was very reassuring on the Travel business. Like-for-like (LFL) sales have continued to grow at their recent rate of 3 per cent with total sales up 19 per cent due to new sites and In-Motion acquisition. The Marshalls Retail Group has been completed and will start adding to profits this year. Contract wins have been good in the UK with a growing presence in hospitals and new US wins are encouraging. The UK retail business continues to decline with LFL sales down 5 per cent but gross profit margins have been better than expected. The managed decline of this busi- ness continues to deliver decent results. £3m of extra cost savings have also been found which will give £12m in total this year. The lack of profit upgrades saw a muted response in the share price, but I continue to like this business. They are not cheap on a one-year rolling forecast PE of 20 times at a share price of 2,520p, but I expect the business to compound in value in the years ahead. One slight note of caution is the current health concerns regarding the coronavirus coming out of China. I remem- www.investorschronicle.co.uk email: [email protected] © The Financial Times Limited 2020. Investors Chronicle is a trademark of The Financial Times Limited.

8 ber the SARS virus in 2003 and the impact it had on the temporary impact it had on the share prices and profits of travel related stocks and there has to be a risk of some- thing similar happening again.

WH Smith forecasts

Year (£m) 2020 2021 2022 Turnover 1,551.30 1,669.80 1,735.40 Ebitda 237.4 267.1 285.9 Ebit 181.5 202.6 210.7 Pre-tax profit 173.8 196.2 210.6 Post-tax profit 130.3 153.1 158.9 EPS (p) 119.6 132.2 142.2 Dividend (p) 62.4 67.4 74.9 Capex 65.8 63 63.5 Free cash flow 167 178 - Net borrowing 294.3 243.6 181.1 Source: SharePad

AJ Bell In some ways, investment platforms are very similar to software companies. They have lots of fixed overheads but once they have built up sufficient revenues each extra pound of revenue adds increasing amounts to profits. This allows those investment platforms with sufficient custom- ers and revenue such as AJ Bell (AJB) and Hargreaves Lansdown (HL.) to become extremely profitable. The big risk with them is that the value of their clients’ investments are very geared to changes in the value of world stock markets and so, to an extent are the fees generated from them. AJ Bell is not as profitable as HL, but still has operating margins of 36 per cent, free cash flow margins of 30 per cent and return on capital employed (ROCE) of nearly 50 per cent last year. If it can keep on growing then I would expect these stunning returns to keep on going up.

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9 Source: AJ Bell Current trading is decent with platform customer numbers growing by 4 per cent to 227,202. Assets under management have increased to a record high with a nice helping hand from buoyant stock markets. At 400p, the shares are very expensive on a rolling one- year forecast PE of 42 times. This is not usually the kind of valuation that attracts me to a share, but I have it in my UK Quality Shares portfolio because I see it as a long-term winner and also a potential beneficiary from HL’s current troubles and high fees. The operational gearing on this business is huge and market share gains give it the potential to grow its profits quickly with the caveat that they are subject to significant stock market risk. I am not expecting this share to perform well in the short term – and it hasn’t – but I am happy to hold onto it with a long-term perspective as these kind of businesses are scarce and have the potential to compound in value faster than many people think.

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10 AJ Bell forecasts Year (£m) 2020 2021 2022 Turnover 119 131.1 145.9 Ebitda 54.1 53.1 61.8 Ebit 51.6 51.1 59 Pre-tax profit 45.5 51.8 60 Post-tax profit 37 42 50 EPS (p) 9 10.3 12.1 Dividend (p) 5.8 9.2 8.4 Capex 1.5 1.3 1.3 Free cash flow 37.1 44.4 51.9 Net borrowing -95.7 -93.7 -110 Source: SharePad

JD Wetherspoon JD Wetherspoons (JDW) continues to demonstrate that it has the best and most consistent pub operating model in the country. LFL sales for the 12 weeks to 19 January were up by 4.7 per cent, with year-to-date LFLs (25 weeks) up by 5 per cent. No other quoted pub operator is coming close to this kind of sales performance and it should not be forgotten that Wetherspoons is doing this while being up against tough comparisons. A year ago, LFL sales for the second quarter were increasing at 7.2 per cent with the 25-week figure growing at 6.3 per cent. Wetherspoons is sticking with a very simple and power- ful business model that works. It offers food and drink at very attractive prices and keeps its pubs in good condi- tion. This has kept the revenues flowing in. This strategy has been complemented by a strategy of improving the quality of the pub estate. Poorly performing pubs have been closed and the business has not pursued scale for scale’s sake as the size of the estate is smaller than it was a few years ago. So far this year, one pub has opened and five have been closed, but 10-15 pubs are expected to open in the year to July 2020. The company also continues to buy out the leaseholds of its estate and give the business more free- hold asset backing and flexibility to weather a downturn in trading. It also continues to buy back its own shares which have been reduced from 221,512,519 in 2003 to 104,678,395 today and have been a key driver of the share price. For me, Wetherspoons remains the pub stock to own in the UK in what is a very difficult sector to make money. That said, on a one year rolling forecast PE of over 20 times I’m not sure I’d be buying the shares at the moment.

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11 JD Wetherspoon forecasts Year (£m) 2020 2021 2022 Turnover 1,890.80 1,970.70 2,053.00 Ebitda 270 275.8 280 Ebit 142.5 145.3 147.6 Pre-tax profit 94.2 97.1 105.6 Post-tax profit 78 82.4 87.7 EPS (p) 73.1 78.5 83.5 Dividend (p) 12 12 12 Capex 108.5 101.5 103 Free cash flow 101.9 107.8 114.2 Net borrowing 723.5 753.2 658.4 Source: SharePad

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