Blackmores a hard stock to swallow

The recent reporting season gives all of us an opportunity to review individual company financial performance based on real information. A critical opportunity thus presents to reassess my view and valuation of Blackmores Limited (ASX: BKL).

This company has been an outstanding performer for many years, with a high recurrent return on equity leading to a history of continually growing profits and dividends. The business for many years benefitted from its alignment of a “health-based” products range to a growing and ageing population. Also, for many years, it presented a unique “branding” offer. Its brand became synonymous with nutritional health care as it was the true pioneer in the Australian industry.

However, the market in which BKL operates is going through transformation in Australia. A new aggressive competitor (Swisse) and the roll-out of generic products or house brands by the dominant retailers are resulting in a highly competitive market. Further, there continues to be consolidation in pharmacies, with Chemist Warehouse being particularly active. The results are becoming clear to see, with slowing revenue growth, declining margins and aggressive trading terms sought from customers. These were starkly on display in the December half-year.

Before these events BKL had moved to export its product into the Asian market and this has seen some relative success. Further, and possibly in response to the rising competitive pressures in Australia, BKL undertook an opportunistic acquisition of BioCeuticles in July 2012 for more than $40 million in a debt-funded deal. This company also has a range of health care products with higher potency that generally require scrip. Therefore, the acquisition or merger does offer a degree of logic. 

Primarily due to the acquisition noted above, the last six months, when compared to a year earlier, have seen revenue grow by 29%. However, over the same period, reported earnings dropped by about 5%. Significantly, the balance sheet has been transformed through the acquisition of goodwill. Tangible equity has dropped from $4.47 per share to $3 per share. Net debt has risen to over $80 million from $34 million. While interest cover remained strong at nine times, BKL has clearly increased its financial leverage. It is unclear to me as to why the company did not raise capital to fund the acquisition of BioCeuticals at the lofty prices on offer in recent months. In any case, the directors have held the dividend flat and sought the reinvestment of dividends through a 5% discount DRP.

Operationally, BKL traded down in Australia, fairly across Asia and better in Thailand and Malaysia. Importantly, the Australian operations are much more significant (at 70% of total group profits) and the headwinds are immense. Operating cash flow dropped substantially in the half as BKL invested more into working capital. Trading rebates demanded by retailers increased substantially and directly affected the profit margins of the business.

This latter point is the crux of my current concern because it shows the immense competitive pressure that BKL is confronting. It also suggests that the acquisition of BioCeuticals was possibly needed to fill an Australian earnings decline, although this was not the publicly stated reason for its acquisition. 

Valuation of BKL

In critically assessing each individual company’s financial fundamentals, companies are rated through a process known as “CQR”, or the “Clime Quality Rating”. Companies are assigned stars from one to 10, with higher ratings associated with better financials.

Notably, in the last three years, BKL has seen its CQR drop from eight stars (investment grade) to five stars (requires monitoring). This accelerated in the last six months as debt increased substantially.

A significant effect of a lower CQR is a higher required return (RR). Think of it this way – the higher the financial risk in a business then the higher the return that an investor should demand. I believe that the RR for BKL is now firmly around 13%.

Further, the lower reported profits on a higher shareholders’ equity base (as opposed to tangible equity) have resulted in a decline in “normalised return on equity”. Going back in time it was common to see BKL achieve a NROE of over 50%. The last half saw this decline to 44% and the consensus forecasts for the next two years are 45%. These are still impressive returns and do attract my interest, but the longer trends suggest lower NROE.

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In particular, consider the next table of five-year performance. What this highlights (see below) is that BKL has lifted ordinary equity from $50.35 million in 2009 to $90.16 million now. This increase in equity of $40 million, mainly from retained profits, has been associated with just a $7 million increase in reported profit. Importantly, the last three years has shown no increase in profit and NROE has therefore fallen.

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To derive forward value I have used a RR of 13% and adopted a sustainable NROE of 45%. From this, I have derived a value of $29.47 for June 2014. Therefore based on this and the disappointing deterioration in the quality of the balance sheet, I have decided to take BKL out of the growth portfolio effective from the close of trade on 15 March.

At this point, I have not replaced this holding and effectively have decided to increase the cash weighting of the portfolio. Given the substantial lift in the market in the last six months and the diminishing signs of value across the market, then I cannot help but think that this may prudent.

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John Abernethy is the Chief Investment Officer of Clime Investment Management. 

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Clime Growth Portfolio

Return since June 30, 2012: 28.43%
Returns since Inception (April 19, 2012): 19.42%
Average Yield: 5.66%
Start Value: $111,580.24
Current Value: $149,681.82
Dividends accrued since 31.12.2012: $1,941.47

Source: MyClime