Ansell: Interim result 2016

By any measure, Ansell is in a league of its own when it comes to protective wear.

Take the industrial gloves division, where the company has a market share twice that of its nearest rival. Or the disposable gloves market, where it is three times larger than the No. 2. Ansell is the largest or second largest player in all of its core divisions, with dozens of popular brands in its stable.

Which is why the mere suggestion that this household name might be undervalued seems so outlandish. Everyone knows it. Everyone understands what it does. Could investors really be misjudging the situation?

The answer is yes. As to why, the short explanation is that share prices don't quite behave the way people assume they do. The slightly longer version is that investors have a range of psychological biases that cause them to overreact to bad news and overproject recent results long into the future.  

Last week, Ansell said January sales were poor and reduced its forecast for full-year earnings per share by 9% from US$1.05–1.20 to US$0.95–1.10, implying net profit will come in around US$15m short of expectations.

The response? One broker we know cut its target price by 34% – implying that Ansell was worth, in its opinion, $1.1 billion less on Thursday than it was on Wednesday. The stock has now halved since its April 2015 high.

Thankfully, to paraphrase Benjamin Graham, Mr Market's manic-depressive reactions are a source of opportunity for those wanting to own high-quality, undervalued stocks for the long term. We've waited years for the right moment to upgrade Ansell. And it's finally here.

Supply issues

Ansell reported a poor interim result, with revenue falling 7% to $785m for the six months to December, though this is roughly flat on the prior corresponding period after removing the effects of currency fluctuations.

The Medical division was the main drag, with sales falling 9% and earnings before interest and tax (EBIT) down 30% in constant currency terms. The division was hit hard by falling sales in Russia (down 45% across all divisions), where the local economy has been severely affected by lower oil prices. Tight government budgets forced Russian hospitals to cut spending and switch from Ansell's premium gloves to cheaper alternatives.

The issues for the Medical division were amplified by the company being unable to fully meet demand due to 'plant management' issues and the botched replacement of a production line. 'We had our management team failing to do all of the things that we expected. And for that reason, we changed management,' said chief executive Magnus Nicolin.

Segments

Revenue in the Single Use division fell 3% due to price reductions. However, EBIT increased an impressive 19% due to various cost-cutting initiatives related to the integration of US-based BarrierSafe, which has a 20% share of the US single-use glove market. The company was acquired in 2013 for US$615m and has been a fantastic addition (see Ansell buys US market leader). 'BarrierSafe continues to run ahead of its business case,' management said.

The company has had success taking BarrierSafe's US product line and selling it in foreign markets, demonstrating the value of its huge established distribution network. Ansell's customers are often multinational companies themselves and seek out Ansell because its distribution network means it can supply products to a wide range of countries. Ansell's breadth of operations geographically is a major differentiator from competitors.

The Sexual Wellness division improved considerably over the year with condom sales in emerging markets increasing 17%, led by China and India. Overall revenue was up 10% and EBIT up 22% – far better than the double-digit decline seen in 2014.

An expanded range of flagship SKYN ultra-thin condoms and a new 'feel everything' marketing campaign increased sales of the brand by 13%. It was an impressive result, though, unfortunately, the division still only accounts for 14% of sales.

Industrial

Ansell's largest division, Industrial, performed decently on the top line but saw declining profitability, with sales up 4% to US$330m (42% of total revenue) and EBIT down 5%. A 30% increase in new product sales was offset by a shift to lower margin products.

The company's flagship HyFlex safety glove, of which Ansell makes nearly a thousand a minute, increased sales by a lacklustre 4% but Nicolin singled out the launch of a new yarn technology known as 'Intercept' saying 'it's the most successful product launch we have done. And why I say that is from launch to getting significant millions of dollars in the bank is the shortest time I've ever seen'.

Ansell has made a concerted effort to focus on and consolidate its core brands in recent years. 'It improves the impact in the marketplace, so that we build the Ansell brand, the Hyflex, Gammex and SKYN brands to be demanded by the end customer by name ... in a few years, we expect to have 80% of our sales from core brands,' up from around 50% today.

We're happy to see the company reducing the number of its brands to a few big banner names. The added recognition should flow through as increased pricing power and, hopefully, wider margins. In any case, it's Ansell's branded products that are contributing all the growth, with core brand sales overall increasing by 10% a year since 2010.

Cash flow holding up

While this result wasn't anything to write home about, the share price reaction seems overdone. There's still plenty to like about Ansell and the outlook.

Despite net profit falling 10% in constant currency terms to $70m, free cash flow fell only 2% to $66m due to the completion of some major capital expenditure projects, such as a new IT system. The Single Use and Sexual Wellness divisions, which together account for nearly a third of sales, are performing very admirably. And, while the Industrial division had a modest result this time around, new product releases from the Intercept range in the coming six months should improve things.

What's more, a big part of the Medical division's woes were, as management put it, 'self inflicted' due to the supply constraints. That issue should correct itself over time.

Even the lower oil price – so damaging to Russian and energy industry glove sales – has a silver lining: Ansell is highly leveraged to industrial demand and the lower cost of energy should encourage growth (for more on this, see Jeremy Grantham's latest letter). In particular, management said, 'the automotive market is growing like there's no tomorrow'.

The share price is up 4% since we upgraded the stock in Ansell: good news, bad news from 4 Feb 16 (Buy –  $15.49), putting it on a price-earnings ratio of 11 using the midpoint of managment's forecast range for full-year earnings and a US dollar exchange rate of 0.71.

Volatile commodity prices and currencies provide a large swing factor to revenue and earnings, and there's no mistaking that Ansell operates in a highly cyclical industry. Still, the company has a formidable distribution network and the broadest product line of any competitor. Ansell's brand recognition and economies of scale make for wider margins, which would cushion the impact of increasing competition or a weakening economy.

With strong brands and a dominant – increasing – market share, able management and economies of scale, there's every reason to believe Ansell will be bigger and stronger 10 years from now. We're (belatedly) increasing our maximum recommended portfolio weighting from 4% to 7% and recommend you BUY.