Beware the company having a “strategic review”. This usually follows one or more earnings downgrades and a steep fall in the share price, then tends to coincide with a protracted period of underperformance while the troubled company sorts itself out.
The triggers for the downgrades and the review are usually structural and involve entrenched exposure to adverse external pressures beyond management’s control. The review typically requires fundamental change in one or more of the strategies, the assets, the capital structure, the divisional management, the dividend payout ratio and the board’s risk tolerance. Usually there is a change of CEO as well and the market takes time to become comfortable with the new boss and with the new strategy, which has to be communicated.
Many investors, before they buy the stock, will require one or two reporting periods of earnings delivery against the strategy, which can delay share price recovery once the new strategy starts to work.
This is the situation in which CCL shareholders find themselves, with a share price back to levels of mid-2009. In FY13 earnings fell by more than revenue (operating deleverage) in all divisions except one, and goodwill was written down by $423 million, sinking reported net profit after tax (NPAT) 83% to just $80 million.
Then, in April, new CEO Alison Watkins told the market 1H14 EBIT before significant items would be around 15% lower than the previous corresponding period and difficult trading conditions would continue. At the board’s request she is reviewing group strategy including brands, distribution, pricing, costs and capability.
Increased pressure and elusive growth
This company used to deliver strong earnings and dividend growth but now finds itself in a new, harder era of increased competitive pressures and more elusive growth.
In Australian grocery weak consumer confidence is compounding price competition from PepsiCo and private label carbonated soft drink (CSD) brands. CCL has lost market share here. The major supermarket chains are compressing margins by seeking supplier discounts.
Per capita consumption of high-sugar CSDs has declined, but CCL used to depend on pricing power in this category and has struggled to innovate low- or no-sugar beverages with pricing power. In the non-grocery channel, volumes to restaurants and cafes are under pressure from weak consumer spending and there is a shift to lower-margin accounts.
In New Zealand earnings and market share growth have improved, but in Indonesia volume growth has not outweighed severe cost inflation from local currency depreciation and increases in wage and fuel costs. New market entrants are making cost recovery difficult.
SPC Ardmona’s sales revenue grew over 10% in the first quarter due to strong consumer and retailer support, and the division should break even in the first half. CCL’s alcoholic brands should deliver incremental earnings growth.
What the review needs to achieve
The review needs to restore sustained earnings growth by enhancing revenue growth, improving productivity and reducing fixed costs. The Coke brand continues to enjoy strong recognition but some of the former pricing power needs to be restored. CCL also needs a stronger brand portfolio outside CSDs and could be faster at innovating outside the core product range.
CCL has access to popular brands and has some competitive advantage in the form of large sunk costs in marketing, IT, production and distribution infrastructure. These, and the large market capitalisation, are reflected in our low 12% required return (green in the chart below).
Value investors can make money out of turnarounds but need to be patient. At the May AGM management said the review is still at an early stage. This means announcements about changes will most likely roll out over the rest of this year and into 2015, with uncertainty dampening the share price until at least then.
Management itself warns FY14 “will not be an easy year.” Our $9.35 FY15 valuation already factors in a recovery in the Australian business by using a 36% adopted normalised (blue in the box below; includes franking credits) return on equity, above the average 30.6% in FY15 for the brokers who cover the stock.
Our generous valuation is only in line with current prices of around $9.40. A 10% discount to value, which implies a $8.42 entry price, balances the risk of further disappointment with our confidence in management and the company’s exposure to grocery, a defensive sector.
By David Walker, Senior Analyst StocksInValue, with insights from Adrian Ezquerro, Alex Hughes and Stephen Wood of Clime Asset Management.