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Portfolio Update
The Qualiport model portfolio continues to do reasonably well. Despite the fact that Rentokil Initial is arguably overvalued even after losing 23p today, the share price continues to do well. I can't help thinking, however, that this is a bit of a false dawn, as we already know that the company will grow by a best case 20% for the next few years. I personally cannot see Rentokil suddenly blowing their historical and targeted 20% growth rate away in the next couple of years. It gets harder and harder for Rentokil to hit that very demanding target, especially as they get bigger and bigger. In the past 4 years, their earnings per share (EPS) growth rate has been 20.8%, 21.1%, 20.5% and 20.2%. If I were a gambling man, I'd predict 1998's growth rate at 20.3%. For those people familiar with Hemmington Scott's Company REFS product, it is interesting to note that of those FTSE 100 companies that are awarded a PEG in June, Rentokil Initial has the 10th lowest mark. By that measure, if we are saying that Rentokil is potentially overvalued, so are a few others, too.
When reviewing EMAP's results last week, despite me saying that they were "no screaming bargain," the actual share price has held up rather well. As with all companies in the Qualiport, we are hoping to hang onto these for a very long time, so these short term share price movements are relatively meaningless. Presuming we've done our homework properly, the great thing about the Qualiport shares is that you don't have to check their share price every day, week or even month. That, in my view, is an important mark of a quality company.
Before we move on, it would be remiss of me to leave this little section without mentioning our Qualiport "dog," Marks & Spencer. The share price continues to hover around the price at which we purchased our part ownership in the company all those weeks ago. Oh well, if M&S continue to be the worst performing share in our portfolio, it bodes well for the health of the overall Qualiport. Despite what the share price says, M&S are continuing on their unprecedented domestic and international expansion programme.
Reckitt & Colman II
Before learning more about Reckitt & Colman, I first want to confess to a grave error in last week's first article about them. I constantly referred to the company as Reckitt & Coleman. Apologies. As punishment, I have typed the word Colman 100 times. (I actually used the cut and paste technique, but the result was the same)
As a quick re-cap, they specialise in the household and pharmaceutical product areas, with the former by far outweighing the latter. They also have a small food product category, which I presume refers to a North American division, of which there is very little mention in the 1997 annual report. Check last week's report for more detail about their structure and brands.
The Numbers
Like Unilever, Reckitt & Colman split their numbers by product category and by geographical area. To be consistent, and because I think it gives a better feel for a company, I'll detail the important numbers by product category.
Turnover (£m)
1997 1996
Household 1,747.8 1,838.3
Pharmaceutical 260.7 254.0
Food 188.1 202.4
Total 2,196.6 2,294.7
Operating Profit (£m)
1997 1996
Household 261.6 272.8
Pharmaceutical 71.6 70.1
Food 35.9 27.7
Total 369.1 370.6
Operating Margin
1997 1996
Household 15.0% 14.8%
Pharmaceutical 27.5% 27.6%
Food 19.1% 13.7%
Total 16.6% 16.2%
The above numbers look far from inspiring, especially when compared to 1996. With the impressive operating margin that the pharmaceutical division can obtain, it is no wonder that Reckitt & Colman emphasise this part of their division. At the moment, it makes up less than 12% of turnover. This could present the company with opportunities to grow this profitable part of the business as they move forward.
Although the sales dropped in pure pound terms, at constant exchange rates the company says that sales grew by 4.3% and operating profits by 7.5%. On a like-for-like basis, sales grew by 4.6%. The operating margins put Reckitt & Colman firmly in the top half of FTSE 100 companies by this measure, and they are the highest out of our 3 branded goods companies. The other two are Unilever and Cadbury Schweppes.
Before we move away from margins, one that I confess to rarely looking at despite its importance is the gross margin. The gross profit is calculated by deducting the cost of goods sold from the total sales. The cost of goods sold number is usually displayed in the accounts, and means exactly what it says. Typical items included in the cost of goods sold line include the cost of the raw materials, packaging costs, and all factory costs. Reckitt and Colman's gross margin was 57.2%, up from 55.8% in 1996. As a comparison, Unilever's gross margin from continuing activities in 1997 was 45%.
Cash & Other Numbers
The gross debt of Reckitt & Colman at the end of 1997 was £871.4m, reducing to net debt of £535.5m after cash at bank and £276.5m worth of short term deposits and commercial paper are added back. In relation to stated shareholder's funds of £910.1m, this represents gross gearing of a high looking 96% and net gearing of 59%. However, if we add back on to shareholder's equity the £601.7m purchased goodwill written off, that gives us an adjusted base of £1,511.8m, adjusted gross gearing of 58% and net gearing of 35%.
Interest cover, calculated as pre tax profit (£302.5m) plus gross interest payable (£55m) divided by gross interest payable (£55m), is 6.5 times. This expresses a company's ability to pay interest on borrowings out of profits earned. This is a comfortable level of cover, although ideally we'd like to see the debt reducing and therefore the cover increasing as the company generates free cash flow each year.
Although R&C's cash flow per share is above their reported earnings per share, at the moment they are not a huge generator of free cash flow. Capital expenditure (£84.1m) easily exceeds depreciation expense (£46.8m). Before taking the plunge, we would have to be sure that the capital expenditure the company is incurring is for actual expansion rather than the replacement of worn out assets. If it is the latter, the company will never create long term value for shareholders, as they have to spend money just to remain profitable at the current levels.
Return on equity is calculated as profit attributable to shareholders before ordinary dividends (£215.8m) divided by shareholder's funds adjusted for purchased goodwill written off (£1,511.8m - see above). That equals 14.3%, meaning that for every £100 invested in the business, the company earns £114.30. The average company earns about 12% on equity.
The final ratio we shall look at today is the price to sales ratio (PSR). This is calculated as market capitalisation (£5.2b) divided by trailing 12 months sales (£2.2b), which equals 2.4. Usually companies with lower profit margins have lower PSRs, reflecting the fact that they are less profitable per sale. Supermarkets with their low margins usually trade on low PSRs, and Tesco for example has a PSR of 0.7 on operating margins of 5.5%. On the other hand, Glaxo Wellcome with its operating margins of 35.5% has a PSR of 7.5.
Pros & Cons
You will note that, as with Unilever, we haven't made any attempt to value Reckitt & Colman yet. We first want to establish whether we think they are a quality company and worthy of our investment. We try to separate quality of company and management from valuation. Once we decide which, if any, of the 3 companies is fit to join the Qualiport, will we look at their valuation. For the qualities of the ideal Qualiport company, click here.
Reckitt & Colman's Plus Points
Reckitt & Colman's Minus Points
Next Step
On Friday, we will begin looking at the third consumer goods company on our list, Cadbury Schweppes. Please feel free to share your thoughts and comments on Reckitt & Colman, Unilever and Cadbury Schweppes on the wonderfully interactive Fool message boards. Which is your favourite, and why?
Bruce Jackson (TMF Googly)
Qualiport Numbers
Today's Numbers Date 10/06/98
Change Bid
pence £
RTO -0.23 4.08
EMAP 0.00 12.87
MKS -0.10 5.49
Rec'd # Stock Buy Now % Change £ Change
19/12/97 1565 Rentokil 2.55 4.08 60.0% 1.53
17/04/98 337 EMAP 11.85 12.87 8.6% 1.02
11/05/98 722 M & S 5.535 5.49 -0.8% -0.045
19/12/97 1565 Rentokil 4,040.63 6,385.20 58.0% 2,344.57
17/04/98 337 EMAP 4,043.37 4,337.19 7.3% 293.82
11/05/98 722 M & S 4,052.24 3,963.78 -2.2% -88.46
Cash 33.96
Total 14,720.13
Day Month Year History
Qualiport -2.9% -1.4% 51.3% 54.7%
FTSE 100 -0.5% 2.0% 16.6% 19.3%
FTSE All Share -0.5% 1.6% 18.1% 20.6%