At the beginning of this year, my Foolish colleague Roland Head picked out defence group Chemring (LSE: CHG) as one of his favourite dividend growth stocks. Citing the firm’s 131% dividend hike from 1.3p to 3p, Roland claimed that the company’s turnaround was starting to pay off, and over the next few years, investors should be rewarded with growth.
As it turns out, this forecast was accurate. Since the beginning of 2018, as market sentiment towards the group has improved, shares in Chemring have added 31% excluding dividends, outpacing the FTSE 250 by 30%.
However, I believe the shares will struggle to replicate this performance during the second half of the year.
Unforeseen disaster
After rising by more than a third during the first half of 2018, shares in Chemring were trading at a premium earnings multiple at the end of last week. Even though the City was expecting a 12% decline in EPS for the full year, shares in Chemring were still trading at a forward P/E of 18.
Unfortunately, on Friday evening, an incident occurred in a flare manufacturing building at the Chemring Countermeasures facility, near Salisbury, which resulted in the death of one employee and hospitalised another. Following this event, the facility is now out of action and management is, at this stage, unable to forecast how it will impact results. Previously, it was expected that Chemring Countermeasures would contribute £15m to group 2018 underlying operating profit. According to management, operating profit is “now likely to be approximately £10m-£20m lower than previous expectations.” City analysts had been expecting a net profit of £37m for the year ending October 2018.
This tragic accident is another setback for a company that has struggled to remain profitable for the last six years. Since 2012, Chemring has only generated £47m of operating profit, on total revenues of £3bn, giving an average operating margin of just 2%. Based on these figures, and the group’s relatively high valuation, I’d avoid the stock.
One company that has a better record of producing returns for investors is FTSE 100 leader Croda (LSE: CRDA).
A price worth paying
Croda has gone from strength to strength over the past five years. The speciality chemicals group has seen demand for products surge as the world grows. It manufactures everything from cosmetic products to industrial lubricants, products for the healthcare industry and agriculture business. Over the past five years, as revenues have increased 30%, net profit has surged 57%. Since mid-2013, excluding dividends, the stock has doubled.
I expect this trend to continue. Even though shares in Croda trade at a hefty 26 times forward earnings, I believe this is a multiple worth paying. Croda is what I would call a wide moat business. The production of chemicals is a highly specialised business with high barriers to entry. It’s not easy to just set up and start producing fertilisers for example. There are whole books of rules and regulations to follow. Croda also has established relationships with customers, who know and trust the group.
With this being the case, I believe the firm can continue to achieve market-beating growth, and it’s worth paying a high multiple to get your hands on the shares.
