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Shares Small Cap

Virgin Money Margins on the Rise, but the Loan Books a Little Lighter

Business Strategy and Outlook

Virgin Money UK consists of the CYBG business (demerged from National Australia Bank, or NAB), and the more recently acquired Virgin Money UK. In 2016, NAB demerged its U.K.-based operations in Clydesdale Bank and Yorkshire Bank, collectively known as CYBG. The CYBG merger with Virgin Money UK virtually doubled the size of the bank’s loan book and provided a foothold in the larger and faster growing London region. The bank’s loan book is split 80% mortgages, 12% business loans, and 8% personal (including cards) as at September 2021. 

Acquiring Virgin Money in 2018 was transformative for CYBG. A larger and more geographically diverse mortgage book lowers risk and presents cost saving opportunities, but also presents the opportunity to grow its business loan book under the Virgin Money banner. Aiming to maintain its share of the mortgage market, the bank wants to reduce its weighting to mortgages to 75% as it grows its business loan book.

Financial Strength

The capital structure and balance sheet are sound. Common equity Tier 1 capital was 15.2% as at Dec. 31, 2021, well above the 9.5% minimum capital benchmark. The bank has a longer-term dividend payout goal of up to 50%. The percentage of funding sourced by customer deposits was 83% as at Sept. 30, 2021, the elevated savings rate in 2021 helped the bank increase the weight of funds to cheaper business and personal current accounts materially. These current accounts and linked savings increased 19% in the fiscal 2021, making up 38% of funding as at Sept. 30, 2021 and up from 31% at end of fiscal 2020. Virgin Money UK received internal ratings-based, or IRB, accreditation from the U.K. regulator for its mortgage and SME/corporate loan portfolios mid-October 2018. Virgin Money UK is now authorised to use its own risk models in determining risk weighted assets, resulting in a reduction in risk weighted assets for the two portfolios and thereby improving its capacity to grow share.

Bulls Say’s 

  • Virgin Money UK is a well-capitalised and well-funded retail and small-business bank with long-established franchises in core regional markets. 
  • Management’s ability to successfully integrate the merger with Virgin Money is critical to our thesis. 
  • Legacy conduct issues have caused pain for shareholders despite balance sheet provisions and conduct indemnities provided by National Australia Bank. It have made no allowance for large penalties or customer remediation in our forecasts.

Company Profile 

Virgin Money UK was formed through the merger between CYBG PLC and Virgin Money. After being divested by National Australia Bank in 2016, CYBG went through a restructuring and recapitalisation process, with mortgages accounting for around 75% of its loan book. Following CYBG’s merger with Virgin Money, the loan book has been reshaped again, with mortgages now accounting for more than 81% of total loans, personal loans around 7%, and SME and business loans around 12%. The merger with Virgin Money does provide upside earnings potential, but operating conditions are tough, with business momentum slowing. An upturn in the earnings outlook is needed after several years of disappointment.

(Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Fixed Income Fixed Income

Schroder Fixed Income Fund – Client Class: Above par on multiple counts

Fund Objective

To outperform the Bloomberg AusBond Composite 0+Yr Index after fees over the medium term.

Approach 

Schroders begins by formulating long-term (10-year) risk/reward forecasts using a building-block approach that includes current yield, long-cycle economic growth, and inflation. These figures are adjusted to shorter term forecasts (three years) based on a proprietary three-factor model that considers valuation, cycle, and liquidity characteristics to identify best- and worst-case risk-adjusted opportunities. Broad risk allocations between cash, bonds, and credit are consequently generated. The team then determines the appropriate trades and physical securities. Risk/reward forecasts dictate positions in duration and curve (domestic and other yield curves), cross-market trades (spread compression between assets in varying geographies), and credit selection (investment-grade, securitised, high yield, and emerging markets). Credit assessment focuses on market position, management quality, firm profitability, and capital structure. The strategy is mostly process-driven, and the long-term capital preservation mindset is a point of differentiation.

Portfolio 

A wide remit of securities can be held, including government, semigovernment securities, investment-grade credit, high-yield, emerging-markets bonds. Derivatives can be used to express credit, rate, and curve views. The team’s caution over valuations saw it hold more cash than most of its cohorts with a short duration bias through most of 2010-18, sizeable at times. Schroders has long held an underweighting in government and government-related securities in lieu of corporate credit, inflation-linked bonds, and cash. As spreads compressed, investment-grade credit fell steadily to 12% in April 2017 from 42% in August 2010. Schroders waded back in to capitalise on more-attractive valuations as global policy support followed in early 2020. It shortened interest-rate duration significantly in early 2021 as concerns over inflationary pressures bubbled to the surface, before softening this stance amid questions over its persistence. By the third quarter of the year, Schroders’ view that higher inflation was more structural saw it re-enter a more-entrenched short-duration stance. Holdings in non-Australian bonds has tended to be about 10%-15%. This vehicle can be used as a core exposure given it mostly holds high-grade bonds. Schroders managed about AUD 2.8 billion in this strategy at 30 June 2021

Performance 

The strategy has had its share of ups and downs over the years, with strong results during 2019-20 offsetting a fallow run that preceded it. The absolute return focus and cautious posture cost relative performance as yields and spreads broadly tightened during 2014-18, notably its short-duration position particularly in the US and preference for cash. An average cash weight of about 20% from 2009 to 2019 was a major drag, though this weighting declined noticeably after 2016. By contrast, the move to a long-duration position in early 2019 helped as yields declined and Schroders handled the volatile conditions in 2020 adeptly. Its long duration position in early 2020 helped it navigate the initial phase of the pandemic, supported by a reduction in credit risk. Its quick reallocation to credit as spreads widened helped sustain outperformance through the rest of the year. An indexlike result over the majority of 2021 saw the team navigate the choppy moves in yields particularly well over the first half of the year before being stung as shorter-maturity yields leapt exponentially higher after the RBA suddenly decided to exit yield-curve control in the third quarter. The strategy has done well in down markets because of the higher-quality portfolio and focus on downside protection. Its high-conviction approach can contribute to meaningful and lengthy deviations from its cohort.

Top Holdings

About the fund

The Fund is an actively managed, low volatility strategy that invests in a range of domestic and international fixed income assets with the objective of outperforming the Bloomberg AusBond Composite 0 Yr Index, whilst delivering stable absolute returns over time. The Fund adopts a Core-Plus investment approach whereby a core portfolio comprising Australian investment grade bonds is complemented by investments in a diverse range of global and domestic fixed income securities.

(Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Funds Funds

Neuberger Berman International Equity Fund Investor Class

Process:

This strategy’s distinctive approach remains in place under its new leader, earning it an Above Average Process rating. Former lead manager Benjamin Segal said he favoured the mid-cap universe because firms of that size–along with those in the smaller part of the large-cap range–tend to be well-enough established that they can withstand some setbacks but remain less familiar to many global investors and thus often sell at attractive prices. They can also be takeover targets. Former comanager Elias Cohen, who became lead manager upon Segal’s departure on June 30, 2021, follows the same approach. This team wants steadily growing firms, but it also focuses on the quality of company management. The team is willing to own firms without hefty margins if other traits are impressive. The strategy has a 15% limit on emerging-markets exposure, but the portfolio has been far below that for a long time. The turnover rate tends to be moderate. Ideas can come from Cohen, comanager Tom Hogan, or the analysts, and decision-making is collaborative, though the lead manager has final authority for portfolio decisions.

Portfolio:

Portfolio shows that this fund makes fuller use of the market-cap spectrum than most peers and its chosen benchmark, the MSCI EAFE Index. The fund had about 33% of its assets in midcaps and another 4% in small caps (as classified by Morningstar), versus just 10% in mid-caps and almost nothing in small caps for the index and just slightly higher figures for the foreign large-growth and foreign large-blend category averages. The portfolio’s figures are nearly identical to those from one year earlier, showing that new lead manager Elias Cohen has maintained the strategy’s broad market-cap approach even as he traded several stocks into and out of the portfolio. Cohen, like former manager Benjamin Segal, favours the mid-cap and smaller large-cap universes. The portfolio often lies on the border between the growth and blend portions of the style box, but the latest portfolio is fully in the blend region. The strategy continues to spread its assets widely, with none of the 78 stocks receiving more than 2.6% of assets. Emerging-markets exposure remains below 5% and is limited to China and India.

People:

This strategy’s long-tenured lead manager, Benjamin Segal, left Neuberger Berman on June 30, 2021, to become a high school math teacher. Replacing him as lead manager was former comanager Elias Cohen. The firm had earlier promoted Thomas Hogan from the analyst ranks to comanager on Jan. 20, 2021. Cohen had worked with Segal for almost 20 years, most recently as comanager–for two years on this strategy and four years on sibling Neuberger Berman International Select NILIX. The analyst staff remained intact including one addition in March 2021. Three of the six members of the analyst team have been in place since 2008 or earlier. They and the managers also talk with the members of Neuberger Berman’s emerging-markets team. Cohen and Hogan each have more than $1 million invested in this strategy.

Performance:

It’s a bit complicated assessing this fund’s performance, but all in all, the fund has a solid record as a core international equity choice. This fund launched in 2005 and was known until late 2012 as Neuberger Berman International Institutional. But an identical fund that was merged into it in January 2013 posted a strong 10-year record prior to the merger, using the same strategy, under recently departed lead manager Benjamin Segal. Another complication is that although this fund’s growth leanings result in its placement in the foreign large-growth category, it is not very aggressive in that direction, with its portfolio often landing around the border between growth and blend or, as currently, in the blend box. That’s typically been a disadvantage versus growthier rivals for a long time. The managers aim to outperform when markets tumble; although it did not do so in the bear market of early 2020, it did hold up well during the 2014 sell-off and the 2015-16 bear market.

(Source: Morningstar)

Price:

It’s critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar category’s second-costliest quintile. That’s poor, but based on our assessment of the fund’s People, Process and Parent pillars in the context of these fees, we still think this share class will be able to overcome its high fees and deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Bronze.

Top Portfolio Holdings:  
Asset Allocation:  

 


(Source: Morningstar)                                                                     (Source: Morningstar)

About Funds:

A growing conviction in the duo that manages JPMorgan U.S. Large Cap Core Plus and its Luxembourg resided sibling JPM U.S. Select Equity Plus, and the considerable resources they have effectively utilised, lead to an upgrade of the strategy’s People Pillar rating to Above Average from Average. The strategy looks sensible and is designed to fully exploit the analyst recommendations by taking long positions in top-ranked companies while shorting stocks disliked by the analysts. Classic fundamental bottom-up research should give the fund an informational advantage. The portfolio is quite diversified, holding 250-350 stocks in total with modest deviations from the category index in the long leg. The 30/30 extension is broadly sector-, style-, and beta-neutral. Here the managers are cognizant of the risks of shorting stocks, where they select stocks on company-specific grounds or as part of a secular theme. For example, the team prefers semiconductors, digital advertising, and e-commerce offset by shorts in legacy hardware, media, and network providers. Short exposure generally stands at 20%-30%, with the portfolio’s net exposure to the market kept at 100%. The strategy’s performance since inception, which still has some relevance given Bao’s involvement, has been outstanding.

(Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Categories
Global stocks Shares

Sensata To Use Bolt-on M&A To Supplement Sensor Content Growth In Its Core Markets

Business Strategy and Outlook

It is understood Sensata Technologies is a differentiated supplier of sensors and electrical protection. The firm has oriented itself to benefit from secular trends toward electrification, efficiency, and connectivity, and it is supposed that investors will see meaningful topand bottom-line growth as upon an automotive market recovery. 

Despite the cyclical nature of the automotive and heavy vehicle markets, electric vehicles (EVs) and stricter emissions regulations provide Sensata the opportunity to sell into new sockets, which has allowed the firm to outpace underlying vehicle production growth by about 4% historically. It is alleged such outperformance is achievable over the next 10 years, given the expectations for a fleet mix shift toward EVs and Sensata’s growing addressable content in higher-voltage vehicles. 

It is observed, Sensata’s ability to grow its dollar content in vehicles demonstrates intangible assets in sensor design, as it works closely with OEMs and Tier 1 suppliers to build its products into new sockets. It is also believed the mission-critical nature of the systems into which Sensata sells gives rise to switching costs at customers, leading to an average relationship length of 31 years with its top 10 customers. As a result of switching costs and intangible assets, it is held Sensata benefits from a narrow economic moat and will earn excess returns on invested capital for the next 10 years. 

Over the next decade, it is anticipated Sensata to use bolt-on M&A to supplement sensor content growth in its core markets. Sensata established a leading share in the tire pressure monitoring system (TPMS) market in 2014 with its acquisition of Schrader, and it is implicit acquisitions will play a key role in allowing the firm to enter new, higher-growth, adjacent markets. Recent acquisitions of GIGAVAC and Xirgo will allow Sensata to compete in the electric vehicle charging infrastructure and telematics markets, respectively, which is likely to begin to bolster the top line and margins near the end of analyst’s explicit forecast and beyond.

Financial Strength

Sensata Technologies is leveraged, but it is held that its balance sheet is in good shape, and that it generates enough cash flow to fulfill all of its obligations comfortably. As of Dec. 31, 2021, the firm carried $4.2 billion in total debt and $1.7 billion cash and equivalents. Sensata closed out 2021 with a net leverage ratio of 2.8 times, which is squarely in management’s target range of 2.5-3.5 times. Over the next few years, it is probable Sensata to stay in its target leverage range as it continues to engage in supplemental M&A. Between 2023 and 2026, Sensata has $2.1 billion total in debt maturing, with $400 million-$700 million coming due each year. It is projected the firm to easily fulfill its obligations with its cash balance and cash flow—it is foreseen over $700 million in average annual free cash flow over Analyst’s explicit forecast. Finally, it is noted that Sensata has a variable cost structure that allows it to keep a relatively healthy balance sheet during difficult demand environments. Even with weak end markets in 2019 and 2020 that shrunk the top line, Sensata’s free cash flow generation held steady, with its free cash flow conversion jumping to 130% in 2020.

Bulls Say’s

  • Sensata should benefit from secular trends toward electrification, efficiency, and connectivity to continue outgrowing global vehicle production. 
  • Fleet management is an opportunity for Sensata to expand its margins and create a recurring base of revenue in an emerging, high-growth market. 
  • Sensata has some of the sensor industry’s highest margins and strong free cash flow conversion, providing it with capital to invest in organic and inorganic growth.

Company Profile 

Sensata Technologies is a leading supplier of sensors for transportation and industrial applications. Sensata sells a bevy of pressure, temperature, force, and position sensors into the automotive, heavy vehicle, industrial, heating, ventilation, and cooling (HVAC), and aerospace markets. The majority of the firm’s revenue comes from the automotive market, where it holds the largest market share for tire pressure monitoring systems. 

(Source: MorningStar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Categories
Global stocks Shares

Strong Revenue Growth Continued in Pentair’s Fourth Quarter, but Cost Inflation Pressured Margins

Stock market digital graph chart on LED display concept. A large display of daily stock market price and quotation. Indicator financial forex trade education background.

Business Strategy and Outlook

Pentair is a pure play water company manufacturing a wide range of sustainable water solutions, including energy-efficient swimming pool pumps, filtration solutions, as well as commercial and industrial pumps. Pentair’s business is organized into two segments: consumer solutions and industrial & flow technologies. Consumer solutions (58% of Pentair’s sales in 2021) concentrates on business-to-consumer sales and includes aquatic systems as well as residential and commercial filtration. 

The aquatic systems business, which offers a full line of energy-efficient equipment for residential and commercial swimming pools (including pumps, filters, heaters, and other equipment and accessories), is the crown jewel in Pentair’s portfolio, as it is both its fastest-growing and most profitable business. Industrial & flow technologies (42% of sales in 2021) focuses on business-to-business sales and consists of industrial filtration (including the food and beverage end market), residential irrigation flow, and commercial and infrastructure flow.

Financial Strength

Pentair ended the fourth quarter of 2021 with $894 million of long-term debt while holding $95 million in cash and equivalents. Debt maturities are reasonably well laddered, with only about $88 million maturing in 2022. Furthermore, the company has an additional $764 million available under its revolving credit facility. The company is bound by a debt/EBITDA covenant that requires that the ratio not exceed 3.75 times.

Narrow moat-rated Pentair reported solid fourth-quarter results, as its full-year sales of $3,765 million and adjusted EPS of $3.40 both surpassed our previous estimates ($3,709 million and $3.35, respectively). For full-year 2022, management expects sales growth of 6% to 9% and adjusted EPS in the range of $3.70 to $3.80. After rolling our model forward one year, we’ve modestly bumped our fair value estimate for Pentair to $70 from $69, mostly due to time value of money as well as reversing the implementation of a probability-weighted change in the U. S. statutory tax rate in our model.

Bulls Say’s 

  • Pentair is a pure play water company poised to benefit from demand for sustainable and energy-efficient water solutions. 
  • The pool business continues to deliver solid revenue growth, consistent market share gains, and lucrative operating margins. 
  • Recent acquisitions of Pelican Water and Aquion will bolster Pentair’s portfolio of water solutions in the residential and commercial markets.

Company Profile 

Pentair is a global leader in the water treatment industry, with 10,000 employees and a presence in 25 countries. Pentair’s business is organized into two segments: consumer solutions and industrial & flow technologies. The company offers a wide range of water solutions, including energy-efficient swimming pool equipment, filtration solutions, and commercial and industrial pumps. Pentair generated approximately $3.8 billion in revenue and $686 million in adjusted operating income in 2021.

(Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Categories
Funds Funds

Vanguard Energy Fund Investor Shares: An energy hybrid sensible

Approach

In late 2020, Vanguard changed this strategy’s prospectus benchmark from the MSCI ACWI Energy Index to the MSCI ACWI Energy + Utilities Index (a custom benchmark that splices the MSCI ACWI Energy and MSCI ACWI Utilities indexes). The firm made the change so this strategy could capitalize on the evolution away from fossil fuels and toward renewable energy sources by investing significantly more in electric and other utilities.

Portfolio

The MSCI ACWI Energy + Utilities Index is a dynamic benchmark, and its sector weights vary based on the performance of energy stocks versus utilities stocks. Meanwhile, the MSCI ACWI Energy Index gained 36% in 2021, whereas the MSCI ACWI Utilities Index returned 10% last year. The MSCI ACWI Energy + Utilities Index’s energy stake increased to 56% as of Dec 31, 2021, as result, while its utilities position decreased to 44% (per Vanguard data).

People

Tom Levering has good credentials for picking utilities stocks as well as energy equities. For starters, he spent several years as a utilities consultant before joining Wellington in 2000, and he served as an energy and utilities analyst for roughly two decades–and led Wellington’s combined energy/utilities team for a few years–before he took charge of this fund in early 2020.

Performance

The Investor share class of this strategy recorded a 27.7% gain in 2021. That’s significantly less than the 36.0% and 44.8% returns posted by the MSCI ACWI Energy Index and the average fund in the energy equity Morningstar Category, respectively. But this strategy is an energy/utilities hybrid that began 2021 with roughly 48% of its assets in utilities stocks and ended the year with roughly 44% of assets in such names, and the MSCI ACWI Utilities Index produced a gain of just 10.1% last year. The Investor share class’ 27.7% gain is significantly better than the 23.6% return of a 50/50 MSCI ACWI Energy/Utilities custom index and better than the 23.0% return of the strategy’s custom prospectus benchmark.

(Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Categories
Funds Funds

Low-cost diversified ESG-focused Australian equity exposure

Young woman trading stock market by touching.

Investment Objective

Vanguard Ethically Conscious Australian Shares Fund seeks to track the return of the FTSE Australia 300 Choice Index before taking into account fees, expenses and tax.

Approach

This fund seeks to provide broad ESG-focused Australian share market exposure in a passively managed, taxefficient vehicle. To achieve that goal, it uses an index-replication approach to track the FTSE Australia 300 Choice Index, a derivative of the FTSE Australia 300 Index. The index is arrived at by excluding companies that deal significantly in business activities involving fossil fuels, nuclear power, alcohol, tobacco, gambling, weapons, and adult entertainment. Additionally, a screen is also applied to filter out names embroiled in severe controversies. Vanguard holds all the securities that make up the index with industry-level exposure limit set at 5 percentage points relative to the parent index. Security weights are approximately the same proportion as the index’s weights. However, the portfolio will deviate from the index when the managers believe such deviations are necessary to minimize transaction costs. The fund may also be exposed to securities that have been removed from or are expected to be included in the index.

Portfolio

The portfolio is top-heavy, with about half of the index in the top 10 companies. The concentration in banks skews the fund’s sector weights, with financial services forming around 34.5% of the portfolio (versus 26.8% for the Morningstar Category average). The basic material is the second-largest sector exposure, but it is meaningfully lower than the category index because of the ESG screening. The industry capping of 5 percentage points further adds to the portfolio diversification. VETH’s market cap does not deviate materially from the category average or index. As such, the average market of the strategy is AUD 25.3 billion versus AUD 29.2 billion for the S&P/ ASX 200 Index category benchmark. Broadly, the portfolio is diversified and offers exposure to almost the entire opportunity set of the domestic equity market. As a result, it has significant overlap with Vanguard’s other broad-based domestic equity products like VAS, both in terms of style and exposure, making it suitable as a core holding.

Performance

Launched in October 2020, the strategy has a very short track record. The trailing nine-month period has been eventful for the domestic equity market with yields moving up and value factor rotation. As such, the fund’s performance has been eventful as well in tandem with broader market movements. From its inception through July 2021, the strategy has closely mirrored the underlying index but trailed the S&P/ASX 200 category benchmark by 87 basis points. As the materials, energy, and commodity sectors rallied during this period, the fund’s relative underweighting in these sectors has hurt performance. As the value factor rebounded toward the end of last year through the first half of 2021, the modest growth tilt of the strategy relative to the category index detracted. Growth names like A2 Milk have been the major contributor to underperformance during this period. Investors should be cautious and not extrapolate this performance, however. Based on the past attributes, investors may expect similar cyclicality in performance tied to the broader domestic economic activities and value/growth factor rotation.

Top 10 Holdings of the fund

About the fund

The Fund provides low cost exposure to stocks listed on the Australian Securities Exchange (ASX) and excludes companies with significant business activities involving fossil fuels, nuclear power, alcohol, tobacco, gambling, weapons, adult entertainment and a conduct related screen based on severe controversies. Diversification requirements are applied to restrict the proportion of the index invested in any one industry to +/-5% of the industry weights of the FTSE Australia 300 Index, subject to any limitation issues resulting from the exclusionary screening.

(Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Categories
Global stocks Shares

Norfolk Southern’s Intermodal a Key Long-term Growth Opportunity

Business Strategy and Outlook

Norfolk Southern is a well-managed enterprise, and from the start of the rail renaissance in 2004 through 2008, it posted the highest margins among U.S. Class I railroads. However, its operating ratio (expenses/revenue) deteriorated to 75.4% in 2009 and remained stuck between 69% and 73% from 2010 to 2015. This pales in comparison to progress made by peers Union Pacific and Canadian Pacific, which lack Norfolk’s exposure to Appalachian coal. However, by 2017 the rail was back on track, and it has achieved record ORs in each year since, including an adjusted 60.1% in 2021. In recent years, Norfolk renewed its commitment to pricing discipline and margin gains, particularly via precision railroading initiatives, which have driven more efficient use of locomotive assets, labor, and fuel. It is anticipated incremental gains as the firm continues to refine its PSR playbook. Of note, in late 2019, former Canadian National CEO Claude Mongeau (2010-16) joined Norfolk’s board of directors in part to help bolster the rail’s PSR efforts. 

Norfolk hauls coal directly from Illinois and Appalachian mines, and transfers Powder River Basin coal eastward from the Western rails. Thus, coal-demand headwinds and changes in environmental regulations will probably remain a factor over the long run, despite near-term improvement off lows posted in 2020. That said, coal runs in unit trains hauling exclusively coal (often using customers’ cars), thus it is believed that the rail can continue to adjust its train and crew starts to match demand conditions. 

Norfolk generated healthy volume growth near 5% on average within its intermodal franchise over the past decade. In fact, intermodal revenue surpassed coal in 2014 and is now the highest-volume segment (roughly 60% of 2020-21 carloads versus 9% for coal). Capital projects targeting capacity and velocity improvement have helped the rail capitalize on net positive truck-to-rail conversion activity over the years. Norfolk’s domestic intermodal volume may face congestion-related constraints lingering into early 2022, but it is still seen as intermodal as a key long-term growth opportunity.

Financial Strength

At year-end 2021, Norfolk Southern held an ample $839 billion of cash and equivalents compared with $13.8 billion of total debt ($12.1 billion in 2020). Historically, the rail generates steady free cash flow, despite investing heavily in its network (capital expenditure averaged 16% of revenue over the past five years). Norfolk deploys this cash on dividends and share repurchases, and occasionally borrows to boost these returns to shareholders. Share repurchases eased briefly 2020 due to pandemic risk to cash flow, but they ramped back up by year-end, and it is held, repurchase activity to remain active in the years ahead. Norfolk Southern operates with a straightforward capital structure composed mostly of senior notes. In terms of liquidity, the rail also has an $800 million revolving credit facility and a $400 million accounts receivable securitization program for short-term needs–both programs are fully available and undrawn as of third-quarter 2021. In 2021, Norfolk’s total debt/adjusted-EBITDA came in near 2.5 times (2.7 times in 2020). It is projected 2.2 times in 2022. The historical five-year average is 2.4 times. Interest coverage (EBITDA/interest expense) was a comfortable 9 times in 2021, versus 7 times in 2020. Overall, Norfolk’s balance sheet is healthy and it is anticipated the firm will have no issues servicing its debt load in the years ahead.

 Bulls Say’s

  • Norfolk Southern reignited operating ratio improvement in 2016 after stagnating over the preceding six years. With help from precision railroading, the rail reached OR records in each of the past four years.
  • Norfolk Southern runs one of the safest railroads in the U.S., as measured by injuries per hours worked; this boosts service levels and helps to keep costs down. 
  • Compared with trucking, shipping by rail is less expensive for long distances (on average) and is four times more fuel-efficient per ton-mile. These factors should help support longer-term incremental intermodal growth.

Company Profile 

Class-I railroad Norfolk Southern operates in the Eastern United States. On roughly 21,000 miles of track, the firm hauls shipments of coal, intermodal traffic, and a diverse mix of automobile, agriculture, metal, chemical, and forest products. 

(Source: MorningStar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Categories
Global stocks Shares

Dr. Reddy’s Continues to Weather Generic Drug Erosion in Core Markets

Business Strategy and Outlook

Dr. Reddy’s Laboratories is a global pharmaceutical company based in Hyderabad, India. It manufactures and markets generic drugs and active pharmaceutical ingredients in markets across the world, but predominantly in the United States, India, and Eastern Europe. Indian pharmaceutical manufacturers have seen success over the past decade in penetrating the U.S. market, where regulatory hurdles are lower than in Western Europe. With competition on price in a commodified space, the entry of low-cost manufacturers has facilitated a deflationary price environment for generic drugs since 2015, putting substantial pressure on the margins of established manufacturers. Conversely, in India and other countries with lower generics adoption, so-called “branded” generics have seen notable success. 

Generic manufacturers have taken different approaches to combat margin pressure over the past few years. While some manufacturers have addressed competition by rationalizing their U.S. portfolio and discontinuing low-margin or unprofitable drugs, Dr. Reddy’s has remained focused on expanding its U.S. market share. While its U.S. portfolio has experienced marginally higher deflation compared with peers, its pipeline is increasingly leaning toward injectables and other complex generics that command higher margins and exhibit relatively more price stability.

Financial Strength

Overall, Dr. Reddy’s reported a relatively uneventful third quarter, with higher revenue across the board largely due to new product launches and market share gain. The company’s revenue grew 8% to INR 53.2 billion ($715 million) on a year-over-year basis driven by new product launches and higher sales volumes in the global generics business. North America generics, which represents the largest share of company revenue (35%), was positively affected during the quarter by launches for four new products but negatively impacted by erosion within in generic drug portfolio. On a sequential basis, revenue fell 8%, largely due to price erosion in generics and reduction of volume of COVID-19-related products.

As of the fourth calendar quarter of 2021, Dr. Reddy’s holds gross debt of INR 28 billion ($370 million), which is more than offset by the cash on the company’s balance sheet. With very low leverage, the company faces little liquidity risk. This compares favorably with other global generic manufacturers like Teva and Viatris, which are saddled with high leverage as a result of an aggressive acquisition strategy over the past decade. The company pays an annual dividend of $0.34 per share, which translates to a dividend yield of under 1%.

Bulls Say’s 

  • Dr. Reddy’s low-labor-cost operations based in India and vertical integration likely provide a low-cost edge. 
  • In the U.S. and Russia, Dr. Reddy’s has grown quickly in OTC generics, which is an attractive segment of the market with slightly higher barriers to entry than conventional retail pharmacy drugs. 
  • Dr. Reddy’s strong branded generic presence in emerging markets provides significant growth opportunities with less price competition than typically seen in developed markets.

Company Profile 

Headquartered in India, Dr. Reddy’s Laboratories develops and manufactures generic pharmaceutical products sold across the world. The company specializes in low-cost, easy-to-produce small-molecule generic drugs and active pharmaceutical ingredients. Its drug portfolio in recent years has included biosimilar drug launches in select emerging markets and has shifted toward injectables and more complex generic products. Geographically, the company’s sales are well dispersed across North America, India, and other emerging markets. 

(Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Categories
Global stocks Shares

Demand for Construction Equipment Continue to Flourish, Benefiting Caterpillar

Business Strategy and Outlook

Caterpillar will continue to be the leader in the global heavy machinery market, providing customers an extensive product portfolio consisting of construction, mining, energy, and transportation products. For nearly a century, the company has been a trusted manufacturer of mission-critical heavy machinery, which has led to its position as one of the world’s most valuable brands. Caterpillar’s strong brand is underpinned by its high-quality, extremely reliable, and efficient products. Customers also value Caterpillar’s ability to lower the total cost of ownership. 

The company’s strategy focuses on employing operational excellence in its production process, expanding customer offerings, and providing value-added services to customers. Since 2014, Caterpillar has taken steps to reduce structural costs and its fixed asset base by implementing cost management initiatives and by either closing or consolidating numerous facilities, reducing its manufacturing floorspace considerably. Over the past decade, the company has continually released new products and upgraded existing product models to drive greater machine efficiency. Customers also rely on the services that Caterpillar provides, for example, machine maintenance and access to its proprietary aftermarket parts. Furthermore, its digital applications help customers interact with dealers, manage their fleet, and track machine performance to determine when maintenance is needed. 

Caterpillar has exposure to end markets that have attractive tailwinds. On the construction side, the company will benefit from legislation aimed at increasing infrastructure spending in the U.S. The country’s road conditions are in poor condition, which has led to pent-up road construction demand. In energy, the improvement in the price of oil since COVID-19 lows will encourage exploration and production companies to increase oil and gas capital expenditures, leading to increased sales of Caterpillar’s oil-well-servicing products. That said, it is believed mining markets will have limited upside, as fixed-asset investment growth in China starts to slow, likely capping commodity price upside.

Financial Strength

Caterpillar maintains a sound balance sheet. On the industrial side, the net debt/adjusted EBTIDA ratio was relatively low at the end of 2021, coming in at 0.2. Total outstanding debt, including both short- and long-term debt was $9.8 billion. Caterpillar’s strong balance sheet gives management the financial flexibility to run a balanced capital allocation strategy going forward that mostly favours organic growth and returns cash to shareholders. In terms of liquidity, the company can meet its near-term debt obligations given its strong cash balance. The company’s cash position as of year-end 2021 stood at $8.4 billion on its industrial balance sheet. It is comforting to find comfort in Caterpillar’s ability to tap into available lines of credit to meet any short-term needs. Caterpillar has access to $10.9 billion in credit facilities for the consolidated business (including financial services), of which, $2.9 billion is available to the industrial business. Caterpillar’s focus on operational excellence in its industrial operations and improved cost base has put the company on better footing when it comes to free cash flow generation throughout the economic cycle. The company can generate $6 billion in free cash flow in our midcycle year, supporting its ability to return nearly all its free cash flow to shareholders through dividends and share repurchases. The captive finance arm holds considerably more debt than the industrial business, but this is reasonable, given its status as a lender to both customers and dealers. Total debt stood at $28 billion in 2021, along with $27 billion in finance receivables and $826 million in cash. In our view, Caterpillar enjoys a strong financial position supported by a clean balance sheet and strong free cash flow prospects.

Bulls Say’s

  • Increased infrastructure spending in the U.S. and emerging markets will lead to more construction equipment purchases, substantially boosting Caterpillar’s sales growth. 
  • Higher fixed-asset investment growth in China strengthens support for increased investment in mining capital expenditures, benefiting Caterpillar. 
  • A continued recovery from the temporary demand shock in oil prices will lead to increased oil and gas capital expenditures, leading to more engine, transmission, and pump sales for Caterpillar.

Company Profile 

Caterpillar is an iconic manufacturer of heavy equipment, power solutions, and locomotives. It is currently the world’s largest manufacturer of heavy equipment with over 13% market share in 2021. The company is divided into four reportable segments: construction industries, resource industries, energy and transportation, and Caterpillar Financial Services. Its products are available through a dealer network that covers the globe with over 2,000 branches maintained by 168 dealers. Caterpillar Financial Services provides retail financing for machinery and engines to its customers, in addition to wholesale financing for dealers, which increases the likelihood of Caterpillar product sales.

(Source: Morningstar)

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Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.