When considering an investment for the Henderson EuroTrust portfolio, we tend not to focus on market noise or any technical factors; the main thing we are doing is trying to establish whether what we are looking at is a good company or not. This is a key part of the research process.
There tend to be many features that most good companies have in common, but there are myriad characteristics and features to analyse that will be unique to each and every business. By undertaking detailed analysis of the 50 or 60 companies we have on our radar (a portfolio of ~40 positions and a watch list of 10-20 names) we try to ascertain whether a business is a good business and if so, whether now is the right time to be invested or not. In this article we will highlight aspects of our process using one of our portfolio companies, the Danish pharmaceutical company Novo Nordisk.
What does the company do?
The Dutch company DSM, was founded in 1902 as a coal mining company; in fact the name DSM comes from the English translation ‘Dutch State Mines’. The company has changed dramatically since the early 20th century (the last coal mines closed in the 1970s) and over the last twenty years or so, the business has been transitioning again; this time away from chemicals and materials towards food ingredients.
As we stand today, around 1/4 of earnings comes from DSM’s remaining Materials activities and around 3/4 of earnings comes from their Ingredients portfolio. Within their Materials business, DSM produce and sell sustainable thermoplastics, industrial resins & coatings and a strong fibre called Dyneema. Within their Ingredients division, DSM sells vitamins, ingredients and solutions for use in human and animal nutrition. In the company’s own words, DSM is focused on ‘creating science-based solutions in health, nutrition and sustainable living’.
Does this company generate strong Return on Invested Capital (ROIC)?
At the moment, DSM’s ROIC is in the low-double digit percentage range according to our estimates. This is an improvement from recent years, is well above the company’s cost of capital, but is materially lower than the ROIC generated by a number of our well-established ‘Compounders’ within the portfolio. In fact, we see DSM as an ‘Improver’; a business capable of improving its ROIC profile over a number of years. There are several things that should help to drive this improvement in returns. First, there should be some natural operational leverage from volume growth (costs should grow more slowly than revenues). Second, we see the movement of the company away from the Materials business and towards the Ingredients business as something that should result in higher margins and lower capital intensity. Third, we back the current management team to improve the efficiency of the business over the medium term.
What are the risks to the business and to this ROIC profile?
Inevitably, by having some exposure to Materials, which tend to have industrial end markets, there is some cyclicality to the business and if there is an economic slowdown, that could certainly delay the improvements being made to the business. Another risk would be that the company felt compelled to make a large and expensive acquisition to speed up their transition towards Ingredients; we rate management very highly and see this as a low probability risk. Finally, within the Ingredients portfolio, DSM has some exposure to vitamins, whose prices are notoriously volatile; vitamin pricing is therefore also a risk to the return profile of the company.
Is there scope for growth?
The Ingredients business has significant scope for structural growth over the medium-to-long term. End markets (animal and human nutrition) will see demographically-driven growth and ingredients are an increasingly important component of nutrition products. You can also make the case that large ingredients companies with global reach will gain share from smaller local competitors. DSM look very well placed. In addition, and as described above, we see earnings growth as likely to be faster than revenue growth due to margin expansion.
We have a long standing position in DSM and it has contributed strongly to performance. We remain positive on the company’s prospects and can see how the business has a good chance of rerating from its current ~11 x EV/EBITDA multiple towards that of its Ingredients peer group (who trade at >15 x EV/EBITDA).
EBITDA (Earnings before interest, taxes, depreciation, and amortization): A company's earnings before interest, taxes, depreciation, and amortization is an accounting measure calculated using a company's earnings, before interest expenses, taxes, depreciation, and amortization are subtracted, as a proxy for a company's current operating profitability