DTY sold, TET bought

I sold my holding in Dignity yesterday morning at £24.12 for a 2% loss following a profit warning in its preliminary results. I am abroad and wasn’t able to sell first thing but sold above the closing price yesterday and just above the price it has rebounded to today.

dignity

The offending part of the outlook statement read:

The Board remains positive about the future prospects for the Group. However, given the increased size of the Group and increasing competition in each of our markets, the Board has revised its medium-term target underlying EPS growth rate to eight per cent per annum from the current 10 per cent.

I am disciplined to sell on profit warnings regardless of the reason though I think I would be minded to sell on this one even if I didn’t follow this rule. While a fall in the medium-term underlying EPS growth rate from 10% to 8% may seem small it would have quite a big impact on the long term valuation of the business. According to my very rough DCF valuation approximations this should knock something like 20% off the valuation of the business. Note that this is bigger than the immediate actual share price drop – I think this is mostly because of ‘technical’ reasons (particularly ‘support’ at around the £24 level where the price has bounced several times before).

More importantly, while I believed Dignity to be significantly undervalued before, the reasons for this belief have now been undermined. Both of the reasons given for this revision, “increased size of the Group” and “increasing competition”, suggest the share may not be high quality as I thought it was.  I had believed Dignity still had plenty of scope for further growth in market share in the UK market (which I believe to be very fragmented still) and had a competitive advantage over its smaller rivals, so these comments undermine the buy case and are a bit surprising. My analysis was very high level (as I intended it to be) so I need to expect some surprises like this across my portfolio. It’s not clear to me that more detailed analysis would have changed my view prior to today. I’ll revisit this at a later date when looking at profit warnings across my portfolio more systematically  to see if there is more to learn.

treatt

Treatt: bought

With most of the proceeds from selling Dignity I have bought a 1.8% holding in Treatt.

Quality

Treatt is a specialist ingredients and flavourings provider to manufacturers across the world in various consumer goods markets, but predominately for beverages. Flavour and consistency of flavour is obviously a core aspect of these products and so Treatt’s ingredients are likely to continue to be critical for its customers for some time.

Overall I’m just about convinced that Treatt is a sufficiently high quality business for me to invest in, but only just:

  • Business economics: I think Treatt has reasonable operating margins (around 10%) given its products are likely to be fairly capital intensive to produce. Its ROCE has consistently been above 15% in recent years. It has very good cash conversion in recent years. These figures may be somewhat flattered by the fact it has deferred some capital expenditure recently due to an impending move to a new facility, and while this is a sizeable investment, the flip-side is that the new facility should allow it to generate greater profits in the future.
  • Track record: Treatt has been providing flavours for more than 100 years which (weakly) suggests it is likely to continue to be around in the future. More recently under its current CEO its track record is very good with consistent ROCE and growth in EPS and FCF. It last had a somewhat bad year in 2012, particularly in the UK, but I’m reasonably satisfied this appears to have been for temporary reasons and that it has diversified its customer base since then and has plenty of opportunities for growth.
  • Competitive advantage: I believe Treatt may have some competitive advantage, particularly given its recent performance but it’s not very clear-cut how strong it is. While its products are somewhat commodity like, their production appears likely to benefit significantly from Treatt’s extensive know-how and IP. It does not appear likely to be straightforward for competitors to replicate Treatt’s specialisms or its reputation though it has not been possible for me to identify what the main competitive threats really are. Given the need to maintain consistency of flavour it seems likely that customers might face significant switching costs.
  • Growth potential: Treatt appears to be in large growing market with big secular growth opportunities – in particular it highlights increased demand for the need to reduce sugar content (and adapt flavourings accordingly). Treatt has a global distribution network and is expanding into China  – there appears to be plenty of addressable market for Treatt to go for. I cannot see any technological or regulatory risks.

Pricing

The main driver behind my purchase of Treatt is its current momentum. It appears to be on a roll in recent years with growth especially accelerating recently. It has recently issued a ‘substantially ahead of expectations’ trading update partway through H1 and I think continuing good performance over the next few years is very likely and further upgrades to forecasts are imminent. Given this the valuation currently at around 19 PE still appears very cheap to me. I’ve missed out on a more than 30% rise in share price since the ‘substantially ahead’ announcement and obviously wish I had got in sooner but I shouldn’t let this put me off.

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