Cyclical companies: a case study of a trap to avoid

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04/30/2019 | 10:05 pm
A classic trap in which many investors - even the experienced ones - fall is to focus on cyclical companies at the worst possible time, i.e. at the top of the cycle, just before the inevitable return to the mean begins.

And it’s easy indeed, out of clumsiness or a lack of knowledge of the underlying assets of the business activity, to gather exceptional results to justify a high valuation, and thus to considerably overpay. Eventually, adjusting the company's valuation to its "normal" performance will therefore lead to a severe loss of capital for the shareholder who entered thinking that the good times would last forever and who is in for an unpleasant surprise when the cycle turns around.

In Europe, the chemical group Covestro recently provided a good example of these adverse turnarounds. The company, formerly a subsidiary of Bayer and separated from the German conglomerate in 2015 to pave the way for the acquisition of Monsanto - and as such the exchange of a cyclical activity with low returns on capital for a growing, almost monopolistic and much more profitable business activity - was listed at the end of 2015 at 25 euros per share, before its price soared to over 90 euros in the following two years.

On paper, and at first glance, the valuation seemed very reasonable. It was around 11-12 times the profits during the ascent - a multiple well below the market despite a growth profile boasted about as being higher than that of the gross domestic product.

However, a broader perspective - i.e. over a fifteen year period - tempered this first impression, and indicated very clearly that the profits of the two previous years were exceptional, as they were two to three times higher than their historical average despite an employed capital of an equivalent level.

In reality, Covestro was trading on the stock market at a multiple of nearly 33 times its normalized profitability over the long cycle - a far less attractive multiple than expected - without the growth prospects corroborating the ambitious projections of the company’s management.

The sudden expansion of the group's profitability was the result of two cyclical factors: a temporary capacity problem on the markets addressed by the group had led to a sharp rise in prices (on average four times higher than the increase in sales volumes), while a successful refinancing in a context of extraordinarily low interest rates made it possible to reduce the company’s financial cost.

Another signal that must have been obvious: former owner Bayer was hastily getting rid of its stake in Covestro - that was divided by ten within a few months time - while the price gradually exploded and disconnected from the fundamentals of the business.

A quick search of the financial press archives also revealed that the German conglomerate wasn’t expecting much more than an IPO between 21 and 25 euros per share.... The fact that the price suddenly rose to more than 70 euros therefore offered a unique opportunity for the company to get rid of the shares thanks to a favorable valuation!

The icing on the cake: despite this historically high valuation, the company’s management had announced a major share buyback program - for nearly 10% of the current market capitalization - which immediately pushed the stock price to new records. However, there was reason to doubt the rationality of this decision. Was it really necessary to empty the undoubtedly precious reserves in a cyclical and highly capital-intensive business activity in order to buy back its own shares at record levels? Definitely not.

Speculation from the author: Since Covestro was not a major player in the industry, the management tried to artificially inflate the price of its shares to prompt a takeover bid under the best possible conditions. The year 2017 marked a record number of mergers and acquisitions in the chemical industry: and since it failed to consolidate - the group does not have the scale to do so - Covestro could have been an ideal acquisition target.

In short, the share price has since returned to a more reasonable level of 50 euros, although the company’s valuation remains relatively high compared to its historical performance and industry standards. In retrospect, the warning signs were obvious - exceptional profits, a majority shareholder that was too happy to sell, a questionable capital allocation - but in the heat of the moment even the most experienced investors can get caught in a trap.

The example of Covestro is all the more interesting because it offers a case study that can be transposed to many similar situations. In Canada, for example, steelmaker Stelco currently has a particular profile: while it is the best-capitalized steel producer in North America, it is also the one with the lowest valuation - barely five times the profits of the previous year - despite a competitive position that, in theory, should allow it to take advantage of the customs protections adopted by its American neighbour.

Although Stelco's financial performance appears attractive on the surface, it seems unusual nevertheless: a return on equity of more than 70% - achieved without leverage! - is new in the steel industry, and would be enough to make a fast-growing and well-managed software company jealous.

A similar dynamic may also be taking place among automotive equipment manufacturers. Their valuations - sanctioned by the uncertainties facing carmakers - have returned to interesting levels, close to their historical lows. However, as the head of a well-known French equipment manufacturer has admitted himself, he and his peers have benefited for the past ten years of zero or very low inflation, including in so-called "emerging" geographies where equipment manufacturers bear most of their wage costs.

This long trend certainly was opportune, but it should not last long. As such, the margin profiles of the last years - typically somewhere between 10 and 15% - may be difficult to preserve.

Neelie Verlinden
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